Irish fixer upper, Source: Elizabeth Bonner
"Higher House Hurdles"
by Bill Bonner
Youghal, Ireland - "The latest report shows the economy shriveling up more than expected. The Hill: "First-quarter gross domestic product (GDP) growth was revised lower Thursday in light of reduced consumer spending, surprising economists. GDP contracted by 0.5 percent on an annualized basis, 0.3 percentage points lower than the last measurement from the Commerce Department."
Does it make any difference? Maybe not. GDP figures are largely meaningless or misleading. They don’t tell you much that is useful. And what they pretend to tell you is mostly fraudulent. More on that next week. Today we look at a way to make money that is probably the least fraudulent and easiest to understand - real estate. But wait. A Redfin forecast: "U.S. Home Prices Will Dip 1% By the End of 2025." Redfin economists expect the median U.S. home-sale price to fall flat in the third quarter, and fall 1% year over year by the fourth quarter. When it comes to mortgage rates, we expect them to remain elevated near 7% for the remainder of the year."
We just bought an abandoned farm in Ireland. We’re enjoying putting it back in order - fixing stone walls, insulating walls, redoing plumbing, electricity and heating, planting new gardens and tidying up the old ones.
There were many bidders for the farmland around it. But no one wanted to deal with a group of dilapidated outbuildings surrounding a wreck of a house from the 19th century. For us, it is a pleasure; but not a way to make money. “Some guys play golf. Some watch TV. We just like restoring houses,” we explained to a puzzled neighbor. (On a practical level, our family - children and grandchildren — is getting bigger while our cottage seems to be getting smaller.)
Property has utility - whether you use it yourself or rent it out. That utility is measurable, simply by checking comparable rents. The calculations are easy. You subtract the costs - maintenance, taxes, utilities, etc. from the (possible) rental income. That is your return on investment. If it is more than the “hurdle rate” - usually measured by the yield on a ‘risk-free’ US 10-year bond - you are ahead of the game.
But investing in real estate that you won’t live in is like investing in a private business. It is specific. You’ve got to ‘know the territory.’ Each market is different. Each property is different. Each has its own story to tell.
Elizabeth, your editor’s wife, invests in small apartment buildings. In Baltimore. The city is in many ways a disaster. But many of its old houses - relics of the Gilded Age, converted to apartments - are handsome and solid. They were built when the city was rich. And, compared to other cities, they can be quite cheap. “You have to know what you’re doing,” says Elizabeth. “I look for a solid place, with good infrastructure, but often in need of a little ‘updating.’ I’m usually willing to pay about $125,000 ‘per door,’ as they say. All you can count on is the rental income. It’s got to pay the taxes, the upkeep and the management. And in my area, if I go much above $125,000 per unit, the numbers are hard to make work.”
Nationwide, the median monthly apartment rent is about $2,100, according to Zillow. We don’t know what it is in Baltimore; probably around $1,400 would be a safer guess. You need a margin of error. That gives you a gross rent of $16,800 per year per door. If you paid $125,000 for the property…spent half of that on management, taxes, and maintenance - again, very specific numbers per property …you end up with $8,400 per unit, which would give you about a 6% return.
Which is only to point out how ‘local’ the business is. You can’t just buy ‘at the market price’ and forget about it. “I try to stick to the rule of eight,” says Elizabeth. “I’m willing to pay eight times gross rents...and hope to end up with a 5% net return.”
Many people look to their own houses as sources of ‘investment’ gains. But houses aren’t ‘investments.’ Builders add wealth by building houses - at a profit. The homeowner may paint the trim or add a sunroom; rarely do improvements pay off. “Real estate never goes down,” was on millions of lips prior to the mortgage finance crisis of ’07-’08. Then housing prices did go down. Four million families lost their homes when prices were no longer high enough to support re-financing.
The Fed in its wisdom, lowered interest rates to try to undo Mr. Market’s correction, creating a new distortion. Over the last ten years, house prices have approximately doubled, rising twice as fast as wages. Over the last five years alone, median mortgage payments have doubled. This, of course, caused an affordability crisis, as the average family was no longer able to buy the average house. The median mortgage payment is today around $2,800, which leaves a lot of houses for sale and few people able to buy them. Sellers now outnumber buyers by the biggest margin ever.
As Mr. Market gets his bearings, we expect prices to come down, as Redfin projects. Already, this year, we’re seeing a drop in the rate of house price appreciation - down to just 1.3% annually. And if we are right about the primary trend in the credit market - towards higher yields over many years - we can also expect that speculative gains on residential real estate will vanish. Prices may go up. But they probably won’t keep up with inflation."
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