Back to Basics: Real Estate Investing

Hi All,

First of all, I’m a data scientist by profession but a history major by training. So I’ve tried to cite all relevant data points with a (<source>) tag. This allows us to separate debating the data vs. the analysis. I’m also a complete newbie to real estate investing. One of the main goals in fact of this post is to organize my thoughts so far and solicit feedback from more knowledgable individuals.

As part of a balanced portfolio, I've invested passively in real estate for several years (both public REITs and a small amount in a private platform). As my assets have grown and I'm entering the age to buy a primary residence, I've been trying to educate myself on the housing real estate market. After all, even if you don't own any investment properties the purchase of a home is the largest single financial transaction you'll likely ever make. In fact, if you look at the chart linked below (1, see Sources below) you'll see housing is the single largest asset for households with net worth below 1 million dollars, i.e. ~90% of Americans (2). In fact, even in 2010 (in the midst of the Great Financial Crisis): "The primary residence represented 62% of the median homeowner’s total assets and 42% of the median home owner’s wealth" (3). In fact, reading the Economist recently (obviously in my slippers) I was surprised to discover housing is the world's largest asset class. This HSBC report (avoiding the Economist paywall) cites housing as a $226 trillion (!) asset class at the end of 2016 (4) out of a total net worth in 2018 of ~$360 trillion according to Credit Suisse.

Even with my casual research, it's clear that real estate is divided into multiple segments including residential, commercial, industrial, farm land, etc. Even the subsector of residential is divided into single family, multi-family, commercial, mobile homes, etc. These segments are further divided across geographies with wildly different tax, capital, and regulatory regimes. So far I’ve limited my research to the US residential sector: single family homes, multifamily, and small commercial apartment buildings. Therefore moving forward when I say real estate I will limit the scope to the above US residential housing market, i.e. acquiring individual or personal portfolio of US housing properties.

More formally, the purpose of my analysis below is:

Understand my options as it pertains to real estate. E.g. is it better to consider “house hacking”, i.e. buying a primary residence and several investment units as part of a duplex, triplex, etc.
Avoid making obvious mistakes in the purchase of my primary home
To summarize what I’ve learned and start to develop opinion about real estate investing more broadly as a complement to public equities investing
Broaden my knowledge professionally (my clients include large real estate companies)
Learn from the community!

Note: I considered posting this in /r/realestateinvesting, but ultimately my goal is to evaluate real estate vs. other asset classes. Obviously some people will simply prefer real estate for a variety of reasons, but personally my goal is to achieve the greatest return for the least risk and work. I should stress that I love my career (data scientist) and have no intention of quitting, so the last point is particularly important.

Analysis

One thing that immediately strikes me as an investor accustomed to public securities, e.g. bonds / stocks, is how odd the real estate market (in particular housing) is in comparison. Having a margin account from a broker, i.e. getting leverage, is often a difficult process reserved for “advanced” investors. In residential real estate, it’s considered “conservative” for an individual to have leverage of 4-5 to 1 (FHA loans, for example, only require 3.5% down in some cases!) . What’s even crazier is that the loan is often issued at only 2-4% over the 10 year US treasury rate. For example today, April 26th, the 10 year treasure is 0.606% while NerdWallet has a rate of 3.3% for a prime credit score, single family home, primary residence 30 year loan.

Perhaps because real estate is the only avenue available for newer investors to take on large amounts leverage immediately, I've seen extreme and, in my opinion, irrational positions on the subject. Even a cursory glance at BiggerPockets, /r/realestateinvesting, etc. uncovers multiple posts along the lines of either "real estate investing is the best investment ever!" vs. "the real estate market is a massive bubble and will crash soon". I've summarized a few of the common tropes I've seen below with my analysis.

Real estate is a huge bubble, and is going to collapse any day!

As noted above, real estate / housing has numerous segments that are further divided across geographies with wildly different tax, capital, and regulatory regimes. Saying that "real estate" will crash is like saying the “food industry” will crash. What segment and where? US soybean growers? Fast Food? Argentinian ranchers? McDonalds in particular?

Limiting our discussion to US housing: the Case-Shiller national price index (7) shows that home prices dropped ~27% from peak to trough in the Great Financial Crisis over a period of almost 6 years (Mid 2006 to early 2012). The reason this was such a catastrophic event is that housing had never decreased nationally in a significant way before in the modern era (see Case Schiller home price index). Of course, it’s worth noting that housing had rarely increased rapidly against inflation before.

Let’s assume we had an equivalent event occur. The Jan 2020 index was at 212, so home prices would decrease by 27% to ~155 (mid 2008 levels). Crucially though, this price drop would be expected to play out for years! During that time vested interests (more on that later) would lobby governments extensively for support, foreign and US investors could form funds to take advantage of the situation, etc. As a reference point there is ~$1.5 trillion available in US private equity funds alone as of January 2020.

However, it is worth pointing out that this is at the national level. Local real estate markets, particularly those dependent on select industries or foreign investors, could easily see more dramatic price movements. The US census has a really cool chart (22) that shows the inflation adjusted (as of year 2000) median home values every decade by state from 1940 to 2000. We see that Minnesota home values actually dropped from $105,000 in 1980 to $94,500 in 1990, a fall of more than 10%.

Everyone needs a place to live, therefore housing can never go down

Everyone needs a place to eat, but restaurants and grocery stores are famously low margin businesses (5). Farms supply an even more basic need, but many go bankrupt (6). The question isn’t whether housing will go down or not, but whether it will return an attractive rate of return compared to alternative investments.

It’s also worth pointing out that for most “retail” US housing real estate investors, they are investing in a narrow geographic area. Migration and births/ deaths can play a huge role in the need for housing in a given area. Case in point, NYC may have actually begun losing population to migration in 2017 / 2018 (23). Even more interesting, NYC has experienced a substantial loss due to domestic migration which is almost balanced by foreign immigration / new births (24). If foreign immigration decreases in the post-COVID we would expect NYC’s population to decline more rapidly given current trends.

It is entirely possible for national housing prices to modestly increase while expensive coastal markets decline significantly, for example.

It's supply and demand. There's a nationwide housing shortage so prices can only go up!

This one has some factual basis. Freddie Mac put out a study in Feb 2020 (18) which indicated that there is a shortage of housing units between 2.5 - 3.3 million units. Some interesting notes about this study is that they consider the “missing” household formation and extrapolate interstate migration trends. As noted below, the US builds ~1.3 million housing units a year, so this reflects ~2 years of housing construction. It’s also worth noting the geographic variation, with “high growth” states like Massachusetts, California, Colorado, etc. seeing ~5% housing deficits vs. states like Ohio, Pennsylvania, etc. seeing housing surpluses of ~2-4%.

However, a Zillow analysis on our aging population (11) points to a slightly different conclusion. Based on their analysis, an additional ~190,000 home will be released by seniors between 2017-2027 compared to 2007-2017. That number increases by another 250,000 homes annually between 2027-2037. Combined, this is about ~50% of the average annual homes constructed in the US between 2000-2009 at ~900,000.

Given these slightly conflicting reports, let’s get back to basics. First, let's separate housing into single family homes, multi-family units, and large apartment buildings. Single family homes, particularly near dense and economically vibrant metros, are far more supply constrained. In contrast, multi family units / apartment towers are, barring regulatory issues (see California), less constrained by available land. See Hudson Yards in NYC, the Seaport area in Boston, the Wharf in DC, etc. It's worth noting that due to costs / market demand most of these developments cater to the entry level luxury category and above, but they are new supply.

I actually wound up looking at US Census projections to get a sense of the long term outlook. By 2030 the Census estimates the population will grow from 334.5 million to 359.4, for a total increase of 24.9 million or an annual increase of 2.49 million (8). In 2019 the Census estimated 888,000 private single family units and 403,000 units in buildings w/ 2+ units were constructed for a grand total of 1,291,000 units (9). The average number of people per US household is 2.52 (10). Some simple math suggests that if we assume each new single family home contains the average number of Americans and each apartment conservatively contains only a single person we get 888,000 * 2.52 + 403,000 = ~2.64 million.

Now, talking about averages in a national real estate market reminds me of a joke about Mars: on average it's a balmy 72 degrees. But the point still stands that at a high level, theoretical sense there is sufficient "housing" for the US population. The question, as always, is at what price and location?

Real estate is a safer investment than the stock market!

This one honestly irritates me. While there are many advantages to real estate I can see, safety is not one of them. It is a highly leveraged, illiquid, extremely concentrated asset when bought individually (i.e not in a REIT). Let’s use an example here. Is there a financial advisoy in the world who would recommend you put your entire investment portfolio in Berkshire Hathaway? Of course not, diversification is the bedrock of modern personal finance. And yet Berkshire Hathaway is an extremely diversified asset manager with well run and capitalized companies ranging from Geico to Berkshire Homes to Berkshire Energy. Oh, and it also has $130 billion (with a B) in cash equivalents.

I honestly think this impression stems from 3 factors:

Almost all asset prices have gone up (barring a few 1-2 month downturns) for 10+ years. There was also a shortage of skilled labor, capital, etc. that dramatically reduced the new supply of housing
Survivorship bias. The people who fail in real estate tend to limp away quietly. The ones who survive and succeed tout their success loudly.

You won’t build your wealth in the stock market

One common theme I’m already noticing listening to podcasts, reading blogs, etc. is that many people started investing in the aftermath of the Great Financial Crisis (2009 - 2011). And, in retrospect, it was clearly a great time to buy property! But it was also a great time it turns out to buy almost every investment.

I plugged in the average annual return of the S&P 500 from December 2009 to December 2019 with dividends reinvested (and ignoring the 15-20% long term tax on dividends) (12). It was 13.3%. If you managed to buy at the market bottom of Feb 2009 it was 15.8%!

The long term annual average of the S&P 500 from 1926 - 2018 is ~10-11% (with dividends reinvested). (13). The S&P has never lost money in a 30 year period with dividends reinvested, see the fantastic book Stocks for the Long Run (14). In fact, if you’re investing before 30 the worst 35 year period (i.e. when you would turn 65) is 6.1% (15).

Housing, in general, has tracked at or slightly above inflation ( 16). Even a click bait CNBC article (17) about “skyrocketing” home prices states that homes are rising 2x as fast as inflation (i.e. ~4%). If you look at the CNBC chart for inflation adjusted prices, you’ll see a compound annual growth rate (CAGR) of 2.3% from 1940 to 2000. Let’s do this same exercise again with the Average Sales Price of Homes from Fred (i.e. Fed economic data) (18). In Q1 1963 the average sales price of a house was $19,300. In Q4 2019 it was $382,300. That is a CAGR of ~5.38% over ~57 years.

Another thing to keep in mind is that while real estate does have some tax advantages, there are also property taxes, maintenance, etc.

But it’s harder than that. Because real estate is an illiquid asset. In general, illiquid assets require higher returns than the equivalent liquid asset because of the inconvenience / risk of not having the ability to transact frequently.

Case study of real estate purchase:

I’d like to focus the rest of my analysis on an area that many members of BiggerPockets, /r/realestateinvesting, etc. seem to gloss over: credit. I was surprised to see that for first time home buyers, 72% made a down payment of 6% or less according in Dec 2018 according to (27). This would imply prices only have to decrease 6% to put these new homebuyers underwater, i.e. owe more after a sale than their mortgage. But this fails to take into account costs associated with buying a property, which are substantial at 2-5% for closing according to Zillow (28). Costs for selling a property are even more substantial, ranging from 8-10% according to Zillow (29). This means that sellers only putting down 6% could be underwater (in the sense that they couldn’t sell without providing cash during the sale) with even modest price decreases when taking into account these transactional costs.

Obviously there are ways to reduce these costs, so let’s walk through a hypothetical example of the median valued home of ~$200,000.

A young, first time home-buyer puts down 10%, or $20k, and takes out a mortgage for $180,000. They also pay (optimistically) closing costs of 2% for $4000. Luckily, they bought in a hot housing market and prices increased 5% (real) over the next 5 years. Their house is now worth ~$255,000. They sell their house and again, optimistically, closing costs are only 4%. This means they pay $10,200. Consequently, after netting out costs we calculate naively that they would make $255k - $10k - $4k - $200k (original purchase price of home) = $41k. Given they only invested $20k of their own money, this is a compound annual growth rate (CAGR) of ~15.4%, which is handily above the S&P 500’s average. This is the naive calculation I first made, but as we’ll see it is deeply flawed. First, let’s look at costs.

WalletHub has a really nice chart that shows (conveniently) property taxes on a $205,000 home across all 50 states (30). The average American household spends $2375 on property taxes, so let’s assume a little less and go for $1500. So 5 years x $1500 = $7500.

For home maintenance, the consensus seems to be ~1% annually for home maintenance with wide variation. We’ll assume that’s $2000 off the base price, so $2000 * 5 = $10,000. (31).

For homeowner’s insurance, Bankrate (32) provides a nice graph that shows the average annual cost for a $300,000 dwelling across all states and then a separate chart for costs based on dwelling coverage. For a $200,000 dwelling coverage we have a figure of $1806 per year, so over 5 years we have $1800 * 5 = $9000.

Finally we need to calculate the interest on the debt. One thing that I didn’t realize until I looked at an amortization table how front-loaded the interest payments are. Case in point, I plugged in the $180,000 loan into the amortization calculator (34) using a 3.5% interest rate and saw that we pay on average ~$6000 each year in interest vs. only ~$3800 to principal.

So lets’s run the new numbers.

You sell your home still for $255,000. After 5 years, your mortgage is now ~$160000 (i.e. you paid off 20,000 over 5 years, or ~$4k per year). So after the sale you are left with ~$95,000. The buying and selling costs remain the same as before, so we subtract the $14k for $81,000. We also then subtract $7500 (property taxes), $10,000 (home maintenance), $9000 (homeowners insurance) which gives us $54,500.

We paid ~$9,700 each year in mortgage interest + principle (~6000 interest and $3700 principal). So 5 * 9700 = $48,500.

So, net of everything we get $255,000 - $160,000 (remaining mortgage) - $48,500 (mortgage payments over 5 years) - $14k (buying / selling costs) - $7500 (property taxes) - $10,000 (home maintenance) - $9000 (home insurance) = $6000. And we put down $20,000 as a downpayment, for a net compound annual growth rate (CAGR) of negative $21.4%.

That is truly an astounding result. We had 10x leverage on an asset that went up 5% each year for 5 years and we somehow lost money on our “investment” of a down payment? Keep in mind we also used fairly optimistic numbers (particularly home price appreciation) and didn’t factor in PMI, etc. On the flip side, this home provided shelter, i.e. you didn’t pay rent. That’s a massive “avoided” cost and I don’t mean to minimize it. But the point here is that many homebuyers I’ve spoken to fail to account for the substantial costs of home ownership and expect their primary resident to generate a substantial return.

Now, of course, for real estate investing you would likely either a) hold the property for less time and attempt to flip it via forced appreciation or b) have tenants in the property. Let’s focus on b) because frankly that’s more of my interest. From what little research I’ve done flipping houses requires much more time that’s incompatible with my day job.

I went ahead and used the rental price calculator I found online at (36) to calculate the return. I used a rent of $1300 monthly, a bit lower than the average national rent of $1476 (35) because our home price was also lower than the national average. I assumed a low vacancy rate of 5%, and no other expenses beyond the ones cited above (i.e. I didn’t assume property management, higher loan interest rate, higher property taxes).

The calculator spit back a 5 year internal rate of return (a metric in this case useful to compare against the securities markets) of 27.79% return, i.e. a profit of $63k on an initial investment of $20k. The IRR as I understand it captures the time value of money, basically accounting for when you made various returns (37). E.g if an investment over 30 years pays nothing then gives you a lump sum payment at the end that’s very different than if it pays 1/30th of that lump sum every year. It’s useful in this case for comparing against the stock market because the IRR takes all future cash flows back to a net present value of 0, i.e. as if we invested all the money immediately.

&Now let’s do some scenario modeling (originally we had 10% down, 3.5% interest rate for an IRR of ~28%):

Let’s assume we have to put down 20%: now we have a 19% IRR
20% down payment and a 5.5% (instead of 3.5%) interest rate: 14.7% IRR
Home price appreciation of only 3% per year instead of 5% with 10% down payment: 20%
Home price appreciation of only 3% per year with 20% down payment: 12.65%
Home price appreciation of 0% per year with 10% down payment: 4.26%
Home price appreciation of 0% per year with 20% down payment: -1.28%

This scenario for me demonstrated a number of interesting properties.

Owning a home for even a moderate amount of time (~5 years) will likely not build substantial wealth unless there is truly massive home appreciation. The transactional costs are too high, the ongoing costs are substantial, etc. And of course I’ve neglected to include all the remodeling, furniture, etc. that every home owner I’ve met has spent money on
With regards to real estate investing, home price appreciation covers up a magnitude of sins, particularly if coupled with a low cost of debt. Changing nothing but the home price appreciation changes the investment from incredible (28% IRR) to about 1/2 the expected return of the S&P 500 (4.26%)
Real estate, whether investing or owning a primary residence, has limited to negative cash flow initially. The loan is amortized so that all early payments go to interest, maintenance is expensive, etc.
To sanity check these figures, I went and looked at the SEC filings of Invitation Homes which owns 80,000 single family homes in the US. In 2019, Invitation Homes made ~$1.764 billion on rent + other property income while spending a combine ~$730 million on property maintenance + management.(49) . That’s about ~41% of the total property income, which aligns with the rental calculator above (rent payments fo 1300 vs ~$570 for maintenance, taxes, insurance, vacancy, etc.). That honestly makes me nervous however, as Invitation Homes theoretically has the scale to centralize and minimize maintenance costs. While I could certainly substitute “sweat equity” for some repairs, it strikes me that it would be foolish to assume my costs would be lower than Invitation Homes’

401k analysis

As I mentioned above, one of the big questions around real estate investing that I rarely see asked is “is it an appreciably better investment than the alternatives”? For W2 workers, which is ~50% of private sector workers, this question becomes even more pertinent because 401ks have massive tax benefits. In fact, only 33% of US households own taxable accounts outside of a 401k, which means the vast bulk of US households either have no accounts, 38%, or own only a retirement account like a 401k, 29%, according to (39). Let’s assume we have a middle to upper middle class worker making ~70k (this puts them roughly at the 75% percentile). They want to invest, and see two options:

Invest $20,000 post-tax in a downpayment on a $200,000 investment property just like in the above analysis (we’ll assume closing costs just get baked into the final net gain)
Invest the equivalent amount of post-tax dollars into their 401k. You can probably see where I’m going with this by the use of “post-tax”.

At a salary of $70k and assuming you took the $12k standard deduction, you would still see much of your income fall into the 22% tax bracket. While certain states charge no income tax, they generally make it up in much higher sales / property taxes, so let’s also assume a 3% state income tax (40). This means that if you invest $19,500 in a 401k (the maximum in 2020) that’s equivalent to only $14,625 post-tax (because the $19,500 would be taxed ~25% before it got to you). That leaves almost $6000 when compared with the down payment figure above, which is coincidentally the exact IRA contribution limit for 2020! The math for deductions for the IRA gets painful, but we can assume a deduction of ~$1500 (i.e. 25% of 6000). Now, if your work offers an HSA it gets even better, because those contributions are tax-free even from social security (which is typically a 6.2% tax) + medicaid (1.45%). This means that if you contribute the $3500 limit, that’s equivalent to only $2300 post-tax.

This is getting rather long, so for the sake of simplicity we can basically say that in lieu of putting down a $20,000 post-tax downpayment on an investment property you could instead invest $19500 + $6000 + $3500 = $29000 into the stock market. What’s more, fees for well managed 401ks through Vanguard, Schwab are often ~0.25% (i.e. $72 annually on the $29k above).

If we assume the average S&P 500 index returns of 10% (we’ll ignore the $72 annually in expenses and of course there are no taxes), we would see $29k compounded over 5 years = $47,809. Since we’re investing the money all immediately, this is (I believe) more or less equivalent to the IRR rate.

So, what do we need to achieve to beat that return with our investment property? Well, we previously assumed a blistering 5% real home price appreciation. With inflation at ~2%, that’s a nominal 7% home price appreciation. According to both Zillow and Core logic, Idaho is the state with the fastest home appreciation values pre-COVID at ~9%. We’re essentially predicting close to this level for 5 years, which is quite rare. In August 2019, US home prices nationally were gaining ~2.6% according to (41).

Let’s plug those numbers into our rental property calculator from above. At a 10% down payment, 3.5% interest rate, and 2.6% home price appreciation we see an IRR of 18% per year. Game, set, match, real estate, right?

Well, sort of. Right now we are assuming optimistic projections about maintenance (1%), closing costs (2%), and selling costs (4%). What if we bump those up to the averages cited by Zillow (3% and 8%)? Uh-oh, now we’re down to 12.38%. Okay, but what if we assume rent goes up by the same amount, ~2%? Great! Now we’re back up to 14% IRR. But if we assume all the other expenses like home insurance and maintenance go up 2% a year as well, we’re back down to 11%.

We could go on forever, but the point is that real estate (particularly for rental properties) are extremely sensitive to assumptions you make on a number of factors. Given the risk, illiquidity, and work involved with a real estate property I would want to see a substantially higher return than the tax advantaged, hands off 10% my 401k gives me. I didn’t even include the typical 3% match for the 401k, which would have added $2100 to the initial investment amount and increased the 5 year return to $51,272.

The bottom line in my mind is that for most W2 workers who have access to pre-tax investments, they should max them out first. If you’re lucky enough to be able to max out all of the above pre-tax accounts + get a 3% match (i.e. $31k total) every year, after 15 years at a 10% return you’ll have $1.2 million. In 30 years you’ll have $6.8 million. And again, keep in mind that maxing out your pre-tax accounts only “costs” you ~$20k, because that’s what you would get after taxes. And you’ll have “made” those millions without spending a single hour outside of your day job working.

Based on the above analysis and calculations, here’s what I’ve come away with as a newbie to real estate investing:

Real estate investing involves significant risk. Achieving high returns relies upon either significant home appreciation or accurately calculating several key inputs (rental rates, maintenance costs, etc.). The past decades strong home appreciation has likely saved some investors from faulty assumptions, simply because their highly leveraged investment increased in value
Given the significant transaction, maintenance, tax, and other costs simply buying and living in a single family home is not guaranteed to build substantial wealth in the short term (i.e. < 10 years) even with significant price appreciation.
The story of real estate investing is really the story of credit availability. Low interest rates, widespread credit, etc. allow investors to take on significant leverage and potentially achieve high returns. On the flip side, if credit tightens we could see substantial movements in real estate as valuations adjust to the more expensive or less available leverage
Personally, I would want to see at least 12+% returns annually before I invested in real estate directly vs. a diversified stock portfolio. Potentially having a cash flow negative, illiquid, highly leveraged asset is a risk that I want to be compensated for by a higher return. Obviously there are many advantages to real estate I’ve not yet learned in depth about (e.g. taxes), so perhaps this premium will change slightly in my mind in the future
If you’re a younger, W2 wage earning in the US with the access and ability to contribute to a 401k, IRA, and HSA you should do that first before even considering real estate investing. The tax advantages are immense, the time investment is essentially nothing, and historically you are guaranteed, at the absolute worst, a 6.5% annualized return if you wait for 35 years. Plus a well diversified 401k fund, like a Vanguard target retirement fund, may very well include REITs
The exception here of course is doing something like house hacking, etc. where you are combining your primary residence with an investment. I’m not sophisticated enough yet to run the numbers there, but it seems reasonable on the surface

Some thoughts on the future:

Forecasting is always risky, but at the same time we all have to form an opinion on where the future is headed. My general thoughts are that crisis tend to accelerate existing trends rather than create new ones. There were already recession concerns in late 2019, and US GDP growth expectations had been downgraded to ~2.0% by the OECD even before COVID (45), albeit with slight optimism around the Phase 1 trade deal with China. Geopolitical tension and capital controls in China had led to mainland Chinese investors slowing their investments in US real estate and increasing dispositions (47).

While there is certainly a housing shortage, even in high growth states we see housing “deficits” according to Fannie Mae of ~5%. While this is clearly substantial, shifting migration patterns, regulatory changes, household preferences (e.g. telecommuting) could easily shift the balance. It’s far from certain in my mind that housing will remain supply constrained in the medium term (i.e. > 3 years)
In December 2019, Zillow was already forecasting slowing home price and rental appreciation to modest 2.8% & 2.3% respectively (42)
As of March 31 2020, Zillow now forecasts home price appreciation at -1.5% nationally.
We are seeing tightening mortgage credit, particularly for jumbo loans that are essentially for high priced real estate markets (44). Mortgage services, i.e. non-bank companies like Quicken, have been hit hard by the mortgage forbearance regulations (although relief measures have been enacted)
The CBO is currently forecasting the unemployment rate to remain >10% until 2021 (48). Even if that proves wildly pessimistic, it’s highly probably that the tepid wage gains of the last few years will slow further or even reverse
Ultimately with slowing wage gains and reduced credit in the short term it is hard to see how consumers retain their purchasing power to drive rents / real estate prices substantially higher.
On the flip side, central banks globally have injected trillions of dollars of liquidity into the global economy. This has driven down yields in traditional safe havens, e.g. investment grade corporate and sovereign bonds. The question becomes, where does this money go? Does it favor real estate over stocks? Does it lead to inflation, deflation, stagflation?
Local & state governments are facing massive budget shortfalls due to dramatically lower revenues (e.g. sales taxes) and higher costs (unemployment insurance, healthcare, etc.). If the federal government does not backstop these revenues, will we see higher state / local taxes or cutbacks in services?
As mentioned previously, the tax law changes of 2017 dramatically affected how individuals / households approach their federal taxes. In particular, it is now far less advantageous to itemize property taxes, state taxes, mortgage interest, etc. Mark Zandi (50) of Moody’s analytics provided some interesting analysis that suggested the tax law changes had already impacted higher cost markets. It will be interesting to see if these trends continue, accelerate, or reverse post COVID.
The question now becomes how investors, particularly those who entered late in the cycle and lack substantial equity buffers, will deal with conditions. A V shaped recovery would likely see minimal disruption as investors are able to cope with disrupted cash flows for several months. A longer recession would see over-leveraged investors forced to short-sell properties
I’m particularly struck by the fact that according to at least one source (27) ~72% of first time home buyers put down 6% or less. These recent buyers lack the equity buffer to deal with any material decline in housing prices, while the modest down payment suggests they may also lack substantial cash reserves to deal with an economic shock.
There also seems to me a disconnect between commercial and residential real estate I don’t fully understand. Take a well capitalized and diversified REIT like Brookfield Property Partners. This REIT is currently offering a 14%+ yield. Of course many of their properties like urban office / retail space are getting hammered by COVID. But if we’re assuming that centrally located, urban commercial office & retail spaces are substantially less valuable than pre-COVID, what does that say more broadly about dense urban real estate? After all, if people work from home and don’t go out to commercial real estate spaces, why bother paying a premium in living expenses?

From my point of view, I’m interested in seeing how the market reacts over the next 3-6 months. Do sellers react by rapidly putting properties on the market before it’s “too late”? Are there enough prime buyers given the tightening credit, particularly for expensive coastal markets, to absorb a spike in listings? As Warren Buffett once said: “"At rare and unpredictable intervals...credit vanishes and debt becomes financially fatal. A Russian-roulette equation--usually win, occasionally die--may make financial sense for someone who gets a piece of a company's upside but does not share in its downside.” We shall see.

Sources:

Submitted April 27, 2020 at 07:28PM by cooleddy89 https://ift.tt/3eW7e3N

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