The 3 Big Trends in Real Estate

The great Warren Buffett said there are 2 rules of investing: "Rule No. 1: never lose money; rule No. 2: don't forget rule No. 1." 

As an investor, I try my best to abide by these rules, which entails being aware of my psychological biases to make rational decisions. The last thing I want to do is succumb to the recency bias and assume that rising homes prices will go on for infinity. That has always been a recipe for disaster.

In this relatively healthy real estate market, the biggest risk is for investors to get caught up in the prevailing trend, only to suffer when the trend reverses. What we've seen in real estate the past couple of years is a classic snapback rally; in other words, real estate prices dropped too far, too fast, and we had a reversion to the mean effect. Now that this process has run its course, it's wise to take a serious look at today's market and what the trends suggest will occur. 

That being said, here are a couple of trends I believe investors should be away of, no matter where their market is. 

Rising Property Taxes

This is generally a phenomenon found in the Northeast. Municipalities are struggling for revenue in large part because of underfunded pensions and the recent recession. The cost of funding government will rise exponentially because of one simple fact: Boomers are retiring with pensions and must be replaced, so governments are essentially paying two salaries for the price of one worker. Not good. Furthermore, local governments have one big problem that the federal government doesn't: they can't print money. This is deflationary.

In oder to close funding gaps, local governments need to go after the lowest hanging fruit, which is property taxes. Raise income taxes too much and people take notice; raise property taxes and the logic is that the honus of taxation is falling on those who can afford it. Whether you are a buy and hold investor or a flipper, and whether you are concerned about cap rates or carrying costs, this is an important trend to consider. 

Rising interest rates

Interest rates affect home affordability, so this is clearly one of the more important pieces of data to track. Interest rates have been held artificially low by the Fed, and this has been supportive of real estate nationally. But will this trend last?

Many investors get caught up in recent data, so it's beneficial to occasionally take a step back and look at long-term trends. From the graph below, you can see that current rates are unusually low. In fact, for the better part of 30 years, interest rates were 7.5% or above, which would amount to a near doubling of rates. If and when interest rates rise, this is bound to have a negative effect on home prices. 

Interest rates are also critical for another reason: it determines the hurdle rate for investors when deciding where to park their capital. The hurdle rate right now is relatively low, which is why real estate is finding support even after a significant rally. But if interest rates rise above cap rates, there will be a rotation of capital out of real estate to assets with better risk-adjusted returns. This is extremely significant for serious investors to consider.  

America: The Only Game in Town

There is one clear positive in all of this. With the global sovereign debt crisis causing significant economic distress in Europe, it is making America attractive on a relative basis. Keep in mind that domestic real estate transactions are inherently different from transactions involving foreign capital. Foreign capital injects new capital into the system, leading to asset inflation, whereas domestic transactions merely transfer capital from one person to another.

If foreign capital continues to be attracted to U.S. markets, this means certain assets are probably rising. And the type of person with the willingness and ability to invest in the U.S. generally has higher wealth. 

But we are not only talking about wealthy foreign capital.

Here in America, a lot is made of the widening gap between the average American and those at the top. From the graph below, you can see that middle class incomes have stayed flat while the income of those in the upper income brackets has exploded. As an investor, this is what I take from this data: head to the higher-end young man! The recession that may be a reality for the recent college graduate is not what's being felt by the most wealthy in our country. Use this knowledge to your advantage.. 

This is the type of data I look at when deciding how to adjust my real estate portfolio. Right now, I am taking a good hard look at anything in my portfolio that depends on the middle class. I am rotating very selectively to higher-end deals, which is where the money is at right now. 

Although parts of this post may seem bearish, keep in mind I am still invested heavily in real estate. I just seek to make the most rational, conservative, and data-driven investment decisions moving forward.