In the Mood for Equity? – Part 2 of 2

Some people think we just sprinkle sunshine.  We think it’s more like singing in the rain.

Long time listeners know we were bullish on real estate from 2002 to 2005.  We still liked it going into 2006, but also started talking about hedging strategies.  We’d be lying to say we anticipated the mortgage meltdown and all of the resulting carnage to the economy and real estate values.  Even the really smart people we talked to, like Robert Kiyosaki and Walter Sanford, who’d started sounding the alarm in late 2005, couldn’t tell us why. They just knew the market would change. They had faith in the cycle (see Part 1).

Many consumers were attracted to real estate in the wake of the tech bubble.  Its strong history of stable appreciation, the fact it’s tangible and easy to understand, plus low interest rates, liberal loan programs and an international investment community eager to buy mortgage-backed securities (oh my, how things have changed!), all fed the fire.  Of course, standing here in 2010, we know the reality of cycles cannot be avoided – and in spite if its remarkable history, real estate was not immune.

The lesson?  Cycles are real and inevitable.  The good news is that cycles go both ways.  If the cycle down was inevitable, is it reasonable to think that a cycle up is also inevitable?  If the cycle down occurred with a reason that was only understood after it happened, then is it reasonable to think that the cycle up might also occur before we understand the reasons why?  If we wait until the reasons are obvious, the cycle may have passed the point of ideal opportunity.  Hmmm.  That’s a dilemma.

There’s no doubt it takes a certain amount of faith to invest.  This is certainly true if you’re seeking to optimize cycles.  By definition, you have to be willing to invest when most others aren’t.  That’s how you buy low.  Duh.  But should man invest by faith alone?  We don’t think so.

So in addition to faith in market cycles, there are some things to think about when investing in real estate.  And these things are fairly unique to real estate:

When properties produce enough income to pay a fully amortized mortgage, after allowing a reasonable amount for expenses and contingencies, then even if prices don’t increase over the long haul, you’ll build equity through amortization (the pay down of the loan with the tenant’s money).  What other investment can say that?

And even though you should never base an investment decision solely on the tax advantages (a revenue starved government can be fickle), investment real estate has a strong history of favorable tax treatment.  Few investments can claim this.  If you really pay attention and use strategies like cost-segregation and are careful to organize yourself (or your spouse) as a full time investor, the tax benefits of investment real estate can contribute substantially to your overall wealth building program. We could go on, but that’s not our main point.

Here’s where we think real estate gets exciting.  It doesn’t take much of a mood swing to affect real estate prices. That’s bad when the mood swings down as we’ve just seen.  But if you’re cash flowing as previously described, it’s not a train wreck.  You’ll get wealthy over time as the property gets paid off.  Even though it’s a much slower road, it keeps you safely in the game for the long haul.  Most people who got killed in this downturn (aside from losing their non-real estate sources of income), were carrying an unsustainable number of negative cash flow properties with no plan B.  We aren’t opposed to a little negative cash flow when a property has good upside, especially when you’re just getting started and prices are running away from you, but you need to be sure you can handle it if the market turns (as it did).  And just because it might make sense to buy one or two that way, don’t buy several unless you’re sure you can carry them if needed.

But when it comes to market appreciation (passive equity),  when consumer confidence begins to swing up, even small amounts of extra cash flow dedicated to real estate can have a dramatic affect on property values.  For example, when a buyer is willing pay an additional $300 per month on a 6% 30-year mortgage, the lender will provide an additional $50,000 in purchase loan.  That means that the buyer can afford to pay up to $50,000 more for the property even though they are only confident by $300 a month.  Of course, the property needs to appraise in order to justify the higher price to the lender.  This can be a challenge for the first properties sold in a market that is turning.  It’s another reason why real estate cycles more slowly.  You’d never have to wait for an appraisal to bid up the price of a stock.

But once the first property is sold, every comparable property in a 1 mile radius will have a better chance at appraising at the higher price – making it easier for each subsequent buyer to get the loans necessary to convert their $300 a month into $50,000 of equity for the seller.  If you didn’t get that, take a minute and think it through.

Once a few properties close at the higher price, IF there is the right supply and demand imbalance (big IF, but that’s what we look for when selecting areas to invest), the market will heat up, things will move faster and the up cycle will be in full swing.  If you wait for all that to happen before getting in, you’ll find it’s much harder to acquire properties that will cash flow.  Chasing trends is always dangerous – even in real estate.

Which brings us full cycle (pun intended).

If you believe in the resiliency of the American economy, the permanency of real estate in the lives of people, the probability of a growing population and the inevitability of real estate market cycles, then when do you want to be a buyer?  Real estate and loans are on sale today – at prices we haven’t seen in some time – and if the cycles are true, we may not see conditions like this again for awhile.  With as slow as real estate cycles are, it would be a shame to miss the next one.

We’re not telling you to buy.  We’re just saying don’t get lulled to sleep watching the glacier and then miss the opportunity.  Fortunately, with real estate, no matter what shape you’re in right now, you have time to expand your education and organize your resources to participate in the next cycle.  We encourage you to keep steadily advancing.

We’d love to hear what you think – and more importantly, what you’re doing.  If you’re stuck, let us know and we’ll work on a radio show or tutorial to help.  Just Ask the Guys or use the Feedback page.

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