As of June 13, 2022, the S&P 500 officially entered a bear market, meaning the index was down a full 20%. Since then, the market has risen, but is still in “correction” territory of -10% since the highs in 2022.

On the housing front, the Case-Shiller home price index has fallen for its fifth consecutive month.

Goldman Sachs (lots of really smart people who make a lot of money) warn that it’s going to get even worse!

This other guy who has made a ton of money also warns it’s going to get way worse.

Despite this obviously terrible bear market that could potentially get more terrible, I bought a foreclosure through the auction that I will most likely fix up and rent. Foreclosures are risky because you cannot walk the property to see its condition. They are also risky because the former owner may still be living there and then refuse to leave when you take over. 

Why would I buy something risky in the middle of a bear market when many people are predicting this is just the start of a terrible downturn? How stupid am I?

Perhaps surprisingly, I came up with many reasons why I bought the risky foreclosure despite all the noise about current market conditions. I’ll focus on a few in the hopes that it provides insight and helps you calmly navigate what could be some turbulent waters.

Reason #1 – Investing is Scary and the Future is Unknowable

First of all, investing is difficult, no matter the conditions. It’s obvious today that everybody should have been buying as much real estate as possible with 3% down from 2009-2016. What we don’t remember is how scary it looked to be buying anything from 2009-2012 without a doubt, and to a lesser extent, from 2013-2016. I bought my first duplex in 2016 and by 2017 was scared that prices were too high. I was clearly wrong until about June of 2022.

In this article I summarized some of Benjamin Graham’s wisdom about investing. The big takeaway is that investing is risky, scary, and is always a leap of faith. Nobody knows the future. Investing today based on the absolute certainty of a future outcome is ridiculous and impossible.

The people predicting all sorts of terrible outcomes might be right. Every week I read articles and listen to podcasts of people predicting all sorts of different outcomes. So far, however, not one of them has been 100% correct. None of them predicted the pandemic. None of them predicted the post-pandemic insane run-up in housing prices. Many of them were technically correct but six months early or late. All things considered, most of them are Stephen A. Smith Sportscenter entertainers and Chicken Littles.

Reason #2 – Time in the Market

If the future is unknowable, then timing the future is impossible. Multiple studies back up how impossible it is to perfectly time getting out at the top and getting in at the bottom. Being in the market is what counts.

Barring a malicious shark attack on my upcoming kayak fishing trip, I have 30-100 years left to remain in the markets. 30 on the low end for a government mandated retirement, 100 on the high end for my kids’ inheritance of my estate. Most of what I do today will be a small blip over this time horizon.

If I’m choosing to be in the markets, then I can listen to others’ opinions to help inform my own, but I won’t allow their chatter to keep me from participating. I adopt the mantra of I’m really in the field and ya’ll just Skip Bayless.

Reason #3 – Long-Term Hold

I’ve tried to internalize Graham’s wisdom that investing is scary, and understand that I should always be invested. From those two fundamental starting points, I focus instead on a minimum 5-year and maximum infinity time horizon. I can’t predict next month’s fluctuations, but I’m reasonably certain that in 10 years people will still live in the United States. If that’s true, then those people will need to live in a house.

Assuming people will still live in houses in the United States, I can project with certainty my mortgage payments and also calculate that a tenant will pay down at least a portion of my mortgage debt, thus increasing my equity. Over the 30-year horizon, these tenants will pay off all my debt if I choose to not refinance.

It is also probable that real estate values will grow by at least 4% over a 10-year time period. The Case-Shiller index averaged a 4.37% compound annual growth rate from 1987-2023. Since I’m 50% levered across my portfolio, my equity value will go up at twice the rate of this appreciation, yielding me about 8.7% returns in appreciation only. Over the long-term, I’m fairly confident I can own real estate and get an adequate return.

Reason #4 – The House Matched My Criteria

Every week I look at the MLS for new listings in my target zip code. I search for a 3 bed 1 or 2 bath cape cod that was built after 1949. I search the foreclosure auction for this same property type. I send mailers for this same property type. I’ve been doing this for over a year and have seen very few on the MLS that meet my criteria. I’ve gotten no calls from mailers. At the auction, I bid on a few properties that meet these criteria and was outbid on price. One house sold for more than $30,000 what I was willing to pay.

Because I know exactly what I want it becomes easy to take action when it shows up on my radar. Since December, the number of auction houses per week that meet my criteria has tripled. With supply ramping up this much, it seemed only a matter of time before I got something under contract. This house matched my criteria, I bid what I thought I could pay, and I got the house. In short, I have a process that I follow and that process eventually delivers a deal.

Reason #5 – The Numbers Worked

Because the numbers worked on this investment, I bought it. It’s that simple. How did I know the numbers worked? Because I followed this process and ran the numbers every week on potential rentals using updated rental income and interest rate data. With interest rates going up, the price I could pay for a house kept going down. That’s why I was outbid by $30,000 on one of the foreclosures. Somebody else might make that work, but I can’t.

My numbers are roughly as follows:

8% unlevered cash-on-cash return – If I buy the house for $100,000, I need $8,000 per year in cash flow as a minimum. The S&P 500 has historically returned about 8%, so I should get the same from a rental property without debt. This does not include appreciation.

12% levered cash-on-cash return – Leverage just means a mortgage. If I put a mortgage on the house, I should get at least 12%. Real estate is more work than the S&P 500, so I need to get a higher return to make up for this. If I get 8% unlevered, I can usually get more than 12% levered. This is tougher lately with higher interest rates.

$200 per month levered cash flow – If I put a mortgage on the house, I should have $200 per month in cash flow in addition to my 12% cash-on-cash return. Cash flow = Rental Income – Mortgage – Taxes – Insurance – Expenses – Capex & Maintenance.

For this particular house I was most likely going to buy it for cash and hold it free and clear with no mortgage. I still ran the numbers as if I were going to refinance in 3-6 months and put a mortgage on it. If I don’t refinance in 3-6 months, I’ll almost certainly refinance within two years. I need to know that the numbers still work when I refinance.

Reason #6 – Market Inefficiency and Downside Risk Mitigation

Real estate is an inefficient market, so I try to take advantage of these inefficiencies. When buying a foreclosure, the county does its best to estimate the value of the house. Once it finds this alleged market value, it begins the auction bidding at 70% of this value. Being a poorly funded bureaucracy that has no incentive to price each house accurately, the county often misprices this starting point.

I bid only on houses that I think have been mispriced by the county. Usually, somebody else has figured this out also and the house just gets bid up to a regular market price and sells. I’m in no hurry to do deals so I set my max bid at 70-75% of what I think the value is and am perfectly happy if somebody else outbids me. This protects me from downside risk, i.e. the terrible market correction that might happen.

To further protect myself from buying a total piece of garbage, I drive by the property and make sure the exterior of the house is not awful. I bid only on foreclosures that require minimal exterior work. As I said before, I cannot walk through the house prior to buying it. I have to assume a base case scenario that the entire interior is trashed and needs $20,000 worth of rehab. I can’t buy a house that needs a new roof, new driveway, new front porch, new siding, AND probably $20,000 of interior work.

My last move to try to stack the information in my favor is to find the MLS listing of when the house sold last. This allows me to see the interior so that I can better gauge a possible rehab dollar amount. Because I’m bidding only on a 3/1 or 3/2 cape cod, I basically already know the floor plan and cost of rehab. Seeing an MLS listing from 2016, however, tells me the age of the roof and mechanicals, will typically show the basement, and will show interior finishes. This helps me to estimate something like painting vs. replacing kitchen cabinets.

If I can’t find the listing then I’m bidding 60-65% of the value. If I can find the listing and like what I see, I’ll go up to 70-75% of the value. I’m sure others do this too, so it’s not like I am the only person who can see the prior condition. However, this gives me another piece of information and helps me eliminate a worst-case scenario of 40-year-old furnace, 40-year-old roof, and a collapsing basement wall. This is all to protect against a very bad downside scenario.

Here are my base case numbers:

Purchase Price: $88,000

Rehab: $20,000 of mostly interior work. Will spend $1,000 on exterior to touch up paint and or landscaping.

All-in Investment: $88,000 + $20,000 = $108,000.

Rent: $1300

Cash Flow: $1300 rent - $100 insurance - $200 taxes - $200 Capex & Maintenance = $800 per month = $9,600 per year.

Cash-on-Cash: $9,600 / $108,000 = 8.88%

ARV: Somewhere between $130,000 - $150,000. This is determined by recent market comps.

Equity:

Low end: $130,000 - $108,000 = $22,000

High end: $150,000 - $108,000 = $42,000

Reason #7 – Multiple Ways to Win

Reasons 5 and 6 lead in to reason 7. If I’m correct in my prior assumptions that the county has mispriced the house, the exterior does not require significant upfront work, and I’m actually buying at 60-70% of market value, then I have such a great deal I can win in multiple ways.

Best Case Win

I buy the foreclosure and the old owner is still there and has taken care of the inside. I evict, clean, paint, add some carpet and appliances for $5,000-$6,000 and rent to a new tenant for $1300 with little to no work. Base case numbers are the same except I’ve spent only $6,000 on rehab and my all-in investment is $94,000. Cash-on-cash is $9,600 / $94,000 = 10.2%. My equity is +$14,000 from my projections. I’m still all-in for 70-75% of the value, have tons of equity, spent less on rehab than I penciled in, and have a higher cash-on-cash return than I forecast. Super big win.

Middle Case Win

I buy the foreclosure and the interior needs the anticipated $20,000 of work. I rehab and sell right away if the real estate market is still tight. I bought for $88,000 + $20,000 rehab = $108,000. I sell for $130,000 (lower bound of my ARV) and net about $15,000 after fees and carrying costs.

This is a great return but I like to buy-and-hold. This is just to show I can exit in a different way and still make a profit.

Middle Case Win #2 – My Base Case

I buy the foreclosure and the interior needs the anticipated $20,000 of work. I rehab and rent to a tenant at $1300. I bought for $88,000 + $20,000 rehab = $108,000.

I do not put a mortgage on the house. My cash flow is $1300 rent - $100 insurance - $200 taxes - $200 Capex & Maintenance = $800 per month = $9,600 per year. $9,600 / $108,000 = 8.88% cash on cash.

The house’s value is somewhere between $130,000 - $150,000 so I also have $22,000 - $42,000 of equity built in. Prices could go down 20% and I still have positive equity.

High Rehab Bad-Case Win

I buy the foreclosure and the interior needs $40,000 of work. This is basically impossible given the square footage. That’s why my base case is $20,000. For the sake of argument, however, I’ll look at the $40,000. My rent and expenses are the same as before ($1300 rent - $100 insurance - $200 taxes - $200 Capex & Maintenance = $800 per month = $9,600 per year) except now my cash flow is divided by $128,000.

$9,600 / $128,000 = 7.5% cash on cash.

The house’s value is somewhere between $130,000 - $150,000 so I also have $2,000 - $22,000 of equity built in. My cash-on-cash is just below what I want unlevered, and my equity position is razor thin to actual market prices. Prices could go down 20% and I might lose positive equity. I don’t care too much about equity unless I’m trying to refinance.

Worst-Case Win

I buy the foreclosure, rehab for $20,000, and rent to a tenant at $1300. My cash flow is $1300 rent - $100 insurance - $200 taxes - $200 Capex & Maintenance = $800 per month = $9,600 per year. $9,600 / $108,000 = 8.88% cash on cash.

High interest rates cause the market to drop another 20%. My $130,000 - $150,000 ARV is now $104,000 - $120,000 so I’m at breakeven essentially. If I refinance at 80% LTV (20% down payment) I can pull out $83,000 - $96,000. This is almost exactly where I would be if I had done a traditional buy-and-hold rental with 20% down. At this point, I’m not refinancing because it would be a bad deal. I’ll keep my cash in the deal and refinance when rates go down and values go up.

If the market drops 20%, then let’s assume my rents drop also from $1300 to $1100. My cash flow is $1100 rent - $100 insurance - $200 taxes - $200 Capex & Maintenance = $600 per month = $7,200 per year. $7,200 / $108,000 = 6.6% cash on cash. This is pretty low. However, I’m still getting $7,200 per year, which is my groceries or two nice vacations or a third of what I need to buy another house.

I have no mortgage so I have zero foreclosure risk. I can easily pay the $300/month taxes and insurance if I can’t find a tenant or the tenant stops paying me. I’m also confident that rents and values will go back up soon. My worst-case win is really a short-term setback that will right itself in a couple of years.

Reason #8 – I Might be Really Dumb

Like all investments, I won’t know how I did until a few years from now. I have to include the possibility that I’m an idiot and my stupidity is actually why I bought this house.

In Conclusion

Earlier I said we can’t predict the future. However, I think we can have a pulse on the market and can see changes. This is why I still read articles about the market and listen to podcasts about the market. When what I’m seeing dovetails with what I’m reading and hearing that others are also seeing, then I feel confident about what might happen in the next 6-12 months.

Based on my observations and intuition, I think I can buy this house, rehab it for a reasonable amount, rent it for market rents, and refinance sometime in the next two years to pull out equity to BRRRR into another deal.

I’ll post updates to let ya’ll know what happened.