How To Evaluate Today’s Housing Market
By Michael E. DeMassa, CFA, CFP®, AEP®
“Remember, cash is a fact, profit is an opinion.”
– Al Rappaport, American economist, educator and author
In early 2012, Warren Buffett mentioned in an interview with CNBC’s Becky Quick that he would buy up a couple hundred thousand single-family homes if it was practical to do so. At that time, housing had stabilized after hitting the depths of the financial crisis a couple of years earlier. Because investors’ appetite for risk in real estate – along with the money supply – was still low, it was not uncommon to find single-family homes for about $175,000 and renters willing to pay $1,750/month in Sarasota. When compared to the 10-year Treasury rate of around 2%, the single-family home rental market offered a compelling risk/return profile at about 12% gross cash flow (before expenses).
Investors, along with some private equity funds, accepted Buffett’s challenge and figured out a way to buy up the undervalued homes, and housing prices have been in an uptrend ever since. Today, there are innumerable real estate investment experts selling their strategies in books and online to impart their wisdom on building wealth with rental properties.
But does the math still work in today’s market?
Let’s look at a hypothetical example, based on median figures in the Sarasota market, informed by recent data. Of course, location, updates, lot size, and other factors will swing one property’s analysis over another in either direction. The point of this exercise is to create a framework to evaluate the general market condition for real estate. From available sales data and rental information available online (Realtor.com, Zillow.com, etc.), the median Sarasota single-family home has climbed to approximately $520,000 for 1,700 square feet of living space, or $306/sq. ft. The average rent for a similar-sized house is around $3,350/month, which would bring the potential total rent for the year (gross cash flow) to just under 8%. However, as every homeowner knows, there are expenses associated with owning real estate. Here is an estimate based on my knowledge and experience of homeownership in the Sarasota area:
Obviously, maintenance and repair costs will vary widely from year to year, depending on factors such as roof replacement or whether the air conditioner (or any expensive appliance, really) needs to be replaced that year. The 1% for maintenance/repairs and another 1% for reserve helps to smooth out the yearly cash drain rather than treating these expenses as “one-time item” losses. However, if the IRS depreciation tables were used (27.5 years or 3.636%), the net numbers would be even lower.
With the projected rental net cash yield at 3.77%, it makes it difficult to justify moving cash out of a money market fund yielding above 4% to become a landlord.
Leveraging the property to improve the cash yield is another change from 2012. Borrowing from a bank today at 7% wouldn’t help, and anything above a $300,000 loan in the above scenario would cause the net cash flow to go negative!
While this example falls into the “cash drain” category today, a drop in interest rates, an increase in rental prices, a decrease in home values, or any combination of these factors would change the math and, possibly, the determination about whether the property is a cash cow or cash drain.
Based on Buffett’s quote from 2012, a simple formula can be used to quickly gauge a rental property’s attractiveness. If the monthly rent is at least 1% of the fair market value, it has the potential of being a cash cow. (For example: $2,000/month rent on a $200,000 property). See the chart below for a sliding scale:
Each property is different and each investor’s circumstances should be evaluated to take in additional factors not discussed here. There may be reasons to keep a “cash drain” investment, such as potential market appreciation or the potential tax implications of selling being cost prohibitive to the investor. Emotional attachments to the property, or location, are non-financial reasons that could outweigh any cash flow analysis. It’s best to start there!
Understanding the cash flow and purpose of each investment is essential to building a solid investment portfolio.
FORZA!