Investing in Real Estate

Prologue

INVEST IN PROPERTY NOW

Invest in property now. Or forever live with your regrets.

Listen to the wealth-building wisdom of Warren Buffett: “Invest when fear, doubt, and uncertainty grip the mind of the crowd; sell when wild hopes and speculative fever burn away reason.”

The emotional herding of the crowd allows you and me to buy cheap and sell dear. Think through that wise advice offered by the Sage of Omaha. What type of markets offer the best opportunities for future profits? What type of market alleviates risk? To answer these questions, contrast those boom market conditions of yesteryear with the potential-filled market we experience today:

1. Boom: Builders brought to market more than 2 million housing units a year.

Today: Housing starts have fallen to fewer than 400,000 per year (the lowest level of building since World War II).

2. Boom: Buyers crowded into open houses and model homes to beg sellers or builders to accept their above-asking-price bids. Sellers set prices. No matter how high, buyers willingly paid on the ill-founded assumption that any price would look cheap compared to 12 months later.

Today: A majority of potential investors and home buyers remain cautious, uncertain, and fearful. Open houses remain sparsely attended. To attract mere lookers, builders are slashing prices and doling out buyer concessions and incentives.

3. Boom: Interest rates averaged plus or minus 6 percent.

Today: Interest rates of 4.0 to 5.0 percent prevail (at least for now).

4. Boom: Inflation seemed under control as far into the future as the mind might imagine. Allan Greenspan, chairman of the Federal Reserve Board, was dubbed “The Maestro” for his then believed-to-be masterful handling of the money supply and interest rates.

Today: Trillions of dollars of deficits, government borrowings, and quantitative easing seem likely to push inflation (and interest rates) to much higher levels within the coming decade.

5. Boom: Properties sell at prices 30 to 100 percent above their replacement (construction) costs.

Today: You can buy properties at 20 to 70 percent below their cost to rebuild new.

6. Boom: Millions of buyers overborrow to purchase properties they cannot afford. Liars’ loans proliferate. Appraisers deliver any market value figure that buyers, loan reps, and sellers want.

Today: Tight credit and high unemployment lead many people to double up (or even triple up) on their housing. Boomerang kids and even three-generation households have increased to the highest levels since World War II. Loan reps and appraisers must comply with strict new regulations that inhibit collusion.

7. Boom: Most sellers can easily demand top dollar.

Today: Financial distress and millions of short sales, foreclosures, and bank REOs (real estate owned) create a ready supply of desperately motivated sellers (and lenders). Buyers—not sellers—set prices.

8. Boom: Property prices are propelled far above the amounts that rental income will justify.

Today: Market prices have fallen to the point where rental income yields from properties substantially exceed the income yields available from bonds and stocks (that is, interest and dividends). Investors can reasonably expect to achieve positive cash flows—either immediately or within a few years. Capitalization rates have increased. Gross rent multipliers have decreased. Rents are heading up, vacancies down.

9. Boom: Hundreds of thousands of new investors stretched financially and overpaid for rental properties that they did not know how to manage.

Today: Many of those same starry-eyed investors have sadly awoken to the reality that safe investing requires reserves of cash and credit, knowledge, thought, an effective operating system, and a tenant-pleasing strategy.

10. Boom: Nearly all soothsaying economists forecast blue sky prosperity without serious recession.

Today: Talk shows and financial news spew out a steady stream of gloom and doom.

[For historical perspective, recall other previous times of economic hardship such as the early to mid-1970s, the early 1980s, and even as far back as 1937—when the hoped-for Depression recovery suffered a discouraging setback (the stock market again fell more than 30 percent. Or say Texas in the late 1980s and early 1990s when the RTC (Resolution Trust Corporation) was selling masses of foreclosures and nearly all of the banks and savings and loans within the state became insolvent. Or revisit the severe recession and real estate collapse that occurred in California during the early 1990s (La Jolla houses at less than $300,000; Los Angeles condominiums at less than $100,000).

Were those so-called bad times actually good times to invest in property? No doubt about it. Investors who bought during any of those doom-and-gloom eras earned extraordinary returns for their insight and foresight. Now’s your sure opportunity to buy a winning ticket. You can match their gains. History does repeat itself. You do not need a “back to the future” time machine to return you to those past golden years.

Today when I travel and tell people that I live part of the year at my home in Florida, they predictably respond, “Florida! The real estate market there is really bad, isn’t it?”

I reply, “Bad? What do you mean, bad? You are mistaken. The Florida market today represents one of the best property markets that I have ever seen—anywhere, at any previous time. I am an investor. Relative to income and cash flows, property prices look good. Relative to risk-adjusted potential for capital gain, property prices look great.”]

TODAY’S ODDS POINT DIRECTLY TOWARD PRESENT AND FUTURE GAINS

In these seemingly bleak days of the real estate cycle, fear looms. Cash balances in banks build up. Most would-be investors and savers crowd onto a flight to quality. They accept certificates of deposit (CDs) and money market accounts that pay negligibly low-single-digit interest rates. These fearful and uncertain folks think, “Who cares about return on capital? I want to feel confident that I am protecting a return of my capital.”

In his perpetually popular book, The Intelligent Investor, Ben Graham (Warren Buffett’s graduate school professor at New York’s Columbia University) created the parable of Mr. Market. Mr. Market represents the crowd mentality whose moods swing like a pendulum from irrational exuberance to bewildered fear and confusion. Which market mood provides the best investment opportunities and possibilities? Which mood of Mr. Market lures investors into taking the highest degree of actual risk? Which mood of Mr. Market presents the least amount of actual risk?

Booms Enlarge Actual Risk

During the irrationally exuberant boom times, investors perceive little risk, but real risks loom larger and larger as prices climb higher and higher, rental income yields fall, and unsustainable amounts of mortgage debt pile up—even though rent collections remain too low to cover operating expenses and debt service.

During the boom in Las Vegas, so-called investors (actually speculators) believed that flipping properties for magnificent gains would never end. Few perceived that their property risks actually laid down poorer odds than the slots at Caesar’s Palace. And who but a fool (or Panglossian optimist) would borrow money to play the slots?

Yet, Las Vegas property buyers loaded up with dangerously high loan-to-value (LTV) ratios of 90, 95, and 100 percent (or more). They naïvely assumed that the future would continue to pay off those same jackpots that they had won in the recent past. Those thousands of Californians stampeding to Vegas thought they had discovered another Sutter’s Mill.

They did not see the fool’s gold. They did not comprehend why the growing gap between mortgage payments and rent levels could not persist. On typically purchased Las Vegas properties, loan payments (principal, interest, taxes, and insurance [PITI]) often approached $2,000 a month. Potential rents for these same properties would reach no more than $1,200 a month.

When such a huge alligator is chewing off your leg, you are in a world of danger (and a world of hurt). As I have often written, high debt, low rental income yields, and exaggerated hopes for outsized continuing increases in price (for stocks, gold, or properties) always trigger a reversal of fortune. (See especially my Value Investing in Real Estate, John Wiley & Sons, 2002.)

True, the hot speculative fever in Las Vegas (as well as Miami, Dubai, coastal Spain, Ajman, Dublin, Phoenix, and so on) does stand out as beyond-the-norm mania. Most other cities did not experience such heightened frenzy among both builders and buyers. Nevertheless, irrational exuberance fueled the manic moods and mind-sets of property buyers and borrowers throughout much of the United States and other countries (though, during the boom of late, not Dallas, Berlin, or Tokyo—each of these cities had suffered its own irrationally exuberant property market 15 to 20 years back, and sat out this...