In this installment of the series on real estate markets, I’ll be discussing the first phase of a seller’s market. In previous articles, I explained the buyer’s market phase I & II. The first phase of the seller’s market is the latter half of an emerging market. During this phase, the market will appear to make economic sense for those who want to start building new properties based upon prior absorption rates. This is called the Point of Equilibrium.
Now the local investors have taken the bait and they think the good times are going to last forever. As they invest heavily in the market, the outside investors smell the blood in the water and start moving in also. This is called a feeding frenzy. All of this new interest drives the demand and prices for real estate to its highest peak. As the demand increases, the supply of good properties starts to dry up and investors start buying up the sketchy properties that most people passed on earlier.
Even worse during this market cycle is that good contractors are getting harder to come by because there is so much work for them with all of the new properties coming into the market.
Signs of a Real Estate Bubble Forming
Speculators are now bidding up the prices of properties based only on the idea of the property value appreciating instead of the actual cash flow. This is a very dangerous practice. This is a house of cards that is waiting to fall. For example, an investor may purchase a property that requires $5,000 in cash flow per month for debt service but it only makes $4,000. They are hoping that the value will continue to go up and they can find a bigger sucker to buy them out of their mess.
This very practice happened across the United States during the mid-2000’s. Low interest rates made real estate an attractive asset and everyone wanted to get into the business. I actually saw people who were waiters start calling themselves investors and start flipping properties. It was good for a while, but what goes up will eventually come down. By 2008, the real estate market had collapsed and some of those shady investors went to jail for loan fraud.
During this phase of the market, many investors believed that they could buy today and literally sell tomorrow and make some easy money. This attitude led many to purchase anything, whether it make good financial sense or not. They paid the inflated asking price, no matter how high, just to own a property.
The end result of all of this is that the properties they bought had smaller and smaller margins and many were left holding the bag when everything collapsed.
How to Invest in This Phase of the Market?
During this phase of the market, the demand for property has reached its highest peak. If you were smart enough to invest during the first two phases of the buyer’s market, you should be sitting on a ton of equity and preparing your properties for sale. Now is the perfect time for you to use a 1031 tax Deferred Exchange to liquidate your properties and put the profits into a larger, better performing piece of property with ZERO tax liability.
When you use this strategy, it allows you to use the IRS code to move into a property with a better monthly cash flow. Bear in mind, you want to take action while your market is still climbing. Don’t get greedy and overstay the market and watch your profits go up in flames.
For example, let’s say you own a property that is currently valued at $1,000,000 and has $200,000 in equity and the market increased just 20% during your ownership. Now your property is worth $1,200,000. When you decide to sell the property, you will now have $400,000 ($200,000 + $200,000) in equity.
You can use a 1031 Tax Defferred Exchange to take all of your equity and use it as a down payment on another more promising property. (Remember not to overpay during this market phase, though!) Let’s assume you’ll be putting 20% down. With this 20% down, you now have enough to buy a property that is worth $2,000,000 ($400,000 is 20% of $2,000,000). Now you are the proud owner of a $2,000,000 property.
The first phase of a seller’s market is the perfect market to buy and hold property because there is still room for rents to increase and for your property to appreciate in value.
Warning: At some point this market will begin to cool off. When it does, I advise investors to count their profits and liquidate. At this point, you should be looking for another emerging market to invest in.
Just as you entered this market when everyone thought you were nuts, you’ll now be quietly exiting it while everyone else thinks the party is just getting started. Get ready for more criticism as you are taking your profits to the bank and making a fat deposit. In the next installment, I’ll be explaining the last phase of the real estate market. This is the second phase of the seller’s market.
If you want to learn more about building a stream of passive income through real estate, join my Wealth Builders’ University community to get step-by-step guidance on building your own portfolio.