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posted on 27 August 2016

Buy When There's Blood In The Streets - Part 2 Of Not The Best Time In History To Invest In Real Estate

by Lee Adler, Wall Street Examiner

Last week I began to show why now is not the best time in history to invest in real estate, rebutting a column posted August 22 at Dow Jones Marketwatch.

In fact, the headline

This is the best time in history to invest in real estate

reminds me of the times when extreme headlines like this have marked major turning points in markets. Perhaps the most famous was Business Week's cover story, "The Death of Equities," in 1979. That was near the best time to buy stocks in my lifetime.

More recently and at a lesser scale, we have the example of the widely publicized piece by Jason Zweig of the Wall Street Journal proclaiming "Let's Be Honest About Gold: It's a Pet Rock." That was in July of 2015 when gold was near its bottom in the $1100 range. It has been among the best performing asset classes since then.

The headline on the Marketwatch piece has a similar feel. It may well mark a major turning point in the multifamily rental investment market.

But I'm not here to argue that. I simply want to show that the headline and the arguments that Reeves puts forth in support of it, are just wrong. Far from being the best time ever to invest in rental property, the fundamentals are atrocious. It's a market that has been rigged by the world's central banks.Ever cheaper financing has pushed multifamily housing prices into the stratosphere, and pushed capitalization rates into the sub-basement of history. This is where the real estate bogeymen live and thrive. If you go there, they will eat you alive.


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Mortgage Rates, Rents, and Multifamily Housing Prices- Click to enlarge

Click here to view image.

The uptrend in multifamily housing prices isn't about improving fundamentals. It's about central banks constantly making real estate financing cheaper and cheaper, not to mention easier. The chart above shows that as money has gotten cheaper, virtually all of the gains in real estate prices can be attributed to the value of the financing. The market is completely at the mercy of a rise in mortgage rates. Certainly there's an argument to be made that the Fed would never allow that, but would the assumption that mortgage rates would never rise be a prudent basis for investing today?

If the day ever comes when they decide to stop driving up the prices of income producing assets, the double edged sword of leverage inherent in real estate will turn from a profit maker, to a killer.

I covered some of this in the piece I posted last week. Now let's get to specifics on a few of the points in the Marketwatch post.

First the author says that the general real estate environment is "quite good" because prices are rising, new home sales are at their strongest level in 7 years. Then he notes that critics (like me) might note that such conditions were present during the bubble. He argues that Realtor.com says it's not a bubble because "conditions" are different now. I pointed out in Part 1 the problem with using Realtor.com to support the bullish view. Realtor.com is the online marketing arm of the Realtors' housing market cartel. It's also a subsidiary of News Corp., which also owns Marketwatch. So there's a built in conflict there that wasn't disclosed.

The author points out that housing starts are only at half their level of the top of the last bubble. But he's not talking about the whole housing market when he says now is a good time to invest. He's talking about the rental market, which is more precisely the multifamily market. Multifamily housing starts are at a 28 year record, well above where they were at the peak of the housing bubble. And they are still rising. Record and growing supply is typically not a healthy environment for investing. That's especially so when rents are rising faster than household incomes, a condition that's been under way since 1999 and has been recently exacerbated as rents soared and incomes didn't.

Multifamily Starts and Rent to Income Ratio - Click to enlarge

Click here to view image.

Today we have record new multifamily housing supply and record low rent affordability as rents soar faster than household income. Does that sound like the kind of market that's a good investment?

This market is now 7 years off its low. The last housing bubble lasted about that long from its base to its high. This does not look like a great entry point, and is clearly not the best ever.

The next point the author, Jeff Reeves, made was that foreclosures are low.The problem with this logic is that low foreclosure rates are consistent with market tops. They are inconsistent with bottoms, or even good market entry points. Foreclosures were very low in 2006 when the housing market peaked. They were high when prices bottomed.

Then he makes the point that Las Vegas, Miami, Tampa, and Orlando are not back to peak bubble levels. That may be true, but it doesn't make this a good entry point. First, on the basis of the national median sale price of all homes sold by NAR members prices have reached new all time highs, exceeding the 2006 peak by a couple of percent.

While prices in former bubble markets have yet to exceed their 2006-07 highs, the price inflation in those markets since 2011 has nevertheless been astounding. The days of rapid housing inflation are probably finished, again because prices, and yes, mortgage payments are outrunning household income.

Former Bubble Market House Prices- Click to enlarge

Data Redfin.com - All MLS listings sold

Click here to view image.

If you think those numbers are impressive, consider that's for all MLS listings. Just looking at condo sales, the numbers are even more astounding. Miami, up 143% or 28% per year. Tampa and Orlando, both up 121% or 24% per year. Las Vegas up 96% in 4 years, again 24% per year. I'm sorry, but gains of 24-28% per year over 5 years only happen in bubbles. This is an echo bubble. It might have another year or so to run. It might not. You pays your money and takes your chances at this point. The risk reward equation isn't to my liking. But be my guest. It's your money.

Likewise new home sales prices have reached all time highs, 20% above the bubble peak. July new home sale prices actually peaked last year. They have been flat since then. The market has reached the limit of affordability as builders have built and sold more houses in a higher price range. This is another warning that the market generally is closer to a top than a good entry point.

New Home Sale Prices - Click to enlarge

Click here to view image.

The Marketwatch piece next makes the point that new online real estate investing tools make it easier for Joe Sixpack to become an absentee landlord. Great idea. You too can be a partner/landlord of a property you have never seen, in a neighborhood and city you know nothing about, with an investment of as little as $5,000! And we'll only charge you 4% percent/year for the privilege. And this doesn't even consider the soundness of the conduit you are using to make the purchase. How sound is it as the custodian and manager of your investment. Can you even get access to that information. At least with a REIT from a well known investment manager, you have some prospect of business continuity. With these new online crowdfunding websites, what assurance do you have?

I just... I mean... I can't.

But I looked at one of these "tools." It featured single family "investments." I tried to think of a place where price inflation on a "single family investment" is virtually "guaranteed." The first place that came to mind was the Upper East Side of Manhattan. I know that neighborhood pretty well. I lived there at one time and I have friends who live there now.

I picked a listing on the north side of 73rd Street between First and Second. I think that's Lenox Hill. Asking price is $500,000 with a quoted cap rate of 1.47% for a 400 square foot condo in what appears to be a typical Manhattan brownstone 5 or 6 story walkup. God knows what the assumptions were on that cap rate. But hell! 1.5% on an investment with NO RISK! I think I'll just jump all over that!East 73rd Street Manhattan

The next point of the article was that financing a real estate investment today is easy! I'm done with sarcasm for now. Let's just just say that easy financing is not a hallmark of great times to invest.

The final point of the post is that there's been massive growth in investment in "alternative assets," of which real estate is the largest. Need I mention that when something becomes so popular and easy that "everyone is doing it," that that's typically not a good time to buy?

Reeves finishes this load by backing off the contention that this is the best time ever to invest in real estate. But he thinks that there is strength in diversification and that your portfolio should include everything from TIPS to gold, to small cap biotechs, and hell, with investing in anything today risky and likely to generate low returns, why not a little real estate? I guess he's not into preservation of capital. I suppose that holding cash in an environment that's fraught with risk just isn't sexy enough.

I know a few people that have made a lot of money in real estate. They all had one thing in common. They made it their full time job. They worked at it every day. They bought low, and mostly never sold, using their own skills to enhance the value of their properties over time. The always bought the cheapest properties they could in the softest market conditions, and in up and coming locations, with obvious reasons for that to be so. This is not what Reeves is recommending. He's recommending easychair, absentee investing via a few computer mouse clicks.

Easy come, easy go, I say. I saw a lot of dilettante real estate investors lose everything even in neighborhoods they knew something about. They're typically people with a lot of cash burning a hole in their pocket. Today, that means at least $150,000-$200,000 to buy anything decent with 75-80% commercial mortgage financing at 4 to 4.5%. The problem is that cap rates in the best locations are no more than 4 to 5% for solid multifamily properties. There is just no margin of safety.

As for single family properties, they can only be bought and financed with negative cash flow. That's the biggest no-no in real estate investment. It bases the purchase on a pile of rosy assumptions that typically never come to pass.

Even a 5% cap rate leaves no margin for error. Leverage cuts both ways, and real estate provides both operating leverage and financial leverage. Any slight uptick in interest rates will instantly wipe out most or all of your equity. Your greedy banker will be standing by to snatch your property out of your cold sweaty hands at a moment's notice.

Likewise your net operating income can be adversely affected by economic softness which would cause rents to fall, and/or vacancy to rise. Inexperienced investors rarely take into account that buildings depreciate. If not aggressively maintained they depreciate physically. They depreciate functionally over time as styles and tastes change in the marketplace. Inexperienced investors almost never budget enough to account for these long term costs. And if they do, some other idiot won't, and will overpay for a property that you want. You end up in a bidding war with an idiot. Don't be a bigger idiot.

This is particularly true when pundits are telling millions of small investors that this is the best time ever to get into the market. That alone is enough to almost guarantee that it's not, and that it's more likely to be a terrible time to invest.

Worst of all, neighborhoods sometimes deteriorate. This is called economic obsolescence. That's a disaster when that happens. Unlike with physical and functional obsolescence, you can't spend your way out of this one. Your equity will disappear and there will be no way to recover.

To have a successful real estate investment, you must buy low. You must be able to recognize upside potential in neighborhoods. You must be able to identify properties that are underrented, with real potential to increase rents with smart improvements. You must be patient, investing in markets that are cheap, holding and maintaining your property for years, and investing in upgrades when called for. It helps if you can do the work yourself, or at least oversee it. This is a full time job. It can't be done from a computer, letting someone else do the work. That someone else is a pro who will skim the cream before you see a dime.

Baron Rothschild famously said in the 18th century, "Buy when there's blood in the streets." While he meant it literally, talking about war, value investors in the modern era have used it as a rallying cry to buy stocks when prices have suffered steep declines.

I saw the same thing in the real estate market. We called buyers who had cash, and were willing to use it to snap up properties in the early 1990s S&L crash, "vultures." They made fortunes.

Conversely, today there's no blood in the streets. There was from 2009 to 2011, but since then the streets have been more lined with gold than flowing with blood.

Since the 2009-2011 bottom rents have risen 20%, occupancy has risen from an all time low of 89% to a 20 year high of 93%, and mortgage rates have continued to decline, reaching all time lows. This has brought cap rates to the absurd point that 4% cap rates and bullish assumptions that would make a streetwalker blush are considered investment grade. They even use the word "investment" to label single family houses with a 1.5% cap rate. What could go wrong?

Can it get any better than this? Maybe, but common sense would suggest that we are much closer to a top than a good time to buy.

In this environment, any adverse market or economic event, such as a rise in interest rates, or a recession, could wipe out your equity. There's nothing like owning a trophy property that's under water. Your banker will be happy to take it off your hands. If you don't have the financial wherewithal to keep up the payments and wait out a turn in the market, you will lose both your money and the property. Unlike a margin call in the stock market, which may leave you with a few shekels, when you lose your real estate investment you get nothing.

N-O-T-H-I-N-G!

That's the elevated risk you assume if you buy rental housing today with a few mouse clicks. Unless you are prepared to pound the pavements and do the heavy lifting yourself, and think and act like a shark or a vulture, and unless you have the resources and the will to absorb the loss of your equity while continuing to make mortgage payments, stay away from rental property. This is no time for dilettantism in real estate.

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