As cap rates on rental real estate continue to soar, single family homes and residential units are starting to look like the world’s best asset class.
In fact, hedge funds are hopping into the game, too. Recently the Wall Street Journal reported hedge funds are chasing the landlord game.
The article speaks of the very attractive 12-14% yields available on rental properties and the sheer number of investment-grade foreclosures available for sale.
In one specific example, the WSJ outlined a deal one struggling homeowner made with a hedge fund investor. After purchasing the home for just under $323,000, one homeowner found their home to be too much. The balance quickly ballooned to more than $400,000 forcing a tough decision.
Ultimately, an investor bought the home for $155,000, a discount of $168,000 to the initial purchase price. The previous owner still lives in the home and his $1,800 monthly rent payment is considerably more affordable than his $2,500 mortgage.
A home stays off the market, and no one goes homeless. The hedge fund earns nearly 14% per year on its investment, and the previous homeowner sees $700 in additional monthly cash flow. That’s a win-win situation if I’ve ever seen one.
The End of Real Estate
Analysts say that the real estate market has bottomed, especially residential real estate. On a cash flow basis, the 12-14% yields available on investment-grade properties are sexy, especially with long-term financing costs now breaching record lows.
But even as the market for residential real estate recovers, the market for commercial properties couldn’t be in worse shape.
A February 2011 (trust me, nothing has changed since) report from Realtor.org shows the following vacancy statistics:
- Office Space – 16.5% of spaces are vacant; 2012 reading should fall to 16%.
- Industrial Space – Industrial real estate is expected to improve from 14.2% vacant to 12.9%
- Retail Spaces – Retail vacancies are expected to fall slightly from 13% to 12.9% in 2012.
- Multi-Family Units – Multifamily housing vacancies are expected to decline from 5.8% to 4.9%
There’s a very clear trend emerging in real estate; all properties which are not expressly live-in properties see very slow growth. Residential properties, however, are improving vacancy numbers at a record pace. The gains, though, do not come as a result of improvement, but stagnation.
As foreclosures speed up, more homeowners leave owned properties to rent a new home or apartment. The long foreclosure process keeps any foreclosed property off the market for months, or even years. The result is that each foreclosure and subsequent rental transaction takes 2 homes off the market for just one failed mortgage.
Retail Real Estate’s Plunging Value-Add
Twenty years ago you could “build it and they would come.” Retailers knew that the best competitive advantage for any business is proximity and convenience. In an era where shopping trips were not wholly-digital affairs, location mattered.
This isn’t true today. I can complete 90% of my shopping needs on my daily commute (stumble) from my bed to my desk.
Mom and pop shops operating out of premium retail real estate are no longer competitive. While I can open a gift shop tomorrow in a premier retail outlet for $15 per square foot, I have to compete with retailers like Amazon, which sell goods online out of warehouse space that costs a third as much.
Online retail’s volume power pales in comparison to general reduction in operating expenditures. Selling goods online is cheap—and the potential market is limitless. Selling goods offline is expensive—and the potential market is the populace that lives within 10-20 miles of your location.
My Biggest Real Estate Fear
My biggest fear in buying real estate as an investment isn’t that there isn’t a need for it. Everyone wants a roof over their head.
And my fear isn’t that the real estate market will fall further-assuming cap rates stay constant it’s hard to care about plunging RE valuations.
My biggest fear is that there is, across the board, far too much real estate in existence. The only difference between commercial real estate and residential real estate isn’t the white picket fence or a cute little yellow kitchen that every woman adores, it’s a mere classification.
It’s easy to turn commercial property into residential property. Hundreds, if not thousands, of properties located in high-cost areas have been converted from office space to homes. Hell, I have an office space for my online business, for which I pay only $14 per year per square foot including utilities, internet, and janitorial services. If I could rent four contiguous units, I’d probably call it home.
And that’s another thing—the lines between home and office are blurred. More people work at home than at any time in history. Each time a worker leaves the cubicle for an already existing area in their home there’s 100 sq. ft. or more of real estate available for another use.
Seniors who purchased homes with thousands of square feet to house their baby boomers are now retiring to senior living real estate, units where footprints rarely rise above 1,000 square feet.
My biggest fear is that the market faces oversupply for years to come. Those glorious cap rates that real estate offers today are, in my view, merely an indication that the current market is in disarray. While home values may hold firm, cap rates will not.
But what do I know. I have no skin in this game. 😉