Today is the last day of 2015. In a few hours, the bubbly will flow and we get to write a new chapter. That’s why this is the best time to reflect back on the year that was, learn the critical investing lessons it taught us and become better investors in the process.
Year in Review
Real estate markets across Texas entered 2015 with a lot of momentum from the previous year but one giant “elephant in the room”. Oil prices had dropped by 50% at the end of 2014 and everyone questioned how it would impact the labor and real estate markets. And nowhere were these questions as loud as in our home base of Houston – the energy capital of the world.
In “Why did oil prices drop in 2014” published here in February, I offered my take on the impact it would have on our real estate market. The central thesis of that article was that oil prices would certainly have an impact as expected layoffs would affect housing demand, but it would not lead to significantly lower real estate prices in 2015.
After a somewhat nervous start in January, the Houston real estate market didn’t miss a beat and resumed the “song” it had been singing over the last 24 months. The spring and summer seasons swept in and brought with them bidding wars, multiple offers, rising prices. Move on, nothing new to see here.
On the rental market front, it was the same story. High tenant demand, low days on market and multiple applications.
In September, official stats remained strong with rising sales and prices but in the trenches we started seeing the signs of a slowdown. Price reductions, more room to negotiate, some unsold listings. Major players in oil and gas had trimmed down their workforces by 15-20%, decimated exploration budgets and the inward migration of people coming here for work slowed. As it’s often the case with the oil market, no one really knows what will happen before the fact (although many are “experts” afterward). I suppose that after seeing lower prices stabilize and slightly rise midyear, the market and its players realized we were in for a longer slog and lower prices were here to stay.
In October and November, the official statistics reflected what we had seen for some time. Year over year sales dipped during that period and average prices were lower in November as the luxury segment of the market bore the brunt of the hit. Properties priced closer to the average price mark still posted stronger YOY sales and prices. December numbers won’t be out for another couple of weeks but they’re likely to follow the same fourth quarter trend.
After intensified calls for location diversification, Investing Architect explored the DFW market in October.
Again, the rental market followed a similar trajectory to the sales market. October and November are typically slower than the red hot spring and summer season for rentals but this year we felt it more than others.
All considered, 2015 was a fantastic year despite some of the challenges posed by volatility in oil markets. When all stats are done and counted, it will be yet another year of strong sales and rising prices.
There are 5 critical real estate investing lessons I learned during 2015 that I want to share with you now.
Lesson 1: Mama said there’d be days like this
When you invest in real estate long term, for next 10, 15 or 20 years, the one thing I can guarantee you is that there will be volatility. I don’t care which period in time you pick, it will never be a linear, sunshine and butterflies, comfortable ride. You can rest assured that there will be times when the rental market is blazing hot and other times when it’s sluggish, when vacancies are zero and when tenants are harder to come by, when values rise by double digits and when they stagnate or fall.
When things are volatile, the best advise I can give you is to trust the process and stay disciplined. Keep your principal goal front and center and don’t forget it. You will be tempted to sell and get out (when you should stick it out) and worst case you might even feel like you don’t have the stomach for it.
Stay the course. Execute.
Lesson 2: “Moving on up” – Interest Rates
December brought us our first FED quarter point rate hike in God knows how long. It was the first but likely not the last. The FED seems determined to get some “bullets back in their gun” just in case there’s another economical slowdown. After all the economy is doing better but not THAT much better. But if they don’t hike now, they won’t have any room in the principal mechanism they have to stimulate the economy.
So in 2016 you should expect a couple more similar hikes. The question I hear most often is: What effect are these rate hikes going to have on investment property mortgage rates? The short answer is: Rates will be higher but only by a fraction of the actual rate hikes. Typically, mortgage rates rise 0.25% for each 1% hike in FED rates. The first hike had more of a 1:1 impact because it was the first time the FED hiked in many years. Subsequent hikes will likely increase rates only incrementally.
Lesson 3: Value increases = Property Tax Increases
Regular readers of Investing Architect know that we are conservative with numbers. Despite the fact that in the last 36 months property prices have appreciated by 2-3 times that rate, we run our cashflow analyses assuming an appreciation rate equal to the rate of inflation (3%). Still, for existing owners of long term investment properties appreciation is the cherry on the cake also thanks to that beautiful thing called leverage.
Let’s say you purchase a property for 170k and you put 20% down. If that property appreciates by 6%, that represents an increase of $10,200 in property value. But you don’t have $170k of invested capital in the property – you only invested $34,000. So that 10,200 increase in property value represents a 30% return on your $34,000 investment. In other words, when you only invest 1/5 of the value of the asset, your return is 5x the property appreciation rate. Like I said, a beautiful thing.
But you know who else notices that your property went up in value? Taxing authorities that rely on property taxes for their revenue. They think to themselves – would you look at that, market values are up, so should property tax values.
And so, your property taxes, the main driver of operating expenses go up.
What are the real estate investing lessons? First, this is exactly why a disciplined long term investor should not engage in optimistic, best case scenario investing. If the analysis was performed correctly, there should be room in the numbers to absorb tax increases when they happen. Second, the disciplined long term investor should always pursue periodical rent increases with their renewal tenants. I know what you’re thinking – they’re great tenants, they pay on time and take care of the place – if I ask for an increase they will walk away and never talk to you again. I get that and the fact is it may not always be possible depending on the market. But it should be the investors ongoing policy to pursue periodical rent increases. Then the decisions on how far that pursuit goes can be made on a case by case basis.
Lesson #4: Greedy when others are fearful
The aggregate behavior of real estate investors is very similar to stock market investors. Both groups tend to invest heavily when the market is comfortable (read: higher) and step back when Volatility brings his old friend Fear to the party. In Buffett’s sage words, be fearful when others are greedy and greedy when others are fearful.
Volatility is opportunity. If properties aren’t selling as fast, you have significantly more leverage in negotiations with Sellers. That presents some interesting opportunities. For example, you could negotiate for the Seller to pay for closing costs thereby lowering your total investment in the property and boosting your return. Or you can make an offer below market and the Seller won’t throw it back in our face like they did 2012-2014.
Don’t sit it out. Adjust your strategy so returns reflect risk.
Lesson #5: Location Diversification
The reaction of the local economy, labor and real estate markets to substantial volatility in global oil markets reinforces our long held belief that Houston remains a strong market for long term investors. If our economy was not diversified, the impact of such a drop in commodity prices would be devastating – similar to 1980s. Having said that, investors with a strong Houston presence in their portfolio should take a look at other Texas locations as well as other similar states to bring some location diversification to their portfolios.
Location Diversification is a major theme for us in 2016. Stay tuned, or better yet (email us) for what’s to come. Hint: We plan to expand our focus to markets across Texas and other similar states in 2016.