Michael Cook wrote a thought provoking post earlier entitled What Happens to the Early Worm. So thought provoking that I found my comments drifting to post length. So how about a little point/counter-point?
Michael, a very detailed and thoughtful post. I would not disagree with you that cautiousness is a safe strategy (although not always a profitable one) and I certainly do not disagree with your assessment of the people here on BHB. But I do have some other questions:
The income / price equation did not get out of whack overnight, so buyers and sellers should not expect it to correct itself overnight either.
All real estate is local and that is never more true than now. In some areas we have seen real estate go through the support level of fundamental value (that value which would allow an investor to purchase a property and cash flow). This is no different than the Dow last week. It was oversold and many companies could be purchased below their fundamental value. So are you suggesting that rents are going to decrease in these areas? Otherwise, the correction has already occurred in some areas.
You are looking at some of the best real estate agents in the business here. So when they write that their business has not dropped off, it might lead the casual reader to believe that the real estate market is not in a tailspin or even that real estate is close to a bottom. Do not be lulled into a false sense of optimism. This group is adaptable, smart and most of all well above average.
Michael, to whom are are you writing this post? If it is agents then I suggest the new market has caused an industry-wide house cleaning. Those that do not belong have seen business disappear and those that do have been rewarded; but this does not necessarily reflect a worsening real estate market. If, on the other hand, you are writing to consumers then I suggest they read you closely when you say that the top agents have found “their business has not dropped off.” It has not dropped off for a reason and would behoove those buyers and sellers to search out the agents that remain busy; again, because the market does not seem to be as bad for them.
Consumer spending is down – Much of it fear-based
Manufacturing is down and declining – As the credit crunch alleviates, this should soften
Jobless claims are up and rising – DEFINITELY A STAT TO WATCH
Housing remains weak – This begs the question
Housing inventory remains well above average – But dropping in many areas. Plus, programs like Hope for Homeowners may put a significant dent in the rate of increase of REOs
Dow Jones has dropped nearly 40% over the past six months – This is significant, as you said. But may be good for real estate. The markets can go to zero but a house is still a place to live
…decline in the stock market. This represents a decline in confidence in the global economy. This level says that investors believe business could be in for sustained economic distress
There are a couple of great articles addressing this over on Coyote Blog. Don’t Panic discusses what stock pricing represents and how it does not always address company value (especially in the comments). There is also a great graph in Good News, Really along with this summary: “(i)n fact, the current level of the stock market is screaming normalcy.”
housing still has room to decline because the historical ratio of median housing prices to median income is still too high
Past is not always prologue. I find problems with the affordability index and have discussed them here.
In the end I agree that people should not try to “catch the knife” (I was wondering if you would make use of that colorful term from the equities market). But neither should people try to time the market. I have asked this before but I will ask it here:
What do you fear more: buying now at $350,000 and seeing in six months that you could have paid $325,000 OR waiting six months for the price to reach $325,000 and finding interest rates have moved up two points and you can’t afford any home?
Interest rates negatively affect affordability much more than pricing. If you are making a long term investment (which is what real estate should generally be) then buying now makes great sense in the areas that are fundamentally sound. Just make sure to work with someone as “adaptable, smart and … above average” as the agents found here.
Michael Cook says:
I always find the best discussion in the comments, so rather than post a counterpoint post to your counterpoint post I will try to address most of your points here:
“So are you suggesting that rents are going to decrease in these areas? Otherwise, the correction has already occurred in some areas.”
I am not suggesting rents will either increase or decrease, but rather what people are willing to pay for growth will decrease. This is a function of two things: 1) Lending standards making money more costly and 2) Real estate being perceived generally more risky now than before. If Value=NOI or Rents / Cap Rate then I am suggesting that the Cap Rate part of the equation will increase and values will decrease.
“You are looking at some of the best real estate agents in the business here…”
This is a numbers game. There will always be some people buying houses. Therefore, there will always be some real estate agents doing well. As the buyer pool shrinks, the best agents will rise to the top and continue doing business as usual or even more business because their services are more valuable. This is why I suspect that the people here continue to do fair to well in this market while the average agent is doing poorly.
I think you discount my stats a bit to quickly. Consumer confidence is partly fear based, but some of it is the very real fear of future employment. Anyone working for a financial firm has a very real fear of being laid off. Anyone selling anything has a very real fear of making less this year than last year. While I will agree that some consumer confidence is media driven, some of it is very real.
Housing inventory is definitely another stat to watch. Housing prices cannot rise while inventory remains well above average. Regardless of how many new programs come on the market, if lenders are playing hardball homes will not be purchased. Even if it takes a year for inventory to get back to normal (aggressive in my opinion) that is a year that I would rather sit on the sidelines and keep my cash ready for better deals.
There are lots of ways to analyze the stock market. By most metrics, it is clear that stocks are being revalued. This radical shift in prices is a clear shift in future earnings expectations. It is clear stocks did not get riskier overnight, but the expected growth prospects have dried up. People understood that housing was driving purchasing power and economic growth. It is clear that housing will not be doing that in the forseeable future and that has shifted the growth prospects for many companies.
“What do you fear more: buying now at $350,000 and seeing in six months that you could have paid $325,000 OR waiting six months for the price to reach $325,000 and finding interest rates have moved up two points and you can’t afford any home?”
The decrease in property value (thanks for the softball on that one). I find it very hard to believe in an interest rate hike of 2%. With the economy reeling, if we were to see a hike of 2% in interest rates we would have far worse things to worry about than investments. We would be looking at the Great Depression. There is absolutely no reason to fear rising interest rates in a declining economy.
On the other hand, the fear of a 10% drop in property value like the scenario you describe above would be devastating. You would have lost 40% of your equity with no clear bottom in sight. Furthermore, in a recovery you could only expect 2-3% appreciation a year. Imagine waiting a year and having an extra $25,000 to invest. Levered up to 80% LTV that would be an extra $125,000 of value you could use. It would be unwise to risk that kind of capital in a declining/stable interest rate environment.
October 16, 2008 — 1:05 pm
Michael Cook says:
“I would not disagree with you that cautiousness is a safe strategy (although not always a profitable one)…”
I forgot about this sly gem… 😉 Real estate is certainly a longer term investment, but with leverage small losses can mean big declines in equity. Waiting in real estate is an unleveraged action. For example if I buy could buy a $100,000 house today or a $105,000 house in a year, I only need an additional $1,000 at 80% LTV (loan to value) and I only lost $5,000 in potential profit.
On the other hand if I buy today and the property goes down $5,000 immediately, I lose the whole $5,000. Levered up, I have now lost $25,000 of buying power.
That being said, I think waiting it actually much more profitable than being too early to the party.
October 16, 2008 — 1:37 pm
Sean Purcell says:
Michael,
Great comments. You could have easily created yet another post and you are right: the best discussions happen in the comments. So lets discuss!
As for rents and cap rates, lets look at this another way. Cap rate is generally understood as the expected rate of return on an investment. It can be found exactly the way you described it, but in and of itself the cap rate does not go up or down. It is simply a reflection of the ratio between value and return. I said “In some areas we have seen real estate go through the support level of fundamental value (that value which would allow an investor to purchase a property and cash flow).” In other words, the rent is covering the cost. While cap rate measures this relationship well, it has no inherent meaning. When you say cap rate will increase I believe you are saying that risk aversion has increased and people want a greater return. Historically speaking, real estate has a nice return between 6 and 8%. If costs are covered then waiting to lock in that type of return serves little purpose compared with what can go wrong to eliminate the return. Only two things would make executing this investment a “bad do”: 1)values go up to a point that rents no longer cover (which would actually drop the cap rate), or 2)rents drop and values stay the same (also a drop in the cap rate). (There is a third option: rates could increase to the degree that NOI drops – acting as a rental decrease in effect, but we’ll get to rates in a minute.)
Since I do not believe you expect values to rise, I have to ask again: do you think rents are going to fall? Why should people wait in those areas where a home has breached its fundamental value? No matter what the median income, median value is; those are simply statistical measurements. Cash flow is real.
I agree with you about the clarification going on within the real estate industry. I celebrate it even. I am simply pointing out that if a buyer or seller wants to participate, the key would seem to be finding a very good agent.
I think that consumer confidence is completely fear based. That is not to say that some of the fears are not justified; you gave some very good examples in your comment. Rather, it is a recognition that spending moves up or down based on perception of what’s to come and not, necessarily, a fundamental reason to base home investment on.
I agree with you that the stock market is being revalued and I say “it’s about time.” It has been too caught up for a while now on earnings per share rather than long term fundamentals. I hope it continues, but I doubt it.
As for inventory remaining high and prices staying flat, I agree it will take a while to work that out. But this brings us back to the final question about “would you rather”. You find a spike in rates unlikely. I find a 10% drop just as unlikely. Most of the real estate news is out there. We may see more foreclosures than expected going forward, but not by much. In comparison to the potential for new mortgage programs such as Hope, I am not overly concerned that inventory will crash prices. As a matter of fact, I see demand potentially increasing due to the credit crunch.
On the other hand, mortgage backs could certainly rise. Right now there is a disconnect between bond, note, treasuries, etc. and MBs. It is not hard to imagine MBs dropping if investors do not like the direction of the bailout. A 2% increase in the 10yr note may be extreme, but not the MBs. And speaking of rates, the government pumping money into the system is ultimately inflationary wouldn’t you agree? That would lead to bond rates increasing, as would the Fed’s desire to reload its gun as soon as possible.
I believe that all things considered, and in the right markets, the time for waiting is over. But the window of opportunity may very well last for a year.
October 16, 2008 — 3:24 pm
Tom Vanderwell says:
Sean and Michael,
If I had a lot of time and the emotional energy, I’d jump into this discussion because it’s a great one.
But alas, I’m recovering from jet lag, and don’t have the time or the emotional energy to do more than read it for now……
Keep up the good work!
Tom
October 16, 2008 — 6:03 pm
Peter Maclennan says:
Gentlemen,
I would love to see Jeff Brown weigh in on this too.
Michael, doesn’t your model leave out some of the other key reasons for investing in real estate? What about current income, depreciation, and amortization?
I think that any “investor” that buys only for appreciation and doesn’t think about current cash flow is more of a speculator. They are betting on the market going up. Granted this is one of the major benefits of leveraging into a real estate deal.
If I buy a rental property today that is cash flow positive after expenses what are the down sides? Do you foresee housing prices going to zero? If rental rates decrease, there could be a foreseeable loss. But a prudent investor would take that into consideration.
I also would like to know your thoughts on alternative investment locations. With Treasuries having traded with little to no yield in the past few weeks, there seems to be safe place for capital.
I would love to hear your thoughts.
– Peter
October 17, 2008 — 11:09 am
Michael Cook says:
Guys I would love to continue this discussion, but I am getting crushed at work. Sadly investment banks work weekends and 20+ hours a day, which is what I will be doing for the foreseeable future. I will be out for at least a week. If there are any threads left, I will try to contribute upon my return.
My main premise is what is the harm in waiting. Worse case scenario prices are slightly higher. I am still not sold on a mortgage rate increase, but if that is your fear swing away. I would bet on the same rates and better terms next year personally, with slightly reduced prices. I wish I could say more.
October 18, 2008 — 2:38 pm
Jeff Brown says:
Hey guys — I hear there’s a discussion goin’ on. 🙂
I love these kinda threads. It drives home the point that experience is what keeps me playin’ with the big boys here, as ‘Ivy’ only enters my vocabulary when out hiking. 🙂
An investor acquires income property of $1 Million. He puts down 20% at 6.5% interest. His BTCF (b4 tax cash flow) is about $16k/yr. His acquisition costs were roughly $225K or so. (And don’t say these numbers aren’t real, as I’m takin’ ’em straight from my files.)
This means he’s earning around 7,1% cash on cash before AND after tax on his money. Gee, I dunno, relatively speaking, that works for me. How ’bout you? Don’t answer, it’s a trick question. 🙂
Let’s say the investor makes $100k/yr at his day job.
If his CPA can spell real estate, he’ll easily benefit from more than the $25K/yr amount allowed by the IRC to be used against ordinary income. If he lives in CA, this will result in an approximate tax savings of $8K/yr, give or take.
That brings him up to $24K for the year in after tax cash flow on his $225K capital outlay.
Again, I dunno. Is 10.67% AFTER TAX return on your capital an OK return, while you’re waiting for the property to move up in value? Let’s say after three years, the correction has ended, and the property is now worth 2% more than he paid.
So what? What if it went down 10%? So what? In those three years he banked nearly $75,000 AFTER TAX cash. He’s not gonna sell. He’s an investor, not a naive speculator.
It’s called risk capital for a pretty obvious reason. If the real estate investor is in for the long haul, much like Mr. Buffett is and has been — then timing the market becomes far less important than getting the broad brush strokes right. If one believes we’re all gonna die, than don’t invest. If you think we’re at or close to the bottom, then invest.
Meanwhile, ask yourself: What instrument in the stock market is gonna get me a double digit after tax return without projecting one penny of appreciation to the asset itself? The best of ’em won’t keep up with inflation before tax for Heaven’s sake.
As for what was also mentioned — RE being local. There are regions which have appreciated in the last 12 months. There are projects which have sold out in several cities in the last 12 months.
Why is that? Why are lenders lending on them? Why can’t the builders build enough to go around?
This is when the congregation says, Duh, I mean, Amen. 🙂
Michael and Sean? Absolutely brilliant thread. Reading you guys is truly a treat. Thanks
October 18, 2008 — 3:18 pm