Avoid Paying Too Much in the Great Unwinding

August 17, 2011

As an investor, how can you tell you are ‘buying right’ in the market?

The conclusion I have come to in the current market is that the days of ‘buying for capital growth’ are over, for a few years yet. Why?

1. Bank money is retreating from residential real estate – new Lending has been at a low for some time. Despite denials from a large number of people, this is the root cause behind the ‘great unwind’ of real estate prices. Less money in the system equals lower values.

2. Prices are still too high. Why can you see a home in Rochester New York with a 25% yield, and a similar house in San Francisco with a 4% yield? Unemployment in San Francisco is higher, % foreclosures are higher, affordability is lower, and prices are well above replacement cost. Las Vegas was the fastest growing city in USA from 2000–2010, therefore the house price growth was largely fuelled by bank lending. Now it is the highest city for foreclosures in USA, demonstrating
not only the banks’ bad policy decision to lend to anyone and everyone, but demonstrating prices need to fall sharply to ensure they are affordable for new buyers in the current banking climate.

3. Interest rates will rise. You think things are bad now? Even the most idiotic government understands that if US wants to avoid the high inflation that could result from printing trillions of $, they will need to raise interest rates. This will make it harder to buy a house, and less affordable. Rentals will benefit from increased demand, pushing rents up further. High interest rates will make it harder for homeowners to keep up mortgage payments and could cause a further wave of foreclosures, pushing prices down again to their ‘real’ price.

So the first and most important thing for an investor is to find a market where houses are already at their ‘real’ price and won’t be vulnerable to further falls.

How can you tell?

1. The price is below ‘replacement cost’ . It is possible to find real estate that costs around half the price that it would cost to build the house. This is typically in depressed real estate markets where bank intrusions were low in the boom time, and the prices were not artificially inflated.

2. Foreclosure levels are low. This confirms that bank lending locally has been responsible, that the local economy is in good stead.

3. Local affordability levels are high i.e. the local income to house price ratios are high. If you see anything towards parity between the annual income for the average house price, then prices are well within range of affordability, and unless there is a dire economic scenario locally, then this is attractive. For example, Syracuse, Western New York has a median income of $64,300 and a median home price of $80,000, i.e. a ratio of 80.37%. While Ocean City, New Jersey has a similar median income of $68,100 but a median home price of $282,000, a ratio of 24%

Unemployment in Syracuse stands at 7.6%, less than half of that in Ocean city. This should make it apparent which market is more vulnerable to future price drops.

Alan W. Findlay is a Partner in Abbotsinch Capital with more than 15 years of experience in real estate investment.

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