Perilous Times for Real Estate
June 30, 2005Speculative residential real estate investing, including the requisite discussions of whether or not values have reached an unsustainable “bubble” level, has become the hottest financial news of 2005. Super-hot markets in Florida and California have seemingly doubled over night. Stories abound of investors “flipping” properties and making tons of money in just a few short days or months (eerily similar to the day trading phenomena of the late ‘90s). And nobody wants to miss out. Flying home from Detroit several weeks ago I sat next to a woman who runs a business in Atlanta. She told me how all of her excess cash is being invested in Florida real estate (ten properties, highly leveraged) where apparently after a few weeks of diligent research she is an expert on property values up and down the coast. Aside from wondering how she can run what sounded like a very successful, non-real estate business and still know so much about intrinsic property values 500 miles away, our conversation started me thinking about how much financial pain may be in the offing for those who lack experience and a proper perspective on real estate investing. Consider the following three major signs of trouble if you or someone you love is being wooed by the siren song of quick profits:
1. Trouble if rental income does not come through. According to the National Association of Realtors, second home sales rose 16.3% in 2004, and investors purchased almost one fourth of all homes sold in 2004. Undoubtedly a factor in the decision was the prospect of rental income covering the carrying costs of the property (mortgage, maintenance, taxes, management fees). Combine the “new investor” mentality with all the literally new rental property construction and we may see dramatically higher vacancy rates. If the cost of carrying your real estate cannot completely be met by rental income, trouble is coming.
2. Trouble if you paid too much at the end of the current cycle. As with any investment, the price you pay determines how much profit you will make. Many real estate investors today expect dramatic gains in the future to cure an inflated purchase price. The truth is that even if growth rates in a particular market continue at an unusually-high 7% per year, if you overpay by just 15% at the top of a cycle, it will take over three years just to break even from an investment standpoint (counting .8% annual real estate taxes and 6% closing costs at sale). And that assumes no borrowing at purchase! If you are purchasing real estate in superheated markets and expect substantial gains on a sale in the next several years, trouble is coming.
3. Trouble if a downturn catches you over-extended. According to The Washington Post, foreclosure rates rose in 47 states in March, and the rates in Florida are more than twice the national average. At the same time we are hearing more stories of folks actually borrowing on their main home to put money down on a second home which then also has a mortgage. Increasingly these are interest-only loans where no equity is built up except through anticipated market gains. Consider this — in 2001 just 1.6% of all new U.S. mortgages were interest-only. In 2004, that number was a staggering 31% (Fortune, 5/30/05). Interestingly enough, the last time interest-only loans were this popular was back in the 1920’s. The massive property foreclosures caused by steep value declines during the Great Depression were the impetus for the modern standard amortizing mortgage. The other major risk (sometimes coupled with an interest-only loan) is the adjustable rate feature which works great until rates start moving up. If you need to take on significant investment debt at interest-only or adjustable rates to make the cash flow work, trouble is coming.
Figure 1 illustrates the number of years to breakeven and the annual return on investment in a medium case scenario where the buyer paid 15% more than the property was worth but values continue to grow 7% per year. The property cost $400,000 of which 90% was borrowed on an interest-only loan at 4.5%. We have assumed the interest rate goes up .5% per year and that closing costs on the eventual sale are 6%. The analysis assumes that rental income is exactly enough to zero out the carrying costs of the property except for real estate taxes at .8% and the mortgage interest. Note that in this case (which does not assume a market downturn) it takes over 6 years for the investor just to break even, and the overall compound return on investment for ten years is unspectacular at best.
Real estate can be a fine investment for those with experience, patience, and financial strength. Considering the dramatic increase in values over the last several years, buyers today may be sorely tested on all three measures. Prudence calls for a careful analysis of each assumption in your real estate purchase with particular attention paid to your cash flow position if interest rates rise, rental income declines, and/or property values stall.
