Why Real Estate Investors Should be Shaking in their Boots

by JT McGee

Foreclosures push up rental real estate returns.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.

Online sales growth in the US

This graph shows the forecasted growth for online sales in the United States.

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.

A graph of commercial real estate vs residential

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. 😉

{ 17 comments… read them below or add one }

Jonathan September 14, 2011 at 10:07

I agree, to an extent. As a real estate investor (SFH), my biggest concern is the possibility that the population in the region I buy will contract over the long term, leaving the thousands of homes built over the past 10 years empty for good (and pushing rental rates way down in the process). That said, I don’t expect it to happen, and rental rate changes would lag the population change anyway, so it’s a long way off.

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JT September 14, 2011 at 11:21

I see it as a long-term transition, but I’m still thinking there’s way more real estate in existence than we may need for quite some time. Luckily for investors the market is warped with the delay between foreclosure and REO sale, so cap rates stay high for now.

Still wish we could see some complete and total liquidation right now. Next post will probably have something about that.

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John Hunter September 14, 2011 at 11:52

Thanks for the post. You raise a valid concern. I am not as worried as you about the substitution of commercial for residential property. Some types can be converted without a huge amount of trouble, but a fair amount I think is very difficult to convert. I do think oversupply is still a valid concern for residential property I just think with the other strong investing factors (and the paucity of other investing options) that residential real estate is a good investing option to consider. Local factors are obviously very important.

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JT September 14, 2011 at 13:14

Yeah, some may be difficult to convert. But at what discount does commercial realty have to sell to residential property to make it profitable? My guess is that it’s not a very big discount.

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Ashley @ Money Talks September 14, 2011 at 12:34

The commercial market in my area is horrendous. About 4 years ago they built a new office complex on the corner near my house. It sat totally empty for about 3 years. COMPLETELY EMPTY. Then a doctor’s office moved in there and was the only thing in there for about 9 months. Just recently another doctor went in. Those are the only two things in the whole complex still to this day. It’s not a huge place, but I’d say there are still 8-10 offices empty 4 years later. And they are super nice, brand new.

But it’s like that all over the city, new and old spaces. Strip malls are basically empty, prime location brand new office space is empty. There’s a brand new strip mall/ office space type place in the same parking lot as Costco that’s been totally empty for years and years. I mean, within site of Costco! That’s a prime spot, Costco is always packed. And yet, not one taker. So weird.

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JT September 14, 2011 at 13:19

Sounds a lot like here. There’s a premium office space (higher income, “better” address, etc) near my home. It’s also right off the interstate. It’s been empty since the RE burst in 2008. These are very nice offices, lakes, trees, all kinds of things that make this “the place” for b2c service providers.

Then if you go a few miles the other direction, there’s a mall. It’s basically empty, even though I bet 10-30k cars pass each day…maybe more. The businesses inside are nothing of the typical mall setting. Lots of antique dealers, a health care office (backoffice stuff–no doctors, LOL), and a couple call centers. Clearly, it just can’t draw the retail premium, and it’s falling to regular office space quickly.

The empty Costco spaces seem really weird. RE on the outskirts of my town is so inexpensive that building out isn’t expensive. Walmart built out and stuffed a shopping center in less than three months. That just doesn’t make sense to me that Costco couldn’t do the same, but who knows…

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krantcents September 14, 2011 at 19:49

I have no desire to get back into rental property, but the cost of homes make it very attractive. Add low interest mortgages, it is quite a combination. You still need to understand the rental market, but it looks really good. If you can break even, it i a winner.

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JT September 14, 2011 at 20:34

Yeah, really, what’s better than record high spreads between cap rates and financing costs? Looks good right now, but the future is pretty cloudy. I’d take it for a few years, though. No way the government will ever let real liquidation in housing to happen any time soon.

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Financial Success For Young Adults September 14, 2011 at 20:12

I hate to take it to a political standpoint but I foresee a republican realizing the same thing and creating another bubble! lol
But really, I also see the oversupply. I’m pretty heavily invested in commercial real estate equities and I’m still buying. My thought is that though recovery is slow, the opportunities around the world are still prime. I have a stock that invests around the world and I feel ok with that diversification within the one stock.

Hotel in Dubai anyone?

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JT September 14, 2011 at 20:33

Republicans are definitely more invested in real estate. The homeowners tax credit is surely high on their radar. Well, any tax credit is, but the interest deduction is one of those credits everyone thinks benefits them disproportionately.

BTW, I heard there’s a few really cool islands for sale in Dubai. 😉 Haha, Dubai is an interesting case in real estate. China’s probably in a similar situation as Dubai 2007, but no one wants to admit it, and their financing regime is so intertwined that no one even has an idea of what is really going on.

Commercial still scares me. Give me a pure-play REIT in residential and I’m in. 😀

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cashflowmantra September 15, 2011 at 14:21

Granted there is oversupply, but banks aren’t landlords so the property is simply sitting there. It is not functional so isn’t part of the rental stock. It will take a long time and attractive prices to work through that supply so I doubt there will be a significant impact on rental rates at least from a residential standpoint. My market has stayed fairly consistent for the past 10 years with little real change.

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JT September 15, 2011 at 14:42

I wish there were a pure play on this bet because I’d take it. Ten years from now I think cap rates will be significantly lower than right now.

According to GS, 60% of the rise in the CPI is due to implied rents. Home values in the CPI are not tied to actual selling prices, but rents for average properties. These can’t diverge forever, and I really do think we’ll see plummeting cap rates in the next few years. Someone should make an ETN for this play. I’d gamble on it.

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Super Frugalette September 18, 2011 at 21:31

I hadn’t considered all of the “emptiness” I have been seeing in offices. I saw one of the greatest examples of over building on a trip to China 6 years ago. It was dark at night and many buildings had no lights on. I was informed that there were no lights because the buildings were vacant…when I mean “building” I am describing 50 stories or more!

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JT McGee September 18, 2011 at 21:53

Frugalette, China’s real estate is freakin’ nuts–there’s no other way to describe it. The government literally pays to build new buildings/infrastructure one year, then destroy it the next all in the name of employment.

Next time you feel like wasting 5 hours of your life, check out some of the “empty city” pictures on Google. Whole cities exist without a single person occupying a home.

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Darwin's Money September 18, 2011 at 21:43

Ahh, the one segment you didn’t cover… college campus real estate! About to close a deal this week on some properties and with costs of college continuing to soar and enrollment steady/increasing everywhere, it’s easy to increase rents annually. Seems pretty disconnected from what’s going on with residential and commercial real estate; a totally different biz.

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JT McGee September 18, 2011 at 21:54

Yeah, real estate near college campuses looks great. I’m in a town with the least expensive 4-yr state university and enrollment is surging as people scale back on costs. Real estate should only follow.

Then again, how many big buildings surround a campus? Could a Walmart turn into an affordable off campus “dorm?”

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Paula @ Afford Anything December 27, 2011 at 00:20

I think the most important consideration is whether or not people are moving to your city or town. I’m not concerned about a Wal-Mart space converting into 100 new apartment units. That’s chump change. I’m concerned about 1 million people migrating away from my city (and the corollary is that I’m excited by the prospect of 1 million additional people moving into it.)

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