Having grown up with a mother that works as a real estate broker, I have always been very interested in real estate. One of the greatest things about real estate is how understandable and real the asset is. Barring the last few years, real estate has historically grown at a very understandable and logical manner. If you understand the market and buy in at a great location with a good cap rate, that property can generate a reasonable rate of return. Coming out of UCLA, I hope to quickly purchase a house and generate rental income. Big questions that I face are, “Is now the right time to buy?” and “What property should I buy?”
There are two things to consider. The first is to examine macro-economic real estate trends. The second is to truly analyze the specific market and property’s specifics.
1) How is the real estate market currently doing?
From looking at the Case-Shiller Index and the Fed’s recent work to lower interest rates, one can make the argument that real estate housing prices have hit rock bottom and because financing is incredibly cheap, it is time to buy. But have prices hit rock bottom yet? There are several arguments that point to the possibility that housing prices will soon increase.
David Blitzer, Chairman of Standard and Poor’s Index Committee, explains that the housing market is currently giving mixed signals. Housing prices, adjusted for inflation, are still higher than the stable 1990 prices. This may indicate there is room for housing prices to fall. A more hopeful indicator is that the cost of renting to the cost of buying ratio is nearing the 24-year average, up from its low in the past few years. For the last couple of years, most households were entranced with the American dream that buying is always superior to renting. Theoretically, the cost of renting a piece of property should roughly equal the cost of buying. But it logically makes more sense for people to pay off a mortgage and build equity at the same time, instead of paying rent to a landlord. As a result, the cost of renting becomes cheaper than the cost of buying because the latter option gives the payer land ownership. This mentality picked up significant traction and was largely responsible for the recent self-perpetuating rise in home prices. As a result, housing prices increased dramatically, which in turn spiked the cost of buying and mortgage prices, and decreased the ratio of rent-to-buy costs. This article shows the lowest ratios from 2005-2007 – which indicates housing prices were at all time high compared to rents.
The fact that this ratio is increasing means that either rental costs are increasing or that housing prices are decreasing. From 2009 to 2011, we can see that the rent-to-buy ratio is bouncing around the 24-year average of 89.5. However, it does not necessarily mean that housing prices will increase because the ratio is near the equilibrium. A closer examination shows that the rent-to-buy ratio was very high in the 1990s, which means prices can continue to drop. This leads back to the previous point; housing prices may still drop to the stable 1990s prices of Case-Shiller Index.
However, financing costs are incredibly cheap. With the Fed’s Operation Twist and QEs, we see interest rates that float around 4%.
Given all of the above, I would currently take a more optimistic stance and be very willing to dig a little deeper into some properties.
2) Is a specific property a good investment?
While the above macro-analysis of the entire real estate market is insightful, it is generally much more necessary to look at and understand local markets. For the sake of keeping this property’s location unknown, I completely skip over understanding a specific market. When it comes down to a specific property, it is important to look at the actual nitty-gritty details to make sure that the property will be generating rental income. Sure, the real estate broker may give you projections, but because it is in the broker’s best interest to sell you the property, it is the buyers’ responsibility to make sure the numbers make sense.
I recently evaluated a large, recently modeled 204-unit apartment complex. I made a model with three tabs: the first has contains the apartment valuation, the second contains the income statement, and the third has the debt service in the possible case of leverage. All inputs are in blue and link to the valuation tab. (Feel free to play around with them to look at different scenarios.) After obtaining the brokerage package, I broke apart projected revenues and used given projections, a downside scenario, and an upside scenario. Change the number under “Scenario” from 1, 2, or 3 to see the income and vacancy projections.
Other assumptions include a 5.50% entry cap on the broker package’s third year revenues and a 10% discount rate. Combine this with 20% LTV, downside revenue projections, and a 6.50% exit cap rate, I ultimately come out with negative IRR of -2%.
Not a good return. Despite the slightly positive macro-economic trends, this property looks unattractive so I will continue to look for opportunities.
PS: I invite people to poke through my model and send me constructive criticism. I would love to know if I missed something essential or if there ways to improve the model