Investing in a property is a highly leveraged investment. If you buy securities, for example, you can only borrow 50% of their value. On the other hand, if you buy a rental property, you can borrow 80-97% of its value. However, with high leverage comes high risk. One weakness of the standard mortgage in the US is the risk that your equity in investment property will decline due to unforeseen circumstances. Higher equity means that the smallest decline in value will negatively affect your equity and add to your debt. This situation is referred to as “going underwater on a mortgage” which could negatively alter your investment property financing.
What Is an Underwater Mortgage?
Before we dive into how you can avoid having an underwater rental property, we should first clearly define what an underwater mortgage is. An underwater mortgage is a property loan with a higher principal than the free market value of the property. An underwater mortgage happens when property values are declining. In such a case, you may not have enough equity available for credit. This scenario usually happens because most real estate investors put down a relatively small down payment when buying a rental property. With an underwater property, mortgage lenders refinance or sell the property unless they have access to cash to make up for the loss.
Many real estate investors are still cautious about their mortgages following the real estate price drops that occurred in 2008 during the financial crisis. You wouldn’t want an underwater mortgage or negative equity. This is not ideal for investors because an underwater mortgage means you owe more than your property is actually worth. This is especially risky if you have an interest-only mortgage or pay-option adjustable-rate mortgage. You can turn to refinancing or live frugally to make it through an underwater mortgage. Alternatively, you could potentially sell the investment property at a loss or lose it to foreclosure. With that said, you still have options to preserve your property’s value and mitigate underwater mortgage risks.
Tips for Real Estate Investors:
1. Buy Right
To avoid ending up with an underwater investment property, it is wise to buy property below its intrinsic value. You should look to buy a property in an area that is known for having a strong history of capital growth. You can gain extra money during high seasons by having a rental property that outperforms the average property. This, in turn, will ensure that you receive a consistently high rate of appreciation in the long-run.
To safeguard against another real estate market crash, you should make sure that your rental property is in a diversified economy. You should avoid any area with one economic driver such as Detroit, which is famously known for its prominent auto industry. You most likely will end up having a vacant property if you focus on a specific industry-dependent area. Other example areas are North Dakota (oil dependent) and Alaska (fishing dependent).
2. Target Positive Cash Flowing Properties
As long as your investment property brings in more rental income than its rental property costs (positive cash flow), then it doesn’t matter what happens in the housing market. If there is a sudden price drop, the only time it will affect you as a rental property investor is if you decide to sell.
Learn More: How to Find Positive Cash Flow Properties
3. Follow the “1% Rule”
To avoid dealing with an underwater property, focus on investment properties that will rent for 1% of the purchase price every month. For example, if your $100,000 rental property yields monthly mortgage payments of $1,000, then it is likely to cash flow positively.
4. Invest in C-Class or Better
Investing in nicer areas such as A-class usually means better neighborhoods and economically diverse markets. This helps you avoid an underwater mortgage and the negative effects of a market crash. D-class properties, on the other hand, are known for having high-crime and high-vacancy rates. Learn more about property and neighborhood classes from this infographic.
5. Have the Investment Property Appraised Annually
You should conduct regular appraisals on your property as it not only helps you determine accurate property taxes but lets you track value losses and gains. This process derives the end value of your investment property from national market trends, recent sales of similar properties in the area (real estate comps), and your property’s individual amenities.
6. Conduct Regular Renovations
You can protect your investment property’s value by having it constantly checked for damages or signs of danger. If you neglect a rotting backyard deck and a tenant gets hurt as a result, you could face charges and even be sued. Not only that, but your property would decrease in value due to the new hazards unless fixed.
7. Be Prepared for the Worst
It is important that you have a financial buffer in place just in case things don’t go as planned. The financial buffer can protect against rising interest rates. One way to reduce the amount of interest applied to your loan in the case of an underwater mortgage is to establish a line of credit. Another way you can reduce your interest is to link an offset account to your loan.
To Sum It Up
If you take your rental property seriously and treat it like a business, you will be able to avoid the risks and downfalls of an underwater mortgage in today’s volatile economy. Similar to any other business, having good risk management practices and tips in place can help you mitigate risks and unexpected fluctuations in property value in the future.
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