Ideas About Investing In A Down Market

 The recently released Core Logic housing data stats for March make grim reading.

Since their respective market peaks, Sydney dwelling values are down 13.9% while Melbourne is down 10.7%. Worse still is Perth, down 18.1%, and taking the booby prize is Darwin – down 27.5%. The only capital city that defied the downturn was Hobart (up 0.6% for the month, and a very healthy 35.7% over the past five years).

Against the backdrop of falling values, I thought it timely to first review several elementary investing principles, and then consider four ways that property investors might choose to apply them to the current down-trending property market.

A Little Investing Theory

When you boil all the hype and hoopla down, there are only two ways to make a profit from property: cashflow and capital gains.

Very simply, cashflow refers to your bank account increasing when you receive more cash in (i.e .from rent and other receipts) than expenses paid out (i.e. cash payments). Capital gains occur if your property’s value (net of sale costs) appreciates above its carrying cost, over time.

Either profit type can be made generically (i.e. by the market), or it can be manufactured if the investor can apply their skill and expertise to find and solve one or more problems in a way that adds more perceived value than actual cost.

For example, a negatively geared rental property is, by its nature, negative cashflow, so it must be a growth strategy – either generic or manufactured. Furthermore, a property that you plan to buy, reno and then rent for positive cashflow would be a combination of two profits – generic cashflow and capital growth (initially manufactured via the reno, where more perceived value is added than its cost, and thereafter generic growth from general market appreciation).

Current market conditions indicate headwinds, meaning there is a generally downwards pressure on property prices. Therefore, we currently need to take generic growth off the table in most scenarios as a realistic profit option, but that still leaves us with: positive cashflow – generic and manufactured, and manufactured capital growth strategies.

Strategy #1: Focus On Cashflow

The first approach is to focus on cashflow as the lifeblood of your investing success, in which case, so long as the property is cash-flowing and sustainable, any downtrend can be considered survivable – i.e. a temporary and transitory incident. 

As I’ve said for many years, unless you’re a speculator, cashflow should be the meat and potatoes of any long-term investing strategy, with capital appreciation being the gravy on top. If so, then it doesn’t really matter if prices are falling so long as your assets remain cash-flowing, in which case your investing is sustainable and you won’t be a forced seller in a down market.

The unfortunate problem is, many investors don’t know how to accurately calculate the likely cashflow outcome of owning the property, and they can also overlook other critical aspects of due diligence, thus they purchase somewhat blindly and then have to suffer the unpleasant consequences. 

This saying is true: all ships float on a rising tide. When the market is booming it doesn’t really matter what you buy. Yet when conditions are tough, due diligence is what divides the speculators from the savvy and sophisticated investors.

I’m actively looking for good quality cashflow properties right now, and have made multiple offers in the past few weeks.

Strategy #2: Manufactured Growth

The second strategy is to buy and manufacture your profit. As mentioned, the not-so-secret formula for doing this successfully is to add more perceived value than actual cost. Of course, the usual strategies apply: sub-division, renovation, and development – but really any problem you can fix for a profit will deliver a manufactured growth outcome.

A down-trending market produces some extra heartache, and risk, when manufacturing your property profits since your gain is predicated on perceived value, and if values are falling, then your profit margin might be shrinking during the time it takes to finish the project.  

Consider a property that is bought for $350,000 with an ‘all in’ reno budget of $100,000 and an expected resale price of $500,000. Such a project is expected to make a profit of $50,000, and so this is your ‘margin of error’. That is, the project’s perceived value can fall by up to $50,000 and you’ll still be okay – any more than that and you will not recoup all of your actual cost and you’ll be in the red on the project.

Low profit margin properties could be acceptable in an up-trending market where the time period will tend to inflate your profit, but they should be avoided during other times in the market cycle.

Premium properties tend to be the best performers in an upturn, and the worst performers in a downturn. Why? Because property prices tend to be more volatile the more expensive they become – rising sharply in up markets, and falling faster and harder in soft markets. The smarter, safer, and more sensible risk-averse approach when in a downturn, is to target properties at the more affordable end of the price spectrum, and ideally where there hasn’t been a sudden spike in supply.

If you are manufacturing growth then be sure to calculate your Plan B Cashflow outcome, which is “how well would you cope if you couldn’t sell the property and instead had to rent it out?”

Strategy #3: Straw Hats In Winter

I’m extremely confident on this point – sooner or later, property prices will recover and several years after they do, today’s property prices will look cheap. The questions I can’t answer are when the bottom of the market will occur, and how quickly will property values recover.

That said, compared to the peak of the market, many properties in high-quality areas are looking cheap and possibly good value. Beware! Value should be based on strategic value now (i.e. scarcity) and the growth narrative into the near future, as opposed to what the property may have been worth on a good day in a property market boom that has long since ended.

I’ll be talking about this topic in a lot more detail at my upcoming 1-day Millionaire Mastermind Workshop. If you haven’t got your ticket(s) I suggest you do so now.

Strategy #4: Ignorance Is Bliss

The final strategy is to forget all the strategy and investing science, and just buy something you like and hope it will be a good asset tomorrow.

This is a strategy I strongly suggest against pursuing, because it involves accepting high levels of risk without being adequately compensated for it. That is, the market could continue to fall for many months, even years, and you’ll suffer for it.

A smarter approach is to simply wait until the market has bottomed, then buy on the bounce when there is more upside for less risk.

Final Words

When it rains, everyone out in the open without an umbrella will get wet.

As simple as it sounds, for some investors the best advice right now is to simply stay indoors – meaning, don’t venture outside for the moment and instead concentrate on indoor activities.

For other investors who are appropriately educated, equipped and empowered to venture outside in the wet, now is an opportune time to make great progress while there are few people cluttering up the investing streets. Certainly, the groundwork you accomplish now will prepare you for handsome profits when the rain stops and the sun comes out again.

Finally, if you find yourself caught in the storm without an umbrella then don’t just stand their getting soaked to the point of catching investing pneumonia. Seek shelter – somewhere safe to ride out the storm. It too will pass, eventually.

By Steve McKnight

Steve McKnight, the founder of PropertyInvesting.com, is a respected property investing authority as well as Australia's #1 best-selling business author.