Buying distressed residential properties, fixing them up, and holding them through the recovery is a great way to earn huge profits.

I am a big fan of buy-and-hold residential real estate, but that isn’t the only way to make money from this asset class. Home flipping is one extreme, and permanent buy-and-hold is another. But is there anything in between?

Yes, buying distressed properties and selling them when the economic cycle is most favorable is a viable investment strategy. However, the analysis is more complex, and timing is critical to the strategy’s success.

The two extremes of flipping or buy-and-hold are much easier to analyze and execute. When flipping, an investor needs to know the after-repair-value and the cost of renovation to determine the most they could pay for the property and still make a good flip profit.

When investing to hold, and investor needs to know the total cost to bring the property to rentable condition and the amount of rent they can obtain from the property to ensure it provides the desired rate of return.

While the calculations for each of these methods are different, they both benefit from the virtue of simplicity. Once investors enter the no-man’s land in between these extremes, the analysis gets much more complicated.

Timing the Economic Cycle

Buying distressed properties for maximum gain requires timing the purchase and subsequent sale to take advantage of the broader economic cycle. It isn’t a strategy that can be executed in any market at any time with a reasonable expectation of success. Realistically, we are already past the point of entry for this kind of trade in our current economic cycle, but it’s a strategy worth learning to implement during the next economic downturn.

To make the most from this strategy, investors want to focus on properties that have extremely high vacancy rates, mostly due to the economic conditions rather than serious defects with the properties. While it’s still possible to profit from distressed properties during the expansion phase of the economic cycle, it’s much more difficult to find good deals, and these often require extensive renovations, limiting their appeal to contractors and rehabbers.

How Vacancy Works

The value of any property is the discounted value of future cashflows. However, during economic downturns, people tend to underestimate the future value, and during expansions, they tend to overestimate them. This strategy takes advantage of people’s natural tendency to extrapolate short-term trends to infinity.

My buy-and-hold strategy is to buy properties that rent to the 25% to 40% of the median income in the area. At these price levels, rents are generally higher than apartments, and the properties are of higher quality. During an economic downturn, these properties don’t experience much problem with vacancy because as a landlord, I can always lower my rent and steal a tenant from an apartment or a lower quality property. Therefore, during downturns, most vacancy gets concentrated at the bottom of the housing market. This is the key to this investment strategy.

When a property is empty and the landlord can’t find a renter, to them, the discounted value of future cashflows is zero. In effect, the only value in the property is the option value of potential future cashflows because the current cashflow is zero. Potential future cashflows always carry a significant discount to actual current cashflow; thus distressed properties are generally undervalued.

For example, when I was buying properties at auction in Las Vegas in 2010-2012, I saw several fourplexes auctioned. The prices generally ranged between $80,000 and $100,000. At the time, it was rare to have more than one or two of the four units with an occupant, and these were located in the worst part of town, often in a state of disrepair. But even discounting for all that, the $650 per month potential rent made for 20%+ capitalization rates — assuming the properties weren’t vacant.

Of course, these properties were vacant, and it wasn’t a matter of lowering the price to fill them. There simply weren’t enough people with jobs to occupy these properties and pay rent. Anyone who purchased one of these needed to expect negative cashflow until the economy improved and demand for housing made even these undesirable alternatives superior to sleeping under the freeway.

The analysis of properties like this become much more complex because an investor must estimate the amount of early losses they must endure while waiting for the economy to improve to fill these empty units. The perils of this strategy are obvious. How many units like these were purchased in Detroit, never to be filled?

Sell when the market is strong

The harder part of executing this strategy is the final sale. The exit isn’t some random point in the future when the investor’s personal circumstances might warrant. The ideal exit is when the property is fully occupied and the expansion is nearing its zenith. This is when foolish optimism and irrational exuberance causes investors to overvalue properties like these. However, it’s also the most emotionally difficult time to part with a profitable investment, which causes many people to hold on too long and miss their chance at a superior exit.

Executing this strategy requires a more complex and detailed financial analysis, an understanding of vacancy in the housing market, and a bit of luck in timing the overall economic cycle. The rewards are superior cashflow and superior appreciation if executed properly.

So where are we in the cycle now?

Home flips accounted for 5.5% of home sales nationally in 2015 — the highest number since 2007 — causing rumors of speculators’ return in anticipation of a housing bubble. However, California’s stifled wage growth and high prices instead suggest a future decrease in home sales volume once the Federal Reserve (the Fed) further raises interest rates in late 2016.

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