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May 15th, 2012 by The Real Estate Guys
When we interviewed Donald Trump a couple of weeks ago, he told us that NOW is a great time to get into real estate – and he specifically pointed to houses.
Fellow billionaire, Warren Buffett, appeared on CNBC a couple of months ago and essentially said the same thing. In fact, he said if there was an efficient way to do it, he’d like to buy 200,000 single family homes!
You may or may not agree with them at first blush, but when two billionaires (neither of whom are trying to sell you houses) both say the same thing, it’s probably worth taking a closer look, don’t you think?
Why are billionaires Buffett and Trump bullish on real estate right now?
1. Prices are low relative to replacement cost.
Rising commodity costs (oil, lumber, steel, concrete, copper, etc.) make it more expensive to build new homes. And even though land and labor are soft in many areas, it still costs more to build a new house than what existing homes are selling for. Until that changes, there won’t be too much building (not to mention the tight construction funding).
Eventually, a growing population (the U.S. is projected to reach 400 million in the next 20 years), should increase demand to where new housing will be a necessity. When that happens, the new houses will pull up the value of existing houses. Or more accurately, competition for existing houses will push prices up until it makes sense to build new ones. Either way, it’s a wave a “value investor” like Warren Buffett recognizes and would like to ride.
2. Rents are high relative to purchase prices.
At the end of the day, rental real estate is an income investment. When you can pay less for more income, that’s a good thing. And with more people entering the renter population, increasing demand is propping up rents in many markets. Robert Kiyosaki’s “Rich Dad” real estate advisor Ken McElroy tells us that every 1% decrease in home ownership is another million people who need to rent. And home ownership is several points down from its peak of nearly 70% just a few years ago! That’s a BIG demographic shift.
Again, the law of supply and demand says that without new housing coming to market, and more people competing for available housing, rents (and prices) will eventually rise. But even if they don’t, RIGHT NOW the rent to price ratio is VERY favorable for income property investors. Great! That means we don’t have to wait for the numbers to make sense. In many markets, they make sense now.
3. The foreclosure inventory remains high.
Why does this matter? First, the people living in those houses haven’t yet joined the renter population. As they do, there will be more demand for rentals. And as those properties work their way into the market, they’ll keep prices down. That’s good if you want to acquire properties at good prices (value investing). If you’re a buyer of investment real estate, how long do you want the sale to last? We hope the sale lasts awhile, so we can stock up!
Interest rates are at record lows. The biggest expense a real estate investor has is the interest on the mortgages being used to control the property. Low interest rates and solid rents mean better cash flows. Right now, the cash flow on many properties (the capitalization or “cap” rate) is higher than the cost of the mortgage (the interest rate). If you can borrow money at 5% and invest it and earn 8%, how much 5% money do you want to borrow? How about ALL of it!
And last but CERTAINLY not least…
4. Inflation benefits real estate investors.
Donald Trump told us that “real estate and inflation get along very well.” Great!
What does that mean?
When the Fed “eases” more money into the system, it causes interest rates to drop. In fact, lower interest rates are a major reason the Fed “eases”.
But easing also means that the dollar falls — that is, it takes more dollars to buy the same stuff (which is why gas, food and almost everything costs more in dollars).
Hey! Don’t tune out now! This is where it gets interesting. Trust us, a little understanding of real estate macroeconomics can go a long way. There’s a reason Donald Trump likes real estate when there’s inflation.
Real estate is one of the items that eventually goes up in dollars because of inflation. But that’s not the reason to buy property. Because whether the property goes up or down in price over time, as long as it cash flows, you win. I’ll say that again: As long as it cash flows, you win. Let’s take a look…
For example, if you put $20,000 down on a $100,000 property and it throws off positive cash flow of $200 a month, you’re getting over a 10% return on our your $20,000, plus tax breaks! That’s pretty good.
But what if (gasp!) Buffett and Trump are wrong, and the house goes DOWN in value?
Let’s say that after 30 years, you wake up and discover your property is only worth $50,000. A 50% decline over 30 years! Ouch. But did you really lose?
Grab a cup of coffee and let’s do some math! C’mon, it’ll be fun.
First, let’s say you paid cash. Not that you’d want to (for reasons to be described), but you may have to. Not everyone is running around with a pristine credit score.
So you pay $100,000 today. Without a mortgage, after expenses, you pocket $700 a month… for 360 months! That’s $700 x 360 or $252,000. Now the property is worth only $50,000 and it still generates cash flow. So you get ALL your money off the table, still have a property that’s paid for, and it’s paying you each month. How are you doing?
But, you say, if the price drops, wouldn’t the rent drop too? Take a look around. We just watched properties lose half their value in many markets. Did the rents go down by half? Maybe in certain isolated markets, but that’s certainly not been the norm. And if home prices are dropping precipitously, are builders adding new supply? Probably not. So unless the population shrinks as much or more, then demand should prop up rents.
However, for sake of argument, let’s say that rent dropped over time so that on average, your take home income on your free and clear property was reduced from $700 to $350. What’s $350 x 360? Survey says… $126,000. Have you lost yet? Isn’t this fun?
But let’s go back to our 20% down scenario…
So you put in $20,000 (down payment) on a $100,000 property and earn over 10% a year for 30 years ($200 a month = $2,400 a year income on your $20,000 down payment). That’s less cash flow than if you paid $100,000 cash. But we can think of about 80,000 reasons why getting a loan is a good idea. And more than a 10% cash-on-cash return is pretty strong. Good luck getting that in a CD.
Plus, at the end of 30 years, the tenant has completely paid off your $80,000 loan and you now own the house free and clear… PLUS, it’s still supplying you with monthly cash! There’s no bank account or mutual fund that can match that deal. We know. We asked. They laughed so hard, they… well, let’s just say they laughed real hard.
Now if Trump and Buffet are right, and today you’re buying houses below the future value, in 30 years your investment property might be worth $200,000 or more. Nice, stable, steady long term inflation of 2-3% per year — just like Bernanke and the Federal Reserve target. The Fed is COMMITTED to inflation!
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