Drivers

I recommend a book called Timing the Real Estate Market by Craig Hall. A contrarian investor, he is founder of Hall Financial Group, a real estate finance and investment firm. Hall has been in the business for a long time and bought his first property at the age of 17. He has made millions and lost millions over the years, especially during the 80's real estate craze. His book is any easy read and again I highly recommend it.

He discusses how the main profit of real estate is at the sale and therefore buying and selling at the right time for the right price is crucial to making money. Buy low sell high is, of course, the premise of any kind of investing and much easier said than done. If you can figure out the main forces driving a particular market, then you have some kind of indication of what point we are in the cycle. Hall indentifies the seven major drivers of real estate. I'll list them and throw in my take on it.

1) Inflation
It can be both good and bad. Inflation means increased rents for income properties but also increased costs. It all depends on whether your tenants are locked into a lease for a set price or whether you can raise rents to keep pace of rising costs. It also is a plus and minus for financing. The higher the inflation, the higher the mortgage rate. With a multi-family, higher inflation is a positive since this translates into more renters and less homebuyers. Unfortunately, this means your mortgage costs go up as well. Moderate inflation is ok, rampant inflation could be a sell signal. Deflation is bad and any indications of it suggest sell. Currently, inflation is moderate thanks to the global availability of cheap goods. Oil prices, which were not sustainable at over $3, have come down. There is a lot more money being printed, but this has translated to higher asset prices and only consumer good prices count. Inflation is neutral right now.

2) Interest rates
Interest rates are at their lowest in recent history. This has caused real estate values to go to levels never seen in some parts of the country. With record low fed rates, banks have been lax with credit standards and have devised some very creative loan products. This made it easier for unqualified individuals to get into the market. The extremity of these circumstances suggest overly inflated real estate values by speculators and lenient credit standards. With rates so low, there is only room for them to go up. Interest rate go up, prices come down. Although there are many forces trying to keep interest rates down so consumer consumption does not stop, there are forces in the form of the Federal Reserve that are intent on raising rates. An economist at the SFAR convention I attended last month suggested the fed has, in the past, interfered with the secondary mortgage market and we can't rule out that they won't now. He got this from an old friend, a former SF Fed Reserver. This is hearsay, but economist tend to run in the same circles. Greenspan kept talking about a housing bubble and we know what Greenspan does with bubbles (just think 2000). The interest rate situation will and is having a negative effect on real estate prices. This is a bearish signal.

3) Flow of Funds
There is the normal flow of funds into real estate driven by normal market conditions and then there is external circumstances that can whip the public into a real estate frenzy. In the early 80's Reagan accelerated the depreciation schedules and large amounts of capital flowed into real estate from investors seeking tax shelter. This created excess supply without the appropriate growth in demand. After the 2000 tech bubble burst, people began searching for a more safer investment. The combination of low interest rates creating large amounts of capital for mortgages coupled with investors moving from the stock market to real estate resulted in increased prices. If capital starts to move out of real estate, this is a sell signal. Fortunately (or unfortunately) getting that equity out of real estate is not easy. It could take weeks or months to sell, so large amounts of capital leaving real estate and resulting in an overnight drop is prices is a long shot. How fast prices drop depends on the will of the investors to hold and also the staying power of all those people who barely qualified for that mortgage. If wages can increase, then people can hold on and there won't be a large downward push in real estate prices. If defaults start to increase, it could get really ugly. Also if all the speculators start to bail (and they have been), this could spell trouble in some markets (a la Vegas). Remember prices in the end are driven by supply and demand.

4) Job growth
Second only to San Jose, San Francisco had the largest net loss in jobs from 2001-2005 yet experienced, over this same time period, one of the highest appreciations in real estate. San Francisco had the hottest real estate market until recently eclipsed by Manhattan. Usually there is a direct correlation between job losses and property values. True, San Francisco is a unique market and we started slowly gaining jobs according to the Employment Development Dept. I believe the recent net increase of 26,000 jobs in the Bay Area will have the most positive effect on rents. Tech jobs in San Jose will continue to be outsourced and this won't be good for the Bay Area as a whole, but we do have one saving grace: biotech. Our position on the Pacific rim is also a plus. Short term, large job losses plus large gains in property values, just doesn't add up for me. For labor statistics and data reports visit www.labormarketinfor.edd.ca.gov. It is run by EDD by the state.

5) In-or-out migration
The 1990's were exciting times in the Bay Area. It just hasn't been the same since all the dot-commers left. At least I can now get street parking. It doesn't take a rocket scientist to know that the Bay Area experienced out migration beginning in 2000. The good news is the massive migration into the city during the heyday of technology was an anomaly and the subsequent out migration was part of a return to normalcy. Some of you may remember the bidding wars for studio aparments. As long as the SF Bay Area can attract companies here, maintain an intellectual and creative environment that brings talented professionals, remain on the forefront of technology and ideas, and leverage our position on the Pacific rim, then out migration should not be a big long term problem.

6) Path of Progress
This refers to buying in an area that is not currently trendy or in favor, but is in the path of development. Think Castro or Hayes valley 15 years ago. Or the South Beach Area before SBC Park went up. Developement is starting to spread in areas like SOMA and property should go up as new development goes in. In the Bay Area as a whole it's hard to find any good path of progress areas with huge upside potential. You might consider Sacramento.

7) New Construction
Too much construction, too fast is a negative. On a positive note, there isn't much room to build around here. This limits supply and keeps prices higher than other parts of California. Developers did manage to find room to build a lot of new condos in South Beach, SOMA, Downtown, and some pockets throughout the city. Developers tend to have a very short sighted view of the market. They make money by building. It's the banks and investors that lose money if there is no demand. New supply should never outstrip demand. As you can discern from my other blog postings, I'm bearish on condos.


Two Myths

Hall tells readers in his book that there are two untrue beliefs held about real estate:
"It will only take $XX to cover needed real estate improvements on this property" and
"Real Estate is a cash flow business".

When investing, always have a reserve. A few days ago, I called up an apartment owner about changing his real estate portfolio around. He informed me that he bought an apartment building in a prime location two years ago for around $2 million. He has already sunk in an additional $200k since then. And that's with him managing the property himself. Needless to say, he had too much capital tied up in the property to sell now.

You make money at the sell, so you should always be thinking about your exit strategy. The exception is the property with the right location, well built and maintained, and producing a strong positive cash flow. That's a property you keep.

In the future, I plan to cut down on the lengthy blogs and focus on imparting my experiences around town and tibits of info I can gather.

Check out his book at Amazon.com http://www.amazon.com/gp/product/0071421955/104-5201187-3116760?v=glance&n=283155&n=507846&s=books&v=glance