Buying your first home or real estate as an investment is a big decision. Real estate is likely to be your most expensive purchase and it doesn't come with a return policy. Thus, it's always good to be aware of real estate warning signs before buying.
There is currently a lot of demand and excitement for real estate due to low interest rates, a desire to own a nicer and bigger home, and a desire to own a more stable asset class other than stocks.
My favorite way to invest in real estate is through Fundrise and CrowdStreet, the top real estate marketplaces today. Both are free to sign up and explore investing in the heartland of America, where valuations are cheaper, cap rates are higher, and job growth is stronger.
Despite the demand and attractiveness of real estate, there are always going to be risks. Invest responsibly. Don’t ever give your money to someone you don’t know or invest in something you don’t thoroughly understand. With real estate, fortunes can be quickly ruined due to leverage. But with the right fundamental framework, you can also make a fortune over time. I highly recommend reading my article The 30/30/3 Home-Buying Rule To Follow.
Be wary of folks who are saying you just can’t lose. Please try and tame your desire for getting rich quickly. If you can avoid stepping on financial land mines, you will be able to reach financial independence more easily.
Before taking any risk, smart investors know their financial standing. Know it cold.
They do things like:
- Calculate how many hours, days, weeks, or months you need to work to make up for a loss
- Ask themselves whether they truly understand the investing environment
- Calculate their net worth composition to understand
risk - Get feedback from at least three people before making an investment
If you're thinking about real estate in 2022, there are six things that you need to know.
Top Six Real Estate Warning Signs Before Buying
1) Rents are on their way down in expensive cities. Experienced real estate investors know that property prices are a function of rental income multiples, and real estate buyers should be looking to buy at similar pricing discounts from peak rental periods.
For example, research whatever comparable property you want to buy today that was sold in the last year or two and aim to buy at a discount based on how much rent prices are down.
In 2017, for example, I experienced softening rents first hand when I tried to find replacement tenants for my SF rental house at a similar rent of $9,000 a month.
After more than a month of aggressive marketing, I got two offers, both for $7,500 (-16.7%). I even hired a rental listing agent for two weeks to find people for at least $8,000 and he failed.
As a result, I sold. Pricing pressure starts at the most expensive markets and works its way down. The large supply of condos in many expensive cities has really put a damper on rents and housing prices.
Be careful not to buy at peak prices when rents have fallen from peak levels because that means you are paying a higher valuation. This is a dangerous scenario.
Pending home sales were up slightly for May 2022 according to the National Association of Realtors. But be aware these figures change constantly and can vary a lot from one area to the next.
Chart: Top 20 Cities With The Most Expensive Rent in The US
2) Mortgage rates are collapsing. Mortgages rates were rising aggressively in 2018, but they collapsed in 2019. Then in 2020, as fear of an impending recession grew, in addition to a COVID-19 pandemic, it caused many buyers and sellers to think twice before buying, selling, and potentially even moving in with a highly contagious, deadly virus.
The irony is, you want mortgage rates to be rising slightly because it shows that the economy is strong. Lower mortgage rates can help buoy the real estate market. However, when unexpected events like the coronavirus pandemic erupt, expectations can be overturned and force us to reevaluate.
I refinanced my expiring 5/1 ARM to a 7/1 ARM at 2.75% before the pandemic hit and several other times prior. The savings from refinancing can really add up. I suggest everyone check mortgage rates online and see how much money you can save.
You can get free, real refinance quotes in one place from multiple qualified private lenders competing for your business. Thanks to technology, it's so easy to compare mortgage rates today. You can get multiple real quotes in under three minutes.
3) Home prices are skyrocketing. Though each and every city is different, if you look at the prices in Denver and Dallas, you’ll find that the prices are roughly 45% higher than they were in 2006-2007.
This price performance is similar to San Francisco’s. Meanwhile, hot cities like Seattle and Portland are only about 20% above previous peaks.
The US median
The goal of real estate investors is to invest in emerging markets where the potential for increasing home values is real.
San Francisco is one of the leading indicator cities. Prices have started to decline and places like NYC have been weakening as well. This is one of the real estate warning signs to be aware of.
4) Tax laws take time to affect the market. Conceptually, we all know that limiting state income and property tax deductions to $10,000 and limiting mortgage interest deductions on new mortgages up to $750,000 are net negatives for expensive coastal city real estate markets.Â
Let’s say you own an average 3 bedroom, 3 bathroom home for $1.5 million. Your property taxes alone cost $17,000 – $20,000 a month, depending which state you reside.
Now, let’s say you earn $120,000 a year. You’ll have paid $6,000+ in state income taxes. In the past, you could have deducted the entire $23,000 – $26,000 from your income. Now, you are limited to $10,000 in deductions.
Some argue that lower income taxes will offset these deduction limitations. Perhaps that's true. But, nobody really knows for sure. Tax reform is a headwind, not a tailwind for coastal city property price appreciation.
5) Construction is booming while rents are stagnant. The construction boom we’ve experienced over the past several years is finally showing up in the data as a wave of new inventory hits the market. When there’s more inventory, pricing comes under pressure.
Although inventory is still historically low, it’s important to realize the inflection point we experienced in mid-2018. In just several months, the amount of inventory came back to where it was at the end of 2012. If the trend continues, we could quickly get back to 2008-2010 levels.
Here’s a look back at detailed inventory job of specific cities in 4Q2018.
It is too late to sell in extremely high-cost places like San Jose, Vallejo-Fairfield, Santa Rosa, Denver, Napa, Seattle, San Diego, San Francisco, and Oakland for maximum dollars.
But giving downturns generally last 2-5 years, pricing is likely going to get worse.
Higher inventory also leads to flattening or lower rent prices. Here’s a look at what was going on with Seattle and San Francisco rent a few years ago, for example. These two property markets have been the hottest in the country. But finally, we saw a cooling as buyer fatigue sets in.
6) The stock market is “unsettled”. We saw a violent 20% sell down in the S&P 500 in 4Q2018, then a small rise to begin 2019, then more volatility in 3Q2019. Then in 2020, the pandemic brought on a recession, but fortunately for only two months. The economy began to strengthen and the stock market climbed its way back and beyond to new highs in December 2021. But, 2022 had a rocky start, volatility returned, and for the next six months the S&P lost all its gains from 2021.
From policy errors by the Fed, to inflation fears, trade wars, and slowing global growth, consumers and companies everywhere are more cautious with their spending.
It's hard to predict where the stock market will be in a month, next quarter, or next year. But pay attention to what the stock market is telling us now. Real estate takes 2-5 years to correct, so there is no rush to buy now. Real estate warning signs become more apparent over time.
Invest In Real Estate Wisely
The risks inherent in real estate are real, but don't let that completely dissuade you from acquiring real estate this year.
Instead, take precautions, and know your financial standing.
If you’re dying to buy a primary residence today, make sure you can withstand a 20%+ correction over a five-year time frame, if history is any guide.
If you don’t have a financial buffer equal to at least 10% of the value of your property after putting down 20%+, then you are not financially prepared for a downturn. Better yet, pay cash.
Recommendations To Build Wealth
It's always good to understand the real estate warning signs out there before making a purchase. You want to model out good, medium, and bad scenarios about the economy before buying.
Real estate crowdfunding allows you to be more strategic in your real estate investing without having to take as big of an investment exposure.
If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, don’t want to tie up your liquidity in physical real estate, and are looking for real estate diversity, take a look atÂ
Fundrise has convenient eREIT funds to help you gain exposure to a variety of investment real estate types and locations. Further, they have specific investments that have been pre-vetted for you to choose from.
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Whether you're investing in stocks, bonds, or real estate, it's always optimal to stay on top of your finances. Nobody cares more about your money than you. I've used Personal Capital since 2012 and have seen my net worth sky rocket thanks to being all over my money. So should you.
