Is Early the Same as Wrong?
Real Estate Market
In his latest piece, Wall Street Greek Real Estate Columnist Michael Douville asks if being early to invest in real estate is wrong. In fact, we remind, the early bird is first to get the worm.
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Is Early the Same as Wrong?
Warren Buffet watched US equities melt in the third and fourth quarters of 2008. The decline corrected from an overvalued equity market to an undervalued equity market, and in Mr. Buffet's opinion became a historic opportunity, as he committed his capital when the Dow was in the 8,000's. He perceived value and committed to buy when most were selling. The equities continued correcting and bottomed in the mid 6,000's; Mr. Buffet was lambasted for poor judgment and many thought he had lost his ability to distinguish inflection points in the economy. Two years later, with the Dow chasing over 11,000, he appears to have regained his genius crown.
At what point is the value of an asset acceptable to become the entry point to purchase? How long does capital sit on the sidelines earning nothing before acceptable levels of risk are established? An investment with a return of 5% net cash flow today may yield 6% in 9 months if prices were to decline, but in the intervening time, the sidelined capital earns absolutely nothing. Conversely, a longer time horizon of 24-36 months may provide rapid asset appreciation which causes the total return to explode due to capital appreciation, but increased entry price action may reduce the cash flow component yield; higher price, lower yield.
At what level of return is capital deployed? Bondholders are signaling a 3-4% annual return is adequate. The perceived low risk in the bond market is masking a potentially much higher degree of real risk that may result in actual capital loss. Money is pouring into bonds seeking safety of principal yet the housing market still stagnates years after the bursting of the bubble, which has corrected price and real risk to much lower levels. Stacks and stacks of capital are sidelined looking for return; every month, more is accumulated. When is the decision to act appropriate? In the securities industry, forecasting a possible severe decline from a potential bubble-top in bonds 3-6 months in the future can be a very long and costly 3 months; shorting bonds while the bubble is still forming can be very dangerous.
The same three-month time frame in a typical transaction involving a real estate asset is often meaningless with the investment horizon often easily beyond five years. Should an investor wait and hope that the asset price may further decline, or should an investor accept a good starting point for returns and grow the asset. No one knows what constitutes the exact low point or when is the absolute optimum time to purchase until prices have risen far beyond the bottom.
During the real estate bubble of 2005-2007, there was NO positive cash flow return on investment; mortgage payments on properties were supplemented by monthly contributions from the owner above and beyond the rent. Cash flows were severely negative. Vacancy factors, maintenance and repair escrows, and management and leasing costs were ignored as if they did not exist. There was no economic benefit to owning properties other than the possibility of future capital gains. Speculators were losing money with a plan to make it up in volume!! Cocktail party conversation revolved around owning property at any price. A negative cash flow loss of $1000/month per property meant appreciation of at least $12,000 per year was necessary just to keep even; worse when vacancy, maintenance, and management were imputed. With Voodoo Economic logic, homes sold, and sold, and sold. Everyone wanted a property. Everyone needed a property. Today things are different.
Real Estate has been decimated across the country. Some segments may be years away from a recovery. Within the asset class there are varied sub-classes such as retail, warehouse, office, multi-family, and single family homes. The last two still represent a commodity of necessity providing one of the food, water, and shelter requirements; these are on the road to recovery. Within the segments of single-family is new construction, which has been severely impacted by the competition from distressed assets being liquidated. The builder segment may be further from recovery than the broader segment of housing.
The US population grows 3-4 million net every year; absorption of excess is taking place. However, there is a lot of excess and the overbuilding supply demand equation has been tremendously impacted first by excess builder inventory, then impacted by the recession which has forced families not only to postpone housing purchases for fear of job loss or adverse business climate, but also postponed new household creations resulting in diminished demand. In addition supply has come to market from foreclosures and short sales exacerbating the problem. This excess is huge, but it is also finite and will eventually be absorbed. The resale market of homes sold in the US is typically 5-6 million units per year; any sustained economic recovery will accelerate the absorption.
There is evidence that the peak in unemployment has been reached and the recovery in jobs will positively affect excess inventory. With very limited new construction adding very little to the supply, pent-up demand and renewed household creation along with historic demographics points toward an eventual recovery. Investors are experiencing increasing cash flow and better tenant quality which reduces expenses via maintenance and repairs.
The price of entry level housing which is typically used as the core of residential rentals seems to be stable to slightly improving. The bursting of the bubble along with a severe recession has forced distressed owners into foreclosure or the short sale process. These former homeowners are prohibited from purchasing for a minimum of two years; hence the investor activity filling the void. Former homeowners have entered the rental market lowering vacancy rates, raising rental rates, and reducing maintenance and repairs due to a better quality tenant experienced with homeownership.
The perfect housing storm has created the the perfect opportunity for investors. Low mortgage rates, low vacancy, low prices, and low maintenance equals high cash flow. A forward looking strategy recognizes the penalty period for former homeowners caught in the maelstrom which is typically 24-30 months at which time the buying population will gradually shift from investors to owner-occupants… families. At this time, a mere 24 months away, half the portfolio could be sold capturing capital gains and applying a portion to reducing the debt on the remaining properties, mitigating risk.
Real estate investment has a different time horizon than a stock or bond investment. Returns are grown as the investment matures. As a farmer knows when he buys land to raise his crops: some years have bad crops; some years have good crops; some years have bumper crops; but the farmer always has a crop. The smart farmer adds to his land bank when land is cheap. Many farmers are selling their land because they fear a drought; they fear a flood; they fear a pestilence; or they just fear. Prices are good. Cash flows are good. Are investors wrong to buy now and start to grow the cash flow or are they just early!?!
Editor's Note: Article should interest investors in Bank of America (NYSE: BAC), Freddie Mac (OTC: FMCC.OB), Fannie Mae (OTC: FNMA.OB), Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), Wells Fargo (NYSE: WFC), Toronto Dominion (NYSE: TD), UltraShort Real Estate ProShares (NYSE: SRS), Ultra Real Estate ProShares (NYSE: URE), ING Clarion Global Real Estate Income Fund (NYSE: IGR), Xinyuan Real Estate Co. (NYSE: XIN), Rydex Real Estate Fund H (Nasdaq: RYHRX), T. Rowe Price Real Estate Fund (Nasdaq: TRREX), Toll Brothers (NYSE: TOL), Hovnanian (NYSE: HOV), D.R. Horton (NYSE: DHI), Beazer Homes (NYSE: BZH), Lennar (NYSE: LEN), K.B. Homes (NYSE: KBH), Pulte Homes (NYSE: PHM), NVR Inc. (NYSE: NVR), Gafisa SA (NYSE: GFA), MDC Holdings (NYSE: MDC), Ryland Group (NYSE: RYL), Meritage Homes (NYSE: MTH), Brookfield Homes (NYSE: BHS), Standard Pacific (NYSE: SPF), M/I Homes (NYSE: MHO), Orleans Homebuilders (AMEX: OHB), Vanguard REIT Index ETF (NYSE: VNQ), PNC Bank (NYSE: PNC), J.P. Morgan Chase (NYSE: JPM), Hooker Furniture (Nasdaq: HOFT), Ethan Allen (NYSE: ETH), Pier 1 Imports (NYSE: PIR), Williams Sonoma (NYSE: WSM), Home Depot (NYSE: HD), Lowes (NYSE: LOW), AMEX: VAZ, AMEX: NKR, AMEX: MZA, AMEX: NXE, AMEX: NFZ, Nasdaq: XNFZX, Nasdaq: FSAZX, Avatar Holdings (Nasdaq: AVTR), Apartment Investment & Management (NYSE: AIV), Equity Residential (NYSE: EQR), Avalonbay Communities (NYSE: AVB), UDR Inc. (NYSE: UDR), Essex Property Trust (NYSE: ESS), Camden Property Trust (NYSE: CPT), Senior Housing Properties (NYSE: SNH), BRE Properties (NYSE: BRE), Home Properties (NYSE: HME), Mid-America Apartment (NYSE: MAA), Equity Lifestyle Properties (NYSE: ELS), American Campus Communities (NYSE: ACC), Colonial Properties (NYSE: CLP), American Capital Agency (Nasdaq: AGNC), Sun Communities (NYSE: SUI), Associated Estates (NYSE: AEC), PennyMac Mortgage (NYSE: PMT), Two Harbors (AMEX: TWO).
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