A subscriber asks: How do you know when to buy and sell investment real estate?

Hi Chris,

You mentioned that you purchased a number of investment properties earlier this decade. How did you know it was a good time to buy? Will you ever sell them? There must be a price that is good for you to sell.

John

When to buy and sell is all about the numbers

Even with unlimited QE, we know that prices cannot move higher forever, and this is especially true with rental real estate. Regardless of the cycles and circumstances, when it comes to rental properties (or most other business assets priced off the yield curve), we can determine a rough estimate of fair market value.

We can also figure out at what price we may seek over time when disposing of the property. With the advent of the heightened boom/bust cycles, I would rarely recommend holding our entire property portfolio regardless of market cycle. There comes a time when it pays to cash out of some of our holdings.

Forget the market forecasters; It’s all in the numbers

Last decade, it became apparent to me and many other knowledgeable investors that real estate prices had decoupled from their fundamentals. Now, most who follow ZeroHedge will always say it’s a lousy time to buy real estate, but this is not true. We can employ some simple math to determine capitalization rates and internal rates of return (IRR), which go a long way in assisting our investment decisions.

After we calculate these values then we can compare the current numbers to their historic averages and variances. Thus, if a property usually has a 5.5% cap rate and the current one based on its market value is 4%, then I would probably stay away. If instead, the cap rate is about 5.5% or higher and you intend to hold it over the long-term, I would generally recommend it, all other things being equal.

Let’s use an example of a 2-bed, 2-bath condo I purchased in mid-2015, which is located in suburban Maryland. Below is a table that demonstrates what my target disposition price would be with my ideal full-market value cap rate of at least 4%.

As we can see, rents have risen more than expenses since 2006, thus comparing bubble-high market prices to today’s is misguided. We can easily look at the changes to the property’s cap rate over the years to get an indication of where we think prices may go, given the massive monetary stimulus that is being injected into the financial system.

I have to believe that based on the massive QE programs in place, I see that prices may rise to $300,000 and more over the next few years. If rents rise higher than my target estimate, the cap rate will climb and so will the market price to compensate.

I paid $91,000 for this property in the Summer 2015 and put in about $18,000 to get it totally rehabbed (plus two full-time months of labor). As we can see, the early part of this decade was a fine time to buy. Prices around this condo have risen about 20% over the past year and have shown recent strength even during this slow season. It is not out of the realm of possibility to see prices move higher. This property with a 6% cap rate still provides an attractive opportunity for a mature investor looking to park cash (or for a prospective homeowner looking to buy).

If we can drown out the collapse Cassandras and stay objective with our math, we can spot opportunities to buy and sell. If the market value of this condo approaches $300,000, I will look to unload. Given that I am making about $12,000 a year in rental income, I will have to find a replacement to that passive income, while paying long-term cap gains taxes.