How to Purchase Investment Real Estate, Part II
Earlier I stated that when investing in real estate, I always assume no property appreciation. I am not saying you should not hope for some capital appreciation on your investment; only that property appreciation should not drive your investment decision. However, it is possible to increase your odds of capturing market appreciation. That will be the topic of this post.
There is no question that the easiest way to make money in real estate is to buy real estate at a price such that it can be quickly sold at a higher price. This is called “flipping” properties. In my opinion flipping properties is not investing, it is speculating. Many people employed this tactic in the mid-2000s. Unfortunately, as most of these people found out, this is the most risky way to try to make money in real estate. I would not recommend anyone buy real estate with the expectation of selling it in a short period of time for profit. Real estate, just like stocks, is a long term investment.
If you follow the recommendations of my previous post for finding a property where the income pays for all expenses, it is possible to purchase investment real estate in almost any market and make money. In fact, in most markets, this approach will require you to buy property below market value. This should ensure that you will gain some capital appreciation from your investment.
However, an important determinant in whether you benefit from the overall increase of real estate values is the timing of your purchase. Just like any investment there are definite periods of time when purchasing real estate will allow you to benefit much more from increased market values than other times.
My personal situation is a good example of well-timed purchases. Referring to the chart below, the blue line provides an index of average US house prices from 1983 through early 2011. I purchased my current holdings as well as my personal residence between 1992 and 1997 before the blue line starts its steep upward slope. As a result, despite the recent drop in real estate prices, the properties I own are still worth about 3 times what I paid for them. Although I have owned the properties for many years, my property appreciation is due as much from when I purchased the properties as to how long I have owned them. I could have bought the properties in 2001 and still have done pretty well.
You may be thinking “the blue line on the chart is a measure of historical home prices; that is 20-20 hindsight, how do I know when to buy in advance of property price increases?” This is where the purple line in the below chart, the “Owner-Equivalent Rent” (OER) index, takes on significance. The OER data measures the average rent applicable to the US house price index. Comparing the US house price index to the OER index is the same thing as performing my recommended cash flow analysis on a specific investment. As you can see from the chart, the OER index increases at a very stable rate. There are no big jumps or drops in the OER index; this index increases primarily based on inflation. However the US house price index shows more volatility. This is because houses, being an asset, are influenced to a greater extent by other factors such as interest rates, overbuilding, tax laws, etc.
As the chart shows starting around 2002 the average home price became de-coupled from the average rent indicating overvaluation of real estate prices. Of course by 2005 real estate prices when compared to OER became severely overvalued. It was not until about 2009, after the bubble burst, that property prices returned to more normal valuations. The one thing the indexes on the chart illustrate is that, no matter how far apart they get, over time the two indexes converge together. This is because, regardless of other factors, house values ultimately cannot increase more than their rental value. In an earlier post I mentioned how you should evaluate all real estate investments on an “absolute basis.” The chart, on a macro-level, is a way to do this by comparing the average US home price to the OER.
Chart Source: www.jparsons.net/housingbubble/
There are several government and private sources for assessing US House prices and owner-equivalent rents. But, keep in mind that this data is usually national data; it may not apply to your particular area. Frankly, when deciding to invest in real estate, I don’t think it is even necessary to review such data as contained in the above chart. Your local market will provide you plenty of clues. In 2003 to 2006, real estate was increasing at 15% to 20% per year, but incomes were only increasing at 1% to 3% per year. Many areas of the country were experiencing property bidding wars forcing buyers to make purchase decisions in a matter of hours. These were obvious signals that it was not the right time to buy real estate.
In contrast, when I started investing in the Washington, DC area in 1990s, it seemed like almost every property I looked at would produce a net positive cash flow. This was an indication that the general real estate market prices were in line with the market rental rates. The chart confirms this fact as the years 1991 to about 2000 show the OER index at or below the US house price index.
The property market in the 1990s was similar to today’s market. It is easier to buy cash flow positive property in these buyer’s markets. Prices are so soft that you can make an offer to purchase a property that fits the cash flow you need to make the investment work. If the seller does not want to sell the property at the price you need, you just move on to the next property. In a buyer’s market like today, you are dealing from a position of strength. Somebody will eventually meet your terms. The best time to buy real estate is when there are very few other buyers.
In regard to selling your investments, if you sell them at all, you should sell when the current selling prices of your investments are not justified by the prevailing market rental rates as was the case from about 2003 to 2007. In 2002, when property prices started to de-couple from the market rents, I sold one of my investments as I thought we were getting near a market top. The property had doubled in value and, having been my primary residence 3 years earlier, I was able to sell it tax free. In retrospect, I would have been better off waiting to sell one or all my real estate investments in the 2005 to 2007 time frame. But it is hard to know when markets hit their high water mark. I did consider selling another property in 2005 but chose not to. The main reason I did not sell was, after paying capital gains taxes, the income generated from my remaining equity would have been lower than the net positive rent I was getting with the property investments. From a purely investment standpoint, in my opinion, the critical question one should ask when trying to decide whether it is the right time to sell an investment property is, when investing the remaining after-tax property equity, is the after-tax income higher or lower than if one kept the property investment? If the answer is selling and investing the after-tax property proceeds produces higher income, this is usually an indication that the property is overvalued.
Property prices have now dropped significantly since 2007. I would prefer that the prices had not dropped, but, frankly, I really do not care because I am receiving significant rental income from my properties. And I have increased the rents every year since 2005. In the beginning it will seem like you are working to support your real estate investments. But, eventually, the real estate investments will support you. And, if you wish, they will do so in perpetuity.
Before ending this post let me re-iterate my opinion that when buying real estate, the income portion of the investment is the most important profit component because it will be with you from day 1 of your investment. The capital appreciation will come later, but it may be years later; and you will not benefit from the property appreciation until you sell the property. You should keep this fact in mind when considering a real estate investment.
Did you enjoy this post? Why not leave a comment below and continue the conversation, or subscribe to my feed and get articles like this delivered automatically to your feed reader.
Comments
No comments yet.
Sorry, the comment form is closed at this time.