Microeconomics 101 for Real Estate

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Basic Concept of Supply and Demand:

One of the most useful classes I took in college and graduate schools was Microeconomics. I love economics theory – so elegant. Economics make sense to me.  At the core of market pricing, there is a concept called supply and demand. How much supply is there in the market place plotted on a graph against price on Y-axis and quantity on the X-axis? How much demand is there in the market place plotted against the same graph? In this theoretical exercise, the Supply curve and the Demand curve intersect and meet within the graph that determines the theoretical price. Simplistically, the following theoretical conclusions can be made:

a)    Supply goes up (Demand remains the same), pricing decreases

b)   Supply goes down (Demand remains the same), pricing increases

c)    Demand rises (Supply remains the same), pricing increases

d)   Demand goes down (Supply remains the same), pricing decreases

TrimTabs Investment Research:

Many years ago, I came across a very interesting investment research and data firm called TrimTabs Investment Research that also runs an ETF and formerly a hedge fund. They have been in existence for over 20 years. Most consumers have never heard of them, yet the largest hedge funds in the world pay 5 to 6 figures annual subscription fee to get access to their specialized research and data which they use to help with their investment strategies. Additionally, several years ago, Goldman Sachs even bought a minority stake in them. The TrimTabs premise is that the stock price movement is as much a function of the supply of float in the market combined with the demand side indicators such as money flows of mutual funds, ETFs and hedge funds, than any other more traditional stock valuation methodologies. Through their proprietary data collection and measurement tools of both the supply side and demand side indicators they conduct data analysis and then put forth bearish or bullish calls for the US market, sectors, and international markets.  See http://trimtabs.com/global/liquiditytheory.htm for more information. Certainly, this isn’t foolproof all the time, but this theory makes sense to me and I certainly believe supply and demand factors contribute to stock market movements.

Real Estate Supply and Demand in the Bay Area:

It appears that the Bay Area (and other key markets around the US) is being impacted by the ‘imbalance’ of supply and demand contributing to the phenomenon of a rapidly appreciating real estate market. Providing some feedback at a rudimentary level:

Demand:

In the mid-Peninsula, in cities which include San Carlos, Belmont, Burlingame, San Mateo, Redwood City, Millbrae, Foster City, Redwood Shores and Menlo Park, you will read about the strength of the economy and how much wealth there is to purchase property and thus driving up price. All of those aspects are directionally true. After a few years of slow demand where people were not feeling as confident about the economy, their job situation, their stock option value, or trend of real estate prices, the last couple years it seems people are feeling good about many of those items. The stock prices have risen precipitously such that there is higher value in stock portfolios or in employee stock option grants. High technology is doing well and lots of start ups abound and growing. Formerly underwater houses have recovered such that equity available for down payments on new houses. But also, as prices have really increased in the past two years, there is now a fear for new homebuyers, investors or move-up buyers that if they don’t lock in and purchase a new house now, that in another year or two, prices will continue to appreciate thus either pricing them out of the market or having to purchase a less desirable property in the near future. Demand appears good.

Supply:

A major driver that seems to be impacting the degree in ramp up of prices is the lower supply of property available in the market. So good demand + lower supply = higher increases in price.  In San Mateo county and Santa Clara county, the heart of Silicon Valley, there is very little land to build new houses/condos. Land is extremely expensive which includes land that currently has an old house on it (“tear down”). New construction appears to be increasing in select pockets, but again, there is limited supply of available land. However, for several years, new construction virtually stopped so there was no new pipeline of new properties in up until recently.

Additionally, supply of homes relies of existing owners selling their current house. Certainly, there are sellers, but it’s clear that buyers outnumber sellers. I have my hypothesis on why sellers have been more hesitant to sell, but I’ll save that for another post.

Open Questions:

In the meantime, what does this mean for current buyers looking to participate in the real estate market? What is your prediction on future demand for property? When do you think the supply side issues will loosen? And how might the recent uptick in interest rates affect supply and demand?

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It is a hot real estate market, is this a good time to invest in a rental property?

Because of my financial expertise and analytical bent combined with people’s wide ranging interest in real estate, I am regularly asked if it is a good time to buy Silicon Valley houses as an investment. There are just so many variables, that it is impossible to answer that question as an overarching conclusion. Everyone’s personal situation, financial style, and economic opinions are different. One’s personal situation absolutely factors into the answer to that question. For example, here is a list of questions you should to consider:

  1. What is your time horizon for holding the property? Silicon Valley will go through normal economic cycles like most areas. Silicon Valley is one of the world’s key technology and biotechnology centers with growing companies and constant flow of new start-up companies. Assuming you continue to believe the area remains important and attractive, the longer your time horizon, the more you will have the confidence to ride out any short term hiccups – particularly considering the recent low interest rates to finance a purchase.
  2. Do you currently own Bay Area real estate or other real estate? This speaks to diversification of your overall investment portfolio or your real estate portfolio and how much experience you have. This can be looked at in multiple ways. Some people like to have their real estate investments nearby where they live so there is property management scale and efficiencies, while others prefer to be spread out in different geographies for diversification.
  3. How much cash/capital do you have to invest in real estate? Bay area real estate is expensive relative to most of the U.S. The amount of capital you have available will help determine if you’ll be able to purchase the type of asset you want to accomplish your financial objectives and within the location you desire.
  4. How much cash do you have set aside to buy a rental property relative to your overall liquid assets? What other asset classes are you considering investing in? You may want to speak to a professional financial planner who can work with you to look at your overall portfolio situation and your financial goals. What are your viewpoints on future appreciation potential for those assets and how does that look in comparison to real estate?
  5. Would you manage the property yourself or hire a property manager? There are pros and cons to either. If you do it yourself, your returns may be better, but there is “management” – more hands on work involved. If you hire a property manager, that will be an incremental expense on your monthly cash flow.
  6. What part of the Bay Area are you considering? San Mateo is different from Cupertino which is different from Morgan Hill which is different from Oakland which is different from Tracy which is different from Pacific Heights in SF which is different from Sausalito.
  7. Are you considering Bay Area rental more as a yield play or for potential appreciation? The answer to this question will drive where in the Bay Area you should concentrate on purchasing. Yield is your near term cash flow in terms of your rents subtracting out all your expenses. Generally the stronger the neighborhood/house/city/etc., the lower your near term yield but higher the appreciation. On the other spectrum, you can get higher near term cash flow by going further away from major economic centers or in not as good neighborhoods, but the prospects from value appreciation is generally lower. Like everything, it’s a tradeoff. What makes sense for one person may be different for another.
  8. What is your viewpoint of the general economy locally? Similar and correlated to question 1 above. It is difficult to totally predict how the economy will fare, the stock market and/or real estate. Of course, if you believe we are in a bubble, you will be more likely to hold off. However, if you believe the market will continue to appreciate and/or rental units will continue to be in high demand, then you’ll be more motivated to buy sooner rather than later.
  9. Are you planning to finance the purchase or pay all cash? If you intend to get a mortgage, current interest rates will be a factor. 30 year fixed rates have increased between 50 to 100 basis points over the past couple months. It is historically still considered low. The lower you lock in an interest rate, the lower your monthly expense and better your cashflow.
  10. What is your tax situation? This factor may help drive both what type of property you may wish to invest in or whether to invest in real estate or not. Additionally, there could be some tax advantages to owning property in your overall financial portfolio as well.

There are even more considerations to factor in making how to proceed even more complex. Feel free to contact me, your CPA, and/or financial adviser if you wish to discuss your situation in more detail.

….Party like it’s 1999

In the mid-90’s, I moved to San Francisco after graduating from Columbia Business School in NYC for a fantastic job executing mergers and acquisitions for Bank of America. I was living in the Marina district of SF until 1999 when I bought my first house in the mid-Peninsula. The SF Bay Area in 1999 was a whirlwind of hot Internet companies getting major funding, going IPO and was one launch party after another – Prince’s lyric around “party like it’s 1999…” sure rang true. The real estate market along with the general frothiness of the economy saw rapid appreciation. After losing out on a couple of offers, I saw a nice 3 bedroom, 2 bathroom house in San Mateo – a small, starter home.  As I was debating how much over the list price to offer, I recall saying to many people that “this would be amongst the highest $ per square foot in the neighborhood”. After crunching a spreadsheet trying to best value the house and predict where housing prices were going to go, and comparing it with remaining a renter and putting my savings into the stock market…..I put the purchase into the following perspective that homeownership is as much a personal ‘lifestyle’ choice as it was an investment decision. Unlike investing in the stock market, one gets to enjoy the tangible product of a house and being able to call it home.

I got the house at 7% above the list price which was aggressive at the time. There is a concept called “winners curse”.  Sometimes when you win an auction in a competitive situation…rather than celebrating, one may be tempted to second guess the decision. In my situation, we quickly assimilated to the neighborhood and loved our house so we were happy with our new home even when the dot com bubble burst which temporarily affected real estate.

Since that time, I sold that house in 2006, and bought another home. During that approximately 7 years, the value increased so much even after a temporary post-dot com blip that my 1st house to this day remains one of my best financial investments ever – and we were able to enjoy the benefits of living in a house we owned. The moral of the story is that no one can predict the future with respect to the economy, the stock market, or housing prices. People ask me all the time what I believe the real estate market will do and I certainly have my thoughts. Even more specifically, the question of “should I buy/upgrade now or later?” is even a harder question to answer. That question can only be answered individually factoring in future opinions of housing values, interest rate dynamics, job situation, life stage, savings, and many other personal factors. In a rapidly changing real estate market (either appreciating or declining), having a long term perspective for owner-occupied buyers that the house is both for investment and for lifestyle purpose will make for a healthier mindset.  And in my situation in 1999 when I was unsure of either, it is a great feeling when both the investment and lifestyle choices work out well. To this day, I sometimes miss the days of 1999 when I would be invited to 2-3 Internet launch parties each week.