Where’s the Beef? Er, I mean listings on the market more than 2 weeks….What does this mean for potential sellers?

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The year was 1984, and a new Wendy’s television commercial caught fire.  An elderly lady with this raspy voice would yell into her telephone asking “where’s the beef?” to some competitor burger joint of Wendy’s complaining about the small hamburger size of their product.  I remember as a kid, everyone in school would use that line for almost any situation. “Where’s the beef?” catchphrase kept going for years after launch.

Current year 2015….over 30 years later…I was just looking at one of my MLS saved searches (on 4/17/15) – single family residence (house) listings Active on MLS in cities from Millbrae down to Palo Alto under $2 million list price that has been Active on MLS for 20 days or more. There are 12 cities in the search.  Guess how many houses there were?  75-150 might be a reasonable guess given the low inventory, high demand real estate market in the mid-Peninsula market.  There were only 25 houses that have been on the market for more than 2 weeks and not pending sale.  That equates to approximately only 2 houses per city.

Although I am not precisely tracking data by recording in a spreadsheet, I have had this internal MLS sort for approximately 4 years now. I do not remember another year, regardless of month of year, where SFR 20+ days in this mid-Peninsula area of 12 cities was able to fit on the 1st page of my web search. Properties sell within 1-2 weeks on the market given low supply and high demand. So, what does that mean for sellers and buyers?

For sellers, you may think this might be all great news.  Both yes, and no.  If you are seller moving out of the SF Bay Area, this should be great news.  Sell your house and be able to buy a bigger house for less money in nearly anywhere else in the US (NYC excluded). Even though other parts of the US also is showing strong appreciation with low inventory situation, it is unlikely to be at the same level as the SF Bay Area.

However, if you were a seller looking to purchase a bigger house in the same area, then there might be challenges. They are not insurmountable, but definitely trickier: 1) buy bigger house 1st if you qualify for 2nd mortgage or can purchase all-cash, then sell current home after purchase, 2) sell current house 1st, negotatiate rent back, and aggressively seek to find AND secure new house before having to move out with back-up plan having to move to temporary residence, and 3) buy bigger house 1st using alternative/hard money lenders, then sell current home after purchase and finally refinancing into traditional mortgage paying off alternative loan. Some other options exist, but those are most common possibilities.

As a seller, it may seem that you may need to do less work to prepare your house for sale. Yes, and No. That may be true to simply “just” sell the house. However, the best agents will still advise you on possibilities to be put your property in the best light to maximize your sale price. Because of my construction project experience, I almost always will talk to my seller clients about possible projects to do to the property prior to selling with some estimated rough range on cost and what the estimated ROI percentages will be on potential upside.  This provides a framework for my clients to decide if the wish to invest time and money into the house to potentially increase sale price. My seller clients really appreciate my outlining in detail their choices so they can make decisions even if they ultimately do the minimum required. Some agents will default to not doing any work or even convince homeowners not to do work, since they can get it on the market sooner and they still know it will sell and it requires less effort to them. Although timing is always a factor in the decision matrix, I believe it is still important for the homeowners to know their options and understand the risk/reward and possible financial outcome of each option.

As always, feel free to contact me if you wish to brainstorm anything related to your home.

 

Why I lectured some relatives about their smoke detectors over Thanksgiving…..

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I just returned from LA where I visited some relatives over Thanksgiving weekend. Good trip, great food and awesome weather. Some retired relatives have lived in their house for over 30 years. They’ve updated some items inside the house but other parts of the house have original details. One part of the house, they have unwittingly ignored is their smoke alarms. They do not work, and the smoke alarms are probably 10-20 years old – none of them have working batteries and it’s not certain the detectors even work at all. When asked why they don’t replace the batteries or detectors, they indicated that the ceilings are too high or that they simply forgot to do so. I spent the next 10 minutes lecturing them on the importance of smoke detectors/alarms and how dangerous it is to live without them.

In selling real estate, one of the California state laws require that “every single-family dwelling and factory built housing unit sold on or after 1/186 must have an operable smoke detector, approved and listed by the State Fire Marshal, installed in accordance w/the State Fire Marshal’s regulations….”  In fact, some local cities impose even more stringent smoke detector requirements. When I recently completed a bathroom remodel to my own house, the city inspector checked my house for working fire alarms and even instructed me to add a smoke detector to a part of the house before he issued the final approval. I was happy to comply.

As part of closing a real estate transaction, one of the disclosure documents that must be signed is a Certification of Compliance with Water Heater, Smoke Detector and Carbon Monoxide Device Requirement. Simplistically, the Seller/Owner signs the certification that they/the house is compliance prior to close of escrow. On the deals that I close as either the listing or buying agent, one of the real estate agents on the transaction ends up providing a working smoke detector on behalf of their client literally the day before close of escrow. Obviously, this is not the ideal scenario because it means the owner had been living on the property without proper working detectors previously.

Nowadays, it’s not just smoke detectors but also carbon monoxide devices. There are many brands that sell single units that detect both smoke and carbon monoxide.

The “chirping” of low battery life is annoying. Over the years, I’ve had to wake up in the middle of the night to dismantle the battery to stop and then procrastinate for weeks before replacing the batteries. I can only imagine the extra hassle it would be for an elderly person to carry a stepladder up the stairs and then have to replace batteries. Low and behold, they now make detectors that come with a 10-year battery life – hooray!

Smoke/carbon monoxide detectors are relatively inexpensive these days. You can see the link below from Homedepot.com that a combination smoke/CO2 detector with a 10-year battery life only costs $40. This investment now lasts for an expected 10 years and replacing the units is very easy. Below is a link for an example of one such unit.

http://www.homedepot.com/p/Kidde-Battery-Operated-Combination-Smoke-Carbon-Monoxide-Alarm-with-10-Year-Sealed-Lithium-Ion-Battery-21010262/204249510?N=5yc1vZbmgjZua

My relatives who I had to lecture were probably annoyed at me for the tone I took, but I am completely comfortable with having done so. It’s a safety issue, and I lecture only because I care and am concerned about their welfare. The only redeeming outcome of the exchange is that I now know what present to get them for the holidays. I will probably purchase nine new units and install if for them throughout the house. No, it’s not a fun gift, but one of necessity to all households alike. I don’t believe they read this blog so hopefully it’ll still be a surprise gift!

Have a fun, safe holiday season!

 

Are you Bearish or Bullish in Today’s Real Estate Market?

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Recently I had a conversation with a local Peninsula friend of mine who I’ll call “Fred”. He is one of my go-to-friends for talking about the stock market, investment opportunities, technology industry, and general business topics. We hadn’t talked about the markets in over a year and compared notes about our opinions. He asked me how real estate was going and what my thoughts are of the current marketplace. I asked him his opinion of the stock market valuations and strength in Silicon Valley at a macro level. The local economy, stock market valuations, health of technology sector, regional job growth/decline, etc. are all strongly correlated with the current situation of local real estate markets.

My friend is a former law partner at a Tier 1 law firm turned technology executive of a company that went public several years ago who views business in a highly analytical fashion. Like myself, Fred has also been living in the Bay Area for 20+ years having been through the dot com bubble of 1999-2000, the subsequent bust of 2001, to Web 2.0 & subprime mortgages in mid-late 2000’s, then the economic depression thereafter, and the current surge of the technology sector, and real estate for the past several years.

There are similarities between 2014 and previous strong economic times in last 20 years.

  1. Early stage start ups getting VC funding thereby creating exciting opportunities for technical and even non technical labor offering attractive compensation packages of salary + equity
  2. Established Fortune 1000 players growing year-over-year, generating health cash flow, and reinvesting it in new jobs, capital investment, acquisitions to further stimulate the economy.
  3. Private equity/hedge funds/venture capital firms with surge of capital from insurance companies, pension funds, and endowments looking for attractive investment opportunities. Post equity investment or acquisitions, early employees often get an influx of cash that allows them to pay off debt, invest in equities, and/or buy their 1st home or upgrade houses.

A by product of all this is my observation of traffic on highway 101, airplane flights where there are rarely empty seats, and sub-contractors charging higher prices due to all the construction activity occuring.

Since I am in real estate, and given my financial background, I get asked all the time what I think of the stock market and real estate prices. Are we at a peak? How much higher can things go up? Is this the right time to buy/sell? The challenge is it is very difficult to truly time the market. For example, if someone believes there might be some technology stocks overvalued right now, that investor would want to “short sell” the stock. However, the risk is that even if the prediction of valuation is correct, it is hard to accurately gauge whether it will take 6 weeks or 18 months for the stock price to move in that way given the innumerable variables that factor into everything.

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It is similar with real estate. I know a friend of a friend who around 1998 thought the real estate value was at its peak and they ended up selling their house to “time the market”, moved back with their parents with the goal that they would buy a bigger house at a lower price when the market correct. Unfortunately, real estate kept going up for several years and when they realized that they “timed” it wrong, they were not able to afford to buy back into the real estate market. What compounded it all was when they realized their mistake, they actually could have bought back in but would have had to purchase a smaller house than what they had before, but they kept holding out hope that they would eventually be right all the while the market kept running up in 1999 and 2000.

Neither Fred nor I really can predict what will happen. We certainly have some predictions and opinions on what is happening. But for me, I view my own house and my stock portfolio on a medium to long-term horizon. My stock portfolio goals is for capital appreciation in the next 10+ years that will serve to pay for my children’s college expenses and eventually my retirement. I seek out investment opportunities for companies that have strong fundamentals and will survive and thrive over time through recession and boom times. Same with real estate, I know I will live in the SF Bay Area for the long haul, and I wish to be comfortable in my own home. Regardless of my beliefs around short-term economic outlook, I continue to be long term positive on Silicon Valley and rest of Bay Area as a geographical location that has great weather, amazing outdoor opportunities, culture, and a hub of highly educated people that companies want to be located near so that will continue to create job opportunities. When I bought my first house in 1999, I thought there was a chance that I was buying at the peak. However, I knew I would be living in the area for a long time so justified it in my mind that over the next 10 years, I felt confident it would be a worthwhile investment regardless of short term movements. That first house turned out to be an amazing investment generating a large IRR and providing comfort to my living situation.

Why Belmont Housing is Hot

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Within my real estate office, I am one of the go to resources for all things Belmont and Redwood Shores with respect to the community. I have had a lot of questions recently concerning some quirky rules for the city of Belmont as it relates to real estate as well as nuances around the school district. Yes, San Mateo County, the “mid-Peninsula” real estate prices continue to increase due to low inventory and strong demand (see previous post https://taosiliconvalley.com/2013/08/26/microeconomics-101-for-real-estate-2/ ). The quaint city of Belmont has always had admirers, but remained a bit under the radar for those who don’t live in San Mateo County. Andecdotally, it seems Belmont has increased in popularity of recent years with nearly every listing generating significant number of offers from home buyers wanting to be part of the community. Why is this dynamic more precipitous than ever? Although this oversimplifies the dynamics….part of the explanation is around the many positive developments of what was already a strong school system. The attractiveness of Belmont includes Water Dog Lake Park, hiking/biking trails, proximity to transportation, and friendly, highly educated people. What ties all of these things together is the award winning Belmont Redwood Shores School District.

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Yes, other nearby cities also have good to very strong public schools. The Belmont Redwood Shores School District has experienced overwhelming community support in the form of passing multiple bond measures and parcel tax measures in the past several years that has allowed Belmont to completely upgrade deferred maintenance, modernize facilities and advance technology investments in the elementary and Ralston Middle schools. Every Belmont elementary school saw major construction projects over the past 2 years that improved the schools significantly and expanded some as well. Within Redwood Shores, Sandpiper is relatively new having been built in the mid 1990’s and Redwood Shores elementary opened in 2010. These schools are nice, clean and (now) modernized. What parent wouldn’t want their kids go to a “newer” schools that rank highly in the state with active parents and a supportive community? It used to be that many of the elementary schools saw strong API scores and would attract homebuyers. Now people hear about the community activism of supporting children’s education above and beyond test scores, and then see the beautiful facilities, before deciding that they will do whatever they can to buy a house/condo in Belmont to be able to send their kids to the schools.

Below summarizes the Belmont Redwood Shores API scores from 2013:

    • Central 935
    • Cipriani 910
    • Fox 915
    • Nesbit 865
    • Redwood Shores 928
    • Sandpiper 938
    • Ralston Middle 907

Belmont and Redwood Shores passed multiple bond and parcel tax measures. Measure U in November 2008 raised $78 million to keep classroom sizes smaller and maintain some enrichment programs, Measures I and N in November 2010 raised $25 million for Ralston and $35 million for the Belmont elementary schools to improve and expand the buildings/facilities. Measure R in November 2013 maintained an expiring $174 parcel tax to support the schools. All of these measures passed with the voters on the 1st try showing a true testament to the community. Passing these measures took time from enormous number of volunteers to drive the campaigns, make phone calls, donate funds, and print marketing materials to educate the people. Then, the people responded overwhelmingly in the polls.

Additionally, there are 3 new City Council members elected/appointed over the past year. Eric Reed, Charles Stone and Cathy Wright all of whom are active in the schools, youth sports and general community happenings prior to them winning a seat on the City Council.

So it’s all positive right? What is the consequence of this popularity?  Simple….a projected continuing growth of school aged children in Belmont and Redwood Shores that will stress school site capacity in upcoming years. There are no easy answers. Many cities/school districts in the Mid-Peninsula face the same challenges. As an example, neighboring San Carlos is seeking new land to build a new school on and evaluating various options to manage growth in their school district.

The mid-Peninsula being midway point between San Francisco and Silicon Valley, nice weather, close to mountains/ocean/bay and really strong schools just offers a balanced lifestyle….and with little raw land to build on, there is just limited supply of new housing units to help absorb this demand. With many changes to the city, and the community support, Belmont may no longer stay sleepy in the shadows of their larger cousins nearby.

Cost and Return on Investment Estimates for Home Remodeling

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As a real estate professional, I get asked regularly the following question…”what is a rough estimate to upgrade/replace/fix <fill in the blank> in my house?”. I love talking real estate. I am passionate using data and analyzing information to discuss options with people. I enjoy brainstorming home projects with people, and am good at providing insight to my clients on potential ways to modernize, change floor plans, and remodeling options on houses they own or are considering making an offer on.  But, it is incredibly difficult to answer very specific question around cost estimates or ROI, primarily due to a huge range in quality of finishes, labor cost, unexpected costs, differences in people’s houses, individual ability to negotiate, geography, space layout, and myriads of other factors. I thought I would write a bit about this dynamic after I just read an article on Yahoo News on “what is the rough estimate of a Return on Investment of a specific home project”. The reason is all these various articles estimating ROI in the United States is not as relevant in the heart of SF Bay and in particular in mid-Peninsula cities where average condo/house sale prices is almost $800,000 and a small 3bd/2ba starter house that requires work in San Carlos, Burlingame, San Mateo, Foster City, Redwood Shores, Millbrae, Menlo Park, and Belmont surpasses $1+ million.

http://news.yahoo.com/home-remodeling-projects-worth-money-155500763.html

http://money.usnews.com/money/personal-finance/articles/2012/10/25/renovations-that-yield-the-best-return-on-investment?page=2

You can see in the article that states the home improvement projects yield below 100% return on investment (ROI) from a re-sale perspective. In the San Francisco Bay Area where homes are selling from between $600-900 per square feet and demand outstrips supply (see previous post, https://taosiliconvalley.com/2013/08/26/microeconomics-101-for-real-estate-2/)  projects such as a kitchen or bathroom remodel generally will yield well above 100% return on re-sale. I don’t like providing blanket statements like that, because the homeowner can certainly “over improve” a space relative to the neighborhood/house, or design to a very specific taste whereby the ROI may be under 100%. When the $/sq.ft. and the average price of a home is so high, the threat of not seeing a good ROI is significantly mitigated relative to other parts of the US where $/sq. ft is much lower than what we see in Silicon Valley.

I indicate kitchen and bathrooms since those projects require more of an upfront investment to do the project but also since these are key rooms that buyers pay attention to and homeowners have pride over. There are other projects that should easily see an above 100% ROI in our location – new paint (interior/exterior) and flooring readily comes to mind.

In terms of cost estimates, I get asked the most about bathroom and kitchens….surprise, surprise. Let’s start with bathrooms, this has a big range for a complete “gut job” remodel project. For a Master Bathroom (for a smaller “regular bathroom” cost estimates are lower), let’s go with anything from $3000 to $50,000. For $3-5k, you are likely doing most of the work yourself, it’s off the shelf big box store vanity/mirror/lighting with no moving plumbing or electrical around and no special tiling work, and is only a small, basic bathroom. I was recently at a high end bathroom showroom store looking at what I thought was a “higher end” vanity. It was around $6k for a 60″ vanity/countertop. It was beautiful. Then, I looked around the showroom and was a kid in a candy store. Everything was so shiny and awesome. First, that vanity the salesman told me was the “least expensive” in the showroom. They had small 30″ half bath vanities for $10-15k, bathroom faucets for $3k, standalone tub for $2,500, a steam shower set up for $4k. You could easily spend $50,000 (or even much more) for a sweet set-up that you probably see on the old TV show “Cribs”. But more realistically for us regular people, a part of your cost component will be whether you are moving plumbing, do you need to upgrade electrical, new lighting, are you doing custom tile work, type/brand of fixtures, jacuzzi tub or just soaking tub or a tub/shower combination. Clearly, each variation adds $$.

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No question, a kitchen is higher cost and has even higher variability. Just a quick example on simple appliance choices, you can buy a nice refrigerator for $2k, dishwasher for $750, stove/oven for $2k, and range hood for $300. There are more basic and cheaper options available at maybe half that pricing. However, if you wanted to get a “higher end” kitchen appliance set, the starting prices could be as follows…6 burner 36″ Viking/Thermador range for $7k, Chimney hood for $1,500, dishwasher for $2k, wine fridge for $1k, Miele built-in expresso machine for $3,500, and a sub-zero refrigerator for $15k. For just the appliances alone, the cost of a good set can be had for $5k or go up a tier or two and add in a couple other appliances (wine, expresso) and you are now in for $25k. You haven’t started construction yet, picked out cabinets, countertop, lighting fixtures, changed the floor plan, upgraded electrical, or paid for any contractor labor. Thus, when I get pressed on providing a “cost range” for an “average” kitchen remodel that is still not an easy question to answer.

And as anyone can guess, the skill and efficiency and cost of a general contractor and sub-contractor run a wide range range. Often, labor is a big component of the overall budget. Lots of dynamics impact labor cost. Highly experienced and professional full service general contractor with a full team will be more expensive than a one person unlicensed person. Your timeline and how quickly you need it completed will impact cost. Type and complexity of project impacts many decisions. How well do you negotiate? How much risk in the project if something goes wrong? How are you structuring the arrangement with the contractor – fixed cost or cost+ markup. Who is paying for materials. Geographic location. Thus, when a friend from Denver asks about estimating costs vs. a client from Palo Alto, I can safely assume the labor cost for a contractor in Palo Alto will be higher than someone from Denver for the same work.

So a key question to ask yourself in evaluating whether to start a home remodeling job is how important is the “financial ROI” aspect of whatever you do vs. doing a remodel purely because this is the house you will be living in for the next 20 years and you don’t care about the specific style, taste, budget of your remodel and how others will perceive and value your work. That dynamic may help determine and drive what you decide to do, how you design your plans and what finishes/colors you end up choosing.

Again, for those who know me, know that I am not someone who likes to just throw out random numbers and prefer to provide lots of details and assumptions when I do use numbers whether to help provide comparable sales information, to analyze sports statistics or to provide direction on a project. When you do read articles online about home remodeling ROI, keep in mind, the statistics are for national averages/estimates and does not necessarily reflect the SF Bay Area’s valuations. But as always, feel free to contact me if you wanted to brainstorm anything regarding real estate or get my expert opinion about the upcoming March Madness college basketball tournament bracket!

Should I Stay or Should I Go Now?

“Should I stay or should I go now?
If I go there will be trouble
An if I stay it will be double
So come on and let me know”

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Those are lyrics by a classic song by The Clash. Okay, so I admit, I’m stretching a bit trying to be amusing and incorporating those lyrics into a blog post that probably should be more succinctly titled “Should I Sell First, Rent, then Buy?”. Last month, the topic of selling your house first, then renting before trying to buy another house has come up in a conversation I had with a friend and during a recent Coldwell Banker office meeting. Thus, I thought it worthwhile to write a blog on the rationale behind this strategy, the inherent risks and the potential benefits. There are various scenarios on why someone would do this and my perspectives change depending how the reason for doing some and your timelines. The following are two common scenarios.

Scenario 1 – The Empty Nester: couple has owned a larger house for a long time, with adult children

In this situation, my friend has lived in a nice, big house in a nice leafy community for decades and now has grown children, and no longer has a need for a large house with a large yard. He and his wife are contemplating the possibility of “downsizing” their house to a) cash out and take some equity out of real estate while their mid-Peninsula house is at an all-time high, b) move closer and within walking distance of an active downtown area in San Carlos, Burlingame or San Mateo, c) change of scenery of just living somewhere different and d) live in a (smaller) single-story house requiring less cleaning and with a lower maintenance yard.

The conversation revolved around the highly common question of do they sell first then buy or buy 1st then sell; I will tackle this bigger question in a separate blog post. My Peninsula friend then said he’d even consider selling first, then renting a San Francisco apartment for a year or two for fun, before contemplating a purchase. In principle, that sounds like a really cool idea. Long time suburbun couple, cashes out of their house as an empty nester, then rents a hip apartment in the big city SF life for a couple years before deciding where to settle back to. From a financial perspective, let’s look at two rudimentary possible market outcomes:

A) the real estate market remains flat/declines or goes up moderately. In this situation, the strategy above would work out very successfully.

B) the local real estate prices continue rising 10-20% per annum. In this situation, being out of Bay Area real estate would come at a negative financial impact. I use the term rudimentary in above paragraph, as you can include dozens of other variables to really determine “financial impact”. For instance, it would be theoretically possible if one freed up capital in selling off a real estate asset and then reinvested that capital in a different investment opportunity that ended up yielding a higher return than if that person remained in real estate; and if you were to include that possibility, you’d need to incorporate “beta” and inherent riskiness between asset classes into that analysis as well. But let’s simplify thing in this following sample calculation. Let’s say your current (larger) house can sell at $1.8 million in Spring 2014 and the target would be to purchase a smaller 3 bedroom, 2 bath house in San Mateo for $1.2 million which would allow you to cash out almost $600k in equity (not factoring in cost of sale, taxes, etc.). What if you sold your current house for $1.8 million, then rented a super-hip SF apartment for 2 years and then started looking to relocated back to mid-Peninsula again in year 2016. And in this situation, the Bay Area real estate market continued going up 15% per year for these two years. That $1.2 million house in 2014 would be priced at $1.587 million yielding net cash of $213k (from the $1.8 million) as the 3 bedroom house would have gone up by $387k. Additionally, there is the cost of the hip apartment rental in SF which will probably be between $4000-6000 per month for a nicer unit in a hip neighborhood which wouldn’t go towards any mortgage principal at all. Now, we aren’t factoring in impact to tax writeoffs, income earned from reinvestment of the freed up capital and other items, but this simple example seeks to illustrate a financial risk in being out of Bay Area real estate market…..in a potentially rising real estate market.

No one knows what any market will do in the short term whether that is stock market, real estate market, currency market, commodities market, etc., but would you be prepared to “gamble” on being out of Bay Area real estate if you ultimately know you wish to own real estate in the long term as both a financial and lifestyle investment?

Scenario 2 – Young Family: seeks to move into bigger house and are not able to buy 1st then sell, so they wish to sell 1st, do short term rental while looking to purchase larger home.

Why would they want/need to do that? They may not have the requisite down payment unless they sold current house, or can qualify for a new mortgage while owning their existing house/mortgage. They may be able to take advantage of having a larger down payment after selling their current house, and be ready to buy and move into a new house, and not have to put in a contingency to sell their current house as part of their offer. There would be more flexibility to put in an aggressive offer with “cleaner” deal terms with this strategy. And certainly, as (B) above references and with any path, there will be potential risks too. There is no right or wrong way to proceed per se.

There will be implications no matter how this situation is handled. Having the money in the bank and ready to make offers with large down payments and without the complications of selling another house would generally improve the probability of winning in a multiple offer situation. But I wanted to just delineate between scenario 1 where my friend would be looking to temporarily cash out of the real estate market for a period of time just to “have some fun” living in the city for a couple years. He and his wife would be gambling in a situation where he has other options should he wish to pursue them. I would advise them to make sure to evaluate all his various options and just to make sure he knows what the various outcomes could be. Versus scenario 2 for the move-up buyer which is a very different situation with different expected timelines; in this scenario, there is risk, but based on timeline and the high competitive Bay Area market, these buyers have more limited options, but the timeline also is presumably shorter too. Thus, there are ways to try to mitigate some of the risks. But more importantly, there is potential upside in going down this path in terms of trying to buy the larger house.

There is generally a major dilemma with many of my friends and clients who are seeking to buy larger houses from their current place. Do you a) sell 1st then buy, b) buy 1st then sell, c) make contingency offers? Very challenging situation in the hot Bay Area market where many/most properties have multiple offers and some have an incredible number of offers. I will do a future post analyzing the options on this. No easy answers no matter how you disect it.

An Example of a Real Estate Investment that Just Didn’t Make Sense

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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.