Recession Real Estate Investing – Growth vs. Cashflow

August 31, 2010

Over the next few weeks I would like to look at a number of ‘conventional wisdoms’ of real estate that influenced investors worldwide, and explore whether they still hold up in the current environment.

Let’s first look at one of the easy targets.

Investing for Capital Growth

This mantra arguably lost more money for investors than any other over the last five years. During the boom time, the bubble pushed yields so low that it was difficult not to jump on the bandwagon.

Like with any stock market boom, the value investor is pushed to one side in favour of the stampede to be like all your ‘property millionaire’ friends’ who became rich in 3 years from flipping and taking capital gains. Of course, ignoring the value means that when markets inevitably find their real value – which meant over the last three years most of the ‘gold rushers’ were left exposed with assets they could not service, and who’s value was substantially lower than the bank loan, so they couldn’t sell either.

So where does that leave us in the current scenario? The values have fallen substantially in some areas, especially in previous ‘buy for growth’ boomtowns like Florida, Nevada, Spanish coasts, the swathes of new apartments in British Inner Cities. Does that mean they are cheap?

Let’s first look at the fundamental economic outlook to answer that question.

Supply and Demand

In areas where buy-for-growth was touted the most, these were characterized by enormous building booms. This led to a large oversupply of both buy to let and normal apartments, which has exacerbated price and rental drops. The issue with buying here right now is that, although prices have fallen back to possibly below pre boom levels, if there are simply too many properties for the market, then prices and rents will remain depressed until that overhang is taken up.

Inflation and Deflation

There are strong arguments for the market going in either direction here. If we have a long period of deflation, like what happened in Japan since 1990 (land prices are still 23% lower than 1990), then prices will continue to stagnate, bank lending will continue to contract, and slowly money will slowly drain out of the sector. If we have an inflationary scenario, interest rates will have to jump up to manage and the investor will need a strong cashflow to survive from the jump in the cost of borrowing. Either way, the real values are likely to erode without proper economic growth.

Bank Lending

There is of course a direct correlation between the amount of money invested in a sector and the growth of that sector – real estate houses prices boomed party because of a boom in bank lending to that sector. Now that lending has contracted sharply, there is a net movement out of the sector, reflected in houses prices. This also adversely affects the banks of course, since in reality, with gearing they have been the biggest real estate investor of all.

Since it is unlikely that we will see another boom in bank lending any time soon, while the banks lick their wounds and unwind positions, then money will continue to leave the sector. This is one of the most compelling arguments against buying for future potential capital growth.

What should we be looking for then? If it is unlikely that capital values will recover any time soon, then buy-for-growth is dead. Can you still make money from cashflow though?

Let us take an example of a market where right now investors are buying for recovering capital growth, for example Florida, and compare it with a market where investors are buying for cashflow, say Buffalo, New York. With $50,000 to invest, you could buy either:

1. A foreclosed Condo in Orlando, Florida.
For $167,000, previously sold in 2007 for $300,000. It may be possible to borrow for 20 years, 60% Loan to Value at 5% interest rate. Rent could be typically $900 a month. The utilities and outgoings here would be $300 per month.

2. Two double unit houses in Riverside, Buffalo.
Price $50,000 each. The price has not moved for ten years. The only finance available would be a 5 year loan, 50% Loan to Value at 10% interest rate. Rent could typically be $600 per unit per month, i.e. $2,400 a month. Utilities and other outgoings here would be $100 per month per unit, $400 per month.

In a scenario without capital growth, the Orlando option would put you ahead by $138 per month, and the Buffalo by $938 per month. However, in 5 years you would own Buffalo outright.

But let us take a recovery play idea – let’s say the market recovers fully over the next ten years and the Orlando condo returns to peak levels of 2007, and that Buffalo grows at 3% per annum. And let’s assume no change in rents.

In this scenario Orlando would have given you the gain of $133,000 (assuming you find a buyer) and rental income of $138 x 120 – totaling up to $149,560 plus ten years of amortization, $58,500. Total uplift of $208,060 profit in ten years.

Buffalo would give you rent of $938 x 5 years, then the full $2,000 a month income. Hobbling growth at 3% per annum, it compounds up to $116,000 value. $16,000 capital growth only, but this is more than compensated by the rent income which totals to $56,280 plus $120,000. So the total profit would be $66,000 from the sale plus $176,280 from the rent. $242,280 profit in ten years.

In other words, even in a positive capital growth scenario, the cashflow investment still returns 25% more than the ‘growth’ investment. If the market does not recover (I don’t believe it will, for the reasons outlined above) then the cashflow investment would return more than ten times more profit (i.e. based solely on the incomes above).

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