Last night a good out of area friend called me at home (yes, phone on a landline…not email, text, Facetime, IM, Facebook or any other numerous ways to communicate) to get my advice on a possible rental house that just came on the market. My friend has some capital that he wants to redeploy to real estate rather than leaving it in the stock market. He forwarded an email from a real estate agent on the opportunity. After doing my back-of-the-envelope calculations, and speaking with my friend in more detail, I quickly concluded that I didn’t think it was a “good” investment for him, and that I didn’t think key points with the original investment thesis applied to my friend. Although the agent wasn’t wrong in his statements per se, it didn’t apply to my friend’s investment profile and situation. The recommendations applied more for an owner occupied buyer rather than a financial investor and could have caused headaches for him at an unattractive financial return.

Below is an edited version of the email and I will attempt to address some of the sections that I reference with names, city and some other details altered to protect confidentiality.

I saw a 2-bedroom/1-bath 900 square feet house today listed at just under $600k. One of the lowest priced SFR for sale in (above average neighborhood). As we discussed, the other (really desireable and one of the best neighborhoods in the area) neighborhood you are contemplating, I believe to be at the peak of the market, too expensive, and with little upside. There is much potential for appreciation with this bungalow and this particular area. The cap rate won’t be that great on it. The play here is that if you add square footage to this property and double the size, this could become a $1 million dollar house. The condition is good overall and livable. It would be perfect for a small family to live in and then down the road add an one or two bedrooms and another bathroom or two. The street location is good with many over Million-dollar houses. If you added an extra couple bedrooms and a bath approximately doubling square footage, it would sell for $900k. Do note that many builders can build for around $125 a sq. ft.

First, let me emphasize there are NO right or wrong answers. Second, although I know a bit about the area where my friend lives, I am not an expert, as I do not live there or buy/sell houses there. With that being said, the points I make below still apply to my friend’s situation as my statements are not geographic specific.

So where do I begin?

1) The opinion of whether the market and the specific “best neighborhood” is at the peak or not is irrelevant when comparing cities in the same vicinity. If one attractive city is near the peak, then the city next to it which is also a good city also would be at the peak or vice versa. The overall market of those cities will be highly correlated at close to 1.0. It wouldn’t affect which city to buy in if they are fairly similar and right next to one another. One city won’t go up while the other city goes down. For example, in SF Bay Area, if Palo Alto represents a highly desirable city, its values will still be highly correlated with neighboring Menlo Park, or even San Carlos.

2) This is actually 1a. Regardless of one’s viewpoint of near term market appreciation potential, what the agent didn’t factor in at all is that my friend is looking at this investment as a LONG TERM (20+ years) rental hold set up through retirement. The asset will appreciate over the course of 20 years. Then the questions become, is one city going to appreciate faster than the other in terms of valuation, rents or other financial factors. The agent’s statement that pricing is at its peak implies his assessment of near term pricing – not long term.

3) The cap rate won’t be that great. That’s an understatement. I did a quick calculation on this and I estimate the cap rate on this deal “as is” to be between 0.5-1.5%. That is horrible for a “cash flow” oriented investor. I won’t go into details on cap rate as there are many, many factors that go into it. Cap rate generally is inversely correlated with attractiveness of the neighborhood/house/street/etc. As an example, Palo Alto will have one of the lowest cap rates around compared that to a house in city with many foreclosures like Stockton or Tracy which will have a high cap rate (8-12%+). A cap rate of ~3% is considered low but typical for a house in a super strong, high demand city with strong school system, etc. that is renovated and in move-in condition. Pitching a 1% cap rate deal on a 2 bedroom less than 1000 sq. ft. bungalow?

4) Doubling square footage and altering it from a 2/1 to a 4/2.5 would increase price from $600k to $1 million. That statement in itself doesn’t lend credence. How much will it cost to double the sq. ft.? Is that even possible on the lot? The $/sq. ft. actually decreases in that statement so why does that support this as a good investment? There isn’t enough data/calculations/analysis to provide support on an investment thesis with that generic statement alone.

5) Builders can build for around $125 per sq. ft. That is a totally misleading statement. My friend has a full-time corporate job. He is NOT a builder, doesn’t have builder pricing for materials and labor. And the data being reference is for big builders, likely not even realistic for a general contractor. A random consumer can’t come close to adding sq. ft. to a house by hiring a General Contractor, Architect, etc. and doing the work for that dollar range. The number cited could have gotten my friend into trouble had he relied on the number for his analysis.

6) And finally, notwithstanding statement 5 above, my friend wouldn’t want to do a MAJOR construction project. The house he recently sold was an awesome house in an awesome city in which he received multiple offers and did well on the house in terms of price. Although the house was in solid condition, he could have done a few small projects like updating the bathrooms, refinishing the hardwood floors, or even done some work to the kitchen. Any updating effort prior to listing the house would no doubt yielded a positive Return on Investment. But he is a busy corporate executive with no interest in a house project. Would he really consider going through and doing a tear down major construction project that is really only (possible) play on what the agent is pitching. And even if they were prepared to do that, I’m not even sure there is enough profit margin to go through that major effort, financial investment and higher risk to even consider it.

Thus, the one statement that may be accurate is the sentence on being “…perfect for a small family to live in and the down the road add on….”. That is probably the target buyer on this house, not for a small financial investor that just want to re-allocate some money to a property that is in good condition in a good neighborhood that will generate solid cash flow and not cause a lot of headaches. The opportunity just doesn’t make sense from a financial return perspective or a good fit in terms of my this particular investor’s time horizon and investment profile.

Back in the early 1990’s a friend who lives in Southern California who I will call “LT” started working as a real estate agent. He worked hard, he hustled, he schmoozed and he sold. LT is a total people person. I knew he would do well. The story could end with me saying that LT is now a top producing agent and that hard work pays off. But not only is he a really good agent, but he became an astute real estate investor and a successful part-time poker player. How did he leverage his realtor experience into investments and poker playing. Are there commonalities between playing Texas Hold ‘Em and investing in real estate?

A few years into LT’s real estate sales career, he started investing his savings and buying rental properties for himself. And he kept buying, and buying. He did this for nearly a decade owning anywhere between 5-10 properties at a time. He bought where he thought were opportunities for upside appreciation potential and/or would generate a good future rental cash flow – probably more based on appreciation potential. LT was bullish on the local S. California real estate market and like everyone in the US had access to easy and low interest rate mortgage financing during the mortgage boom of late 1990’s to early 2000’s.

During that time, many high income earners who were in successful corporate careers were super busy and didn’t buy investment real estate even though they were tempted to – particularly as prices increased. But they were very conservative in “diversifying their portfolios” (given many owned their own homes) and also did not want the extra responsibility of being a landlord. In the mid-2000s, LT sensed the market was softening, and over a few year stretch LT sold most of his real estate investment portfolio. He timed the market on both the buying and selling side nearly perfectly. A couple friends commented that LT had a lot of luck on his side. Although I certainly believe there was a bit of luck, but I believe more that LT possesses some attributes that led him to become successful in his investment decisions and timing.

Here is my opinion on LT’s real estate endeavors:

• LT was active in the market, knew the neighborhoods and was an expert in his field of real estate so he had high confidence in his opinions on the local real estate market.
• LT was able to take on some more risk than others given his personal situation
• LT had relationships within the industry and was aggressively seeking opportunities
• LT uses gut instinct, and trusts it enough to put his money where his mouth is

Many of us would be building large spreadsheets and running sensitivity analysis and other forecasting tools. I certainly recommend this as a core activity as a potential investor and I always do this exercise even when I know right away if is a good deal. You want to know your cash-on-cash returns, cap rate, IRR, effective gross income, GRM, and other metrics. I’m sure LT made some of these calculations. But what often happens is “analysis paralysis”. The future is uncertain, you may be bullish on an investment opportunity, but there are always 2 or 3 things that can go wrong. This is when many if not most people are reluctant to act or don’t have the gumption to just make the leap.

• Did LT have skill in timing the market perfectly? Yes!
• Did LT see a bit of luck in just how well he timed it? Sure!
• But what did LT have that most others didn’t have? He had courage and conviction.

I have such high respect for LT, and he remains a very good friend of mine. Sure his timing was remarkable, but I give him 100% credit for how things worked out for him in real estate. The fact of the matter is that he put money behind his belief that real estate would be a good investment during those years and it paid off for him. He is still doing real estate sales, but he also spending part of his time as a semi-professional poker player enjoying the fruits of his earlier labor.

I believe investing of any sort (stock, company, real estate, currency, start-ups, etc.) has many similarities to playing poker. In poker, you must be able to i) calculate probabilities under uncertain scenarios, ii) have a read of the situation of what others are doing, iii) evaluate each hand against your current chip count to figure out betting strategy, iv) determine pot odds and make decision around the risk-reward proposition, v) have courage to go with your read and calculations, and vi) possess just a bit of luck. You want to minimize the luck factor as much as you can to maximize your pot odds. Back in my day of playing home games with friends, I was a strong poker player. LT is one of the few poker players amongst my friends who I would hesitate in playing seriously against. But when we do, and he occasionally beats me….of course I tell LT that he just got lucky!

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?

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.