Some of you may have noticed a drop in my postings over the last two weeks. The driver behind this has been mid terms. For those of you who don’t remember what that was like when you were in school, imagine doing all of the work you do in a typical month in a week. All of my studying got me really thinking about this issue of theory vs. practice. One of my pet peeves about most educational experiences is that there is too much theory and not enough practice. Worse yet, many of the theories do not work in practice. I thought I would spend some brief time outlining a few higher level theories that work and their implications in practice (don’t click away, I promise there is good practical knowledge to come).
Theory #1: Most markets tend to have a natural vacancy rate and there is a mean reversion tendency if prices get too high or too low. A lot of very complicated math proves this out for most markets
Practice #1: Most markets tend to stay at a certain vacancy rate. If the level of vacancy gets too high, rents come down until the natural vacancy rate is achieve. If vacancy gets too low, expect prices to increase until this vacancy rate is achieved.
How can the investor use this? Take a look at the historical vacancy of a market. If you are technically literate a simple chart will give you an idea of the natural vacancy rate. If you are not, you can probably simply eyeball it and be close. Try to buy when vacancy levels are above the natural vacancy rate. Properties will be cheaper and you will experience appreciation by simply waiting for the market to correct itself. This is a simple strategy that really works in practice. Smart buying can keep an investor in profits in an up or down market. This point is an interesting twist on buy low/sell high. Essentially buy vacant, sell full.
Theory #2: Interest rates affect cap rates directly and indirectly. As interest rates rise, cap rates rise and property values fall. Additionally, apartment rents tend to increase because demand for apartments rises. Again, lots of math behind this, so trust me on the theory.
Practice #2: Many investors are very fearful of interest rate increases. However, if you have diversified your property types or if you are an apartment investor, increasing interest rates should decrease your vacancies and allow you to do some rent increases.
How can the investor use this? Look at apartments as a nice hedge against small increases in rates. While cap rates will rise, this will be offset by a higher NOI due to the lower vacancy and higher rents. Additionally, make sure as your vacancy declines you take the time to increase rents. Otherwise you may miss out on this opportunity. A good investor knows how to profit in just about any market (no one wins during times like 9/11). Understanding how macro factors affect your investments can help you better diversify and profit in good and bad times.
Theory #3: A rational investor should make investment and financing decision separately. An investment should make since regardless of financing because financing is simply a numbers game designed to profit maximize for an individual. There is a lot of research to bear this out as well. A lot of people will probably object to this, but this is a theory that I really believe in. Feel free to battle it out with me in the comments section.
Practice #3: Investors should never invest in a property for any other reason than that piece of property is a good investment.
How can the investor use this? Simply be rational. This problem affects a lot of investors trying to do a 1031 exchange. They get so concerned with finding a property to qualify that they lower their investment standards and make poor decisions. Simply saving on taxes cannot give you a return on investment. For those of you, who may have missed the comments on the Five Mortgage Tips article, check them out for more conformation. Financing is a tool of investing and should be treated as such. Tools are great for building a house, but they are no substitute for a good solid foundation.
Hopefully if you stayed with me, you got something out of this article. I have essentially spent a year and a half trying to glean as much practical knowledge as I can out of the many theories that are thrust upon me daily. Real estate, more than most industries, is a practice business. You can learn the majority of the business by trial and error, ask Donald Trump and others. There is some value to theories (especially in down markets); however, if they can be boiled down into practical and applicable knowledge.
Here is a bonus for making it to the end.
Theory #4: Investors should buy properties based on stablized Net Operating Income (NOI). This is essenitally a continuation on the first theory.
Practice #4: Investors should investigate what the normal vacancy is an be willing to pay that price (NOI/Cap Rate). Dont let up markets fool you into paying too much for a property. Just because a property is 100% full when you buy it, does not mean it will stay that way. There should be some discount to the expected long term vacancy. I have personally seen a lot of people pay way to much for a property, only to see their vacancy rate rise and property value decline. The reverse of this is true as well, but most people who list their property dont take this into account. Many people listing with higher vacancies dont think about the natural vacancy rate, and if you are a buyer of the property, I would not suggest you point them to this article.
Brian Brady says:
I hate to repeat myself, Michael, but will do so for your benefit:
Astounding! Your have the gift of making the B-school stuff sound like a barbershop conversation.
March 9, 2007 — 11:47 am
Sharon Simms says:
Michael, thanks for giving us the benefit of all the $$ and time you’ve spend on your education – and distilling it as well.
March 9, 2007 — 12:20 pm
William J Archambault Jr says:
Michael,
I followed Brian Brady’s link from Active Raine to you. When Brian speaks so highly of someone, he’s either related or they are truly great. The article is great, so you’re probably not in Brian’s will.
Can we discuss it?
Theory # 1, is simply the best expatiation of the subject I’ve seen. All to many “investment salesman” show a property before they have analyzed the numbers with their buyer, and then, assuming we represent the buyer not the seller, we have to ask “what makes you think you can do so much better than the market average?” The answer normally is “it’s full now and I’m a better manager than the seller!” Your theory and practice take the personal aspect out of the argument! I love it, well said!
Practice # 2, requires no comment. Well said.
Theory # 3. Your first sentence bothers me. I’m not sure we have any differences, but I can’t be tell. Personally, when I teach “Captialaziton” people always ask “what is the “cap rate?” I believe that each investor has to develop their own rate for each investment. I start with a “Safe Rate, like the guaranteed loss available on a “CD” then I add to it for management (the investment not the property, that’s included in the NOI) and risk. I then blend this proportionally with the annual loan constances of available financing, this gives me a way of determine the value of the investment to me. I can’t separate the available financing from the property.
Traditionally NOI does not included financing and personal taxes. Two properties that both “cap” at say 7.00% will not produce even similar returns if the financing differs! Tax rates and depreciation allowances are not what they use to be or may become, but they remain a huge consideration to the high income investor.
One caveat if the investor is looking at a “sweetheart deal” he must also look at the financing available for an eventual resale.
Theory and Practice # 4. Excellent advice.
As you finish your MBA and I’m sure you will, with Honors, don’t forget how to sell a 2% return. The better you get at crunching numbers the easer it is to forget we’re in the people business. It does no good to find the perfect investment if your client can’t have it.
Bill
William J Archambault Jr
The Real Estate Investment Institute
http://www.reii.org
March 9, 2007 — 3:12 pm
Ed says:
So what is the situatio in terms of vacancy now with regrds to #1? I’m not a real estate agent, just an interested party
March 9, 2007 — 3:26 pm
Ed says:
and also obviously someone who can’t type very well heh heh
March 9, 2007 — 3:27 pm
Jeff Brown says:
Michael – First, I agree with Brian. Great job.
> A rational investor should make investment and financing decision separately. An investment should make since regardless of financing because financing is simply a numbers game designed to profit maximize for an individual.
I’ve had to pass on many growth based investments due to the financing. Just because the investment is solid on its own, doesn’t mean it is separate from the financing needed for it’s acquisition. If available financing requires an increased down payment, I often walk away. The reason? If I”m there for growth, the difference in the actual capital growth rate of a particular property is retarded by 50% just by increasing my down payment from 10 to 15% or from 20 to 30%.
At that point the financing has virtually assassinated the deal. Yet the property is still a solid investment.
When investing purely for growth, looking at financing separately can waste a lot of time. By the time you’ve figured an area out, you know a good from a mediocre investment property when you see it. Not knowing whether the numbers work with the necessary financing/down payment, is asking for a lot of frustration.
March 9, 2007 — 3:32 pm
cebu real estate says:
are you a realtor sir ? how do i become a realtor ? im in cebu and im planning to make a cebu real estate company or ealty , but what are the things i need to learn first ?
March 9, 2007 — 7:52 pm
Michael Cook says:
William,
From my perspective a cap rate should be the blend expected return of debt and equity (weighted average return to both). Typically, cap rates are seller driven, but buyers can certainly choose where they want to buy. If you are comfortable buying 4% cap rate properties, then those are the markets you choose. Keep in mind that the return does include risk. Lower cap properties have far more stable income and are more likely to experience higher rent appreciation.
Comparing rates on cds is actually a good start. Not sure if you are familar with the capital asset pricing model (capm), but it essentially helps you find the appropriate return on equity (one half of cap rate equation). Since the return on debt is pretty much fixed at whatever financing cost you can get, I think you are right on the money. Keep in mind that your risk assessment will be subjective however. One mans outrageous investment is anothers dream. All that said, I think we are in agreement on Theory #3.
March 10, 2007 — 4:07 pm
Michael Cook says:
Jeff,
I think we are still in agreement. A good investment makes since both on its on and with financing. A lot of people think its ok to only have one and not the other. If you can get a bad property with good financing, many people feel this is ok. Its not as common to find a good investment that cant be financed properly, but that would also be a bad idea. Financing should be used to maximize returns.
An additional point to consider Jeff would be the Net Present Value of an investment. Sometimes an investment can have a low IRR, but still be a better Net Present Value opportunity. Growth or no growth, the higher the NPV the better the investment.
For those reading who are not familar with Net Present Value, it is essentially the total cash returned to an investment, adjusted for the opportunity cost of that cash. Essentially, if I can either invest in real estate or a cd, then my opportunity cost would be the rate of a the cd. The reason why this is important is because if you are not actively investing, your money has to be somewhere. If its under your mattress or in a savings account, it makes a certain return. The net present value shows you how much more of a return you get from investing vs. from not investing.
This is important because if you have to put more money in one investment, but you get a higher return than you could get not investing at all it is typically better to invest. If this was confusing sorry, wikipedia has a great explanation of it as well.
March 10, 2007 — 4:23 pm
Michael Cook says:
Ed,
It really depends on where you are. There are a lot of great resources for finding local vacancy rates as well as historical rates. Most of these reports do cost money, but are well worth it if you are an active investor in a market. Here is a list. If anyone knows any better sources, please feel free to add a comment.
http://www.nareit.com
http://www.costar.com
http://www.reanalytics.com
Additionally, if you are lucky enough to live near a university, many of them keep this information on file as well. I have not had much luck with local libraries.
cebu,
I am not an agent, just a real estate investor.
March 10, 2007 — 4:30 pm
William J Archambault Jr says:
Michael,
If we’re in agreement on Theory # 3, we are of a like mind!
I don’t believe in showing investment properties until a tentative offer has been accepted, because unlike a home investments should be purchased on the buyers terms. The Cap rate determined by the seller’s stated NOI and list price are of course “seller driven.” Offers should be made from the investors numbers and a blended cap rate based on available financing and the buyers perceived needs. Investors should never fall in love with a property. If the seller will not sell for the value the buyer sees there are always more properties.
Bill
March 13, 2007 — 1:49 pm
Fred Bullard says:
Great article. Simple explanation of complex theory.
January 18, 2008 — 6:48 pm
Sue says:
Excellent article, very informative. I’m going to send it to several “young” investors. I really enjoyed reading this and learned something…thanks Michael!
June 4, 2008 — 7:16 pm
Taylor's Mom says:
Imagine that, great information at no charge… I’m certain many of your readers have paid handsomely for less. I am new to real estate investing, as a matter of fact I just began the John Beck program. My initial focus will be deed sales on a national level,what are your views on this avenue?
September 2, 2008 — 5:53 pm
Alex Reo says:
Paying attention to rental market helps to. No sure how other areas are doing but here if you can get your mortgage to be below your rent buy it. Oh yeah short sales, if you have the time are a pretty good way to get a good deal.
September 15, 2008 — 11:56 am
Sue says:
>>Oh yeah short sales, if you have the time are a pretty good way to get a good deal.
I imagine they can be a good deal..take a long time to get to closing and lots can go wrong…this is just from what I understand. I have yet to be in a position to do a short sale. However, things are changing daily in my area.
September 23, 2008 — 7:27 pm