What factors are important when looking at real estate?

If being in the real estate industry was easy, well, then everyone would be doing it.

However, the truth is that no matter how wise or smart you are, no matter how many connections you make, no matter how hard you work, no matter how much you read and learn, there are certain factors you simply can’t control when it comes to the real estate market. Here are some things to consider when evaluating real estate, whether it is buying a home or an investment.

When selling a home, or investment real estate, there are many factors which affect market value and the eventual sale price of a home, such as location, condition, size, amenities, features, improvements and upgrades, local economic conditions, the current real estate market and mortgage interest rates, among others. Some of these factors are within the control of the owner, and others are beyond the control of the owner. Real estate ownership has been blessed with appreciation in values, but that appreciation is not always in a straight line. Real estate values are not static. Over the long term, an investment in real estate is generally considered the most valuable type of investment, one with the best financial returns.

Reality check

All owners would like to get the price they feel they should get for their home when they choose to sell. The reality is their home is worth what a buyer is willing to pay. First remember economics 101 – supply and demand. Lower supply greater demand than higher value. If supply outstrips demand, values drop appropriately. Most of Texas is in a seller’s market, where demand is outstripping supply. Also, remember a buyer will not pay more for a home than what they would have to pay for another home with similar features and amenities in a similar location, something called the “Principle of Substitution”. Put simply, what else is on the market that is similar to this price?

The price paid for a home one year ago, three years ago, five or ten years ago has nothing to do with what the home is worth today. Real estate values exist at a fixed point in time. A home may have been purchased for $300,000 three years ago, and may be worth $315,000 today. Someone else may have bought a substantially similar home for $250,000 five years ago and it is worth $315,000 today. That is a drastic difference in equity in a relatively short period of time. You cannot take the annual appreciation of one year and plan to use it as a constant portion of the equation. Real estate fluctuates in value almost every year, usually on the positive side. One year it can be less than 1% another, the following year 12%, all depending on supply and demand. That appreciation is not always in a straight line.

As stated before, all real estate is local, therefore values appreciate differently within the same local. A sale in one part of a city has little to no effect on properties in other portions of the city. The good news is that for most real estate is the one asset that maintains and appreciates in value in the long term. While it is true that that the condition of a home has a definite affect on its market value, and that a well maintained home will sell for more than a home in need of updating and repair, the actual cost of making repairs and improvements may not be equal to the increase in market value. Why? Cost does not necessarily equal value in real estate. Repairs and improvements are two different things.

Depending on the market conditions when the home was purchased, some owners were fortunate and purchased their home in a buyer’s market before the increases in real estate values like we witnessed after the tech crash between 2001 and early 2006. Others may have bought at the end of a strong real market and were forced to pay top dollar in a highly competitive sellers market, as many owners in other parts of the country are experiencing now who purchased their home in 2006. It is economic market conditions, the economy, employment, mortgage rates and supply and demand that create changes in the real estate market and cause real estate values to increase, remain stable, or perhaps drop at different periods of time. These are the factors that are beyond a seller’s control.

Real estate is typically a long hold period compared to many assets. To look to invest in real estate as a short term investment usually has harsher consequences. A great example of short term real estate investment is flipping, which entails buying the investment underneath market norms and selling around the middle of the surrounding market values. It has the risks of any other speculative investment. It can be high risk because it is a short term investment play. If the investor can hold long enough, most markets will increase in value due to the lack of inventory and demand outstripping supply. Decisions to sell may be more difficult for owners with short term ownership especially when real estate values have not increased or have dropped since the home was purchased. Home owners with short term ownership may have mortgage balances higher than the value of the home and a sale would require bringing cash to the closing to pay off the mortgage balance. Home owners with long term ownership and substantial equity can make selling decisions easier than owners selling their home without the benefit of real estate appreciation. In either case, the real estate market is the real estate market, regardless of when the home was purchased, and the home is worth what is worth.

There are many factors that affect the value and acquisition of buying and selling real estate on a national scale.

Economic factors

Like it or not, it seems like every real estate downturn gets blamed on the economy. There is a reason for this. The state of the economy plays a huge part in the amount of money that is available for people to buy homes. This is generally measured by economic indicators such as the employment data, manufacturing activity, the prices of goods, etc. Broadly speaking, when the economy is sluggish, so is real estate. However, the cyclicality of the economy can have varying effects on different types of real estate. For example, if a REIT has a larger percentage of its investments in hotels, they would typically be more affected by an economic downturn than an REIT that had invested in office buildings. Hotels are a form of property that is very sensitive to economic activity due to the type of lease structure inherent in the business. Renting a hotel room can be thought of as a form of short-term lease that can be easily avoided by hotel customers should the economy be doing poorly. On the other hand, office tenants generally have longer-term leases that can’t be changed in the middle of an economic downturn. Thus, although you should be aware of the part of the cycle the economy is in, you should also be cognizant of the real estate property’s sensitivity to the economic cycle.

The economy obviously pays a huge impact on how banks and equity or lending institutions will lend. If lenders are recovering from bad loans, the opportunity is not as great. Factors such as politics, both on a local as well as a national stage, can restrict or open financing for real estate. We need not look farther than the recent real estate and financial bust to see the effect of liberal then conservative lending parameters and its effect on not only the economy but real estate in general.

Interest rates

Politics, banks, and the global economy can all influence the real estate market when it comes to interest rates. The real estate and financial crash proved the global impact of the real estate market and increased awareness of how interest rates and loans are used in home buying. If things aren’t looking good abroad, it might affect your ability to sell homes domestically. Keep an eye on what’s happening in the global market and with foreign investment as these play large roles into the expectations of the local market as well.

Remember, banks are in business to lend, and today unlike their troubled counterparts in other parts of the world, they have good balance sheets and plenty of money available. So what’s with the apparent reluctance to open the money spigot? Remove your negative emotions towards these much maligned and penalized institutions for a moment and look from their side of the ledger. In today’s world of low interest rates and a flat yield curve a bank has less than a 3 percent net interest margin, which is the amount between what it pays depositors and what it makes on loan rates. The very best possible outcome on a loan for our forever criticized, highly regulated bank is to get paid back all its principal and make a small spread on the interest. Get paid back 95% of every loan and it goes broke. Careful scrutiny of any type of loan is judicious business practice and necessary to remain solvent. A top quality financial lending institution can be lucky to earn is 1 to 1.5 percent on assets historically.

Certain factors have the greatest impact on what lending rate a consumer will receive. Start with the general level of interest rates in the national economy, which is influenced by actions of the U.S. Federal Reserve Bank, levels of inflation, demand for borrowing money, the stock market, and a number of other factors.

Then you get to the factors for your home loan, the lending rate is influenced by the amount borrowed, what kind of loan you get, and whether you put up collateral or not. For instance, the interest rates on a home equity loan (where you use your home as collateral) are generally less than for unsecured credit. The term of the loan — how long you take to pay the money back. Even a small difference in your interest rate can have a big impact on the amount you eventually pay, so it’s worth understanding how interest rates are determined and what you can do to lower yours.

While lenders control who gets approved for a loan and on what terms, actual mortgage interest rates are largely determined on the secondary market, where mortgages are bought and sold. As with the stock market, interest rates in the secondary market tend to move up and down. When the economy is on an upswing, investors demand higher yields, forcing lenders to raise mortgage rates. In a market downturn, rates tend to drop for consumers because of increased investor demand.

While home or real estate sellers hope to get top dollar for their property – and some have an inflated idea of what to expect – establishing value can be a complex, multifaceted process.

Location

Most consumers know that the three rules of real estate are “location, location, and location”. Location includes factors such as the price and availability of recent nearby transactions and inventory, the quality and desirability of local schools, and whether the area has the lifestyle and community buyer’s seek.

What does location mean, it is more than closeness to the center of the community; does it have the qualities of a dwindling asset? Location encompasses many other considerations. Waterfront of most types is limited in any scenario, but particularly in our Texas metros. Those that have it, will demand and get a higher value / return than similar properties not on the water. What type of view? What’s it next to? Is it near retail establishments? Or a highway?

With location comes school district. The Voice covered this almost a year ago Oct. 18, 2013 with “The effect of school performance on local home prices.” The school district or even a specific school within a district can drive demand for a particular area. Ask any real estate agent you know and they will confirm that having strong schools and an overall strong district can affect home prices by as much as 10 percent over a neighboring district.

Your family doesn’t have kids of school age? Buying a home in a good school district is still smart. When the schools are desirable, homes tend to hold their value better in down markets and appreciate more in good times. A 1 percent, 2 percent, or even 3 percent difference in a home’s value can be thousands of dollars. I educate people all the time, ‘You need to look at supporting and maintaining a good school district much like you would the maintenance of the roof or siding on your house.’ Why? Both will significantly affect the value of your home. Whenever a school tax increase comes up for a vote, my thought process is it seems like a pretty small price to protect the value of your investment.

This just scratches the surface of the factors affecting real estate values. Understand that in our Texas markets, the home you look at today will be gone tomorrow. Investment property in the Texas region, particularly in any of our metros if priced correctly will sell quickly. Educate yourself with your financial planner and real estate professional on what you are looking for and the history of the neighborhood. If you think you will have plenty of time to do this after the purchase, guess again. It is a sellers market, meaning the seller decides many of the terms of purchase, which may not allow the buyer much time to analyze after the purchase.

What’s the best investment? Start with sitting down with a financial planner, real estate professional, and if financing is needed, a mortgage professional. Actually I would probably reverse the order in today’s harsher lending environment. The size and scale of the current and historical real estate market make it an attractive and lucrative market for many investors. Investors can invest directly in physical real estate (this analysts preferred method) or choose to invest indirectly through managed funds. Investing directly in real estate involves purchasing the residential or commercial property to use as an income-producing property or for resale at a future time. Indirect ways to invest in the real estate market include investing in real estate investment trusts (REITs), real estate exchange traded funds (ETFs), commingled real estate funds (CREFs), and infrastructure funds. Again this is a decision you and your family and your real estate and financial experts need to make together.

There are many factors that play a significant role in moving the real estate market, but there are also more complex parts that come in to play. And although some of these aforementioned factors suggest a clear-cut relationship between the factor and the market, in practice, the results can be very different. However, understanding the key factors that drive the real estate market is essential to performing a comprehensive analysis of a potential investment.

If you have the assets and capabilities, there is not a better time to invest than now. Lending rates are the second lowest they have been in the last 100 to 5000 years. Seriously. Values have maintained in Texas during the worst recession in my memory. Six years is the longest positive market we have had in Texas over the last 50 years. We are 2.5 year into this positive run. Other than a catastrophic economic event, your investment in Texas real estate should have a good run for 10 years are more.

Investing in real estate

Now may be an excellent time to make a real estate investment, particularly in Texas. We have seen strong rental value appreciation over the last three years in all five major Texas metros, but particularly in Austin and Houston, where over the last ten years we have seen a 60+% increase in rental rates. This is much stronger than value appreciation and wages over the same time period. Maybe the bigger question from investors, is “Will values hold?” Based on current demand and inventory in all metros, I say yes.

We buy property in hopes that our investment will generate some kind of return down the road. The chance of that occurring is very low if one does not hold the investment for at least five or more years. The reason is that transaction costs, repairs, monthly ownership costs higher than comparable rent, and ownership hassles dictate that it is better to invest your money elsewhere and stay as a renter if you are not sure you will own long term. Therefore, since you are going to be a long-term holder (the longer the better) you really should not be that concerned with short-term market price fluctuations. Even during the recession this was true, if you looked at real estate investment from a longer hold period, such as ten years plus.

Nationally we have seen a slowdown of the large investor funds, known to many as vultures because they swoop in and buy “distressed properties” — foreclosures and short sales – cheap. Other parts of the country experienced this, places like Las Vegas, Chicago, Phoenix, Atlanta, and Miami were popular because home prices there dropped as much as 70% at the bottom of the market.

We aren’t seeing this kind of investment strategy in Texas. We never saw the run up of values like those other markets did. Therefore its difficult to profit on flipping/speculating on the housing market in Austin. Are we seeing the vulture groups? Again, not really. What we are seeing is true real estate investors who are looking long term. Once they analyzed their decisions based on home-price appreciation, which is very speculative. Now they consider potential rental profits, which are far more stable.

When planning a residential real estate investment, do not even factor in price appreciation for at least a year. After that, calculate only a 3% annual increase or less — a return that won’t turn heads of investors who only want to buy low and sell high. Look for cash flow. Know that you will have to put 20% to 30% down on the investor loans. At today’s low interest rates, they’ll get a near 5% loan, 20% down. Figure another 10% of the price for property management (unless you like getting calls in the middle of the night to unstop toilets, etc.), 10% for maintenance, an 8% vacancy rate, plus taxes, insurance and other home ownership expenses.

Cash flow vs. appreciation

• Properties that appreciate quickly are generally in higher income areas (desirable) and generally don’t cash flow immediately. But, you should look to increase rents to cover your mortgage payments within a minimum of 12 to 24 months.
• How do you rate good opportunities? I start with costs (rates, values, rents) that are low, with some upside. Historical trends and history as well as potential conservative appreciation.
• Raw land is not going to have cash flow. As we have stated before, there is a limited number of developable lots. There has been limited funding (bank loans, etc.) for development. If more product is not coming on the market to compete, rents will increase – less supply, therefore values increase.

Although conditions are very favorable, investors have to be adaptable because the market is evolving rapidly. It’s the income from rentals that’s paramount right now. The beauty of cash flow, of course, is that even if prices declined 10% or 20%, the investors should be able to live with that. Investing in rental properties is a long term investment strategy. You need to look at a minimum of five years to hold. As always, you need to visit with your CPA, financial consultant, mortgage professional, and real estate professional before you dive in.

What do I look for in real estate? I look for an investment almost like dating or getting married. You should be concerned about finding an investment that you “love”— one that fits all the right reasons. Once you invest, that investment will be part of your family and financial planning for a long time! If you are looking for a ‘quick fling’ in real estate, I would look at other investments. Real estate investment typically is a long term play.

What things should you look for?

• Location, location, location. First rule of real estate.
• School district and schools are paramount after that in all price points. The higher the demand for the schools in the area, the higher the rent and value.
• Jobs! Long-term strong employment is what you want in your metro. Without jobs, demand is less, and your rental property may go vacant.
• What type of investment are you comfortable with? Do you need cash flow immediately? Is leverage important? The answer is typically yes, but be careful, should the market shift negatively, you do not want to be overleveraged or ‘underwater’ on amount borrowed vs. value.
• For experienced investors, most expect less than 5% appreciation and look for positive cash flow from day one. With today’s current values in Texas, most residential rentals are able to achieve positive cash flow.
• It is fairly priced relative to the recent comparable sales in the immediate area for similar properties? Look at values over the last 5 to 10 years in the area.
• Vacancy isn’t too high in the area. This is very important whether an owner occupant or investor. Empty unstable neighborhoods or communities have a higher risk of vandalism and risk downward price spirals. A lot of times this is a byproduct of neighborhood schools.
• It is in decent shape and doesn’t need much fixing-up. Skip the massive fixer uppers, the ones with foundation issues, or anything labeled as “needs a little TLC” in the listing, as that means it is a wreck. Leave the fixers for the contractors, they know what they are doing….. doing it yourself doesn’t usually save you much money.
• If there are big vacant parcels question the use. A non-residential zoned parcel, empty or retail/industrial/etc. site where you are not 100 percent sure what is going to be built there could affect your values later on. Confirmation of use is the best insurance of protecting your investment. A new use of that land could impact your “quiet enjoyment” of your residential rental unit.
• You complete the proper due diligence steps to reduce your risk as much as possible. Mind your contract terms and contingencies, pencil out your deal, get a couple of bids on financing and dissect your GFE, review the HOA condition, review the property condition, make sure you have the right type and amount of property insurance in place, make sure you adequately review the title abstract and title policy and everything else you need to do to lower your risk.
• Affordability! Record low rates and stable values in most Texas metros compared to the rest of the nation makes this one of the best buying opportunities consumers have seen in years.

History is a great teacher, however the last seven years were an anomaly in real estate investment. If you bought at the bottom, good for you. Those type of discounted investments only come along once or twice in a lifetime. If you are going to buy, look to the above suggestions. Get with the professionals and listen. Find a mentor that has done this before. Find a house you love or rental property that makes sense, that you will own for a long time, is in decent shape, lock in long term financing, and sleep well.

Is now the time to invest in real estate?

Is now the time to invest in real estate? Have the glory days of the residential real estate investor passed? Low prices, rock-bottom interest rates and stable rental markets had created buying opportunities. Now, regionally, locally and nationally we are seeing the “long term” real estate investors (known to many as vultures because they swoop in and buy distressed properties cheap) are no longer making as big a splash. Does that mean that the opportunities for real estate investment have passed?

It would have been great if you had realized that the buying opportunity was 2-4 years ago. But it was hard to convince sophisticated investors how strong the local markets would be, much less neophyte investors. But in my eyes, the economic strength of job creation and lack of new product in high demand neighborhoods bodes well for local investors.

Continued distressed markets such as Las Vegas, Phoenix, Atlanta and Orlando and others continue to be popular even though the 70+% discount of the past few years is no longer available. Are we seeing this in Austin, San Antonio, Houston and our Texas metros? No, not as much. Why? Unlike other markets such as above, we never saw the run up of values (appreciation) like other markets did. Therefore it makes it hard to profit on “flipping”/speculating on the housing market in Austin. Are we seeing the vulture groups? Again, not really. We saw a little in DFW, but not the other Texas metro markets. What we are seeing are true real estate investors who are looking long term. Once, they analyzed their decisions based on home-price appreciation, which is very speculative. Now they consider potential rental profits, which is far more stable. But how they’re investing has changed. In the boom years, they would buy a property and flip it for quick cash out. Today, they are holding and renting for steady incomes. The new economy dictates that you have to have a long term view.

To underline the small appreciation on an annual basis in the Austin local market, below is a chart showing residential appreciation over the last 5 years.

4-4 graph

What should you look for? For example, do not even factor in home price appreciation for at least a year. After that, calculate only a 3% annual increase or less — a return that won’t turn heads of investors who only want to buy low and sell high. Look for cash flow. Know that you will have to put 20% to 30% down on the investor loans. At today’s low interest rates, they’ll get a near 5+% loan, 20% down. Figure another 10% of the price for property management (unless you like getting calls in the middle of the night to unstop toilets, etc.), 10% for maintenance, an 8% vacancy rate, plus taxes, insurance and other home ownership expenses.

What are you looking for? Cash flow vs. appreciation.

Generally properties that cash flow immediately come from “blue collar”, low income, lower priced areas. Many realtors would call them the ‘entry level’ buyer. Nationally as well as locally this buyer is not as able to purchase with current lending guidelines. Historically these areas appreciate, but not as fast as higher income areas.

Properties that appreciate more quickly are generally in higher income areas (desirable) and generally don’t cash flow immediately. But, you should look to increase rents to cover your mortgage payments within a minimum of 12 to 24 months. Both are good opportunities, but do it now while affordability costs (rates, values, rents) are low.

As we have stated before, there is a limited number of developable lots. There is limited funding (bank loans, etc.) for development. Those that are currently being built will take a while to get to the market. Why is this important? If more product is not coming on the market to compete, rents should stay high…economics 101 – less supply, therefore values increase. Although conditions are very favorable, investors have to be adaptable because the market is evolving rapidly. It’s the income from rentals that’s paramount right now. The beauty of cash flow, of course, is that even if the prices decline another 10% or 20%, the investors should be able to live with that. Investing in rental properties is a long term investment strategy. You need to look at a minimum of 5 years to hold. As always, you need to visit with your CPA, financial consultant, mortgage professional, and real estate professional before you dive in. Now is the time to buy investment property!

Why rates should increase and the housing market will improve

Milton Friedman once observed that low interest rates are an excellent indicator that inflation is low, so consumers wonder why economists keep predicting that inflation will rise. Short term, after this week’s Federal Reserve meeting, rates will remain low for a short while longer, hoping to encourage small and large business to expand and hire.

However let’s look at historical economic facts: low inflation does indeed lead to low interest rates, and vice versa, but the two don’t necessarily move in lock step. Often it takes a period of high interest rates (the result of Fed tightening) before inflation moves down and interest rates eventually follow. The early 1980s would be a great example of this. Similarly, it often takes a period of low interest rates (the result of Fed ease) before inflation pressures rise and interest rates eventually follow. The 1970s were a good example of how low interest rates can lead to higher inflation and higher rates. I think we’ve been in the latter kind of period for some time now. Milton also observed that the lags between monetary policy changes can be long and variable.

The consumer looks at today’s rates that are very low, adds in Milton’s observation about low rates and low inflation, and infers that inflation may actually be at risk of being so low as to threaten deflation. There’s a decent chance the market may not be reading things correctly and may be failing to learn the lessons of the past.

Historically, it is also the case that low interest rates can be a sign of a chronically weak economy, as Japan has suffered for decades. When investment opportunities are scarce, it doesn’t take much of an interest rate incentive to balance savings flows with investment demands for cash. This could be the reason why mortgage rates are so low and why so many continue to worry housing prices have not yet hit bottom: low mortgage rates could be signaling that there is a shortage of mortgage borrowers relative to the number of investors willing to buy MBS—thus, the demand for housing could fail to absorb all the housing supply that is due to hit the market over the next year or so as foreclosures allegedly pick up.

One needs to keep in mind, however, that there is no indication that the housing market is not improving or will soon fail to improve nationally (by improving I mean that sellers are able to find buyers at some price). According to the NAR, the monthly supply of unsold homes in the U.S. has fallen from a recession high of just over 11 months to now just under 9 months. Sales volume is up in many markets, particularly in California and Florida, and the Case-Shiller index of home prices in 20 major markets shows that prices have been flat to slightly up since early last year. Texas and Austin continue to lead the market.

The housing market is improving, and has been improving for over a year. Between declining mortgage rates and declining housing prices and a recovering economy, the market has found a price that equates buyers and sellers. The ongoing decline in mortgage rates is obviating the need for lower home prices. Think of it this way: the bond market, thanks to its conviction that the economy is going to be very weak for the foreseeable future, has been acting as a great shock absorber for the housing market by bringing mortgage rates down to all-time historic lows. In this view, low mortgage rates could be signaling simply that the market is very pessimistic about the economy, not that there is a shortage of homebuyers. Higher rates wouldn’t jeopardize the economy or the housing market, since they would signal rising confidence, stronger growth expectations, and the prospect of rising incomes and rising home prices. Higher rates would also be a sign of rising inflation expectations, and that would only add fuel to housing demand.

So we don’t see any reason to think that the recovery is fragile or that the housing market is on the verge of another collapse. Instead, we see lots of signs that consumers are concerned about the future of the economy. Those consumers with focus on their bottom line are out buying and financing at rates we won’t see again for a long time.