Tuesday, April 29, 2008

Rental Market Overview (8/20/2007)

Here is my promised update on the rental markets and what I see as the potential impacts of the current macro-economic issues. The big issues everyone sees in the newspapers are 1) the Mortgage Crisis of 2007 and 2) the instability of the stock market, which is being blamed on the fear and uncertainty created by the Mortgage Crisis of 2007. I want to talk about the residential rental markets in the areas served by Prime Properties. The impact we have seen is that there is every reason to be upbeat about owning residential rental properties in our markets once you begin to understand the forces which impact us and our clients. What I will discuss is directly relevant to the Dallas/Forth Worth and the Tulsa markets. The Baton Rouge and Austin markets have additional influences which I will discuss at a later date, but much of what I discuss will also impact these markets as well.

I will jump into the middle of the issues first by stating that the markets we serve tend to be “buy and hold” markets, not “buy and flip” markets. If you want to “buy and flip” you should be in markets of low supply and extraordinary (>10%/year) appreciation. Right now it looks like buy and flip markets do not exist anywhere in the US. I am still buying rental properties and I am looking for additional buy and hold opportunities.

To understand our market for rental properties you should first understand the general economy in our markets and what economic engines drive the growth in our areas. Dallas and Fort Worth (when I refer to Dallas I include the whole metroplex area of 6,000,000 people) is business driven. Although Dallas was first settled in 1839, it became a young adult in 1873 when the city paid the Houston and Central Texas Railroad US $5,000 to shift its route 20 miles to the west and build its north-south tracks through Dallas, rather than through Corsicana as planned. A year later, Dallas leaders could not pay the Texas and Pacific Railroad to locate here, so they devised a way to trick the Railroad. Dallas had a rider attached to a state law which required the railroad to build its tracks through Browder Springs—which turned out to be just south of Dallas’ Main Street. If they had been honest, disclosing that Browder Springs was basically downtown Dallas, the verbiage in the law would probably not have passed. So in 1873, the major north-south and east-west Texas railroad routes intersected in Dallas, thus ensuring its future as a commercial center. Since that time and until now Dallas has made its mark on the world as a business center, growing to be the fourth largest metro area in the country, trailing only New York, Los Angeles and Chicago. We are not known for our beaches, our mountains, our mineral resources or much anything other then our business acumen.

Current business (and job) growth is based on an eager work force with a good work ethic, business friendly environment with minimal government interference and an active business recruitment effort, a lower wage environment which is partly attributable to a low cost of living (especially housing) and strong, consistent immigration. Our two natural resources we rely on are our eager workforce and low cost, easy to manipulate land. Curiously, until the recent Barnett shale natural gas finds there has been almost no oil & gas drawn from Dallas County. Even this natural gas field may not make it any further east than Tarrant County (Fort Worth). We leverage our easy to manipulate land by building a transportation and communication infrastructure in advance of needs. Few places in the country have the gumption, the land, the foresight and aggressiveness to plan and build an airport right in the very middle of their commercial centers. The DFW airport covers a land area larger than the island of Manhattan and the cities have used this asset to help grow the whole surrounding area.

Immigration into Dallas is another factor which makes the area attractive to business. Each year, for the past 20 years, the area has grown by around 100,000 people. This means an additional 50,000 households that need a place to live and heads of households who need work. This growth is forecasted to continue for the next 20 years. This expanding workforce helps keep employee costs competitive and the fact that the cost of living remains low means that the workforce can lead a comfortable life even at reduced wage levels.

Austin and Baton Rouge, with their major education emphasis have more of their economic growth from high-growth start ups. Dallas does not have a reputation as a high-tech business incubator even though such high-tech firms as Texas Instruments, EDS, Perot Systems and Broad.com had their start here. We are a tremendously attractive to more mature high-tech firms with companies such as Nortel, Ericsson, Microsoft and other major international firms using Dallas as a primary employment location. One of our shortcomings is the lack of the major higher education institutions relative to our population size. Dallas has more slow-growth start ups and a history of major corporation relocation. A slow-growth startup which requires a longer time to achieve traction can survive longer in the low cost environment of Dallas.

Dallas employers which want to keep their headquarters in high cost areas like New York, Boston and San Francisco can provide lower cost major back office support with large, employee intensive, operations here in Texas. A call center employee costing $80,000/year (burdened pay) in San Francisco and $24,000/year in Mumbai will cost a company about $40,000/year in Dallas, and this back office support is only three hours by plane from either coast without the cultural challenges of going to India.

Understanding these economic drivers is important in order to have proper expectations on where you make your money owning a rental home in Texas. Leverage is important, since the appreciation is slow. It will continue to be slow because it is relatively inexpensive to put up new homes and almost all our towns are for pro-growth. Too much leverage can hurt; if you buy a house with no money down you may not have enough cash flow to cover your expenses from rental income. I always buy with 20% down, in part because I do not want to cover expenses out of my personal income’s cash flow. A 20% down payment usually allows me to pay for all expenses out of cash flow and even take home some tax free income at the end of each year. I will say it again, this is a buy and hold market. This emphasis on the amount of the down payment is based on an understanding of proper cash flow to achieve your goals. At times I am willing to sacrifice cash flow for greater appreciation, but as I said earlier we have a track record of mild appreciation in most our markets.

After all the comments above - what impact has the current Mortgage Crisis had on rental properties? We started seeing the positive impacts in November of last year. That is when three things happened, 1) the majority of people who wanted to buy a house had made their way to the builders and bought a house (including many who should not have become homeowners) 2) the tightening of mortgage qualifications found people who wanted to buy houses could no longer qualify (meaning that if they wanted to live in a suburban lifestyle in a house instead of apartment then they needed to rent) and 3) interests rates kept creeping up until the costs of a monthly house payment sometimes surpassed the cost of rent. November of 2006 is when our vacancy rates dropped from the 12% range down to the current range of 5-7%. The job growth in Dallas has continued to be strong at this time and the unemployment rate has continued to drop. The combination of continued job growth and declining vacancies has led us to start pushing up rents for the first time in four years.

Will the current Mortgage Crisis harm the rental market? I believe the current situation could have that potential if it creates a declining employment market, but, because of the other market forces which impact Dallas, we may even have a chance for Dallas to defy a declining national job market. Remember that in the 1970’s when the country’s economy was failing across the board Dallas was growing. The reason for growth in Dallas was that as major corporations looked to cut costs one of the ways they did this was to relocate whole departments and sometime whole companies to locations where they could cut their overall expenses. The 1970’s saw some of Dallas greatest growth and its true emergence as a national and international player. As jobs became scarce elsewhere aggressive minded job seekers move to where the jobs are and they will move to Dallas. These types of employees are the go-getters who move here and make good lives for themselves by creating value for themselves and the companies they work for.

So here is what you need to watch. Immigration rates into Dallas, job growth in Dallas and unemployment rates in Dallas. If your homes are in Tulsa, Baton Rouge or Austin then you need to look for the same information for these towns. Another point to remember is that rents are a lagging indicator. What this means is that as the economy deteriorates, rents are one of the last things to turn down, as it goes up, rents are the last to catch up. If the Mortgage Crisis turns into a situation where prices in Dallas are declining, then I will be looking to aggressively buy in Dallas and I may even change my personal guidelines, going to a 10% down payment when purchasing a new home. I hope you have done a good job of protecting your credit - you should still have mortgage money available to you. If banks have money then they need to lend it out. Remember that banks view money as a liability; they need to find people who will borrow it.

As you can tell I am a fan of history and what it might tell us of what will happen going forward. I am sure this new period of changing economics will teach us additional lessons, but for now I believe the future looks bright for the investments I have in residential rental properties.

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