Sunday, July 18, 2010

Make Money on Appreciation or Cash Flow?

Are you looking to make money on your investment property from appreciation or cash flow?  If you are looking to make money primarily from appreciation then you must look at the investment as a commodity and you must place a greater emphasis on timing and have a greater awareness of the market trends.  The most important market trend has to do with the supply and demand of the commodity.  California is famous for the wide swings in home prices and is a good case study of making money from appreciation.  California's market contains many unique properties, unique as defined by the location of the real estate and the attributes available due to its location.  There is only a limited amount of land near the ocean.  This land has been built out in greater and greater density.

The appreciation happens when the job market is good and there is inward migration from around the world and other states.  Because California has a limited amount of land available for development near the desirable locations any increase in jobs and immigration creates a recognizable and often severe upward price pressure.  Right now California has job loss and emigration, so the prices have dropped.  All the talk about the "sub-prime mortgage crisis" masks a downward price adjustment which would have happened regardless.  The irresponsible lending aggravated the increase on the upside and the decrease on the back end, but every investor in California real estate should have expected these cyclical trends and should expect them to continue as long as California has ups and downs in jobs and the immigration/emigration cycles.  So, to determine when the California market will again turn up I believe you must look closely at when jobs will return and when people once again start moving into the state.

Now take these same measures and apply them against other real estate markets.  Phoenix, which has easy to develop land which is still widely available at a low cost (keeping prices down), a diverse economy with a strong ability to rebound (adding jobs drives prices up), a current environment of people moving out from 2008-2010 (emigration drives prices down).  Here is a situation where I believe the irresponsible lending, to developers and to homeowners, created a situation where prices ran up far higher then they should have.  When you see Phoenix add jobs and immigration the home prices should again increase, but I don't believe you will again have the huge appreciations you saw between 2004 and 2008.  I believe that in the future there will be a more normal appreciation which reflects the dampening affect of the high availability of easy to build on land.

In Dallas there is widely available, easy to develop land (which has always dampened aggressive appreciation), there has been continued immigration, primarily from rust belt states, but the job growth has been flat (as contrasted by enormous job losses elsewhere in the country).  The continued immigration has put pressure on existing housing stock because the population has continued to grow but there has not been a corresponding increase in available homes. For each of the last three years builders have sold more homes than have been constructed in Dallas.  According to Steve Brown of the Dallas Morning News, builders have sold 13,000 more homes than they built over the past two years.  Dallas has a three month inventory of new homes as compared to an average seven month inventory across the nation as a whole.

The wild card in Dallas going forward is the impact of less efficient building processes and availability of financing for developers.  Building out large subdivisions allowed builders costs to be lower, and they passed much of these savings to the new home buyers.  As construction again ramps up the cost/square foot to build new homes will be higher because builders will have lost some of the economy of scale they had when they were building 500-1,500 home subdivisions.  Although credit is less expensive than in the past, banks are not loaning money to builders for new projects.  I do not know if the banks will charge developers higher interest in an effort to make offering loans to builders more attractive, but that may be what it takes to make more funds available, but if that is the direction they take, this will add to the cost of new homes.  I fully expect that new homes will cost more in the future, simply because the builders expenses will be higher and this will create greater appreciation for existing stock.

So, California should rise again, once they get both jobs and immigration, and when that happens there should once again be high appreciation.  When that will happen is anybody's guess, but I believe it will happen again, and again, and again.  California real estate is a roller coaster, just accept it and enjoy the ride.  I, personally, cannot stomach the risk so I stay away from this ride.

Phoenix will rise again under the same circumstances of increasing jobs and immigration, but because of the over supply of existing stock it may be many years after the rise before housing prices tick up again.  The good news is that the current cheap housing makes Arizona a very attractive location for business, both start-ups and relocations.  I believe the attractive business climate in Arizona means job growth will start here before it does in California.

Dallas, is best poised for an up-tick in the near future because they have job growth (small but it is happening), immigration and a pending shortage of housing units.  Texas is ranked #1 for a favorable business climate (Business Facilities Magazine), and it has held one of the top spots for the past five years.

The opportunity is that the prices in all markets are down or flat.  If you want to make money from the appreciation of real estate you need to be in real estate.  The greatest returns will be greatest where there is a shortage of the commodity and there is the greatest demand.  Right now I don't believe there is a pending slam dunk, home run opportunity. There are mostly a series of compromises because where there is a shortage of land (California) there is limited demand.  Where there is demand (Texas) there is availability and the opportunity to create more availability, but not at the same low price point as in 2004-2008.  The nice part of investing in Texas is that you can put a small amount down, get cash flow so there is limited need to service the asset with additional funding, and there is a viable reason for prices to increase in the near future.  Arizona is another good opportunity, simply because prices are so low right now, but the light at the end of the tunnel is not visible at this point in time.

So, am I buying and where?  I am buying, and right now I am buying in Arizona.  Because I do not need to realize immediate appreciation, or do I even want to see appreciation for 5-10 years, this is where I am putting my money.  Real estate in Arizona is selling at price significantly below what it costs to build.  I am happy to see the prices stay depressed for 5-10 years since this will keep my property tax bill lower.  This is a riskier venture for me, if I need to sell in the next five years I may end up selling at the same price, or lower (after selling costs) then I am currently paying for each home.  I feel that once the economy kicks back in, the jobs return, people start moving into the state and the existing housing stock is absorbed, then the prices will return once builders can again build for a profit.

A more conservative play would be to buy in Dallas where the recovery is already happening and prices should be moving up again before anywhere else.  In Dallas I feel more comfortable that I would be able to divest without bringing money to the table.  I already own quite a few homes in Dallas, so I have assets which I could sell if I needed to move money out of my real estate.

Where not to buy?  Right now I am on vacation, visiting family in Michigan.  I would not buy here.  Jobs are leaving Michigan and people are leaving Michigan.  There is an overabundance of stock in the state and without jobs or people moving here there is no reason for real estate to go up in price.  There are some micro markets which  will buck the trend, like the city of Ann Arbor or the vacation homes on Lake Michigan which attracts money from around the world for the lake views and mild summer weather.  In any market there will be opportunities, but at the macro level I would stay away from Michigan as an investment no matter how inexpensive the real estate is.  I love the state, it is beautiful and has many things to enjoy, but it is not where I want to invest my money when I have other opportunities available to me.

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