Tuesday, March 12, 2013

Reality and Real Estate

Are Reality and Real Estate connected?  Sometimes I wonder.  I think that at the point where Real Estate, specifically residential real estate stopped being a place we live and became an "investment", Real Estate pricing disconnected with Reality.

Of course city, state and local taxes, schools and businesses all play a little part.  Those things separate one area from the next.

The last housing bubble has been exhaustingly studied, and the problem is clear.  When Freddie Mac and Fannie Mae got greedy and joined the sub prime game, too many people who couldn't afford a home bought one.  Others used their home like an ATM and just kept taking out money because "it was worth more".  Craziest thing I ever heard.

In Texas a second mortgage was banned for many years.  I don't know if it still is.  This ban if nothing else prevents things like a complete meltdown when houses go down a point or two or interest rates go up a point or two.

They say that history repeats itself.  If this is true, we should be looking back to about 1976 when Jimmy Carter was in office and the long cycle of stagflation started.  During that era, I was a youngster, but I could see that buying homes was a way to make a lot of money and keep up with inflation.  Somehow I understood Warren Buffets philosophy of infinite returns and applied it to homes.

In simple terms, if you buy a house and have a 100% mortgage on it, and rent it out for the same amount as the mortgage after taxes (meaning a slight cash flow loss at first), then raise the rents to match inflation, two things happen.  First, you become cash flow positive in just a few years for doing nothing more than being responsible.  Now there is an observation I hadn't made before.  Second, at some point the house is paid off, you get all of your money back AND now you get free money as long as you own the property and keep it rented.

The same is true of dividend stocks.  If I buy Coca-Cola for $30 and it pays $3.00 per year in dividends, in 10 years, I got all of my money back and I get $3.00 per year for free.  This is why Warren Buffett is so rich.

So how does that make the housing market disconnected from reality?  Just like non-dividend stocks, flipping homes based on speculative price rises rather than real income adds a significant amount of volatility to the the markets.  Just last night I was discussing a property that peaked at $810,000 according to some appraiser trying to push through yet another re-finance for someone who couldn't afford it.

That property bottomed at $299,000 a little over a year ago.   It's real straight line value is about $440,000 in my book.  I look at all property just like stocks, and value it based on average returns to get a straight line value.  Many commercial investors do this.  It is when investors are willing to make a little less that prices go crazy.   Last year Zillow showed the property in the range of $265,000 to $310,000.  A year later Zillow is showing a 20% improvement.  Do the math and it won't be long at that rate to reach $810,000 again.  At 20% per year, it will take a bit over 4 years.  So do you walk away or ride it out?  That is the very question the owner was asking me.

This pattern is very similar to what we saw after the completion of the sales through the RTC or Resolution Trust Corporation when I was much younger, late 70's early 80's for those of you who forgot about the last real estate meltdown.  Last time it was called a "Savings and Loan" crisis.  This time the big banks got caught too.

The owner of the house above is trying to short sell the property and can't get the bank to budge.  Quite frankly he is a little late to the game.  With prices on the rebound, banks are inclined to wait it out.  So are investors.  When investors stop dumping prices level.  When speculators buy prices rise.  How can you tell speculators are buying?  Look at the number of homes that are purchased and are still vacant, without a "for rent" sign.  One investor in my area has announced he wants to buy and hold five waterfront homes.

I like rentals and I like dividend stocks.  I am not much of a flipper or speculator.  Just like dividend stocks that are out of favor with "the street" and yet highly coveted by Warren Buffet, there are certain types of real estate that make great rentals that speculators overlook.  When Coca-Cola makes an error, it loses 8% and recovers quickly.  When Netflix made a bad move it went from over $300 to $64 overnight, that isn't investing, that is speculating or more correctly gambling.

Yes in SoCal the speculators are back.  Eventually they will move back to Vegas, Reno, Phoenix and other areas that were headlines for empty homes just a few years ago.

If I want to gamble, I am going to the craps table in Vegas. At least I know when I lose it all they'll at buy me a drink and if I spent enough they might even let me stay the night before kicking me out.  Wells Fargo and BofA won't do that when your homes start sinking will they?

So is Real Estate connected to Reality?  I guess that depends on what you are looking at.