In a free market, a good or service is priced by determining the level of supply and demand. In an efficient market, where prices instantly change to reflect new information, the price would be an accurate reflection of all current supply and demand factors currently known and would also include an adjustment based on expected future changes in the supply & demand relationship. Interesting, you might say, but why do we care about whether the market is efficient?
In an efficient market it is impossible to "beat the market" because all information known about an asset is already baked into the purchase price of an asset. The stock market is this way, and although many will point out that so and so made $X Million or $X Billion in stocks, the vast majority don't beat the market, and those that do are typically lucky (there are some that beat the market in casino's and state lottery also). If real estate is inefficient, however, it would mean that it would be possible to beat the market by capitalizing on information not readily known to other investors. So, is the real estate market efficient, which would make it impossible to "beat the market" or is the market inefficient, enabling investors to beat the market?
In many ways it could be said that real estate is efficient. Real estate trends are tracked and broadcast instantaneously to market participants enabling them to adjust prices as needed. There are multiple real estate investment companies that are traded on the New York Stock Exchange, as well as other exchanges. These companies' values change instantaneously based on changes in information, reflecting what many would call an efficient market.
I believe that real estate is not efficient, or at least not as efficient as other asset classes. The reason for this is that real estate, more than any other asset I know of is extremely local. If you buy a share of GE stock, the value of that stock is going to be the same in Connecticut as it will be in Florida, Washington or Kansas. However, the value of a 3 bedroom, 2 bath, 1,600 square foot single family house will be completely different in those same places. You can even add in detail comparing the quality of build, proximity to transportation arteries and job centers, rating of school district, type of neighborhood, location within neighborhood, etc, etc. In short you could have a clone house in a clone neighborhood and the value would be completely different when placed in different locations. But, does that fact make real estate inefficient? Couldn't the differences between pricing simply reflect supply/demand differences or possibly other factors not mentioned that can be accounted for and adjusted in the price, such as cost of living, desirability of climate, etc?
Yes, they could be. However, efficiency refers to the speed at which the market adjusts to the new data. Since new data is coming out constantly and we're not seeing prices change instantly on our 3 bed, 2 bath properties, then clearly the price does not accurately reflect the value of the property. Again, there is a counter-argument that the list price is not the final price - that usually there is some sort of negotiation over price and the final accepted price will be reflected in the value of the property at time of acceptance of offer. However, the fact remains that the value usually doesn't change all that often.
Complicating any assessment of value is the fact that different economic factors hit different locations differently. An overly simplistic example is that should there be an economic downturn, a community with many manufacturing jobs will have housing prices decrease faster than a community with more jobs related to education. Since each piece of economic news will have a slightly different effect on a property in State A as opposed to State B, it becomes extremely difficult to accurately determine an effect on any given property. Add in the variations within State A, and then within each town within State A, then the different neighborhoods within each town and then the streets in each neighborhood - it becomes difficult quick!
Besides outside economic factors, there is also differences in taste shown in different locations. Some locations will value certain fixtures, layouts, colors, amenities more than other locations. For example, understanding that Neighborhood A, will pay more for a granite counter top than Neighborhood B is extremely useful information and highly relevant, but when considering how many variations there could be, it again becomes very complicated.
What this complication means is that there will always be opportunity for the investor who knows his or her local market. An investor who has worked/lived/played in a certain area for a period of time will get to know how the value of a particular piece of property changes. Another investor in another town will not understand those intricacies and therefore will not know to act when a favorable buying opportunity opens up.
In short, change in supply and demand are going on all the time, however, due to the vast majority of market participants not understanding the effects of that change - or even that change took place in a particular area, the people who do realize that values have changed will be in a position to take advantage. They will be in a position to exploit inefficiencies in the market.
Monday, June 13, 2011
Thursday, June 2, 2011
Housing Prices up Nationally, Down in Arizona
Could it be housing prices are heading up, finally? Well, maybe, maybe not, but good news from CoreLogic, which announced that prices nationwide increased from March to April of this year. Although still early, some good news (for those selling at least). However, the rise in prices was not uniform throughout the country. Some states were still seeing enormous price declines. Leading the list in price drops was Idaho which averaged a 15.2% price drop from March. I'd say it must be those Idaho'ans leaving the cold weather to head south but Arizona certainly didn't show much demand increase as its prices dropped by over 11%.
Although price drops seem like a bad thing, when price drops are combined with rising rents you've got an increasingly attractive investment. Combine that with record low interest rates and it really does not get any better for those who are looking to invest for the longer term. To help make my point, check out what Marcus & Millichap wrote for their 2011 National Apartment Report: (You can access the full report by registering here)
National Apartment Overview
◆ All 44 markets will post employment growth, vacancy declines and effective rent gains in 2011, confirming a sweeping recovery and expansion in the U.S. apartment sector above expectations. This year will mark the first across-the-board reduction in vacancy since at least 1990. This is driven by the release of pent-up demand in the aftermath of the Great Recession, lower turnover rates, falling homeownership and job growth.
◆ Apartment completions will total 53,000 units this year, 46 percent fewer than delivered in 2010. New supply will again fall critically short of demand, which is expected to reach 158,000 units. U.S. apartment vacancy will decrease 110 basis points in 2011 to 5.8 percent as a result, matching the decline recorded in 2010.
◆ As vacancy in 2011 aligns closely to pre-recession levels, owners will regain pricing power. Asking rents will rise 3.5 percent to $1,067 per month, while effective rates will increase 4.5 percent to $1,002 per month.
Amazing what happens when strong demand meets limited supply. The fact that you are still able to pick up single family properties in great areas for fire-sale prices is not rational! Eventually, the market will correct and those that got in now will have made a bundle, first off of the cash flow generated from holding the property and properly managing it, then later from the appreciation of the asset itself.
For a more in depth look at a property I'm currently working on, see my previous post on why you should invest in real estate.
Although price drops seem like a bad thing, when price drops are combined with rising rents you've got an increasingly attractive investment. Combine that with record low interest rates and it really does not get any better for those who are looking to invest for the longer term. To help make my point, check out what Marcus & Millichap wrote for their 2011 National Apartment Report: (You can access the full report by registering here)
National Apartment Overview
◆ All 44 markets will post employment growth, vacancy declines and effective rent gains in 2011, confirming a sweeping recovery and expansion in the U.S. apartment sector above expectations. This year will mark the first across-the-board reduction in vacancy since at least 1990. This is driven by the release of pent-up demand in the aftermath of the Great Recession, lower turnover rates, falling homeownership and job growth.
◆ Apartment completions will total 53,000 units this year, 46 percent fewer than delivered in 2010. New supply will again fall critically short of demand, which is expected to reach 158,000 units. U.S. apartment vacancy will decrease 110 basis points in 2011 to 5.8 percent as a result, matching the decline recorded in 2010.
◆ As vacancy in 2011 aligns closely to pre-recession levels, owners will regain pricing power. Asking rents will rise 3.5 percent to $1,067 per month, while effective rates will increase 4.5 percent to $1,002 per month.
Amazing what happens when strong demand meets limited supply. The fact that you are still able to pick up single family properties in great areas for fire-sale prices is not rational! Eventually, the market will correct and those that got in now will have made a bundle, first off of the cash flow generated from holding the property and properly managing it, then later from the appreciation of the asset itself.
For a more in depth look at a property I'm currently working on, see my previous post on why you should invest in real estate.
Monday, May 30, 2011
Real Estate as Inflation Hedge
The idea of this post is to follow upon my recent post regarding inflation and why I think it is likely in at least the relatively near future. Real estate is commonly regarded as being a hedge against inflation since it is a hard asset, similar to gold, silver, corn, fine art, etc. I believe there are strong reasons to prefer real estate to those other investment alternatives, especially at this point in time.
All of the above mentioned alternatives, plus many others would serve to hedge inflation risk. However, in picking between them we need to analyze what value are we paying now to hedge that future risk, what kind of income can the hedge generate for you and what happens to the value of the asset if inflation doesn't occur?
On each of these questions real estate fares better than the other alternatives.
What price are you paying? Gold, silver and commodities such as coffee and cocoa beans are hitting record highs. On the other hand, real estate has been mired in a multi-year decline in prices. As far as buying low, its a much more difficult argument to make that gold and silver are cheaper than real estate.
What kind of income will this asset produce? Gold, silver, corn, wheat are to be bought and sold. At the end of the day, either you have made money in commodities or you have lost money. If you buy too high and can't sell for a profit - you lose money! Real estate is unique in that even if you were to buy for a price that was too high and that would prevent you from turning around and selling at some point in the future there is always the possibility to lease out the property! As long as you are buying real estate that, when purchased, provides a positive cash flow, then you can't lose. If financed, worst case scenario is you rent the property out and have a tenant pay off your mortgage for you. If purchased with cash, worst case scenario is you receive a monthly payment - which can be adjusted for inflation or market conditions as needed.
What happens to asset if inflation doesn't occur? If the expected amount of inflation doesn't occur, or at worst if there is deflation, history has shown that commodity prices get crushed - in most circumstances. In the last recession we saw oil drop from a high of $147 a barrel in 2008 to a low of under $40 a barrel by 2009. Other factors played a role in the price of gold which actually increased, however, corn, wheat and other consumables crashed in late 2008 as well. Real estate which was in many ways the instigation behind the crash also did very poorly. However, again, the difference between those other asset classes is that real estate can generate income, which will mitigate price declines. Of course, the majority of people investing in real estate during the last boom weren't focused on cash flow - if you were then you are still doing just fine.
All of the above mentioned alternatives, plus many others would serve to hedge inflation risk. However, in picking between them we need to analyze what value are we paying now to hedge that future risk, what kind of income can the hedge generate for you and what happens to the value of the asset if inflation doesn't occur?
On each of these questions real estate fares better than the other alternatives.
What price are you paying? Gold, silver and commodities such as coffee and cocoa beans are hitting record highs. On the other hand, real estate has been mired in a multi-year decline in prices. As far as buying low, its a much more difficult argument to make that gold and silver are cheaper than real estate.
What kind of income will this asset produce? Gold, silver, corn, wheat are to be bought and sold. At the end of the day, either you have made money in commodities or you have lost money. If you buy too high and can't sell for a profit - you lose money! Real estate is unique in that even if you were to buy for a price that was too high and that would prevent you from turning around and selling at some point in the future there is always the possibility to lease out the property! As long as you are buying real estate that, when purchased, provides a positive cash flow, then you can't lose. If financed, worst case scenario is you rent the property out and have a tenant pay off your mortgage for you. If purchased with cash, worst case scenario is you receive a monthly payment - which can be adjusted for inflation or market conditions as needed.
What happens to asset if inflation doesn't occur? If the expected amount of inflation doesn't occur, or at worst if there is deflation, history has shown that commodity prices get crushed - in most circumstances. In the last recession we saw oil drop from a high of $147 a barrel in 2008 to a low of under $40 a barrel by 2009. Other factors played a role in the price of gold which actually increased, however, corn, wheat and other consumables crashed in late 2008 as well. Real estate which was in many ways the instigation behind the crash also did very poorly. However, again, the difference between those other asset classes is that real estate can generate income, which will mitigate price declines. Of course, the majority of people investing in real estate during the last boom weren't focused on cash flow - if you were then you are still doing just fine.
Inflation and Real Estate
Much has been made of the potential for inflation in the United States lately. Most of this speculation is due to the enormous budget deficit seen in the US, exacerbated by the multiple stimulus packages enacted during the recent recession as well as the increase in the monetary supply based on actions from the Federal Reserve. Despite this there are still many out there that don't believe inflation will be a problem in the future. I will discuss some scenarios I believe are likely to happen and how they will cause inflation to rise. I will then discuss the implications for real estate in an inflationary environment.
The US has a huge fiscal problem. Currently, we spend MUCH more than we take in as income (on the order of $1.7 Trillion for 2011). While there are multiple reasons for this (and it's probably best to not get me started) the fact of the matter is our country is nearing a point where something has to be done as investor confidence is already being shaken. The total national debt is currently over $14 Trillion dollars and this doesn't even include future obligations for medicare, medicaid and social security (although, over $4T is money the gov't owes itself in the form of social security & medicare trust funds). In the long run the US has the option of either not making some or all of these payments (defaulting) or it can crank up the printing presses and send out suitcases of cash, mafia style, to all of its creditors. I suppose the government could also cut spending to below the level of income that was raised, thereby paying off the debt little by little... hahaha, sorry, thought I would check to see if you were paying attention.
Default by the US would be very bad and would be a potentially government ending, revolutionary type moment for our country with panic and blood in the streets. Obviously, the exact circumstances of the particular default would be of huge importance, but being that as it is, given the two options, the government will lean towards printing more money. More money in the system, all other things being equal, leads to each dollar being worth less in purchasing power than it was before.
Related to the governments fiscal problems is the Federal Reserves policies regarding the money supply, particularly the responses to the financial crisis, including QE 1 & 2. Amazingly, with the large amount of money being lent out the money supply has not increased all that dramatically. Although this might be surprising at first it makes sense when you look at who the recipients of the cheap, or even zero cost money loans are - the banks and other financial institutions. These organizations have taken the money given to them from the various bail out programs and have piled into government securities. The yields aren't all that great on government bonds right now but when you are borrowing money at no cost from the government or through demand deposits, then a yield of 1.71% from a 5 year treasury bond isn't that bad. However, since this money isn't going to loans for individuals or businesses this money isn't being multiplied. In the not too distant future I predict that banks will decide that by increasing their risk tolerance slightly they will dramatically improve their profitability. It will take one bank to have an absolutely blowout quarter by offering financing on slightly more liberal terms before everyone else jumps back in. When this happens you have the multiplier effect of pent up bank balance sheets unleashed - leading to what could be a huge increase in the supply of money, leading to a large devaluation of the dollar in comparison to hard assets.
Obviously, this is a brief explanation of a couple of scenarios that could play out in the near or later future that would trigger inflationary pressure. Inflation is a topic that has been studied in great detail and there are multiple books that have been written on this single topic. Nevertheless, if I missed something or if you have a question regarding anything I talked about, leave a comment and I'll do my best to answer you.
I will post a follow up article on why investing in real estate makes sense for anyone who is expecting inflation, or who just wants to hedge against the possibility of inflation. However, in brief, real estate is considered a hedge because it is a hard asset. It's value is not tied up in dollars, therefore the change in the value of the dollar is irrelevant because the price of the asset will adjust upwardly as the dollar loses value. Obviously, there are other factors likely going on at the same time which could affect the value of real estate, namely economic activity at the time but other factors constant, inflation won't effect the value of real estate in real terms. In nominal terms, the value will increase at the rate of inflation.
The US has a huge fiscal problem. Currently, we spend MUCH more than we take in as income (on the order of $1.7 Trillion for 2011). While there are multiple reasons for this (and it's probably best to not get me started) the fact of the matter is our country is nearing a point where something has to be done as investor confidence is already being shaken. The total national debt is currently over $14 Trillion dollars and this doesn't even include future obligations for medicare, medicaid and social security (although, over $4T is money the gov't owes itself in the form of social security & medicare trust funds). In the long run the US has the option of either not making some or all of these payments (defaulting) or it can crank up the printing presses and send out suitcases of cash, mafia style, to all of its creditors. I suppose the government could also cut spending to below the level of income that was raised, thereby paying off the debt little by little... hahaha, sorry, thought I would check to see if you were paying attention.
Default by the US would be very bad and would be a potentially government ending, revolutionary type moment for our country with panic and blood in the streets. Obviously, the exact circumstances of the particular default would be of huge importance, but being that as it is, given the two options, the government will lean towards printing more money. More money in the system, all other things being equal, leads to each dollar being worth less in purchasing power than it was before.
Related to the governments fiscal problems is the Federal Reserves policies regarding the money supply, particularly the responses to the financial crisis, including QE 1 & 2. Amazingly, with the large amount of money being lent out the money supply has not increased all that dramatically. Although this might be surprising at first it makes sense when you look at who the recipients of the cheap, or even zero cost money loans are - the banks and other financial institutions. These organizations have taken the money given to them from the various bail out programs and have piled into government securities. The yields aren't all that great on government bonds right now but when you are borrowing money at no cost from the government or through demand deposits, then a yield of 1.71% from a 5 year treasury bond isn't that bad. However, since this money isn't going to loans for individuals or businesses this money isn't being multiplied. In the not too distant future I predict that banks will decide that by increasing their risk tolerance slightly they will dramatically improve their profitability. It will take one bank to have an absolutely blowout quarter by offering financing on slightly more liberal terms before everyone else jumps back in. When this happens you have the multiplier effect of pent up bank balance sheets unleashed - leading to what could be a huge increase in the supply of money, leading to a large devaluation of the dollar in comparison to hard assets.
Obviously, this is a brief explanation of a couple of scenarios that could play out in the near or later future that would trigger inflationary pressure. Inflation is a topic that has been studied in great detail and there are multiple books that have been written on this single topic. Nevertheless, if I missed something or if you have a question regarding anything I talked about, leave a comment and I'll do my best to answer you.
I will post a follow up article on why investing in real estate makes sense for anyone who is expecting inflation, or who just wants to hedge against the possibility of inflation. However, in brief, real estate is considered a hedge because it is a hard asset. It's value is not tied up in dollars, therefore the change in the value of the dollar is irrelevant because the price of the asset will adjust upwardly as the dollar loses value. Obviously, there are other factors likely going on at the same time which could affect the value of real estate, namely economic activity at the time but other factors constant, inflation won't effect the value of real estate in real terms. In nominal terms, the value will increase at the rate of inflation.
Wednesday, May 25, 2011
Different Ways to Invest in Real Estate (If you only have $5,000 to invest)
Opportunity is all around us. It is easy, especially in my stomping grounds of Phoenix, AZ, to see bargain priced property that a few years ago were "worth" double, sometimes triple what they are now being sold for. However, many, if not most people out there have a hard time taking advantage of the opportunity to buy at the bottom due to limited cash available and/or poor credit. So, what is one to do if they want to invest but only have, say, $5,000?
First option is to see if you qualify for an FHA or VA loan, in which case you would only need 3.5% or, in the case of a VA, nothing down. At only 3.5% down $5,000 could purchase quite a bit of house. Of course, most readers likely wouldn't qualify either because they own a home currently, recently foreclosed or most likely - would be using it for investment purposes only and not for their personal residence.
Second option, you can scale down the size of your investment, if you had $5,000 to put towards a down payment then that would allow you to purchase a house up to $25,000. Even in Phoenix, that won't buy you a whole lot but there certainly are houses, condos and mobile homes that can be found in that price range. In fact, returns can be very high on some of those properties but they are usually much more management intensive.
The next way to invest is to purchase equity in an existing, publicly traded company, or group of companies. If a particular geographic area and investment strategy is particularly appealing to you then you can research companies that match what you are looking for. REIT's or Real Estate Investment Trusts are publicly traded companies that invest in real estate. They are attractive to investors as they are required to pay out 90% of their earnings back to shareholders. There are also a lot of them and they encompass a variety of different investing strategies. Some invest in apartment buildings, some office, some single family housing, some even invest in land for timber.
Still another way to invest in real estate with $5,000 is to purchase tax liens or deeds. In Arizona an investor can purchase the property tax lien on a property and receive up to 16% interest annually when the owner pays off the lien. In the off chance that the back taxes are never paid back by the owner then the holder of the lien (the investor) can foreclose on the property. For more information on tax liens and how they work see my previous post on tax liens.
The last way is to attach your money to a pool with other investors. Hedge funds, private equity groups and other investment groups solicit funds from individual investors, then pool those funds to target a particular investment opportunity. Most hedge funds and private equity funds require minimum contributions in the $1M+ range, however, there are other groups that will take smaller contributions (including MCA Properties). There are many of these companies out there and some do provide enormous returns, however, some funds have lost large amounts of money for their investors and indeed, as Bernie Madoff proved, some funds are simply scams.
First option is to see if you qualify for an FHA or VA loan, in which case you would only need 3.5% or, in the case of a VA, nothing down. At only 3.5% down $5,000 could purchase quite a bit of house. Of course, most readers likely wouldn't qualify either because they own a home currently, recently foreclosed or most likely - would be using it for investment purposes only and not for their personal residence.
Second option, you can scale down the size of your investment, if you had $5,000 to put towards a down payment then that would allow you to purchase a house up to $25,000. Even in Phoenix, that won't buy you a whole lot but there certainly are houses, condos and mobile homes that can be found in that price range. In fact, returns can be very high on some of those properties but they are usually much more management intensive.
The next way to invest is to purchase equity in an existing, publicly traded company, or group of companies. If a particular geographic area and investment strategy is particularly appealing to you then you can research companies that match what you are looking for. REIT's or Real Estate Investment Trusts are publicly traded companies that invest in real estate. They are attractive to investors as they are required to pay out 90% of their earnings back to shareholders. There are also a lot of them and they encompass a variety of different investing strategies. Some invest in apartment buildings, some office, some single family housing, some even invest in land for timber.
Still another way to invest in real estate with $5,000 is to purchase tax liens or deeds. In Arizona an investor can purchase the property tax lien on a property and receive up to 16% interest annually when the owner pays off the lien. In the off chance that the back taxes are never paid back by the owner then the holder of the lien (the investor) can foreclose on the property. For more information on tax liens and how they work see my previous post on tax liens.
The last way is to attach your money to a pool with other investors. Hedge funds, private equity groups and other investment groups solicit funds from individual investors, then pool those funds to target a particular investment opportunity. Most hedge funds and private equity funds require minimum contributions in the $1M+ range, however, there are other groups that will take smaller contributions (including MCA Properties). There are many of these companies out there and some do provide enormous returns, however, some funds have lost large amounts of money for their investors and indeed, as Bernie Madoff proved, some funds are simply scams.
Tuesday, May 24, 2011
Why invest in Real Estate?
The other day Zillow came out with a report that showed another large drop in housing prices. This particular report showed an 8.2% drop in housing prices nationwide year over year, certainly demonstrating for many people that real estate is a terrible investment right now. I, myself, have talked to multiple people who think real estate might be a good investment in the future but, with the expectation that housing prices will drop further, they want to wait until prices pick up.
I believe those who are waiting on the sidelines are wrong to do so. Price declines are scary for sure but, as Warren Buffet said, "I'm fearful when others are greedy and greedy when others are fearful". Price declines have corrected to the point where they are below most rational measures of value. In many places, including my town of Phoenix, Arizona, properties are so cheap that it would be more expensive to dump all building material on dirt than to buy an existing house. Sure, prices could drop a little further but it is highly unlikely that they will drop substantially more than they already have. Anyone remember back in early March 2009? The same thing was happening to the stock market, I remember reading about and hearing so much negativity about stocks and how stock market investing was no longer a good investment. Remember how that story ended? Stocks have almost doubled from their March 2009 lows and the most beaten up stocks - the banks, are up anywhere from 2-6 times what they were trading for in early 2009.
Of course, just because the stock market came roaring back after a protracted drop doesn't mean that housing will follow the exact same pattern. Obviously, there are differences in the two asset classes and, like stocks which have seen largely diverging returns based on the individual company, real estate will recover unevenly based on geographic and specific location as well as asset type. However, as I will show in a few examples real estate is a fantastic investment right now even if no appreciation to the asset is expected. Add in some appreciation and you have an investment capable of producing annual returns of 30% for the life of the asset!
How could this be you ask? Consider a property I am currently getting ready to sell in Surprise, AZ. Selling price of this property is $110,000, with all closing costs paid by the seller. Current market rents for comparable properties (4B/2B, ~2,000 square feet) are $1,100 - $1,200. (It rented a little over a year ago for $1,050 and rents have gone up since then). Additional expense assumptions are as follows:
Maintenance allowance: $100/month ($1,200 per year)
Vacancy allowance: 1 month vacant per year
Taxes, Insurance, HOA, marketing: $1,800 per year
Annual return on investment in this case is 8.3% (will be less if property management services are needed - property management typically charges 10% of rent collected)
Not a bad investment for someone looking for regular cash payments for retirement or supplemental income purposes. And much better economics and upside than purchasing an annuity, CD or bond.
Now, lets look at the return if this investment were to be financed. Assumptions:
Purchase price: $110,000
Assumed rent: $1,150
Down payment: 20% = $22,000
Interest Rate: 5%
Term of Loan: 30 Years
Mortgage Payment: $472/month
As this example shows the investment opportunity is incredible. If interested in this property give my office a call at 480 532-7999. We should also have pictures up soon on our website www.betterinvestingre.com.
We are very interested in the long term success of our clients which is why we offer 3 years FREE professional property management for any property purchased through us.
End of quick plug
The amazing thing is that although this property is indeed a fantastic deal, we are finding amazing investments throughout the valley with similar returns. It looks like Warren Buffet might have been onto something after all.
I believe those who are waiting on the sidelines are wrong to do so. Price declines are scary for sure but, as Warren Buffet said, "I'm fearful when others are greedy and greedy when others are fearful". Price declines have corrected to the point where they are below most rational measures of value. In many places, including my town of Phoenix, Arizona, properties are so cheap that it would be more expensive to dump all building material on dirt than to buy an existing house. Sure, prices could drop a little further but it is highly unlikely that they will drop substantially more than they already have. Anyone remember back in early March 2009? The same thing was happening to the stock market, I remember reading about and hearing so much negativity about stocks and how stock market investing was no longer a good investment. Remember how that story ended? Stocks have almost doubled from their March 2009 lows and the most beaten up stocks - the banks, are up anywhere from 2-6 times what they were trading for in early 2009.
Of course, just because the stock market came roaring back after a protracted drop doesn't mean that housing will follow the exact same pattern. Obviously, there are differences in the two asset classes and, like stocks which have seen largely diverging returns based on the individual company, real estate will recover unevenly based on geographic and specific location as well as asset type. However, as I will show in a few examples real estate is a fantastic investment right now even if no appreciation to the asset is expected. Add in some appreciation and you have an investment capable of producing annual returns of 30% for the life of the asset!
How could this be you ask? Consider a property I am currently getting ready to sell in Surprise, AZ. Selling price of this property is $110,000, with all closing costs paid by the seller. Current market rents for comparable properties (4B/2B, ~2,000 square feet) are $1,100 - $1,200. (It rented a little over a year ago for $1,050 and rents have gone up since then). Additional expense assumptions are as follows:
Maintenance allowance: $100/month ($1,200 per year)
Vacancy allowance: 1 month vacant per year
Taxes, Insurance, HOA, marketing: $1,800 per year
Annual return on investment in this case is 8.3% (will be less if property management services are needed - property management typically charges 10% of rent collected)
Not a bad investment for someone looking for regular cash payments for retirement or supplemental income purposes. And much better economics and upside than purchasing an annuity, CD or bond.
Now, lets look at the return if this investment were to be financed. Assumptions:
Purchase price: $110,000
Assumed rent: $1,150
Down payment: 20% = $22,000
Interest Rate: 5%
Term of Loan: 30 Years
Mortgage Payment: $472/month
Maintenance allowance: $100/month ($1,200 per year)
Vacancy allowance: 1 month vacant per year
Taxes, Insurance, HOA, marketing: $1,800 per year
First year return on investment (cash return only - no equity) = 18.6%
First year return on investment (considering equity paydown) = 24.5%
First year return on investment (with equity and with 3% appreciation of house) = 39.5%
*These returns don't even take into account the tax benefits of mortgage interest that you would be able to take advantage of.
A quick plug:
As this example shows the investment opportunity is incredible. If interested in this property give my office a call at 480 532-7999. We should also have pictures up soon on our website www.betterinvestingre.com.
We are very interested in the long term success of our clients which is why we offer 3 years FREE professional property management for any property purchased through us.
End of quick plug
The amazing thing is that although this property is indeed a fantastic deal, we are finding amazing investments throughout the valley with similar returns. It looks like Warren Buffet might have been onto something after all.
Tuesday, February 15, 2011
Financing Rental Properties
I was talking to a friend of mine the other day and he brought up something interesting. He was interested in buying a rental property but he was worried that if he did he would have a hard time buying a home for himself in a couple years (he currently lives in an apartment and wants to stay there - for now).
Its an interesting predicament because he recognizes the incredible opportunity there is right now for investors to own rental properties, however, he doesn't want the banks to hold it against him and not lend to him when he wants to buy a home himself. As I told him - if its a good deal don't worry about not being able to qualify in the future since, if there is a positive cash flow, the effect will be minimal.
Banks typically lend based on a debt to income ratio. This debt to income ratio is calculated one of two ways - either by taking your gross earnings for the month - yes, gross earnings before taxes, insurance, 401k, etc and comparing it to your mortgage payment (including principal, insurance and property taxes). This is a simple and fairly aggressive method of determining how much a person can afford to pay on a mortgage since it uses gross income and it ignores other expenses such as credit card or car payments.
The second method takes into account the mortgage but also adds in the other expenses that a typical family would have, such as credit card payments, car payments, student loan expenses, etc. That is then divided over gross income to come up with a ratio.
The two debt to income ratios are known as the front end ratio and the back end ratio (respectively) and in general a rule of thumb is that when applying for a mortgage it is assumed that a homeowner could afford a front end ratio of up to .28, or 28% of gross income going to the mortgage and a back end ratio of .36 or 36% of gross income goes to total revolving debt.
So, how is our debt to income ratio affected by the addition of a rental property? Lets look at some numbers:
Lets say for example our potential rental property investor makes $100,000 per year, which equals $8,333 gross per month, lets also assume that investor were to purchase a house and take out a $200,000 mortgage at 5% interest and amortizes the loan over 30 years (a payback period of 30 years). The Principal and interest payments would be $1,074 and assuming another $300 in insurance and taxes that would mean that the PITI (Principal, Interest, Taxes & Insurance) would equal $1,374. Taking the PITI over the gross income of $8,333 equals a very manageable front end ratio of 16.5%. Adding an assumed $800 in other monthly debt gets us to a back end ratio of 26.1%
All in all, assuming that this investor has a decent credit score - at least above 680 and a down payment of 25% then there shouldn't be any problem getting a loan for the first house. Now we see the effect of renting out this house and buying a new house.
We will use the same assumptions as above but assume that this house is rented out for $1,500 per month - just barely producing a positive cash flow. We need to assume some maintenance and will subtract $100 per month for maintenance on the house, leaving this investor with rental income of $1,400. Next we'll perform a simple calculation to see what is the maximum that this investor could take out on another property and still fall under the .28 and .36 thresholds for front and back end ratios.
As it turns out this investor can take out another $250,000 before hitting the .28 and .36 thresholds. Assuming that this investor was happy living in a house with a mortgage of $250,000 then there shouldn't be any problem. Naturally, the investor would have to have the extra down payment and still have a qualifying credit score - at least a 680 in this lending environment.
This is just one scenario and in actuality the investor could certainly, if purchasing wisely, do much better than cash flow $50 per month. However, for purposes of this example I wanted to show a conservative guess and to show that you can indeed take advantage of the incredible buying opportunities out there and still be able to finance a personal residence.
If interested, I would be happy to send out the spreadsheet that I used to analyze the debt to income ratio for our investor friend. Leave a comment or follow my blog, make sure to include an email address and I'll send you my custom built spreadsheet free of charge.
Its an interesting predicament because he recognizes the incredible opportunity there is right now for investors to own rental properties, however, he doesn't want the banks to hold it against him and not lend to him when he wants to buy a home himself. As I told him - if its a good deal don't worry about not being able to qualify in the future since, if there is a positive cash flow, the effect will be minimal.
Banks typically lend based on a debt to income ratio. This debt to income ratio is calculated one of two ways - either by taking your gross earnings for the month - yes, gross earnings before taxes, insurance, 401k, etc and comparing it to your mortgage payment (including principal, insurance and property taxes). This is a simple and fairly aggressive method of determining how much a person can afford to pay on a mortgage since it uses gross income and it ignores other expenses such as credit card or car payments.
The second method takes into account the mortgage but also adds in the other expenses that a typical family would have, such as credit card payments, car payments, student loan expenses, etc. That is then divided over gross income to come up with a ratio.
The two debt to income ratios are known as the front end ratio and the back end ratio (respectively) and in general a rule of thumb is that when applying for a mortgage it is assumed that a homeowner could afford a front end ratio of up to .28, or 28% of gross income going to the mortgage and a back end ratio of .36 or 36% of gross income goes to total revolving debt.
So, how is our debt to income ratio affected by the addition of a rental property? Lets look at some numbers:
Lets say for example our potential rental property investor makes $100,000 per year, which equals $8,333 gross per month, lets also assume that investor were to purchase a house and take out a $200,000 mortgage at 5% interest and amortizes the loan over 30 years (a payback period of 30 years). The Principal and interest payments would be $1,074 and assuming another $300 in insurance and taxes that would mean that the PITI (Principal, Interest, Taxes & Insurance) would equal $1,374. Taking the PITI over the gross income of $8,333 equals a very manageable front end ratio of 16.5%. Adding an assumed $800 in other monthly debt gets us to a back end ratio of 26.1%
All in all, assuming that this investor has a decent credit score - at least above 680 and a down payment of 25% then there shouldn't be any problem getting a loan for the first house. Now we see the effect of renting out this house and buying a new house.
We will use the same assumptions as above but assume that this house is rented out for $1,500 per month - just barely producing a positive cash flow. We need to assume some maintenance and will subtract $100 per month for maintenance on the house, leaving this investor with rental income of $1,400. Next we'll perform a simple calculation to see what is the maximum that this investor could take out on another property and still fall under the .28 and .36 thresholds for front and back end ratios.
As it turns out this investor can take out another $250,000 before hitting the .28 and .36 thresholds. Assuming that this investor was happy living in a house with a mortgage of $250,000 then there shouldn't be any problem. Naturally, the investor would have to have the extra down payment and still have a qualifying credit score - at least a 680 in this lending environment.
This is just one scenario and in actuality the investor could certainly, if purchasing wisely, do much better than cash flow $50 per month. However, for purposes of this example I wanted to show a conservative guess and to show that you can indeed take advantage of the incredible buying opportunities out there and still be able to finance a personal residence.
If interested, I would be happy to send out the spreadsheet that I used to analyze the debt to income ratio for our investor friend. Leave a comment or follow my blog, make sure to include an email address and I'll send you my custom built spreadsheet free of charge.
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