The Approach

The internet is a dangerous place to ask for advice.

There are a lot of haters our there – trolls – who spew negativity because their life is miserable.

Yet everyone I’ve encountered on personal finance blogs is very accepting and the comment sections are full of positivity. There are people who offer help if you need help and it can be a weight off your shoulders knowing that you’re not alone with particular problems. My guess is anyone who takes the time to better themselves by reading stuff like this is just a little more awesome.

So I’m seeking your opinion on a not too hypothetical situation.

Imagine This…

These aren’t my numbers, but let’s go through this as a thought exercise. You have:

• $20k car loan, 5 years at 3%
• $50k student loan, 15 years at 6%
• $100k rental property mortgage, 25 years at 5%

After a fitful night of sleep, you wake up grumpy and blame it on your lumpy mattress. Why is it so lumpy? In an uncharacteristic fit of anger you punch the mattress. To your surprise, it feels like something is inside …

Not wanting a dead animal in there, you decide to cut it open with the best tool you have in your apartment: a kitchen knife.

The battle is long and messy, but eventually you make a hole big enough to peer in. It’s too dark to see anything and you are scared to just reach in. So you take out your iPhone, turn on the flash light, and finally get a glimpse.

Bills, bills, bills.

$20k in cash is all yours.

What do you do with it?

Oh the Possibilities

Let’s quickly rule out blowing the money on an extended vacation. You want to use this to get ahead financially.

What a coincidence, your car loan balance is exactly $20k. Maybe you should just pay that off in full?

But the student loan is the highest interest rate – maybe the $20k should be put towards that?

You are also a rental property investor and that is exactly the down payment for another single family home. With a 20 year time horizon, you are confident you can make a 20% yearly return.

What is the right move?

People Face a Similar Decision all the Time

Many people with student loans are also contributing to retirement accounts. They are facing a similar decision with every paycheck – should I pay down my loan that is at 6% or contribute to my 401k with a tax advantaged projected 8% return?

If you run the math, it says to use low rate loans to your advantage. Rather than paying off a 3% car loan, you are better off putting that money to use anywhere else.

Obvious side note – that doesn’t mean it is a good idea to go get as expensive a car as possible to have a large loan. Let’s say the example above was actually two dependable $10k used cars, not one brand new car. You want a car that will get the job done and also to put your money to work.

Borrowing Money is Not Inherently Evil

Credit card debt is absolutely horrible. However, it is something that people can find help to get out of; the services of CreditAssociates are an example of the forms of debt relief that are available to people in such situations. About a third of Americans carry a balance and pay an extreme 20% interest on their borrowing. To make it worse, too often the money is used with very little thought to buy crap they don’t need. However, others are genuinely in need of money to help them out of a rut and that could require some flexible borrowing. A solution to this could be using a title loan (https://www.thenetlender.com) to help them acquire the necessary funds they need to get by – it involves utilizing the money tied up in your existing vehicle.

Credit card debt can seriously affect someone’s credit score and they may find that they can’t lend money when they need to as they have numerous debts against there name. There are specifically designed credit cards for no credit so if someone desperately needs a credit card, they do have a lifeline.

This hatred of credit card debt is extended to other areas as well. Rather than evaluating each situation on its merits, many are lazy and extend this belief too far, not realizing the power of leverage through rental property investing – loans your tenant pays off for you.

So I Have a Car Loan…

Car loans are in fact bad debt. You are paying for something that is worth less as time passes. Compare that to a rental property, where you are paying for an asset that keeps going up in value. Obviously one is better than the other.

Despite know this, I just purchased a used car and took out 100% financing! Shocking right? What was I thinking?

First, I am capable of purchasing without taking the financing into account. Too many people purchase the nicest car their monthly payment will allow.

I also know I have the discipline to pay it off early if it is the best path. In fact, I can treat it as a 4 month loan and pay it off completely in one lump sum. I decided to pay a little bit for this option with wedding and honeymoon expenses these next couple months.

But I’m interested in hearing your thoughts.

What Do You Think?

1) How should the person who found $20k in the mattress use the money?

2) Should someone who is purchasing a car and has a student loan at 6% – pay in cash OR take out a 3% car loan to pay down the student loan faster?

3) Should someone who has a student loan at 6% and is able to save $1k per month – pay down their student loan OR contribute to a 401k.

“Actual results may vary” read the tiny disclaimer at the bottom of a commercial for the latest fad diet. Ain’t that the truth!

And so it goes with projecting real estate. We can make as many sophisticated models as we want, but the actual results will vary. There are just too many unknowns to make it an exact science.

In the previous article, How to Visualize the Real Estate Cycle, I showed a rough estimate for how rental markets behave. It compared a linear market like Indianapolis to one that is more cyclical like Dallas.

The goal was to help you visualize the cyclical nature of rental home prices and how things even out in the long run.

Now let’s zoom in to examine how prices rebound after a crash. We are going to see how the rough projections stack up to reality.

Finding the Data

The hard part is finding the right data to use. Many home sales have nothing in common with the rental properties we would purchase.

There are 5 bed, 4 bath mansions with a pool, which you will find plenty of in cities like Los Angeles and Las Vegas. In turn, properties like this will make it so much easier to “sell your home in las vegas” when you want to move on, granted that you have the assistance of the best real estate company in your area. Furthermore, there are beat-up 2 bed, 1 bath homes that go through foreclosure. And there are a ton of homes in between.

Ideally we want our data to fit the exact home we would potentially purchase as a rental. For me this is in a B to A- neighborhood, roughly 35th to 50th percentile in home price for the metro area.

This exact data is tough to find, so let’s go with what we have. Zillow estimates for the middle tier homes in Dallas and Indianapolis.

Massaging the Data

We want to match this up to our projection graph. Since the Zillow data shows January 2008 to be roughly the peak, let’s look at the January price for every year since then.

The middle tier home prices are a little too high, so we have to adjust them down. For example, Dallas peaked at $121k in the data and $113.5k in our projection. So to normalize it, we will take 94% of the Zillow numbers.

Now we are ready to add the data to our graph.

The Result

It matches up ok…

The peak to trough projections were too low – in Indianapolis there was a 12% decline with only 6% projected. The Dallas price drop was even farther off from the expected 16% – according to the data, it was a 24% drop.

The period of the cycle projection and data don’t exactly match up. In the projection, it took 6 years from the peak to the trough. In the data it only took 4 years.

Basically rather than a perfect sine graph over the whole 18 years, we have the crash and recovery effect condensed. I would expect a more gradual ascent as well.

Both markets recovered to their original peak within 8 years. This is exactly what the projection said for Indianapolis and three years ahead of schedule for Dallas!

Improvements and Caveats

There is a lot of data on Zillow and if I knew these two markets better, I might be able to find something that is closer to the rentals I would purchase. With Zillow you can narrow in on a certain neighborhood like Southwest Dallas.

Zillow estimates aren’t always accurate. I feel the numbers on Zillow are sometimes too high, especially at the peak of the market. Perhaps we could adjust those numbers down a bit to take this into account, as it has a huge affect on our peak to trough calculations.

I also don’t think Dallas is a perfect market to explore for this because it is experiencing tremendous growth. Its price recovery from the recession might not be typical of other cyclical markets because of the extra demand.

So take all of this with a grain of salt and realize it’s not perfect. But it actually matches up decently well!

Linear and Cyclical Markets

We projected that linear markets like Indianapolis, Memphis, and Kansas City will be affected by market cycles, just less than more cyclical markets like Dallas, Phoenix, and Las Vegas. The real data shows this to be true. This is why it is important to learn everything you can about real estate in your area. Articles like What You Need to Know About Las Vegas Closing Costs can help you stay informed about changing costs and the fluctuation of markets.

Investors can ignore market cycles by taking a long enough time frame. If one complete cycle is roughly 18 years, our investments over 15 or 20 years will be just about equal whether in Dallas or Indianapolis. They both match the trend line of inflation, roughly 3% a year appreciation.

But if you know you are at the bottom of the market crash, purchasing in a place like Dallas will set you up for huge appreciation in a short amount of time.

Looking at this graph, ideally you would:

• Years 1 through 6 purchase in Indianapolis
• Years 7 through 9 – notice prices are crashing and wait to purchase
• Years 10 through 12 – notice prices are rebounding and purchase in Dallas for extra appreciation
• Years 13 through 18 purchase in Indianapolis

Do you reach the same conclusion looking at the graph? Do you think it is possible to roughly time the market like this?

“Oh, I’m a visual learner” said the high school student assigned a stack of books to read over the summer. “I guess I’ll just have to watch the movies instead…”

Do you ever get the feeling that people decide they aren’t good at something out of laziness? Have you really tried or is it just an excuse?

I also suspect there is an enabling parent behind the scenes. Socially awkward? We must homeschool or his self-esteem will suffer! Bad handwriting? Let’s tell the principle it is stupid to learn to write in cursive, so we can get out of it.

Let’s not let this rant go too far though, there is some science to support these “visual” learners. And somehow this article is eventually going to be about real estate cycles…

Different Learning Styles

There are 7 different learning styles that are widely accepted, including verbal and visual.

Everyone can learn from every different style, although some might be more effective for you. If you learn the same thing in multiple styles, you can learn it even better.

For example, you might start by reading a book. Is there a graphic that sums it up? Is there also a song with the same content? Can you make a social role-playing game out of it?

If so, the concept will sink in deeper.

Linear and Cyclical Markets

We all have heard that real estate has cycles. The prices will run up for 7 to 10 years and then come crashing back down. Rinse and repeat.

Rental property investors understand that markets behave differently. This is the kind of information you would only be aware of if you had consulted a real estate investing coach though. Some markets (A.K.A. cities) are really effected by this, others just a little bit – real estate investors often label these cyclical and linear markets.

Examples of cyclical markets are dallas real estate, Phoenix, and Las Vegas. Examples of linear markets are Indianapolis, Memphis, and Kansas City.

Even though we know these markets behave differently, it is hard to get a feel for just how different they are. All too often, people who live in places like California, New York, or Washington D.C. assume real estate has huge swings everywhere.

If only there were another way to get this point across…

A Visual for Real Estate Cycles

Here is a theoretical view of the cyclical and linear real estate markets:

A house that costs $80k in year 0 (completely neutral point in the cycle) will appreciate differently in each market. In Dallas it will peak at $114k, but in Indianapolis only $108k.

This extra appreciation leads to bigger crashes too.

In Dallas the peak-to-trough is a swing of $18k. So if you bought at the top of the cycle, you would see your home value take a big dip. In Indianapolis the peak-to-trough is $7k. Prices do decline, but they are much more manageable.

This means that if you want to sell or buy houses in Indianapolis, you’re less likely to see a drastic decrease in prices like you would in Dallas. There are still high and lows in the market but that’s just the nature of real estate – you would probably feel more comfortable investing money into a more manageable market like Indianapolis.

Also notice how many years it takes to get from the top of the market, through the crash, and back to the original price. In Indianapolis this is about 7 years, in Dallas roughly 10 years.

The Most Important Thing to Notice

Two things contribute to appreciation – inflation and the market cycle.

Over the course of an entire market cycle, roughly 18 years, both markets keep up with the inflation trend. So take away all the market swings, and they are equal!

This is why I’m not as concerned about timing the market. For my long time horizon, say 15 or 20 years, the cycle doesn’t really matter.

If you are investing with the goal to sell in 3 to 5 years, you better get the timing right. Unfortunately that is extremely hard to do – many people claim they can, but in fact they just got lucky.

It is for these reasons that most real estate agents nowadays use circle prospecting and other approaches to generate leads. In real estate, you never know when someone in a specific area might be considering putting their home up for sale, and therefore it is vital to use real estate technology tools and geographic farming techniques to stay one step ahead of your competition.

Theoretical Look, Real Take Aways

This visual gives you an idea of how the cyclical and linear markets behave differently. But this is a theory – how does the actual data match up? This is something we’ll dig into next time.

Does this visual help show the differences between the market types? What specifically would you like to see in the actual data?

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Here is the complete spreadsheet of calculations.

You know the saying can’t see the forest for the trees?

I always thought it was kind of dumb. The trees literally are the forest, so if you see the trees you see the forest!

But now that I’m old and wise, I get the point. It’s about stepping back and seeing the bigger picture. Don’t take it so literally.

The most common question I’m asked is what is the best city for a rental property? I worry that everyone who asks might be missing the forest for the trees.

The Best City

Of course you want the best. You saved up twenty thousand dollars for the down payment and want the best possible returns. What’s so wrong with asking for the best?

There is an assumption built into the question that there is one city that is the answer.

The best city for you depends upon your goals. What is more important, cash flow or long-term wealth? How active or passive do you want to be? At what price point are you looking to invest? Having sorted all of the above out, you can start looking for a rented apartment on home search portals like Craigslist or others like it. This can be considered as an orderly approach towards finding a property.

I would much rather you ask, what are the top cities I should consider given my goals? Not just one, but several to compare.

Learn How to Fish

You should be able to evaluate the cities yourself because things change over time. If you wanted to know the “best” in late 2009 and I said Dallas, does that still hold in 2016? Nope.

No matter what answer you get, you need to be able to verify whether it is correct. And when you save up your next chunk for a down payment, you need to evaluate whether the last city is still the best option.

It’s the whole “Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.”

The Most Important Factor for a City

Rihanna knows:

Work, work, work, work, work, work!

It’s perhaps all about jobs that have good employers who care about their employees, especially about employee health. They feed population growth, which increases the demand for housing. However, this might not be the case for remote jobs. By allowing the employees to work from the comfort of their house, be it from Philadelphia or Denver–where employees only need to have a computer and stable Internet connection (perhaps provided by reputed internet providers in philadelphia or Denver)– such employers ensure that employees do not have to relocate to new destinations, hence reducing the overdemands for housing.

Anyway, when you dig into the jobs in a specific city, you want to see many different industries and think about how they respond in times of turmoil. Tourism isn’t exactly recession proof, but big medical centers are.

Specifically, how easy is it for those jobs to move elsewhere? Transportation hubs likely aren’t going anywhere. I also look for a big corporate presence, including headquarters, of established Fortune 500 companies in low-cost cities. If you want to work on a farm, it might be worth checking out some Texas ranches for sale. If you want to be a lawyer, LA or Vegas might be best for you.

You want to see some job diversity as well. That is the issue with more remote towns, if the one industry declines for some reason, you don’t want to have all your eggs in one basket. There was a real estate boom in North Dakota based on excellent job growth in the oil and gas industry, but those aren’t looking like sound investments now.

To sum it up – we want a growing number of jobs during the good times and stable industries for the bad times.

Where Are We in the Cycle?

There is a natural cycle to real estate. I won’t get into why or how it works right now, but here are a couple things you can read if interested.

It generally takes 7 to 10 years to get from the bottom to the top of the cycle. And the same back down.

Some places are affected by this cycle more than others though. A ‘boring’ city like Indianapolis will be able to return a steady cash flow even at the top of the cycle when things are their most expensive. However, for states like Texas, Florida, and Arizona the numbers only work when we are at the bottom of the cycle.

If we are within 1 or 2 years from the bottom of the cycle (either before or after), it might be a good idea to look at places like Dallas or Phoenix – they will cash flow and have greater potential for appreciation.

Otherwise we can eliminate a lot of those cities from our search. During the vast majority of the cycle, we should look at the more boring cities.

Does it Make Sense to Buy at the Top of the Cycle?

If the numbers work for the property to still cash flow, yes. But we should also consider that there is potential for the rent to drop a little.

In the boring cities, I believe we shouldn’t just purchase at the very bottom of the cycle, but during most times. I don’t pretend to be able to predict when the up slope will end. I don’t think you should either by keeping your money on the sidelines (or in the stock market, which has it’s own cycles as well).

When it does hit the top, it might be a good idea to wait a year or two for prices to go down before purchasing. This means still purchasing 90% of the time throughout the cycle.

I am more concerned about the gains over 15 to 20 years rather than the appreciation potential over the next 2 years. If you are trying to precisely time the market, you might be missing the forest for the trees.

Do you feel there is one best market? How important is timing to you?