Phoenix Real Estate Investors: Time to Take Profits

Let’s step back 4 years to a time when the “Great Recession” was in full force and Phoenix, Arizona had fallen from the #1 builder market in the United States to one of the worst MSA’s (Metropolitan Statistical Area) in the nation. The Metro Phoenix Builder Community had completed over 60,000 new homes in 2006, a record year. Builders in October 2008 had thousands of finished homes completed and ready for delivery when “The Lehman Moment” changed everything.

Phoenix Real Estate

Builders, including major companies like PulteGroup (NYSE: PHM), D.R. Horton (NYSE: DHI) and K.B. Home (NYSE: KBH), had a cascade of buyers refusing to close and their finished homes became “Specs Available,” or expensive inventory on short-term construction notes that would eventually no longer belong to the builder, but become Real Estate Owned (REO) of many local and national lenders like Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC) and J.P. Morgan Chase (NYSE: JPM). The Arizona Regional Multiple Listing Service (ARMLS) listed a low of less than 6000 available properties in 2005 to a ballooning inventory of over 59,700 properties for sale and 9800 properties for lease in late 2008. The housing industry in Phoenix was in a depression with a glut of new and existing homes.

To exasperate the problem, over 300,000 individuals working in or connected to housing and new construction left the Valley of the Sun in search of other employment. In Phoenix almost everyone was connected to housing, which included the obvious roofers and framers, but also title and escrow officers, loan officers and loan underwriters, thousands of real estate agents and brokerage houses, surveyors, and the not so obvious furniture , electronic, decorating centers, and even movers. Tens of thousands lost their jobs and most had their income severally curtailed. The loss of business was felt everywhere in Metro Phoenix. Incomes and available capital were declining while underwriting standards for new loans was rising and excluding buyer after buyer. Phoenix had crashed and was burning.

As with any commodity, the law of supply and demand dictated terms in the market place, and the over-inflated prices tumbled past fair value to in some instances 50-60% below replacement costs. As costs declined, the over-valued status of Phoenix changed to an under-valued market, and then to an extremely undervalued market. Many local business people and employees alike were experiencing the loss of income, and many local homeowners were burning through their savings and capital to pay monthly expenses. Eventually, many depleted entire nest eggs while their real estate wealth evaporated as prices declined well below mortgage values, condemning them to future foreclosure or short sale. Incomes, down payments, and then credit issues excluded many potential buyers and shrunk the buying population, further reducing demand. The cleansing process is brutal, but necessary in the business cycle, and the excesses needed to be removed in order for the eventual recovery. Prices plummeted to ridiculous levels because there were very few buyers. Enter the original courageous and foresighted investors.

Everyone knew buying real estate was a very bad idea; however, the properties were priced below cost, and if unemotionally approached, were very compelling. Further, rental rates had declined about 15%, but properties had dropped 60-70%. Although rental rates were lower, the acquisition cost was much lower. So were operating expenses including: repairs, insurance costs, taxes, and long-term mortgage rates. Rents for the now distressed and depressed properties purchased at much lower prices were cash yielding investments. The gut wrenching declines, the turmoil of speculators buying high to sell higher, and the builders and developers caught in the final capitulation doomed the average homeowner. The simple indicators of value: Own vs. Rent; the Gross Rent Multiplier; and the Affordability Indexes all shifted wildly from indicating an overbought market to a hugely undervalued one. Cash flows began to yield 9-15%.

Much of the buying public had already purchased in the frantic years of 2004 to 2007 and was trapped in underwater homes. There was a void in the buying pool. Prices and returns were exceptionally compelling as a result. My recommendation for several years has been unabashedly bullish. Investors in Phoenix have helped clear the inventory and pave the way for a fresh set of homebuyers to replace the rental homes with owner occupied. Former homeowners that liquidated their properties via the short sale process are becoming eligible once again to purchase.

As demand began to enter the Phoenix market, prices rose steadily and have recovered a portion of the decline. Many early investors have seen cash purchases double and those that assumed more risk with leverage have realized huge capital gains as well as monthly cash flows in the range of 5% on cash to over 8%+ levered. The investment in Phoenix real estate has been exceptionally profitable. It may be time to take some profits now, and those properties not sold should be evaluated for long-term mortgages.

Real estate is local; however, real estate is economically sensitive. The economy may be heading for difficult times and if the economy enters a recession as Charles Nenner and the Economic Cycle Research Institute (ECRI) predict, and as our site's founder warns is highly possible, a better buying opportunity awaits just a few years away.

A specifically aggressive, but overall cautious approach may be the appropriate theme for the foreseeable future. A good price on a good property is usually profitable, but the low hanging fruit has been picked and much of the recovery is priced in current values. Low long-term rates indicate more potential for future capital gains, but rental rates are stabilizing indicating a normalization of rental growth rates. Some properties are gems and should be kept for the long-term; marginal properties may be considered for liquidation.

In 2006, I reviewed the market dynamics with my clients and advocated selling as I believed the direction of the market was down. Enormous profits had been gained. Most did not heed my advice and in fairness, I was 9 months early to the peak. Now once again enormous profits have been gained; my advice is to take some profits.

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