On the surface that must seem a foolish idea. After all, though many call flippers ‘investors’ we realize that’s simply not the case. They’re the embodiment of speculation. They buy low with the plan to add value through the fix up process, then sell quickly and for a significant profit. At least that’s the intention, right? On the other hand, those who invest are lookin’ long term. In fact, they’re banking on the investment, in and of itself to give a return worthy of the time and capital invested into it. They expect reasonable and predictable cash flow. If they used leverage, they expect, over time to increase their net equity position through principal reduction via loan payments. Moreover, they expect solid retirement income from their long term investments.
Many argue that the potential for appreciation is appropriate when calculating long term yields on real estate. OK, I get that. My view is that the very existence of any expectation of appreciation begins to taint the concept of long term investment. Once it’s allowed to become an assumption in the spreadsheet, that investment capital has begun its journey into SpecLand. This is especially true if appreciation is at or near the top of the list of reasons why the yield is attractive. The years have taught me folks don’t like hearin’ that.
This leads me to an important question…
“What will your retirement look like if your investments don’t go up in value?”
But they will, cuz they always have, right’? isn’t an answer. It’s a hope at best. At worst, well, you can figure that one out.
Investors in my neck of the woods, San Diego, were spoiled since the mid 1970s. Double digit appreciation accompanied by equally insane rent increases, while vacancy factors were virtually nonexistent convinced most real estate investors they were brilliant. I include myself in that group. But since that region was growin’ in leaps ‘n bounds year after year, we all knew it would never end. Those who began in 1975 were buyin’ 2-4 unit properties for roughly $30-50,000. By 1981 those duplexes were worth, give or take six figures! Things flattened out during the early 80’s recession, but came roarin’ back in late ’85 with more double digit appreciation. ‘Course, by then we’d come to expect that as our due. During those two huge run ups the rents did the same thing. In those days San Diego County’s population was growing in the range of 50-80,000 annually, with no end in sight. No end in sight? Does that mean we have 20 million population here now? Um, that’s a negatory, Bertha. We’re at a comfortable 3 million, give or take few thousand. Real life happened.
But then we entered the new millennia, and the process began anew. By then you were considered a complete moron if your spreadsheets didn’t assume a ‘San Diego’ type increase in value for every year represented on your Excel sheet. Most folks ask me at this point, “But wasn’t all that appreciation a pretty cool thing?” Yes and no. If you benefitted from it, AND made all the appropriately well timed moves taking advantage of all that increased equity, you loved it.
But there’s a catch. There’s always a catch, right?
See, the price based upon the ever increasing incomes of these units was also goin’ up. Specifically, here’s what I mean: A four-plex that sold for around seven times the annual gross scheduled rent in the 1970s, was selling for 8, 9, 10, then 15 times that GSI. Think that’s horrible do ya? It only got worse. When the latest bubble began growin’ in 2000 or so, it was noticeable that our third ride on the ‘Get Rich Train’ was leavin’ the station. All aboard!!
Try $600,000 — at least.
Not only that, but even with the rents significantly higher than they’d been just six years earlier, the 2006 value represented a gross rent multiplier of around 22! Ya can’t make up somethin’ that insanely stupid. Yet, way too many San Diego real estate investors merely assumed the new gravy train was no different than the two that had preceded it. Not hardly.
Exit — Stage Left
Turn the clock back to late summer of 2002. This latest ‘rocket to the stars’ rise in values didn’t pass the smell test, but I couldn’t see the forrest through the trees when it came to the ‘why’ of it all. What a dunce I musta been. I called up the last mentor I had standing, and asked him for the answer. In return, he just cackled, tellin’ me I had a couple days to figure it out on my own, or he was gonna be sorely disappointed in all the years he spent with me. ‘What’s different this time around’? was the only bit of insight he gave me. I felt like the dullest tool in the shed about then.
Fortunately for me, Captain Obvious showed up with the answer. I don’t know what word expresses the concept of Duh! to the millionth power, but that’s the thought I had when the answer hit me. What college freshman majoring in finance didn’t already realize that it was the insane, fantasy loan underwriting that was fueling the cartoonish appreciation this time around? I felt so dumb I walked around the next few days in a funk made up mostly of self-pity. Am I really that blind? Wasn’t I smarter than that? Please, Lord, tell me I am.
My mentor took me off the hook by generously placing the blame on the fact I’d been way to close to everything to see it clearly. Lookin’ back I can see he was dead on. Still not an excuse I’ve allowed for myself, as accurate as it was, at least in hindsight. Close or not, I was a very experienced pro who shoulda known better.
Appreciation is something we all enjoy when it deigns to bless our portfolio. However, cookin’ it into your spreadsheets for the expressed purpose of predicting overall yield is an invitation to major disappointment, and that’s being kind. For the next six months after being so humbled, I spent all my time preparing to leave my hometown market for good. I kept my intentions to myself, except for clients. Very few of ‘em believed my reasons were credible, deciding to reap the rewards of another patented San Diego real estate boom. It was a boom alright, and those who remained when the bubble burst learned firsthand: they were at ground zero.
The lessons learned were many and priceless. But one lesson, at least to me, stuck out. Predicting future value increases is the answer to an old joke.
How does a real estate investor make a small fortune? They begin with a large fortune, then base investment decisions on a crystal ball’s assurance their properties will skyrocket in value.
For the record, that joke’s funny, ’til it’s not.