The biggest challenge of 2014 for long term real estate investors

Sometime around the summer of 2013, the investing landscape in Houston began to change at a rapid pace. Demand soared, inventories shrunk to record levels and the Houston real estate market lit up like a wildfire.

Bank owned foreclosures, the perennial sweethearts of investors everywhere that had accounted for one in four sales just a year ago, now barely contributed six or seven percent. The few properties that banks were bringing to market were either inaccessible to investors (in favor of owner-occupants) or priced at market prices despite the need for repairs.

Meanwhile, builders started ramping up construction to complete subdivisions that had been developing at a snail pace and break ground on new communities. But as one builder told me, “after five years of increasing construction costs and stagnant prices the market was finally allowing them to raise prices”. And raise prices they did. Same subdivision, same property that had been selling in the high $140s, first went to the mid $150s then mid $160s in six months’ time. Fortunately, rents kept on rising right alongside prices so it made sense up to a point. Then prices rose out of reach.

Finally, the owners of existing homes with plans to sell started setting their pricing sights ever higher boosted by anecdotal evidence of neighbors’ homes selling in a matter of days at full price and multiple bids.

As a result of this combination of higher demand and tighter supply, we ended up with record numbers in sales, prices and inventory for 2013:

So what does this mean for investors in 2014?

After that synthesis of the second half of 2013, the knee-jerk conclusion that some investors might draw is that the “train has left the station” and the prudent course of action would be to sit tight and wait for prices to come back down to the good old 2010-2012 levels. While I understand the impulse to draw that conclusion, I think it’s misguided on several levels.

First, the idea that if we just wait it out, prices will come down in short order is based on the assumption that we are currently in a bubble that will burst soon. That couldn’t be further from the truth and here’s why. From 2008 till the end of 2012, home prices in the Houston area were pretty much flat. They didn’t go down much (like California, Nevada, Florida and the like) but they didn’t go up either. That was during the 2008 recession. In 2013, prices went up 10% for a single year after five sideways years. If that constitutes a bubble, I’m Irish. In a real estate recovery, what do you suppose prices should do? Not only are prices not going to come down shortly, but they are likely to go up some more. In fact, Forbes (among others) predicts that prices in the Houston-Sugar Land-Baytown metroplex will grow about 24% over the next 3-4 years. So waiting on the sidelines will not help but rather hurt your efforts as an investor.

Second, if you are an all cash investor that does not utilize financing, the price you pay for a piece of property is the single determining factor in how that property will perform as an investment. But for the overwhelming majority of long term real estate investors, that’s not the case. They will put down a large down payment (20-25%) but will finance the rest. For that overwhelming majority, prices tell only part of the story. The terms of their financing tell the rest.

Here’s what I mean: Suppose there is a property that you can purchase for $150k today (and finance $120k of it at 5.25%) or you could wait a year and buy the same property for $127,200 (and finance 101,750 of it at 6.75%). Do you know that for cash flow purposes, the cost of both properties is exactly the same? And here’s the kicker – the scenario where interest rates rise 1.5% over the next 12 months is a lot more plausible than the possibility of prices dropping by 15% in the same timeframe!

Third, it’s very important to understand what happens to an investment’s returns in an environment of rising prices. There are two dynamics at play – On one hand, paying more for the same stream of income puts downward pressure on cashflow returns. If before you could get 12-16% cash on cash returns, now you’d be looking at 9-10%. But, on the other hand, suppose you acquire a property for $150k in January 2014 investing $35k out of pocket in the process. If by the end of the year prices rise a modest 5%, your return on investment from that appreciation for the year is over 20%! How? Well, when you purchase the property with 20% down, you invest only 20% of the amount out-of-pocket but reap 100% of the price appreciation. Therefore, that $7,500 increase in asset value (5% of 150k) represents a return of over 20% on your invested cash of $35k in addition to the cashflow return you realized. So, the same factor that compressed your cashflow returns is the same factor that caused your appreciation returns. To be fair, cashflow returns are different in the sense that they are reaped every year whereas appreciation returns require the sale of the asset to be reaped. But the goal of a long term real estate investor is maximum cashflow at retirement facilitated by capital growth until that point. In that context, this new environment of slightly lower cashflow returns and higher appreciation returns accomplishes the same goal via a different path. 

The Biggest Challenge

That brings us to the crucial point of this article – the biggest challenge of 2014 for long term real estate investors. One Word: Supply. From where I stand, the ability to find and acquire assets to assemble your portfolio will continue to be the principal challenge for long term real estate investors this year. Over the last six months or so, my principal focus has been to find solutions for this challenge. And I am happy to report that I will be sharing some of those solutions with you in the coming posts. So stay tuned – it will be worth it.

Note:

After an avalanche of a fourth quarter and a major life event (we had a healthy baby boy in December), I have been absent around these parts for quite some time. I really appreciate that many readers have reached out and missed the regular writing. I can’t begin to tell you how much I miss it myself.  Although mildly sleep deprived (sleep is overrated, anyway), I’m back on the saddle and I look forward to the discussions on the blog. Thanks for sticking around –

Investing Architect

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