Imagine that a few years ago you could have bought a nice investment property and had the option of financing or paying cash. Which would you have chosen?
I have no doubt that the majority of investors would have financed and with some reason: By getting a mortgage they could use their remaining cash to purchase additional properties, thus leveraging their money and increasing their income.
Leverage was surely an attractive idea a few years ago, but let’s take a look at the question from a different perspective: Imagine that a few years ago you could have bought an investment property for cash but believed that real estate values would fall.
Now the question becomes more complex. First, if you really believe that values will fall does it make sense to buy property at all? Second, if you were going to make a purchase in a market where things looked dour, why would you leverage your money? In fact, these were the very questions which savvy investors faced several years ago — and which investors face today in many local markets.
Leverage, Part I
Until foreclosure rates started rising and bank profits started falling it was an easy matter to buy investment property with 10 percent down and a decent interest rate. If you were going to buy a $500,000 property in my area the rough numbers might have looked like this:
Purchase Price: $500,000
Plus: Buyer Closing Costs: $10,000
Less: Mortgage Amount: $450,000
Total Cash Required: $60,000
Alternatively, you might have gone the all-cash route. In that case the settlement sheet would have shown:
Purchase Price: $500,000
Plus: Buyer Closing Costs: $10,000
Total Cash Required: $510,000
Looking at the two sample ways to handle this transaction the thinking of the last 50 years would plainly favor the financing option. With leverage that $510,000 in cash would let an investor stretch and buy perhaps eight properties worth some $4 million. ($60,000 x 8 = $480,000 for down payments. 8 houses x $500,000 = $4,000,000).
Leverage in a rising market is a joy to behold, a financial marvel that’s the investor’s best friend. But today’s markets are often not rising, and a few years ago you could plainly see that home prices were headed for a fall.
How could anyone know? Toxic loans — especially financing based on stated-income loan applications where lenders did not bother to check earnings claims — meant that huge numbers of unqualified borrowers had entered the marketplace. Saving rates were below zero so many borrowers had little or no reserves. While the barriers to entry were low, the pace was fast. Many loans were designed so that rising monthly costs were a certainty — as were huge prepayment penalties to discourage anyone with a zest to quickly refinance. Once locked-in, buyers could fall fatally behind on their loans with a single slip. No less important, if the home down the street was foreclosed it meant the value of your property would also drop.
Leverage, Part II
The leverage that’s so wonderful when markets are rising can be deadly if prices stall or decline. The S&P/Case-Shiller home price index shows residential property values in 20 major metro areas declined 19 percent during the one-year period that ended in April 2009.
Let’s go back to our $500,000 properties and imagine that values fell 19 percent.
The cash purchaser now has a property worth $405,000.
The leveraged investor with eight properties has now seen his investment drop in value from $4 million to $3,240,000 ($4,000,000 less 19 percent).
The cash purchaser has equity worth $405,000. The leveraged investor has no equity: Property worth $4,000,000 was purchased with $480,000 down, meaning that financing worth $3,520,000 was required to buy the eight properties. The debt owed is greater than the $3,240,000 market value — and that number does not count selling and closing costs.
The Joy of Rent
As long as the mortgage is being paid it doesn’t actually matter if a property owner is underwater unless he’s selling or refinancing. Our two model borrowers both get rent for their properties, say $2,200 a month per unit in my area or $26,400 a year. Given property taxes of $5,000 a year, $1,000 for insurance and $2,000 in other costs each property throws off $18,400 in cash.
That $18,400 is what the cash buyer sticks in the bank before income taxes, taxes which are made significantly lower because of the write-offs which real estate investors are allowed.
If $18,400 from a $510,000 investment doesn’t seem like much of a return, consider the alternatives from a few years ago. How about a nice five-year CD at 3.25 percent — and no depreciation to offset taxes. Or maybe stock in a safe investment such as a big bank, stock brokerage or even an auto company.
Our leveraged investor has a different situation. Let’s say that his eight properties were financed at 6 percent with 30-year, fixed-rate loans. Figuring an initial balance of $440,000 for each unit ($3,520,000 divided by 8), the monthly cost for principal and interest $2,638.02. Add in $416.67 per month for taxes ($5,000 divided by 12) and $83.33 for insurance ($1,000 divided by 12) and each leveraged property requires a monthly payment of $3,138.02.
For eight properties the leveraged investor needs $25,104 each month just to pay the mortgage. Unfortunately, his total monthly income is $17,600 — meaning he has a monthly loss of $7,504. That’s a shortfall of $90,048 a year.
Is this a problem? Not if the leveraged investor has a spare $7,500 each month plus money for repairs, vacancies and other costs.
It’s true that some of the investor costs will be offset by lower tax bills, but the bottom line is very simple: If the investor doesn’t have that $7,500 a month in cash, every month, he’s screwed.
In the example above we have two investors, each with $500,000 invested in real estate. One is ahead by $18,400 a year while the other is short $90,000. That’s a cash difference of $108,000 annually.
Which investor would you like to be?
There is, of course, the selling option. Our unleveraged buyer has actual equity, not as much as he used to have but enough to assure that in the event of a sale he will leave closing with a check.
Our other investor, the one who went big into real estate, has a problem. He cannot sell any property for enough to cover the mortgage. If he sells he must engage in a short-sale if the lender will allow it, bring cash to closing or accept that the property must be foreclosed. The probability of foreclosures, deficiency judgments and bankruptcy is high.
Is This An Opportunity?
We are now in a financial environment where the next several years look bleak. There is talk of a “jobless recovery,” an expression which does not bode well for either the economy or for humans who like to eat on a regular basis.
Truth is, no one knows how long the “next several years” might last. In Japan, a nation with a strong history of savings and export surpluses, the Nikkei reached 38,915 on December 29, 1989. Twenty years later the Nikkei recently closed at 9,792.94.
I suspect there’s an opportunity here for selective and cautious investors, not a guaranteed winner and certainly not a sure-fire, can’t miss, mortal lock on future profits. Instead, I have an observation to consider.
People have to live somewhere. Our population is growing. We’re not producing a whole bunch of new housing units. A large number of housing units have been foreclosed and are now vacant — perhaps the reason why the percentage of vacant homes went from 1.6 percent in the first quarter of 2000 to 2.7 percent during the first quarter of this year. During the same period, rentals also had more vacancies — going from 8.2 percent to 10.1 percent.
If we had an increase in vacancies then should we not also have a decrease in rental rates? The answer is yes, but curiously the fall has been minimal. The National Multi Housing Council reports that the average rent per square foot for Class A apartment buildings went from $1.26 in 2007 to $1.22 in 2008. That’s a drop, but nothing like the fall we’ve seen with property values.
“In the same way that not all areas of the country have been equally damaged by the mortgage meltdown, not all aspects of real estate have been equally impacted,” says James J. Saccacio, chief executive officer at RealtyTrac.com, the nation’s leading source of foreclosure listings and data. “For instance, interest rates are near historic lows, making financing and refinancing unusually attractive. In a similar sense, if local rental rates continue with some strength while home values drop the economics of rental property investments become more inviting.”
But what if conditions change? What if the marketplace comes roaring back?
I don’t see much roaring in our immediate future, but if conditions change and leverage again makes sense then properties with little or no financing can be mortgaged to raise capital. And if things don’t quickly change, assets which generate cash-flow will likely remain a good idea.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.