Single family home prices have not collapsed because the banks, the guys who had to dump all those foreclosed homes, sold them in bulk to investors like American Homes 4 Rent (bought 20,000 homes or Blackstone Group who invested $7 billion and bought somewhere around 35,000 homes. The bulk sales prevented these homes from coming on the market. As the nation recovered from the Great Recession and housing demand picked up, there weren’t enough existing listings to go around and prices began to rise.

Income property values are at levels not seen in several years.  It seems that as long as the Federal Reserve keeps interest rates low, capitalization forces prices up. Even if interest rates don’t go down any more, each dollar of net income adds a lot to value because it is capitalized at a low rate. For example, a $5,000 increase in net income adds $50,000 to the property value when capitalized at 10%, but $100,000 when capitalized at 5%.

The rise in income property prices does not necessarily indicate a bubble. Now, that doesn’t mean that apartment prices won’t go down in the future if cap rates go up faster than net rental income. But the changes (up or down) are justified by the yields on competing investments so it’s not a bubble.

Rocketing single family residence prices, on the other hand, may indicate a bubble in the making. Eventually, the big investors who bought all those homes will sell them. If the disposition is not managed very carefully, a large block of homes coming on the market at one time will tend to depress prices. Seeing the depressed prices, other big investors will feel pressure to sell everything quickly because “the markets are collapsing”. Think of it as a negative feedback loop.

At a fundamental level, an economic bubble is when a lot of people expect to get most of their profits simply through the passage of time: it is a speculative enterprise. It’s not necessary to add value during the holding period, as businessmen must. If somebody buys a length of cloth for five cents, cuts it in two and sells each portion for three cents, he’s adding value. No bubble is created. Similarly, if a real estate investor updates an apartment thereby earning higher rents, no bubble is sustained. She’s added value. To be a bubble, the expected profit must be achieved without adding value, as a function of time only.

There are three different types of bubbles: the Bigger Fool, the Discounted Cash Flow (DCF) and, way over on the other side of town, the Interest Rate Bubble.

The Bigger Fool

The Bigger Fool was identified back in the mid-1930’s by John Maynard Keynes, but he called it something else. His opinion was that successful investors forecast the future and try to determine the products that would be most in demand in, perhaps, a year or a little more. For this to work demand must increase faster than supply. It’s a temporary thing: eventually supply ramps up, demand is satisfied, and homeostasis is reached. The tricks in the Bigger Fool approach are to know what to buy, when to buy it, and when to sell it. It’ll make your head hurt.

Sometimes the time-centric Bigger Fool approach works. Nothing grows to the sky, but it’s pretty obvious some things consistently go up faster than inflation, at least for a period. This is especially true of luxury products. Think of the price trend of the Kelly bag in blue crocodile, and try to not clutch your pearls.

And sometimes the Bigger Fool approach just doesn’t work. Disregarding dividends and considering only the speculative elements (“Will my stock go up due only to the passage of time?”), a person could accurately recognize a trend line but pratfall on the details. American auto sales in 2012 were up 13% from 2011. That same person could have correctly forecast that car sales will trend upwards, but have lost money on the particular stock(s) purchased. For example, automobile sales have climbed up over time, yet over 500 car companies have gone tummy-up. Considering that American car companies didn’t even get started until 1900 or thereabouts, that’s almost five a year. It’s not just the early companies, either. Oldsmobile failed in 2004.Pontiac in 2010. Fisker Automotive, the all-electric car, collapsed in 2012. That was just a year ago. And sometimes the passage of time is counterproductive: a person could have bought General Motors stock (or bonds) in 2005 and lost massively in their 2009 bankruptcy.

Simply acknowledging the trend isn’t always enough. It clearly isn’t sufficient when speculating in finished goods, but may be all one needs if buying sector index funds (“I think people will use more health over time, but I don’t want to commit to a specific company”) or commodities (“That horrible blizzard in South Dakota? Killed tens of thousands of cattle? I’m going to buy cattle futures”). Back when she was inArkansas, Hillary Clinton put $1,000 into cattle futures and cashed out $100,000 in less than a year . . . so it can’t be too hard.

Takeaways:

  • Profit is expected only through the passage of time.
  • It is important that demand grows to exceed supply.
  • May work better with indexes or commodities than with specific companies. 

Discounted Cash Flow

Some folks argue that the Discounted Cash Flow approach makes bubbling impossible. They are wrong, of course. Remember the geek’s mantra, GIGO? “Garbage In, Garbage Out”? The result of the DCR approach is only as good as the data inputted. Very often the data employed is aspirational at one level or another. “I really want that Kelly bag, and maybe matching shoes, so if I assume earnings will go up 9% instead of the historical 2.5%, in a year or so the bag becomes possible!”

The idea behind Discounted Cash Flow analysis is that the present value of an investment is the value of the total future stream of income discounted at some appropriate rate to the present day. For example, suppose an investor buys a property that generates a $10,000 cash flow, and after ten years the property is forecast to be sold for an expected $250,000. How much can she pay if she requires a 10% yield before inflation and taxes?

It’s not as simple as all that: there are pivotal complications. Is the annual cash flow fixed at $10,000 or are there rental bumps? What figures are we inputting for fixed and variable expenses? How will they change over the years?  What is the certainty of actually selling for the forecast price?

It depends on what we’re analyzing. If we’re looking at a single tenant property net leased to a national credit corporate tenant on a triple net basis with a bonded third-party purchase at lease expiration, given all that we would probably arrive at a reasonably strong number.

On the other hand, if we’re analyzing 9 master metered SRO units way out on the east edge of Fresno, all sharing a common bathroom at the end of the first floor hall, we will almost certainly wind up with a number more on the aspirational fringe. There are just too many variables.

The result of all this penciling and erasing and penciling again is only as good as the assumptions we make. In one case we have reason to assume that each of the tenant commitments will actually happen, so it’s a simple discounting problem. Rummage through your purse for your financial calculator.

If we’re talking about theFresnounits, what numbers will you use? What are the current rents? Will occupancy rates change when the lettuce crop comes in? How will the rents vary over the next decade? How did we come up with that number? How much will utilities increase? Why would somebody buy it ten years hence? What capitalization rate will they require? There may not be institutional financing available, so will you need to carry back the paper? And if you sell the paper, how much will you have to discount the nominal value and how will that affect your (present) Discounted Cash Flow model? The numbers we plug in for each of these variables will have a significant impact on the present value of the property. And there may not be any very robust data supporting any particular projection. So what we’ll do is insert six or ten squishy variables and try to come to some sort of value conclusion.

Sidebar: The way some folks work this out is to plug in the worst possible numbers for each variable and then press “equals”. Whatever appears on the screen then becomes the most they are willing to pay. In that way, IF (and that’s a big “if”) they get the property, no matter what happens they are probably going to be ok.

What is probably the major determinant of whether high numbers or low numbers are used in a DCR? My guess is that it’s investor enthusiasm. Remember, it’s the investor who’s doing the inputting. The more he wants the property, the more favorable the numbers. If he thinks interest rates are going down, the city is expanding in that direction and the newspaper will announce tomorrow that two major new manufacturing plants are moving in down the block he might happily wind up offering an awfully lot of money for 9 Single Room Occupancy units.

Takeaways:

  • Value is determined by inputting variables.
  • The variables are often estimated.
  • There is seldom robust data supporting the estimates.
  • Market psychology significantly impacts final price. 

Interest Rate Bubble

The Interest Rate Bubble usually applies to investments that generate enough net income that the project is not entirely speculative (in that way it differs from the Bigger Fool and the Discounted Cash Flow bubbles). Nonetheless, the likelihood of selling the investment years hence for more than its original cost is often a major desiderium of the purchase decision. The IRB recognizes as capitalization / interest rates change so will values. It’s a function of the normal market cycle and we can benefit from it, or not, as we wish.  The Interest Rate bubble is affected by changes in net income in addition to changes in cap rate. Sometimes these two elements magnify each other, and other times they offset each other.

If the investment is an apartment building, let’s stipulate that net rental income will increase over time. Let’s also presume that the area has seen net rental income increasing 5% annually over the past who-knows-how-many years. Both population and per capita incomes have gone up and we see no reason that trend will not continue. Right now, net income (I’m just making this up) is $100,000 and the building is available for a 6% cap rate. That cap rate is supported by the 10 year Treasury note plus an appropriate margin that’s been historically typical of the area. Additionally, several recent sales of comparable properties in the area have sold at a similar capitalization. At a 6% cap, that $100,000 stream of income will be worth $1,667,000. We make the necessary down payment, call Klarise for the loan, and the building is ours.

Ten years pass. The net income has increased the expected 5% annually and is now $162,000.

  • If local conditions still support a 6% cap rate, the building is now worth $2,700,000. The value is higher only because the net income is higher.
  • If cap rates have gone down to 4%, the property is worth $4,050,000 ($162,000 divided by 0.04).  A lower cap rate magnifies a higher net income.
  • If cap rates have gone up to 8%, the property becomes worth $2,025,000 ($162,000 divided by 0.08). The higher cap rate offsets some of the increase in net income.
  • Cap rates would have to be 10% or higher for the property’s value to be less than its original purchase price ($162,000 divided by $1,667,000)

The argument has been made that it’s probably better to purchase income property when cap rates are near their cyclical highs (meaning values are correspondingly low). Clearly, that is theoretically best, but it doesn’t appear critical. As long as cap rates don’t increase catastrophically, increases in net income can offset, partially or wholly, higher cap rates.

Takeaways:

  • A property selling at a cap rate that reflects the 10 year Treasury note plus the margin that’s historically been typical of the area (for that sort of investment) is probably not part of a bubble. 

Disclaimer:  This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Klarise.Yahya@Charter.net.

If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com.

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