By: Jason Schmidt, CCIM
Senior Market Analyst
Stockworth Realty Group
Updated: October 10, 2016
The analyst in me, that side of my personality that loves pouring over mountains of data to find that glimmering and shiny key to unlock all of our investment potential really, and I mean REALLY, wants to write a lengthy dissertation tying in the trajectory of rates and associated values with economic policy overlaid with historic market performance and trends, all sprinkled with that bit of magic pixy dust outlining and defending my position on where we are in real estate markets and where I think they will go….but, I’m not going to do that…very simply I’m going to tell you why I feel that now is the time to both buy and sell.
Buyers are able to capitalize on low interest rates and mitigate risk against future downturns.
Sellers are in a position to maximize disposition value.
What are the Details?
Real estate is a funny thing. In a way it is like food. We need it. We cannot survive without it. As you read this, unless you are on a plane, you are somehow on or in real estate. Whether you are at home, in a classroom, at your office, in a warehouse, in a hospital or even driving, you are on real estate. As a species we have always intuitively understood its value. As the old mantra goes, “location, location, location.” To this very day, wars are fought over who controls various areas of the world and countries lay claim on pieces of dirt to which they feel they are entitled to ownership.
In our everyday context, for a large portion of the U.S. population, real estate is something used as merely a physical space to live or work; somewhere to raise our families, operate our business and/or house all of our stuff. If we start to scratch the surface and look at the make up of existing real estate types, according to the U.S. Energy Information Administration, of the combined +/- 120 million housing units and commercial buildings in the U.S., only +/-5% of that portfolio is represented by commercial buildings (excluding manufacturing, industrial or agricultural facilities), with the +/- 95% balance being residential units. However, according to the National Association of Realtors in its 2016 Investment and Vacation Home Buyers Survey, less than 20% of residential purchases in 2015 were for the purpose of investment.
Personally, I view real estate as an asset, something far more powerful than simply where we live or work. Think about it, there is a very simple and quantifiable reason behind why a bank will lend money to buy real estate and why it will not lend money to buy a stock. Real estate is a tangible and, historically, appreciating asset that serves as its own collateral, whereas a stock is a gamble against corporate performance, something that has little to no actual value. This is something on which we all have a basic grasp, but what many people do not consider is how one can use real estate as a major income and revenue stream-producing asset to amass a portfolio and acquire real and measurable wealth.
On the highest level, when we consider where to invest money, we will often ask three basic questions, in no particular order: 1) What is my return? 2) When will I receive my return? and 3) What is my risk? There are literally hundreds, if not thousands, of companies, industries, markets and indices to invest your money; and knowing where to start can be overwhelming.
In a basic sense, there are three tiers of risk to consider, all with corresponding returns, low risk, moderate risk and high risk:
Your returns, though, are matched with the potential for loss:
Considering historic performance, real estate, within the risk vs. return spectrum, has consistently presented itself in the middle of what we think of as the two extremes in today’s market, the stock market (high risk, high reward) and the bond market (low risk, low reward). Real estate though is something quite unique when compared to common investment alternatives…you hold actual physical ownership of the asset. If you lose $100 in the stock market, it’s gone. If you lose $100 on a real estate deal, but own the real estate, you still retain the asset to later monetize and recover your loss, even having potential to capitalize on future performance and profits.
Now, let’s take a quick look at the market today. We have all seen that values have been consistently climbing for the past several years. Though there are many more moving parts to this equation, simple supply and demand theory tells us that since our supply is low and demand is high, values are and will continue to rise, at least for a period of time. If you’re in the real estate industry, you’ve seen this first hand.
Not adjusting for inflation, national median home value (MHV) is near its highest peak, and in commercial real estate markets, to me, it feels like with each passing week cap rates are being driven lower and lower. That then begs the question, if values are so high and, by all appearances, it is a “seller’s market” from a value perspective, and if history repeats itself with a correction of these high values, what is different and compelling about real estate purchasing today as compared to previous peaks in the market?
Let’s look at 2005, arguably the peak of residential markets in the U.S. At the beginning of Q4 2005, MHV was +/-$244,000 and a 30-year FRM was trading at +/-6%. Today, MHV is +/-$293,000 (20% increase in value) and that same FRM rate is hovering around 3.4% (43% reduction in borrowing cost). For a residential property, a $250,000 mortgage at 2005 rate levels, equates to roughly $1,500 in monthly principal and interest payments. At today’s rate, that same static payment will provide you with a loan of almost $340,000; a $90,000 or 36% increase in your borrowing capacity; or, on a $250,000 purchase, a +/-$400 (26%) payment reduction.
$250,000 30 YR FRM COMPARISON:
These historically low borrowing rates are driving both residential and commercial users and investors to capitalize on the use of leverage. According to a recent report from CoreLogic, over 70% of residential buyers (personal and investment use) financed their purchase, levels we have not seen since 2007; and when considering the declines and equity corrections following the 2008 recession, we are at a very interesting place in the market in comparison to the previous 2005-2006 residential market peak.
Post 2008, some investors and homeowners experienced portfolio value declines reaching or exceeding 30%, and although a devaluation of this magnitude would again be devastating, current leveraged purchasing power and the relative low cost of debt service provides a borrower a much greater hedge against a repeat of extreme value correction.
Blended average cap rates for single family and multi-family properties in the U.S. are currently in the 6.5%-7.5% range depending on your market, and, saving the discussion of return on equity and levered returns vs. non-levered returns, even factoring premium interest rates for investment property as opposed to private use, the return vs. cost of capital debate leans heavily in the direction of leverage. With borrowing cost for investment real estate sitting in the 4.5% range, considerable margin for profit after debt service remains; and considering a worst case scenario with large scale devaluation, rental markets generally perform well in those conditions, further bolstering the return position of the investor.
Comparing the cost of capital today as outlined above with that of 2005, an investor is able to sustain a much greater devaluation than in previous market cycles. We all know that as rates tick up, and they eventually will, value will commensurately decline. The conditions surrounding the decline in value and increase in overall borrowing rates are not entirely known and can be the topic of much longer writings, but today’s market conditions, despite high value levels, remain supportive of both selling and purchasing real estate.
Those looking to sell are in a position to either maximize value from a long-term hold or recapture potential losses sustained had they purchased in previous market peaks. Alternatively, investors are now in a position where refinancing and maximizing current leverage potential can allow for more favorable performance considering future long-term holding and declines in value.
In today’s market, when leverage is deployed, an equilibrium exists amongst the parties to a transaction. Sellers are maximizing their value potential and buyers are maximizing their leverage potential. In the history of real estate and finance, we have not ever seen this particular set of market conditions co-exist. Today is truly the day where everyone is able to grab a piece of the pie and carve a path for their future success in the market.
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