Chapter 18: Isn’t Real Estate in the Dumpster?
We first acknowledged this question in the Foreword to this book. Another way to ask this question would be “Why should I invest now when the real estate market is so depressed and perhaps going still lower?” Aren’t still thousands, perhaps millions, of homes in foreclosure? Aren’t banks swamped with REOs (real estate owned)? Doesn’t that mean there is a glut of houses available?
All are valid questions and certainly deserve a serious answer. The serious answer is “Yes, but so what?” Not to be flippant, but what better time to invest than when no one else really wants to buy? Isn’t that what you’ve always been taught? You make money by being a contrarian; by going against the grain; by going against the majority opinion. Usually, when “everybody knows” something, what they presume to “know” is worthless information. It’s the herd instinct. It may feel emotionally comfortable to be part of the group, but the value of that position is practically worthless.
Consider basics for a moment. There are basically two (2) types of products available in the market: products actually needed for everyday life and products that are life-enhancing, life enriching. The first is absolutely necessary for survival while the second represents the internal desire to improve one’s lifestyle. Housing would certainly fall into the first category. People can do without vacation homes but they need food and primary housing to survive. We’re in the primary housing market.
Earlier, I challenged you to live where you want to live but invest where it makes the most sense (cents) to invest. I suggested that you not let the 50-mile radius limit your selections. Implicit in this statement is that all real estate is a local market. When you read national statistics, they are almost meaningless for investment purposes. Real estate “in the dumpster” is one of those national statistics that is practically meaningless. It affects the value of Home Depot and Lowes stock on a national basis, but it doesn’t affect the pricing of a desirable home in a desirable neighborhood. All real estate is local.
When very few buyers are “in the market for a house,” the price of houses decline. Current economic conditions, bank lending restrictions and interest rates further limit the real estate market. When these conditions occur, what happens? Don’t the prices of available housing drop? Isn’t that what you’re interested in? Don’t you want to buy “low” now and then be able to sell “higher” at some point in the future?
While we’re on the topic, be aware of just how interest rates affect the price of real estate. Contrary to general belief, low mortgage interest rates actually cause higher real estate prices. Think about that. If you can get a mortgage at a low interest rate, you can afford a more expensive house for the same monthly payment. Conversely, if interest rates rise, people can’t afford the higher priced homes and real estate prices tend to drop. Interest rates are dramatically influenced, if not totally controlled, by the Federal Reserve. As such, they always give a false indication of market prices. If they keep rates low (as at present), house prices tend to be higher than if mortgage rates were allowed to increase to what a free market would demand.
Very recently (early 2012), Warren Buffett issued a statement to the effect that if he had a way to manage them efficiently, he’d be a buyer of thousands of single family homes. What he meant was that in his opinion, today represents a good environment in which to start buying real estate. Is it the absolute low? Who knows? That is probably not even an important question. What is important is do people need or not-need housing; today as well as into the future? We’ve found a “need” and now we know how to fill that need.
In recent history, we began with what has been dubbed “The DotCom Bubble.” That was followed by the “Real Estate Bubble.” That was followed by the Banking Crisis and Crash which resulted in trillions of dollars of deficit spending that had virtually no effect on saving or improving the economy or reducing unemployment. In other words, for over 12 years, we’ve experienced one economic disaster after another. You really have to pity the poor real estate owner. How could he survive under such horrible economic conditions?
The income property owner prospered very well, thank you. How can that be?
What happens to your investment when hard economic times hit such as today? You get wiped-out, right? Wrong! You bought the property on a very stable cash-flow basis. The worst thing that might happen is that you’d have to lower your rents somewhat. We’re still working with a building for which you paid $100,000 but now, instead of $10,000 per year net operating income, you’ve had to reduce your rents by 20% (to keep your tenants). You’ve had to lower your NOI from $10,000 to just $8000 per year. Eight thousand divided by $100,000 is only 8%. Now, instead of getting a 10% return on your building, you’re only receiving 8%. Horrors! End of the world! Not! Couldn’t you live with 8% on your money for a period of time until the economy recovers and you can again increase rents? Does this lead to bankruptcy?
Maybe. It all depends on how you financed your building. Recall that we’ve already covered all the operating expenses. The only additional payment we have is the mortgage payment of principle plus interest (PI). So your financial solvency depends on how much in-hock you went to acquire this property. And this is where the real estate problems lie. All those so-called hot shots out there used so much leverage, that they didn’t leave themselves any room to cover mortgage payments in case of an economic downturn. If you were financed to the hilt based on $10,000 per year income and had to reduce the rents to only $8,000, yes, you might find yourself short of the full mortgage payment. So the correct answer is just don’t over-leverage any property. Isn’t the credit crisis we’re currently suffering a direct result of debt – too much borrowing? Isn’t that how we got into this mess in the first place? So just don’t do it. Be patient and finance a smaller portion of each property so you don’t get caught in this type of squeeze in the first place. It won’t hurt you to even have some free-and-clear.
Are you beginning to recognize how stable a portfolio of income-producing real estate can be regardless of external economic conditions? Could you sleep at night instead of lying in bed, wide awake, worrying about your investments? Does it really matter to you if someone else, someone who has absolutely no idea how real estate works now proclaims “Real Estate is in the Dumpster?”
NOTE: Stay tuned for Part 19) You Are In Control