Trying to assess value in the real estate market

[returnonmycapital]

A while back (2008 as I recall), we had a discussion on real estate values around North America. I would like to see where we stand today.

My method of valuing residential real estate is to compare the rental yield to the cost of borrowing.

For example, just outside of Toronto, annual rent of $15,000 on a property acquired for $250,000 has a rental yield of 6%.

The cost to finance 75% (a Canadian norm) of this acquisition today might be 3.5% on a 5-year fixed mortgage (a variable mortgage is 2.25%).

 

The pre-property tax, pre-insurance return on equity in this transaction is ($15,000 - .035*.75*250,000)/.25*250,000 = 14%.

If you factor in property taxes and insurance, the cash return on equity falls to 8%, if you can collect 100% of the rent. Not half bad.

 

For those who have some understanding of what is going on where they live, it might be interesting to see how things have changed and where there might be value.

Please specify what area you are referring to.

[StubbleJumper]

Actually, IMO, that's a disaster.  If you're getting $15k on a $250k dwelling, once you pay municipal tax and insurance, your cap rate is probably going to be lower than 5%....if there's any management or condo fees, it could be a poor as 4%.  The only reason why this appears to be of any interest to you is that you are levering the investment 3:1 (ie, 25% down payment).

 

If you have good credit, you can probably do the same by purchasing a basket of perpetual preferred shares.  There are any number of issues that have dividend yields of 5-6%, which you could use leverage to get similar returns to your real estate example at a lower risk.

 

Personally, I would not even consider real estate unless I had a 8-10% cap rate....heavens, today I can buy Walmart shares at a 7% cap rate by just making a phone call to my broker, and I know that I'll never have a 3 am phone call from Bentonville complaining of a blocked-up toilet!

 

 

SJ

[Myth465]

Houston is pretty decent regarding returns. In Suburbs and ok areas you can buy a house for $60-$80k (within 3-5 years old), and rent it out for $800-$1000 or so. You could probably put as little down as 3%. My issue is you are not likely to see much appreciation for a number of years.

 

My issue is I want amazing returns to deal with the headaches. Stocks dont call you with broken ACs and Toilets. I also dont see that blood in the street moment. The final problem is I would prefer higher rates and lower housing prices. I am watching though.

[returnonmycapital]

I am not debating the relative merits of investing in real estate, equities, bonds, cash, etc.

I am trying to get some understanding of present real estate values and where John Q. Public is concerned, the value of owning a home versus renting a home.

And doing so from an economic perspective.

 

My example suggests that on a basic economic level, it is better to own than to rent in the area I referred to.

 

If the general consensus suggests that it is better to own than to rent today, unlike in 2007, real estate values should begin to help the general economy. However, if it is better for John Q. Public to continue to rent, then real estate will continue to work against the economy. Leaving aside one's opinions on the general level of indebtedness, this sort of survey might be helpful when organizing one's thoughts on banking and other economically sensitive industries.

[returnonmycapital]

Myth,

 

Those are outstanding numbers, if the rent is collectible, and suggest that real estate is undervalued in the area you are referring to.

 

My general feeling is that the correction in residential real estate in the US might be overdone. Again, I am only speaking from an economic standpoint. Whether prices appreciate in the near-term is irrelevant with economics like you have described. What I mean is, if you require price appreciation for the economics to work out, stay away.

 

Your numbers suggest an attractive return on equity, even without a mortgage.

[Myth465]

Yes, Houston has not quite recovered from S&L / Oil Crisis. My folks bought houses for $15k - $20k during that period. They held them too long and should have sold out for $70k or so during the boom. Houses were probably built for $75k and sold for $110k in 2005 - 2010 and you can buy them for $75k - $85k today.

 

The issue is all appreciation is in the Loop and Houston has limitless amounts of land for new building. I am a bit spoiled and dont want the headaches, but I want to buy some properties at some point with my Brother. Maybe each put in $10k and buy a number of properties for tax losses. Its been in the works for a while, but I havent seen anything screaming yet.

 

Should rates move up and values move down, I dont want to be left holding the bag. Its a good deal, but I want a great one. Perhaps I am being greedy. Also I would likely be the financial backstop should renters move out or destroy everything. I dont like the thought of dealing with an unexpected cash call, but I guess thats what Savings and Margin is for.

 

----

 

Also Houston kills your hopes of buying realty anywhere else. You could grab a huge property in Prime location here for $300k which makes the NE and West Coast seem nuts.

 

In Houston at the height of the crisis, it was probably still better to buy then rent. The issue is some people bought a bit too much home.

[Ballinvarosig Investors]

I am still waiting for my "Necker Island" moment. For those of you that aren't aware of the story, let me quote Wikipedia.

Branson first became aware that some of the islands in the British Virgin Islands  were for sale in 1979. In 1978 Richard Branson went to the British Virgin Islands for a holiday in order to investigate the prospective real estate. On first observing the islands, Branson envisioned using them to put up rock stars for his record label. Upon arrival, they were given a luxury villa and travelled around islands for sale by helicopter. The final island he saw was Necker Island, and after climbing the hill and being stunned by the view and wildlife, fell in love with the island. After making a lowball bid of £100,000 for the £5 million island, however, he was turned down and evicted from the island. A while later, the owner, Lord Cobham, in need of short-term capital, eventually settled for £180,000 after Richard Branson had offered his final price of £175,000 three months before the actual sale took place. However, the Government imposed a relatively common restriction on alien landholders; that the new owner had to develop a resort within five years or the island would revert to the state. Branson committed, determined to build a resort on his tropical dream island, notwithstanding his relatively modest capital at that time in his career.

Now I'm not saying that I'm looking for a Caribbean island, but I think the time to snap up a bargain will come. Having patience and the means to act quickly will be key.

[StubbleJumper]

returnonmycapital:

 

I didn't really understand your intention of a consumer-oriented rent vs buy thread....instead I understood it as a buy a rental vs buy a stock or bond thread.  

 

Rent vs buy is actually a more interesting situation.  Since you are effectively your own landlord, if you intend to live in your house forever, your investment is effectively risk-free (ie, you do not face deadbeat tenants who skip out on the rent or trash your unit...and you face no market price risk because you're planning to stay there forever).  Given the fact that a huge element of the risk is eliminated, you can accept a much lower cap rate.  Further, since your investment return on an owner-occupied home is effectively imputed rent (ie, the rent that you would otherwise pay to a landlord), you pay no income tax on your investment return.  

 

So, returning to your Toronto example (ignoring leverage), a cap rate of 4-5% after tax is actually equivalent to 5%/(1-tax rate) on a before tax basis.....meaning it could be as high as 8% before tax, and it's low risk (almost risk free?) because you are the tenant in your own house.  Personally, that would meet my hurdle rate.

 

 

SJ

 

P.S. Those *are* outstanding numbers in Houston.  It would probably work out to a 10-12% cap rate (after municipal tax and insurance).  That offers a reasonable risk-adjusted return.

 

 

 

 

[Myth465]

I think Rent vs. Buy works for a family or a lifer at a job. Mobility and opportunity cost dont get a consideration in those calcs. Those who own in Michigan probably would like to move for better employment ops.

[ericd1]

There are some real deals in the hardest hit areas...I believe it was a Forbes article where a ~$500K house recently sold for ~$125K...The couple bid on 10+ foreclosures and finally won one...But who wants to live in Detroit anyway?

[mpauls]

For what it's worth, (if you are logged in) you can download this attachment which displays Berkshire, Gold, and Real Estate since 1965.  The real estate column are not actually from housing index, but rather from "net worth" figures taken from Business Statistics of the United States.

 

Please note: the percentages at the bottom state 65 years.  This should be 45 years.  Also Berkshire Numbers are "Book Value" figures, gold is per troy oz, and real estate net worth is in billions of dollars.  

(This data was for personal use so please excuse the lack of clarity.)  

 

 

[mpauls]

If you intend to live there for 15 years or more, just take your time and find an undervalued property and buy it.  What more is there to consider?

[twacowfca]

For what it's worth, (if you are logged in) you can download this attachment which displays Berkshire, Gold, and Real Estate since 1965.  The real estate column are not actually from housing index, but rather from "net worth" figures taken from Business Statistics of the United States.

 

Please note: the percentages at the bottom state 65 years.  This should be 45 years.  Also Berkshire Numbers are "Book Value" figures, gold is per troy oz, and real estate net worth is in billions of dollars.  

(This data was for personal use so please excuse the lack of clarity.)  

 

 

 

 

Thanks, mpauls, for the interesting table.  The price of gold had been artificially depressed as it was pegged to the depreciating dollar between the early 1930's and 1965, the start of the series.

Had this not been the case, and the series had gone back to the 1930's for real estate and gold, the percentage returns for gold would have been less than for real estate, about 4% to 5% per annum, instead of the 8% return that gold had from 1965 through 2010.  Real estate and gold compounded at a much lower rate than BRK during the period as you show.

 

This later series is not representative of returns from the centuries of records of gold prices because it's a trough to bubble series.   Even the longer series from the 1930's isn't representative of the complete historical record because it ends in a bubble.  The full historical record shows that gold prices have lagged inflation by about one half percent per year.  :)

[SmallCap]

I live in West Michigan which is very different economical from the east side which has Detroit and Flint. I am amazed at the prices of RE and the way they cash flow. I picked up a house in Holland, MI 3 months ago for 24,000 and put 6,000 into it and it is now on the rental market with a rental management company for $650. Management company cost 8% of revenue and they do all the work and take care of all the issues and maintainance. taxes and insurance will run $2,900 per year.

 

I am also right now buying a 50% interest in a company that holds 3 single family houses in Grand Rapids. all three of them are rented out with a 1 year lease agreement at $600 each per month totaling $21,600 per year revenue. Taxes and insurance should run right around $8100 per year on all of them together. the management company will again take 8% totaling $1760 per year. This leaves gross profit of $11,740 my half of which is $5,870. For this 50% interest I am paying $25,000 which seems like a great deal to me. Those numbers assume full rental with is the current situation and the rental agency is currently running 97% occupancy. We also have the possibility of selling these houses and my estimate of the sales price is between 75K and 90K. I am comfortable with that margin of safety.

[Guest broxburnboy]

I live in West Michigan which is very different economical from the east side which has Detroit and Flint. I am amazed at the prices of RE and the way they cash flow. I picked up a house in Holland, MI 3 months ago for 24,000 and put 6,000 into it and it is now on the rental market with a rental management company for $650. Management company cost 8% of revenue and they do all the work and take care of all the issues and maintainance. taxes and insurance will run $2,900 per year.

 

I am also right now buying a 50% interest in a company that holds 3 single family houses in Grand Rapids. all three of them are rented out with a 1 year lease agreement at $600 each per month totaling $21,600 per year revenue. Taxes and insurance should run right around $8100 per year on all of them together. the management company will again take 8% totaling $1760 per year. This leaves gross profit of $11,740 my half of which is $5,870. For this 50% interest I am paying $25,000 which seems like a great deal to me. Those numbers assume full rental with is the current situation and the rental agency is currently running 97% occupancy. We also have the possibility of selling these houses and my estimate of the sales price is between 75K and 90K. I am comfortable with that margin of safety.

 

Sounds great..I assume you have a variable rate mortgage on these properties.I have heard that it's hard to get a fixed rate?

If so the prospect of a sudden increase in interest rates puts more risk into your cash flow assumptions. It might be better business buying them cheap, fixing them up, renting them then flipping them back out for capital gain. Glad to hear that one can make a buck here again, although the home prices are far below the bubble peak... the original lenders are obviously taking a bath.

 

Cheers

[SmallCap]

broxburnboy,

 

I am not using leverage at all with the 50% ownership of that company in Grand Rapids which has no debt. the reason it was setup without leverage is so that we have the potential of selling them on land contract.

 

On the single home in Holland I am using my home equity line of credit which has variable interest at 2.25% which means my interest is $55 per month. I currently have that home on both the rental market and the for sale market and whichever happens first I am fine with it. it is for sale at 64K

 

SmallCap

 

 

[Guest broxburnboy]

Good on you.. someone making a profit in this space the old fashioned way... sustainable cash flow sans layers of leverage.