Dollar Cost Averaging Overview
Investors are often familiar with dollar cost averaging when it comes to stocks. An investor purchases stock in a company or index fund over time at various prices. Some shares are priced high while others are priced lower. The process averages out the share price, which helps avoid only buying shares when prices are particularly high.
For example, an investor buys ten shares of Microsoft at three separate times. The first ten shares are $100 each, the second ten are $180 each, and the last ten are $281. The average price for the 30 shares is $187.
Real estate investing can work the same way. Real estate prices are particularly high now due to a lack of supply and strong demand, and many investors are feeling priced out. It is more difficult now to find profitable investment properties than it was a few years ago. But dollar cost averaging may help in thinking about real estate investing over the long term.
Real Estate Investing Example
In 2005 Fiona was an investor looking at two-bedroom, two-bathroom luxury condos in Florida. The development she liked is new and the units are offered at $280,000. Fiona buys a condo with a 20% down payment of $56,000 and finances the balance over 20 years. This was in the lead up to the Global Financial Crisis and prices for these units continued to rise to $380,000. But, then the real estate market collapsed.
Declining Values Create Negative Equity
Fiona saw the value of her property fall to $180,000 over the next few years. Fiona owed more on the property than it was worth, meaning she had negative equity in the property. This can be a scary prospect for investors, but it is not a time to panic. Fiona continued renting the property with the rents covering the mortgage and condo fees. Fortunately, her loan rate was fixed, and not adjustable. This means she did not have to worry about refinancing the property, which would be much harder now that the value has declined. This is one of the reasons it is safer to use fixed rate mortgages with investment properties.
An Opportunity to Dollar Cost Average
An investor only loses money in real estate if they have to sell. Even though Fiona's property did not generate the hoped for returns, it did not become a loss. Fiona was able to hold on to the property and wait for real estate to recover.
During this recession Fiona continued to monitor the situation. She saw that more properties were going into foreclosure or short sales (pre-foreclosure) which pushed prices down further. She viewed the market as oversold and saw an opportunity to dollar cost average.
She reaches out to a few banks to finance her next property and learned that they will not lend on investment condos in Florida, regardless of the borrower's credit rating. The banks advise they will only lend if the property is a primary residence. These restrictions limited the pool of potential buyers and contributed to the decline in condo prices.
Creative Financing is Required
Fiona is convinced this is a buying opportunity. She starts working with a realtor who is familiar with short-sales. Since banks will not lend, she takes a loan from her 401k and her husband does the same. She adds in some additional cash that she saved to make an all-cash offer of $140,000 for another condo. She is essentially buying a second property for half the price of the first property.
Fast Forward to 2022
As we fast forward to the start of 2022, the total price Fiona paid for the two properties is $420,000 and the average price is $210,000. The real estate market has recovered and the condos are each worth $340,000. The rents have also risen over the years.
The appreciation earned on the first property is minimal, essentially $60,000 over 16 years. A different investment might have earned a better return, but Fiona avoided a loss during one of the worst real estate markets in modern history. Also the property will be paid off in four years, which will increase her monthly rental profits.
The appreciation on her second property was better at $200,000 over seven years. She timed this purchase well by closely monitoring the local real estate market. But, due to the banks being unwilling to lend on investor condos at the time, she had to come up with cash for that purchase. Raising this much case during a downturn which might be hard for some investors. Over the following years Fiona used the rental income from this property to repay most of the 401k loans used to buy the property.
Lessons Learned
Not every investment is going to go perfectly as planned and all investors make mistakes. The key to long term real estate investing is to not become over extended with leveraged debt and not to panic when markets crash. In real estate, you can find opportunities to dollar cost average as you can with stocks.
Like most real estate investors, Fiona had some months when the property was vacant and some expensive repairs that temporarily reduced her profits. But having some cash reserves helps navigate these challenges. By sticking with her plan she now has two properties in a desirable location with rising rents and appreciation. These properties will provide a valuable income stream when she retires.
For more on real estate investing see Ten Things to Know About Real Estate Investing and a Comparison to Today's Market to the 2007-08 Real Estate Crash. For more detailed information on real estate investing and creating a plan for financial independence see Become Loaded for Life and the 10 Stages Workbook.
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