Orange County Real Estate
Orange County Real Estate: Cavalier Expectations
by Peter Schiff
“…As I recall, such arrogance, unbridled confidence in absurd rationalizations, a complete disregard for logic, history and time-honored, previously widely accepted investment prudence typified the stock market bubble of the 1990’s…”
Recently, I visited a house that was advertised for rent in the Orange County Register. The house was approximately 15 years old, 2,600 square feet in size, and located on a 10,000 square foot lot in a gated community called Coto De Gaza, about 30-40 minutes inland from the Pacific Coast. They wanted $3,900 per month in rent.
There was nothing particularly special about this place, it had a nice view of the hills, but there was no swimming pool, Jacuzzi, upgraded flooring, elaborate stonework or even an in-built barbeque. This was just a typical middle-class residence. When I arrived, the real-estate agent who was representing the owner, and upon whose advice this property was recently purchased as an investment, greeted me.
Orange County Real Estate: Monthly Expenses
Being curious, I asked the agent how much money his client had paid for the house. The house had sold for $1 million he replied. I then inquired how much his client might incur as a result of the annual taxes, homeowner’s fees, gardening, insurance, routine maintenance, and other monthly expenses in owning this house. He estimated such expenses to be no more than $1,500 per month. I then pointed out that, with a monthly rent of only $3,900, and monthly expenses of $1,500, the net rental income of $2,400 would certainly leave his client in a position of negative cash-flow after interest expenses. I than asked him why he would recommend making such an “investment?” His reply was that since his client had plenty of income from other sources, that this particular purchase did not put him in a negative cash flow position, and that since his client had plenty of other income, he needed to keep buying more units. In reality, his client needed to “keep buying units” like he needed a hole in his head. What this agent really meant was that since he needed to keep generating sales commissions, he needed to keep dispensing bad investment advice. He also stated that some of his client’s other real estate investments, no doubt those made quite a while ago, produced positive cash flow.
First of all, the fact that his client has income against which to offset investment losses does not mean that his client should actively seek such losses. I reminded this agent that each investment must be evaluated on its own merit, that this particular “investment” reduces his client’s income and that his having made some wise real estate investments in the past did not justify making foolish investments now. At this point, not surprisingly, the agent became defensive.
“Do you realize how much this property is going to appreciate?” he foolishly exclaimed. “Why, it’s in a community of multi-million dollar homes and will probably be worth at least $1.5 million in just a couple of years!” he boasted.
Orange County Real Estate: What if the price falls?
The debate continued. How can you be so sure about that, I asked? What if the price falls? He responded, almost in disbelief, “What do you mean, if the price falls? Real estate prices don’t fall, not here; they’re not making any more land you know.” (As it happens, I drove by miles of undeveloped, flat land, on my way to Coto de Caza). I then posed the question: “If this property produces a negative cash flow now, with a million dollar cost, why would anyone buy it for a million five, with an even greater negative cash flow?” His reply was that rent had nothing to do with it, and that I obviously did not understand real estate investing. As proof of my ignorance he referenced examples of houses his client had bought last year that also produced negative cash flow but which had already appreciated substantially. He also reminded me that the rent could rise. What he failed to understand was that it could also fall, or could become zero if the property were vacant, as it was currently. He was right about one thing, apparently – I just didn’t get it.
Then again, perhaps I do. As I recall, such arrogance, unbridled confidence in absurd rationalizations, a complete disregard for logic, history and time-honored, widely accepted investment prudence typified the stock market bubble of the 1990’s. Dividends did not matter, earrings did not matter…the only thing that mattered was price, which, it was thought, could only rise. The only mistake was to refrain from buying or, heaven forbid, sell. The higher stock prices climbed, the more arrogant buyers became as the nay Sayers, the people who just didn’t get it, were increasingly proven wrong with each up-tick, until the bubble burst and all that remained were the memories of the paper profits that were never taken.
Let’s take a closer look at this property. Assuming this investor had paid cash for the property (which he did not) and was able to rent it at the full asking price of $3,900 per month, his total annual return would be approximately 2.9%. After tax, and including an allowance for depreciation of the building, the net yield, assuming the investor is in the top federal and state income tax bracket, would be about 2%. Alternatively, he could have purchased general obligation bonds from the state of California for an after-tax yield of 5%. Why would a rational investor accept a 2% return for assuming all the risks associated with paying $1 million for a property that was appraised for less than half that value a few years ago, and all the other risks and potential aggravations inherent with being a landlord, when he could earn 150% more by simply buying general obligation municipal bonds? The answer is: he wouldn’t. Only an investor whose judgment was impaired by the intoxicating effects of a bubble, or in this case by an equally inebriated, over-zealous real estate broker, would take the plunge.
However, this particular “investor” used leverage, with the down payment no doubt having been “extracted” from equity accumulated in his other properties, which, themselves, produced negative cash flows. Therefore, instead of simply producing a low rate of return, this “investment” produced significant monthly losses. For now, the “investor” is able to use his considerable current income to fund these losses, which, in effect, amount to a rent subsidy paid to the tenant (similar subsidies nationwide are temporarily suppressing rents, keeping the core CPI artificially low), which, the investor feels is justified based on future appreciation. That this property was already vastly overpriced, as evidenced by its negative rate of return, and would be even more so were it to appreciate, was irrelevant.
Orange County Real Estate: The New Monthly Payment
The cavalier agent, who so boasted that this property would soon fetch over $1.5 million, did not even stop to think that, in order to justify such a price, given higher interest rates, the property would have to rent for about $10,000 per month! Could a typical middle class southern California family afford that kind of rent? He couldn’t care less, because, in his mind, rents have nothing to do with real estate values. Even if rents were to rise, how high could they go? If rents increased substantially, imagine the effects on the core CPI, of which rent composes 40%. Such a sharp increase in the core CPI would certainly mean much higher short-term interest rates, and thus much lower property prices. Ironically, higher rents, the only factor that might legitimately lead to higher property prices, will actually cause lower property prices, due to their immediate effect on the core CPI and their ultimate effect on interest rates.
The fact that this particular property was located among multi-million dollar houses over-looked the fact that such properties, brand new five-to-ten thousand-square foot structures on two-to-five-acre parcels, were themselves vastly over-priced. Ironically, this agent, who had just advised his client to purchase highly appreciated real estate solely on the expectation of higher prices, insisted that he saw no signs of speculation in the current real estate market. As proof, he offered the fact that the average mortgage in this area was made with a 20% down payment, as opposed to the late 1980’s, which in his option was a bubble, when average down payments were only 10%. In other words, he was convinced that this time it was different, and relied on distorted statistics to produce his desired conclusion. What he ignored was that the 20% average had been skewed by the million dollar-plus homes for which large down payments were financed by equity, accumulated through trading up. The mortgages for the starter homes, which produced the equity to fund the trade ups, and which form the base upon which the current real estate pyramid rests, were made with little or nothing down. Plus, the fact that 80% of those people making large down payments chose adjustable rate mortgages is the most alarming example of speculation possible.
The reason I have been placing the word “investor” in quotes is that investors buy assets that generate superior current rates of return. That said, the purchaser of this property can hardly be called an investor. In fact, even the term speculator would not be appropriate because speculators purchase assets based on the rational anticipation of price appreciation. In reality, this individual is simply a real estate fool, buying assets solely on the expectation of selling to an even greater one.
The most likely outcome for this fool is that he and his real estate equity will soon part. When interest rates rise and the economy slows, not only will the cost of servicing his adjustable rate mortgages rise, his other income, currently funding the negative cash flow, will most likely fall. To reduce this growing drain on his diminishing income, he, along with many other similarly situated fools, will most likely try to sell properties. However, in a weak economy, with rising interest rates and falling property prices, there will be no fools left to buy, only those investors who had the foresight to remain liquid during the mania, and who will only buy properties offering superior rates of rental return. Given low rents and higher interest rates, the sale prices necessary to attract such investors is likely to be less than the outstanding mortgage debts, resulting in bankruptcies, foreclosures, and distressed sales.
While most accept that those who forget the mistakes of history are doomed to relive them, few appreciate just how short people’s memories really are. Since even those who remember such mistakes seem to repeat them, it is likely that history’s mistakes will repeat indefinitely whether they are remembered or not.
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Peter Schiff C.E.O. and Chief Global Strategist of Euro Pacific Capital. He has been quoted in the Wall Street Journal, Barron’s, Investment Business Daily, CNBC and now The Daily Reckoning.