HOME     SITEMAP     RSS     TWITTER     EMAIL    
Search:   

FollowSteph Follow Steph as he posts Blog Blazer Friday
 

The Great Real Estate Dilemma

As you probably know from my previous real estate posts, I believe that we’re past due for a real estate bust. This week I came accross another very interesting article related to the topic by Dr. Steve Sjuggerud. I’m not sure I’m in full agreement with the article, but it does provide some very interesting arguments that are definetely worth reading.

Home Prices Adjusted For Inflation

For example, the graph above shows the prices of new houses adjusted for inflation. There are a few interesting points to notice about this graph. First, the general trend over time has been upwards. That is, as populations increase and space within cities become more condensed, prices have to go up, that’s the law of supply and demand. What’s also very interesting is that the prices have not always gone up steadily, there have been some drastic dips!

The delimma faced by today’s real estate investors is whether or not to buy, or to hold out until the bust when you can buy properties for much cheaper. Based on the fact that interest rates have nowhere to go but up, and the effect interest rates have on property prices, I know a lot of you out there are thinking of waiting it out. The reality is that a great investor can invest successfully in any market! The key is what you select and how you finance it. That’s the topic of this article.

If you look closely again at the graph above you’ll quickly notice that over the last 40 years that no dip has lasted 10 years. Although this graph is for new houses, let’s take the assumption that it applies for all housing (since conceptually it’s very similar). Therefore, assuming that you buy a property at the very height of a boom, if you can hold it for at least 10 years, than by all accounts you should be able to sell it at least the price you paid! At quick glance, that might not look so good, but take a second to think about it…

This means that no matter what the market, if you have at least a 10 year fixed mortgage at today’s interest and you can hold it for at least 10 years, you’ll make money (assuming you picked a good income property). At the very least you’ll have paid down the equity with your rental income. However, chances are that you will be able to sell it at a price higher than what you paid for at at least one point over those 10 years.

All said and done, it’s important for today’s investor to lock in their interest rates for at least 10 years and select positive cash flow properties. Actually, You should never purchase a negative cash flow property!!! Why would you? How can you call it an income property when you continually dump money into it? What’s the benefit of it? I’ve heard people say that they will make their profit when they sell. Why would you want to do this? You might need to make payments for who knows how many years before you can sell at a profit, maybe as much as ten years. How much profit will you really make? If I have a negative cash flow of say $200/mth for 10 years (which some people accept today), that’s $24,000 that you will need to put into your property over those 10 years.

Scenario 1 – $200/mth Negative Cash Flow

Total cash flow payments over 10 years

$24,000.00

Total Annuity earned on $24,000.00

$7,056.46

Total equity paid down

$37,711.66

Total

$6,655.11

 
 

What about the equity you paid down? Sure, you’ll have paid some down, but very little. At the beginning of a mortgage, most of your payments go to pay the interest. Actually, you’re $200/mth from the above example probably pays half your principle. Anyways, getting 5% interest on your money will not make you rich quick, so let’s look at some real numbers. Let’s say you paid $200,000 for the property at 5% interest. After 10 years, you’d have paid the equity down to $162,288.34, or $37,711.66 of equity. Based on our previous example, after you calculate the money you put in, you only made $13,711.66 profit. Now let’s make it more accurate and take that $200/mth and put it into an annuity for the 10 years. After 10 years, we’d have $31,056.46, or $7,056.46 in interest. That means that we made a total profit of $6,655.11, which is pretty poor interest on $24,000 over 10 years! Especially considering the leverage and risk. Going back to our example, to break even after 10 years, we need to sell the house at no more than $6,655.11 less than what we initially paid for it. That’s not counting any commissions, lawyer fees, home inspections, etc. which would probably bring us to a loss. This makes it very difficult for us to make a profit, even if we hold out for the next boom.

Scenario 2 – Break Even Cash Flow

Total cash flow payments over 10 years

$0.00

Total Annuity earned on $24,000.00

$0.00

Total equity paid down

$37,711.66

Total

$37,711.66

 
 

Do the scenario with a break even cash flow, or +200/mth positive cash flow, and you can see the numbers change drastically! A small difference of $400/mth cash flow, the difference between -$200/mth to +$200/mth is over $60,000 over 10 years at today’s low interest rates! By the way, although I haven’t yet done the calculations, I assume these changes get much more drastic as the interest rates climb.

Scenario 3 – $200/mth Positive Cash Flow

Total cash flow payments over 10 years

$24,000.00

Total Annuity earned on $24,000.00

$7,056.46

Total equity paid down

$37,711.66

Total

$68,768.12

 
All in all, if you plan on investing in real estate today, and you want to absolutely guarantee a profit in today’s market, invest with at least a 10 year forecast because you might just be investing at the height of a boom market. With a 10 year forecast, at a profitable cash flow today with a locked in interest rate for at least that term, you should on all accounts come out ahead. Make sure you do the numbers and you should come out ahead in all markets!
So for today’s investors the dilemma should be simple, if you’re going to invest make sure you can hold at a fixed cost for at least 10 years and that you are at least making some positive cash flow for that duration. There are 10+ year fixed rate mortgages out there for low interest rates, you just need to find them. I personally found one recently for 5.4% fixed for 25 years that is both assumable and transferable. This means that should the market dip as I expect, I should be safe because I can outlast the dip, even if it’s the longest dip in recorded history! Like I said at the beginning, smart investors should be able to invest and profit in every market condition, it’s just that the it’s much much tougher to find good deals in boom markets than it is in bust markets.


 
Like this article?

Comments:

  •     FollowSteph.com » Manias, Panics, and Crashes: A History of Financial Crisis
    · October 5th, 2007  · 8:34 am  · Permalink

    […] their purchases of these assets on the anticipation that their prices will continue to increase. Some of these investors may have a ‘negative carry’ in that the interest rates on the fu…; these investors anticipated that they would be able to use the increase in value of the asset as […]

  •     FollowSteph.com » Is it Possible to Predict When a Market will Crash?
    · October 16th, 2007  · 10:07 pm  · Permalink

    […] What does this all lead to? Well over time an asset can only deviate so much above or below its intrinsic (real) value before it has to re-align itself (adjust its price back to a reasonable value). Right now, at least in North America for sure, prices of real estate properties have deviated significantly above their intrinsic value, so much so that they are now correcting themselves and trying to re-adjust to their intrinsic value. And don’t think we’re there yet, they’ve still got a lot of re-adjusting to do. I expect significantly more fallout before it stabilizes. As a very basic general rule of thumb, a real estate investment property should generate you at least a yearly revenue of 10% of the purchase price (including all costs – renovations, closing costs, etc.). Right now we’re not even close to this, many properties are running at negative cash flow values! This isn’t sustainable. […]

Write a reply:





 
FollowSteph RSS
FOLLOWSTEPH'S
RSS FEED!


SOFTWARE AND BOOKS BY STEPHANE GRENIER:

LandlordMax Property Management Software

LandlordMax is the EASIEST
Property Management
Software available!
Try it for free!

Real Estate Pigeon

Real Estate Pigeon
The place to ask and answer
all your real estate questions

Blog Blazers: 40 Top Bloggers Share Their Secrets to Creating a High-Profile, High-Traffic, and High-Profit Blog!

Blog Blazers is a book that
features secrets from the
Top 40 Bloggers on the web

How to Generate Traffic to Your Website ebook

How to Generate Traffic to
Your Website
is an ebook for
to you achieve success


 

FollowSteph
More resources from Stephane Grenier:
PUBLICATIONS
For people who work on the web
Blog Blazers
How to Generate Traffic to Your Website
 
SOFTWARE
The EASIEST Property Management Software available!
LandlordMax


Copyright @2003-2013
LandlordMax Property Management Software

Disclaimer: This is a personal blog about my thoughts, experiences and ideas. The contents of this blog are for informational purposes only. No content should be construed as financial, business, personal, or any other type of advice. Commenters, advertisers and linked sites are entirely responsible for their own content and do not represent the views of myself. All decisions involve risks and results are not guaranteed. Always do your own research, due diligence, and consult your own professional advisors before making any decision. This blog (including myself) assumes no liability with regard to results based on use of information from this blog. If this blog contains any errors, misrepresentations, or omissions, please contact me or leave a comment to have the content corrected.