Chuck Ponzi June 19th, 2005

June 15, Dataquick pronounced the death of reasonable real estate speculation in San Diego. Although they didn’t say it specifically, it’s easy to read into their statistics. You’d have to be insane or stupid to put your “investor” money into real estate: the annual price appreciation dipped below 10% for the first time in 6 years. From May 2004 to May 2005, the rate of appreciation registered a measly 7.5%.

While some would argue that this is not a bad return, after all, the stock market only averages 12%, and can’t always be depended on to even return anything. This is true, but what is more important about real estate is its illiquid nature and high transaction costs. You can’t sell your house for $9.95 on E*trade.

The recent spate of “investors” buying up properties, renting them for a year, and dumping them for a fantastic return in a year is at an end. We will no doubtedly look back to June 15, 2005 as the day the bell tolled. With such rapid deceleration in price increases, there has been a rash of people ready to “call the top”. So many articles come online every day, John barely has time to read all of them, much less comment on them all.

Now, one might ask how I come to the death of speculation… After all, 7.5% isn’t that bad… Well, you have to look at the numbers. Transaction costs, I mean. Holding costs…, all out of pocket expenses we can expect here in California. Here are a couple, if it’s a smooth transaction. Real estate disputes such as title disputes could make this much, much messier:

1. Realtor brokering costs. Many people mistakenly think this is 6%. Actually, you will more likely pay 5.5% due to current market conditions. So, we’ll give them this one.
2. Purchase closing costs. Typically, these run 2-3% of the purchase price, but since prices have doubled in recent years, I will be generous and give it 1%. This pays for origination fees, title transfer fees, document fees, appraisal fees, etc…
3. Sales closing costs. Typically, these run 3% on top of the brokerage costs due to title transfer insurance (1% alone), inspection reports, and a myriad of fees. I sold my home in May 2004, and found that I spent 2.5% of my sales price for ancillary fees, but I am willing to concede to 1%, just to be non-contrarian.
4. Yearly taxes. This is a biggie. In California, property taxes are 1.25% of the purchase price minimum. No exceptions unless you want to lose your property to the state.
5. Vacancy costs. Typically, 15% vacancy is normal. This means, it takes you some time to find a renter, move them in, move them out. This is really low, and would most typically be much higher with a short-term rental. I am going really low here, but .5% is the absolute minimum of the purchase price. This means, basically $2500 for a $500,000 house (about 1.5 month’s rent)
6. Rent Shortfall. This is really going to blow you away. In San Diego, it is a fact that rents are only 40% of the cost of owning. This considers out of pocket expenses. Considering that you can typically rent a $500K house in SD for about $1800 per month (I know since I live in one and rent it for that amount), the typical out of pocket expenses for this loan will be $3600 per month (not including the taxes I included above). This amounts to $21,600 per year shortfall, for a 4.3% of the purchase price total.
7. Average time to sell. Average time to sell is now 2 months. This means, you need to move your renter out and put it on the market. Holding costs being $3600 per month, or .72%, for a total of 1.44%

In total, you need to appreciate 14.99% in the year to break even. If you’re only getting 7.5%, you have a 7.5% shortfall, or about $37.5K for a median home.

While most prudent investors have left the market (and never dealt in single family dwellings in the first place for the reasons I mentioned above), novice investors perhaps don’t see the risk of losing, and might just hold on for a few more years. While you can spread out the nonrecurring costs, hoping to at some point break even, your money become even more illiquid. You really need to be in for the long-haul. Exactly the point that I am making. The fast money is over. The tombstone is carved, and placed above the buried coffin. It’s already in the ground. Anyone arguing otherwise is not working with the total picture.

One last argument that would be “investors” could make is about the tax benefits… Well, just think about all of the capital losses you can deduct on your tax return. It’ll really reduce your tax base.

Short-term investors are also notorious for offloading bad performing investments as soon as possible. None of us would be surprised if there is even more inventory on the market in one month’s time. Prices peaked in December 2004, and as soon as we see year over year appreciation rates of 0%, panic should set in nicely. For those a bit more prescient, the game is already over.

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