Insight 14
Choose Your Exit Strategy Before You Make the Deal
Two things are very clear in the current US market: first, anyone can buy at a discount, and second, it's what you do after you've made the deal that really matters.
The need to have a solid exit strategy in place as you make an investment deal is old news to experienced investors. They plan to make money when they buy and they know that a deal is defined by its exit strategy—their plan for how and when they will sell the investment and take their profit. If you do not have an effective exit strategy in place for the property, you stand to lose money, even if you acquired the property for pennies on the dollar.
That prediction takes a lot of new investors by surprise, so be clear about how important an exit strategy is. In a market like this, it's very easy to get caught up in the deal and not think through the process. That is an abdication of solid due diligence. To drive this fundamental home, we'll share a story based on dozens of phone calls a US investor colleague has fielded in recent months. He's been buying distressed investment properties for years and he says all the calls go like this:
“Hi there! It's me, your newbie investor friend, and guess what? You were totally right about what's going on in the US market for distressed property! I just bought an incredible deal at a huge discount. It was a foreclosure sale and the price was incredible. The single-family home is located in the kind of neighborhood you told me to look at and while it's got a few cosmetic issues I'll need to clear up, it's structurally sound. The HVAC, roof, plumbing, and electrical systems are in great condition,* too, so I figured I've saved some real money there.”
“That's wonderful news. What are you going to do with it?”
“Do with it? I'm going to renovate first and then . . .”
* See Insight 24: Do the Big Four Renos on a Rental Property—Now.
The phone goes quiet at this point. After a few moments of awkward silence, some novice investors will insist a plan doesn't really matter “since I got the property so cheap!” Others will dismiss the question as an issue they'll deal with as work proceeds on the property upgrade. Some will stumble with a response as they start to appreciate the magnitude of the question they've just been asked. All three reactions indicate a problem, but at least the last caller is starting to see the forest for the trees.
It does not matter if you're buying real estate investment property in your own backyard or in a foreign country—you need to have an exit strategy. If you cannot fix it up and sell it or rent it out, it is not an investment, it's a gamble. And that's the case if you got it for ten cents on the dollar or fifty cents on the dollar.
Identify Your Exit Strategy
There are three real estate investment markets where you can make money: the fix-and-flip, the long-term rental, and the wholesale market. In the latter, you buy deeply discounted homes to sell to other investors. When you're choosing an exit strategy that focuses on one of these market niches, remember that while each can make you money, their potential differs depending on what stage of the real estate cycle that market is in. (See Insight 16: Understand the Real Estate Cycle.) In light of the current market situation, let's zero in on the part of the real estate cycle where the investment opportunities are driven by two factors: discount prices and high foreclosure rates.
We know those two factors contribute to your ability to find a good deal. At this stage in the market, all three exit strategies can work, assuming you have a buyer or renter who wants that property. But there's no question one exit strategy is especially well-suited to these market conditions, and that's the buy-and-hold exit strategy.
Before we look at why the buy-and-hold strategy is particularly advantageous in this market, let's dig beneath some of the common misconceptions about using the wholesale and buy-and-flip market at this stage in the real estate cycle. A lot of inexperienced investors (or those who don't pay close enough attention to market fundamentals) say their exit strategy is based on the wholesale market. They plan to flip the property to another investor (one who'll do the required property upgrades) and while they'll only make a few thousand dollars on the deal, this strategy quickly frees up their time and money. Others say that their exit strategy involves buying a discounted property, fixing it up, and flipping it back onto the resale market.
Both are workable strategies. Both also can be more difficult to put into play than the short-sighted investor might think. For one thing, both strategies require a buyer. No problem, since you're in a buyer's market, right? Wrong! Because you are selling into a buyer's market, your position is naturally compromised. There may well be money to be made, but it's risky because buyers are inundated with choice.
Why Buy-and-Hold Makes Sense
Once a market-smart investor realizes the risks of selling into a buyer's market, she may develop her deals a little differently. In this current market, the best exit strategy is to be found in the buy-and-hold market. That potentially means a long-term relationship with property managers who know what they're doing and tenants who respond to being treated well. This adds up to years of stable cash-flowing revenue. But most importantly, down markets go up, so investors who buy and rent properties will also benefit from their property's appreciation. Here, the exit strategy looks ahead to a time when prices are rising and fewer houses are on the market.
Our main point is that the buy-and-hold strategy is successful when applied to neighborhoods with a stable tenant market and steady demand for rental properties. This strategy also exemplifies what smart investors talk about when they say they are after the “patient money.” What they advocate meets market fundamentals because they buy at a discount in a buyer's market, rent the property for good cash flow, allow the market cycle to do what it has always done, and then sell when the market shows clear signs of being a seller's market. In fact, that's where some investors discipline themselves to be even more patient. Instead of selling early in the seller's market of the real estate cycle, they hold onto their properties longer than planned because inflation has kicked their rents so high they don't want to give up the healthy cash flow.
If you've purchased a property in the right way—with cash flow— and property values go up, you have to consider the capital gains payable on the sale, in which case it may not be advantageous for you to sell. Buy and hold means that you buy a solid residential income-producing property, which could end up becoming “pool side revenue.”
Wholesale and Fix-and-Flip Options
The wisdom of patient money aside, some investors will stick to the wholesale or fix-and-flip markets and it's clear that both can make you money. But be careful. These markets are often perceived (and aggressively marketed) as “easier” because they appear to demand less commitment (you won't have to deal with property management issues). Reality paints a different picture. First, the historic number of distressed properties on the market means there are more houses than buyers. Be honest about what that means. The opportunities are there, but buyers—including investors—can afford to be picky. Unless your properties are deeply discounted and located in prime neighborhoods, you will have trouble finding buyers as there is a much greater chance they will be able to find better deals in better areas.
To make wholesale deals work, you need a business strategy that includes a good relationship with a group of investors. You also need to know reliable real estate owned (REO) agents (who typically work for lenders) and others who can find you these deals, cheap. You'll need tips on when auctions are going to be held, when REO houses will be on the market and, ideally, a way to find out when homeowners want to discount a property for a quick sale to ward off the foreclosure process.
Even with all that background work, the investment facts remain the same. If you pay too much for a distressed property and set the wholesale price too high, you might get stuck with the property. As it's currently more difficult for Canadians to finance the wholesale deal, carrying a property for longer than anticipated can cause big problems for your next deal, too.
Canadians who want to get into the wholesale and fixer-upper retail markets also should be aware that the most successful wholesalers and property flippers live in the markets where they work. This gives them critical and timely access to buyers and sellers.
Recognize that financing is more difficult on the wholesale and residential retail markets. If you decide to fix and flip homes into the first-time homebuyer market, you will need to understand how federal assistance mortgages work.
Historically speaking, Federal Housing Administration (FHA) loans have allowed lower-income Americans to borrow money to buy a home when they cannot afford a conventional down payment or do not qualify for private mortgage insurance (PMI). Veterans Affairs (VA) home loans play a similar role for veterans, active duty personnel, reservists and National Guard members, and some surviving spouses. Canadians in this market must understand that FHA and VA financing are the most active loans in the nation right now.
Besides understanding that your market targets people who qualify for FHA and VA loans, you will need to fine-tune your marketing plan to meet the needs of the first-time homebuyer. While you may think it's enough to market on price, these buyers are not familiar with the market, and they respond much more quickly to information about “how much down and how much a month.”
US market insiders say that property condition in the current fix-and-flip market is also very important; to make a sale, the property must be stellar and stand out from competing inventory. As the success of this exit strategy hinges on the quick sale, you also may need a more aggressive marketing program that uses everything from lawn signs to what the industry calls “bandit signs,” which are eye-catching signs posted in high-traffic areas.
Working with a top-notch real estate agent is another way to push your house to the market. In addition to costing you a commission (arguably a good use of someone else's time!), you will need to be in close contact with that agent to make sure your house is being marketed aggressively.
Pick Your Partners Carefully
There's no question that a hot market attracts money. Before you hand over any investment cash, make sure you know what you're getting! Some investors already doing business in the US market have proven track records and do high-volume business. That's a good starting point. Also look for good contacts with local investor groups and buyers—you want to make sure your partners have a team on the ground before you invest with a particular company.
Again, this is a buyer's market. It's relatively easy to acquire and upgrade property, and if you've got an influx of cash, you can do a lot of deals. But do you want to get into a large-volume market that makes your money swim against the real estate cycle's current? Absolutely not. You want to partner on deals that sell and that require people on the ground that are familiar with that market. What works in one part of Arizona may not work in another part of the same state, let alone California, Florida, or Nevada.
Choose an Exit Strategy That Makes Money
A smart investor once said that no man is bigger than the market. E.W. Howe summed it up a little differently when he wrote, “No man's credit is as good as his money.” These sayings address two of the central points about investing in the US distressed property market. First, you can make money there, and second, you can lose money there. As an investor, you want to stay on the positive side of the investment ledger.
To do that, swim with the current. In the real estate investment market right now, that means focusing on the buy-and-hold side of the market. It's a niche where you can develop a volume business with less risk, all because the market fundamentals are so positive. As long as you're paying attention to where you're buying, there is no shortage of renters. As long as you're attentive to how much you're paying, there are good opportunities for cash flow. With good management and some patience, your “patient money” properties can develop future wealth.