Real Estate in an All Cash Market

by JT McGee

Investing in cash has never made better sense.The tide has turned in real estate. Where buyers were coming into the market with leverage in 2003-2008, today’s market rewards cash and pushes aside buyers using credit.
The National Association of Realtors reported that 31% of all transactions in April were all-cash deals, down from 35% in march but still far higher than the 26% level in March 2010.

The NAR isn’t the only group reporting the surge in all-cash deals. CoreLogic suggests that investors coming into the market are more likely to buy with cash than they are to buy with leverage. In 2010, investors used cash to finance 60% of all purchases, up from 48% in 2009. Levered interest in real estate peaked in 2005, a year when the most second mortgages were written on investment properties.

Why Cash-Only Matters

As part of the NAR’s monthly report was a mention of the abnormally low default rate present in the current market. When investors go in with cash, they simply cannot default. Besides that, all-cash deals (or mostly-cash deals) mean that any capital loss is attributed to the investor first. Lenders who finance only part of a purchase are protected by the owner’s equity.

The effects of cash-only purchasers can be seen in rental real estate. In recent deals, buyers looking at in-land US properties have bid down multi-family real estate (read: apartment buildings) to cap rates of 6% annually. That return is only a few points higher than US Treasuries, suggesting that investors feel safe working into housing at today’s prices. It might also suggest that investors see rising rental rates on the horizon. The National Association of Home Builders is the most bullish on improving rents as it has been during the past 5 years. A recent survey suggested rents could rise by 2-4 percent per year for the next five years.

Current Rental Environment

On Friday, the Financial Times reported that rents are improving in the US. In fact, rents are improving so quickly that they’re throwing macroeconomic indicators out of whack.

According to the Case Shiller Index for US housing, home prices fell at an annualized rate of 4.2% in the first quarter of 2011. But don’t tell the Bureau of Labor Statistics, which reports the critical Consumer Price Index. The BLS uses rents to determine both inflation and the current value of property—if rents rise, then the BLS adjusts home prices upward by the same degree.

Actual and implied rents make up 30% of the CPI, and Goldman Sachs says the rental rebound makes up for 60% of the inflation rise in the last 12 months, according to Financial Times.

Why Housing is Hot

At the end of the day, our job is to determine “why” from “what.” Why is housing on the radar:

  1. Foreclosures – Every foreclosure means one more family has to find a new place to live. Clearly, they can’t go buy a new home, so they’re moving into apartments to put a roof over their head.
  2. Low interest rates – Rates are playing into the market differently than they were during the 2003-2008 housing boom. Today, buyers are playing with all cash—they’re looking for better returns on cash, not better returns with leverage.
  3. Implied returns – Even as home prices dip with each foreclosure, rental units are expected to see 2-4% growth in rental prices for the next five years. Naturally, this bodes well as an anti-inflationary investment, as rental income should grow at a rate equal to (or greater) than implied inflation.
  4. Investors have plenty of cash – A recent report on money-market funds revealed that retail investors housed $916 billion of cash in money-market funds. Institutional money-markets had $1.7 trillion in money funds. All told, money-market funds are worth $2.7 trillion—and the returns are pitiful.

According to the Case-Schiller Index, home prices are now as inexpensive, or less expensive than they were 10 years ago. Accounting for inflation, rental real estate has never been a better investment.

Prices for real estate in brand-name markets presents opportunity.

I’m beginning to wonder how so-called “shadow inventory” is affecting the market. Shadow inventory being all the homes that banks have foreclosed on but have not yet put on the market for sale.

Unorganized thoughts:

  • Buyers are bullish – There seems to be plenty of demand for investment housing. When buyers come on the market with pure cash they’re essentially saying they see limited or zero downside. Additionally, all cash buyers could presumably come into the market with leverage. If you have enough cash to buy an investment property, you probably have the credit to buy five investment properties.
  • Shadow rents – With the shadow inventory off the market, rental properties are limited. Each home that lies in wait is unoccupied, which does help to bolster rents.
  • Second wave? – The numbers look great. But what happens if rents rise while the supply of homes for rent dwindles? Notice how shadow inventory still leaves housing prices in decline (a constrained supply still fails to keep up prices) but it does the opposite for rental incomes–earnings are rising amid home price declines.

Readers: What’s your best guess for housing? Will prices continue on the downtrend, and will rents continue on an uptrend? Leave your opinion; it won’t cost you anything. 😉

Photo by: LoosePunctuation.

{ 8 comments… read them below or add one }

Jonathan June 20, 2011 at 10:10

I haven’t been in the market long enough to be able to comment on the direction of rents, but I do expect that housing prices will continue to stagnate or even decline in the market I am involved in. There is a MASSIVE shadow inventory there which will keep a steady supply for years more.

But if rental rates rise while the price of housing falls, there should be a stabilization as the cost of buying reduces toward the cost of renting (or even becomes cheaper than renting). In other words, market forces will work their magic.

Regarding your point #2 above, that low interest rates are causing people to pull money from money market accounts and other low-interest-bearing investments and buying rental property with cash, and combined with your statement that buyers are bullish and COULD buy with leverage – Given the historically low interest rates on CAPITAL as well, it’s a wonder to me that the cash buyers DON’T leverage their purchases, especially if they don’t see the purchase as a risky investment. Being 20% invested in 5 properties is MUCH better than being 100% invested in 1 property, from a risk management standpoint; and also, you get the full benefit of rising rents on all 5 properties and get a much larger return on investment.


JT McGee June 20, 2011 at 14:24

See, that’s what I’m trying to find out…are market forces really affecting this market? If someone defaults on a mortgage, then moves into an apartment, they essentially occupy 2 homes–the one that is in foreclosure and empty, and the home they presumably rent after defaulting. Demand is up, rents are up, maybe the decline in housing is just a time lag?

Maybe equilibrium prices are still a long way away since the buyers who would normally finance a purchase can’t do so? This makes for an interesting macro study either way.

I’ll never understand why people don’t leverage up. It makes very little sense not to leverage. As you mention, 5 homes are better from a risk management standpoint, and debt does protect a buyer against downside risk. Even 3:1 leverage would make a lot more sense, and buying in with 33% equity does give you quite the competitive advantage in being able to afford down moves in the rental market.


Squirrelers June 20, 2011 at 13:48

I suspect that there’s a huge shadow inventory of homes.

Looking the bigger picture – people were getting used to being able to treat their homes as a semi-liquid asset. However, transaction volatility has come to a screeching slowdown in recent years, and I suspect people are effectively “trapped” geographically by A) being unable to sell their homes, B) not wanting to sell their homes due to loss aversion of paper profits, or C) Having trouble obtaining financing on a home purchase. Maybe all 3 come into play.

Buyers are in a good position these days IF they don’t have a place to sell. If they do have a place to sell, I’m hypothesizing that they fall into one of those 3 groups I noted above. Overall, the market appears stuck, and any stimulus effect is long gone.

What’s interesting to me is that despite interest rates being at remarkably low levels and home prices much lower than a few years ago, homes still aren’t selling much in many markets. That tells us a lot.

You know, I’m generally a believer in market cycles, bubbles, and the presence of overreactions. Clearly, the bubble burst. Has this ‘burst’ bubble’s impact been excessive to the point of offering really opportunities that many seem to see now?

I’m not so sure of that in general. With the economy sputtering along and drifting in the wrong direction, and all the factors above – with the shadow inventory – my truly non-expert opinion sees a weak real estate market for the short-term at least. Prices here in the Chicago area, where I’m at, seem to have some room to drop more.

The time just might come where we’re at a point of this truly being a really undervalued market, but I don’t see that being the case for the short-term anyway. Longer term, after things stabilize, I can see being bullish again on real estate….but just not yet.


JT McGee June 20, 2011 at 14:28

It does definitely tell us a lot that rates are at all time lows but yet people aren’t 1) confident enough 2) in the financial position 3) generally willing to purchase a home. I think you’re right about future movements to the downside. I think most areas are still 10-12% overvalued in the aggregate, based on price-to-rents.

I wonder if rates might be so low because no one is buying? I mean, clearly the banks are well-capitalized…if rates are so low, it has to be because supply is greatly outpacing demand. Are investors/homeowners lacking that much confidence, or has it become that difficult to convince a banker that you’re a good borrower?

As Jonathan said in his comment, and I echoed, I wonder why investors are so bullish (going in with all cash is clearly a bullish sign, since all downside is yours to eat) but aren’t willing to leverage up? It’s weird, really.


Jonathan June 20, 2011 at 15:09

For what it’s worth, we’ve had no problem convincing banks we’re good borrowers (putting 20% down on investment properties).


JT McGee June 21, 2011 at 14:32

I probably have some geographical bias. Being semi rural, I’ve heard it’s a pain to get a loan with the markets being so illiquid.

Do you keep a total low DTI ratio? I suppose that goes into the calculus, too.


Ginger July 4, 2011 at 16:01

All banks seems to want 25% down, where are you finding someone who will let you put 20% down?


Jonathan June 22, 2011 at 10:48

I can’t speak to a regional bias…Our debt-to-income ratio is a little less than 1-to-1, I suppose…we only have one rental house so far, and the mortgage is 80% of all of our debt. As soon as we get another, the ratio will nearly double. I don’t know how that would factor into the bank’s decision, though our mortgage officer always has told me that as long as we have good income and the down payment, she can approve us.


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