Chuck Ponzi October 28th, 2005

Recent events have made us all reflect on the current state of the housing bubble, most recently are a few that I can think of:
1. the Fed’s raise after Katrina
2. Fannie Mae’s rapid unwinding
3. Interest rates are on a scorcher

I recently moved out of the San Diego area into California’s Orange County. So, in a twist of fate, the family has moved to an even more expensive part of California. No worries, my new job prospects allow me to be more flexible with higher rent; it still makes us all wonder how everyone else is making it.

This post’s title is a poke at my new landlord. Frankly, he rented when he should have sold. Successful investors would consider all investment options whenever a major event occurs like a tenant moving out or major life changes. To share the math he must have gone over, I’ll present a few facts that I have uncovered.
1. He originally bought the house in early 2000 for $295,500. It has always been a rental.
2. The realtor who rented it opined that it would sell for $750,000. I would agree with that after looking at similar properties and recent comps.
3. My rent is $2500/month.

I am confident my landlord is cash-flow positive, and would assume that he bought with 20% down, and carries a note of about $235,500. Taxes for the area (including MelloRoos) run 1.9% per year, and add-in about $3500/year for maintenance and upkeep of the home. You would also need to assume insurance of about $1000/year for earthquake and homeowners. Assuming a fixed interest rate of 6.0% that he could have refinanced an investment property to (this is generally not as favorable as personal residences), his monthly total expenses should be about $2,400. His monthly cash-flow is $100 ($1,200/year). Since the mantra of long-term real-estate investments have always been cash-flow counts, not appreciation, and long-term investments do not include a sale of the asset, this is his total return.

One of the reasons that real-estate rental investments tend to be popular is the inflation-adjusting nature of the return; over time, rents increase by a percentage closely resembling inflation. A 2% increase in rent ($50) results in a much larger increase in cash flow (tempered because some costs, like insurance and maintenance also adjust to inflation). Unfortunately for my landlord, time hasn’t been so kind. In 2000, the home originally rented for $2,600/month, for a yearly negative increase in rents, luckily offset by lower interest rates. Still, over the long-term, one would expect that rents increase by about 2%/year and consequently, his return increases about 10%/year.

Our landlord’s return would normally be compared with a risk-free rate of return delivered by US Bonds. On the average, these bonds can return about 6%, but have been closer to 4% more recently. His after-sale equity is estimated at $462,500 (750K-7%-235K) due to transaction fees and payoff of the note. At 4% interest, his cash flow is $18,500. There’s little math that can compare the return of both options.
This, good readers, is the “new mathematics” of real estate investing. Returns are no longer based on cash flows. The asset appreciation is the basis for investment, not the intrinsic discount of the cash flow from the investment.

In my post “Strong hands, weak hands”, I found that economists have noted that during the run-up of an economic cycle, assets pass from strong hands to weak hands. The term strong hands is an investor definition of those intending to hold an asset for a longer period of time, while weak-hands are intending to hold the asset for a short, speculative period of time. Essentially, the return offered under the original method of valuation by strong hands cannot compare with the immediate valuation and profit-taking ensues. Weak hands are not committed to rigorous financial rationalization, so wide price swings occur during these speculative periods. Often, the basis for the asset appreciation is masked in environmental factors, allowing only those speculative bubbles that conform to originating basic economic fundamentals in the onset of the bubble to generate enough groupthink and attention to foster an actual bubble.

Eventually, asset bubbles rise beyond rationality, but prediction of their deflation is nearly impossible until it happens. Asset bubbles can consume every available resource for long periods of time before final deflation; however its fate is always mean-reversion.

When investors have long since thrown rationality out the window, any guess as to its origin and rate of descent is mere, well, speculation.

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