Why appreciation matters in the SF/Bay Area

168 Replies

With respect to salary in Tech, one of my tenants, who is a software engineer at AAPL, was making $160k/year in 2012. I had several hi-tech applicants for one of my townhouse recently, they are making between $180k-$210k/year each. A gal was making $180k as a software engineer at Cisco, the other guy was making $210k as a product manager at Intuit, another guy was making $190k as a staff engineer at Qualcomm. I was shocked seeing these people's paystubs. I also had inquiries from GOOG and FEYE employees, but I didn't bother to get to them. 

The school districts in good areas of Cali normally are far superior than 99% of private schools. There are some solid reasons you would live in these good areas even if you took a loss. You can basically get a world class education with the best schools, teachers and admistrators on the planet for free. There is no where else that this happens. Just thought  I would comment on one more reason the momentum continues for these areas.

thanks, 

Matt

@John T. et al.

This is the graph from the 2nd article in your link.  Now let's look at the resemblance of human behavior between the last housing market and this one.

1989 and 2005 - top of the market

1991 and 2009 - bottom of the housing market

1992 and 2010 - 1st rebound

1994 and 2012 - 1st small pull back from the rebound

1995 and 2013 - 2nd rebound

1996 and 2014 - 2nd small pull back from the 2nd rebound

1997 and 2015 - the 3rd rebound???

Do you see the resemblance between the two cycles?  The only difference is the magnitude of the movement.  The pundits will find ways to justify for the housing rebounds for every cycle.  However, we, as human, tend to behave the same way in every cycle.  It may look and feel different, but it is never different.  

Here's to more appreciation in the coming years.

Originally posted by @Johnson H.:

@Minh L.  - With the market as hot the way it is and with lenders having tons of deposits, if FRB won't do it, I'm sure another bank will. Greater fool theory, and its the reason why I have a job.

Funny you mentioned multifamily, I was interested in a 10 unit in Concord, ran the numbers, turns out actual cap is 3.5% and proforma of 4.5% when rents are brought up to market. Sellers are definitely reaching these days.

 4.5%  pro-forma for Concord?  You can do better in San Jose.  You can probably get the same number for Redwood City.  We missed out on 436 Clinton St in Redwood City and still disappointed until this day.    

Originally posted by @J Martin:

@Bob Bowling ,

I'm with @Minh L. on the long-term asset appreciation average. One thing that makes a huge impact though is inflation. Note that the huge increases in the periods Minh mentioned above were correspondingly periods with insane amounts of cumulative inflation equal to multiples of the beginning-period dollar. Then the RE topped that high inflation increase..

So if inflation stays around the Fed's target of 1-2%, I think stronger areas like the Bay could be higher at around 4-5%. If you're 3-4X leveraged on average, that's another 12-20% return on equity (IF you're staying leveraged), about 8-15% of which you can tap in equity later (~70% of the change for LTV), in addition to any cash flow.

I think we would need to see some higher-than-target inflation levels like we did back in those decades. The reason for the increases were obviously different this time, with the preceding collapse, but I think long-term average real estate increases are strongly influenced by inflation (and with housing costs at about half the gauge, it partially tracks rent and RE price increases)..

Minh's price increases above compared to cumulative inflation:
1970 - 1980: RE: Quadruple; Inflation: Prices doubled
1980-1990: RE: Double; Inflation: 62%
1990 - 2000: RE: 25%; Inflation: 32%
2000-2014: RE: ~40%; Inflation ~35%

Total Inflation By Decade

It looks like during times of higher inflation, real estate prices have increased at about twice the rate of inflation. During less volatile times, the % increases seem to be more in line.. Of course, all sorts of differences in locations, neighborhoods, A/B/C properties, etc..

 Thanks for the graph, can't help but notice that periods of high inflation followed first the founding of the Fed in 1913 and then Nixon making the dollar a fiat currency by decoupling it from gold in 1969. Obviously, there are alternative explanations for both periods such as WW1 for the first period and the Arab oil embargoes for the second.  Once we return to a more normal employment participation rate in say 2017, I wonder if QE will be seen as a likely cause for another round of high inflation.  It is kind of hard for inflation to get going when you have such massive unemployment as we do now, but hopefully that will change in a few years. 

Originally posted by @Matt Rosas:

The school districts in good areas of Cali normally are far superior than 99% of private schools. There are some solid reasons you would live in these good areas even if you took a loss. You can basically get a world class education with the best schools, teachers and admistrators on the planet for free. There is no where else that this happens. Just thought  I would comment on one more reason the momentum continues for these areas.

thanks, 

Matt

It's only free if you don't pay state income tax, property taxes or pay rent to someone who is paying property taxes.  As Milton Friedman said there is no free lunch.  

The recovery so far has been led by investors. That's about done now. Sales are down and inventory went up across the nation. But that just sets up stage for the real recovery: regular mom and pop. Credit has been tight and job market crappy. But both are showing signs of improvement. 

I am very bullish about where our economy, local as well as national, are headed. That translates to more home buying. There is no two ways about it. There is a ton of pent up demand out there. 

Originally posted by @Minh L.:
Originally posted by @Johnson H.:

@Minh L.  - With the market as hot the way it is and with lenders having tons of deposits, if FRB won't do it, I'm sure another bank will. Greater fool theory, and its the reason why I have a job.

Funny you mentioned multifamily, I was interested in a 10 unit in Concord, ran the numbers, turns out actual cap is 3.5% and proforma of 4.5% when rents are brought up to market. Sellers are definitely reaching these days.

 4.5%  pro-forma for Concord?  You can do better in San Jose.  You can probably get the same number for Redwood City.  We missed out on 436 Clinton St in Redwood City and still disappointed until this day.    

 It was a shady deal, I didn't get the listing price until I contacted the agent. His marketing package didn't include any numbers but the owners actual financials hand written! I ran the numbers and that is what I got. I can get 4.5% in much better areas like you said.

I took a look at that apartment in Redwood City, lots of upside in rents. Too bad it sold for $140k over list. You should have threw down on that deal!

Originally posted by @Johnson H.:

@Manch Hon   - Minh mentioned 436 Clinton St in Redwood City. How is your rehab going in the city?

 It was a 1031X buyer and who sold his apartment in Hayward and traded for this. He paid $131k above list, all cash and closed in 9 days. How do you beat it? $2M all cash and close in 7 days? :-)

Smart move in my opinion. He traded a C class building for a B+ building. If I had the money, I would have done the same thing. 

@Minh L. @Johnson H.  It's on the good side of El Camino. 

Trading up makes sense if timing is right. Lower class buildings are much more volatile. They go down more but also go up more, percentage wise. Potentially someone could ride the rapid appreciation climb, capture the bulk of the price gain and then trade up. Makes sense?

Yes, 2M cash is hard to beat. :) You will get there Minh.

Originally posted by @Manch Hon:

@Minh L. @Johnson H. It's on the good side of El Camino. 

Trading up makes sense if timing is right. Lower class buildings are much more volatile. They go down more but also go up more, percentage wise. Potentially someone could ride the rapid appreciation climb, capture the bulk of the price gain and then trade up. Makes sense?

Yes, 2M cash is hard to beat. :) You will get there Minh.

When you start to be wealthy, you look at ROI less and less and start to look for piece of mind. The B+ class building and paying all cash will throw off plenty of stable income for many years to come without worrying if there is enough cash flow to pay the mortgage on a monthly basis.

Fascinating story to follow!

Our national unemployment rate is at a low 6%, almost exactly where we were 10 years ago!: http://data.bls.gov/timeseries/LNS14000000

Premise 1: Since this is average, then some places must be doing better, while some are doing worst.

Premise 2: Since some of the highly populated metros are doing very poorly (Detroit and the like), then some other must be doing very well!

Real estate in the bay area is rather unique. Because of our high tech oriented economy, real estate prices are driven by VC money and tech IPOs. While some stellar IPOs may create some local bubbles (e.g. Google, Facebook IPOs drove Palo Alto to the sky), VC investments in startups should drive general housing prices up. So far VCs are not slowing down.

@Minh L. , @Manch Hon  @Johnson H.  

Looking at the Redwood City property, I think one of the sites listed cap rate @ 3.5% which I know you don't think is a great deal. I was wondering if you would mind sharing what you think the improved cap rate would be and how you would have reached it. Would it have been a long term hold?

(Just starting my multi-family education as I have a local single family oops (Cap rate 2.6%, ~GRM 23+) that I have decided to sell and trying to work out what to move to. I am pretty sure it would appreciate (mebe 10-15% for the next couple of years, but I want to mix in more cashflow as I generally aiming for buy and hold).

Edited to Add

BTW @Amit M. as you know I am a very, very happy and fully subscribed member of the Appreciation Matters club... with 2 other properties barely making the 0.5% club, I am feeling a little oversubscribed :-)

@Kathryn M.  ,

If I remember correctly, the cap rate is around 5% after the building is stabilized. The building has three 1-bed and four 2-beds. Fair market rents are about $1,800 for 1 bed and $2,500 for 2 beds. If completely remodeled, you can get and additional $200-$250/month for each unit. Redwood City doesn't have rent control so you just have to serve a 60-day notice for the rent increase. 

For this deal to pan out, you have to be able to pay all cash or borrow money at 2.75%-3%. Therefore, it's hard for an average Joe to compete in this arena. If you put 35% down, you will get about 5% cash on cash return after stabilized and about 4% from principal pay down. If history is any indication, you will get another 14%-16% return in appreciation. More than likely, your cashflow will be off-set by depreciation so your cashflow is tax-deferred (free) until you sell the building. 

This building is in the good part of Redwood City and on the west side of El Camino Real. The street has all single family homes except this building. It's also within walking distant to downtown and Bart. Building is in very good condition. This building can be considered a trophy property with pride of ownership. Therefore, it would have definitely be a buy and hold. 

Parents passed away so 3 kids sold the building to get their tax-free money. The listing agent used to be the dad's business partner. 

@Minh L. 

Thanks again for the detailed explanation. Are you expecting 14-16% p.a. return on equity from appreciation? If so, this seems like good multi-families appreciate at comparable rates to single family homes?

Sorry, to ask for the "multi-family for dummies" explanation.

@Johnson H.   I think your dead on about how the wealthy look at things vis a vi returns.

one of my bizz partners over the years loved to suck stockbrokers into this conversation.

Stock broker :   How are your investments.

Bizz Partner:  I am in double tax free muni's

Stock Broker:  Well return on those are low you could do much better.

Bizz Patner:  Well the return is fine if your like me and you have enough of them.

IE he has 8 figures and his tax free cash flow is more than that what most investors starting out and looking at that magic goal of 10k a month passive income ( or rental income which is anything but passive as we know) His double tax free's return him more than that DAILY

So yes as folks get truly wealthy they look for Safety then return... those starting out or in the middle of their careers are the one's looking for the homeruns.

And one might ask where this Bizz partner made his money.. Simple he owned a Garbage company and sold it to waste management in the day...Cashed in put it all in double tax free muni's...

While I agree you can't discount appreciation in CA... There has to be a ceiling at some point. Housing can't continue to double every 10 years if incomes don't keep pace. At some point even the professional DINK couples are priced out of the market and opt to take a good job in Austin, Portland, Nashville or Raleigh.

This is a fascinating discussion and I'm soaking it all in. However, the business degree side of me is constantly crunching numbers that my brain can't fully comprehend based on the appreciation model. 

Isn't the run-up in the Bay Are the result of a confluence of forces: low interest, strong economy with high paying jobs, and cash from foreign investors (Chinese and Indians) and start-up stock option cash outs? Isn't there going to be an end game to this as one, two, or three of these forces end?

Take @Minh L. Example of the Redwood City unit for example. For a 2m property, straight cash is great with gross of 3x1800 + 2500x2 = 10400. What is net after taxes and expenses? Property tax is about 20k. So even if we expect 5% cash on cash return is that the best use of 2m cash when that amount earns more in mutual funds but is truly passive?

Now, if we use leverage, 500k down and 1.5m in loans, at 5% makes it a 8k mortgage not including taxes. If the rates go up 1%, the monthly payment increase 1k to 9k. The historic average for mortgage rates were 7-8%. When that happens, a 25% increase in appreciation, the monthly payment would also increase by 25% assuming the same 5%, or 40% if rates rises to 7%. If mortgage payments go up, sales price must go down right? To me, I just don't see how prices could appreciate indefinitely.

Income does not go up as fast as property appreciation whereas mortgage rates are trending up. Rents are tied to income so can the rent keep up with the property appreciation?

I must be missing something because, ultimately, if REI is an investment and not pure speculation, the numbers have to make sense right?

@Kathryn M.  ,

14%-16% return on your investment is based on an average 5%-6% annual appreciation for the Peninsula. Even a modest 3% in appreciation would give you 8.5% return on your investment. That's assuming $700k down payment on a $2M building. 

@Bob Bowling , LOL!  It's Caltrain. I hate it when you're right. If real estate doubled again in the next 10 years, my networth would be in the 8 figures so taking you and J Martin on a cruise should not be an issue. We can triple or quadrupole date on this event. It should be fun, and we can celebrate my 50th birthday then. I like it already. Let's hope it will come to fruition. 

@Joe Bertolino , it's four 2-beds. When you can borrow at 2.75%-3% and get a 5% CAP, it's positive leverage. Maintenance on a 2-beds renting $2,500/month is the same as a 2-beds renting for $400-$500/month in mid-west state. I would easily argue it's less on the $2,500 unit due to less extreme weather and better quality tenant, but that's another story. Utility usage is likely less here compared to the mid-west. Insurance is the same for the two. 5% for property management is $125/month for here compared to 10%, which is only $50/month for the mid-west. Vacancy here is so low that it's not even funny. Once you factored in all of these, the expenses here are much lower compared to the mid-west. If a 50 to 100 year old building in the mid-west is selling for $25k-$30k and renting for $500/month, what's the likelihood of appreciation on that building in the future. If a tear down shack on the Peninsula sold for $50k in the 1970's, now selling for $1M bucks, what's the likelihood of that shack continue to go up in value in the future? If you look at history, you will have your answer. Real estate is about location, location, location. Why do you think people pay $3.5M for a 2,000 square feet Eichler house in Palo Alto when that same house can be bought for $50k in the mid-west? :-)

@Minh L. 

  I am still working for a living far from done.  But I agree with you on pricing.

When you have a rare commodity... and demand you have value... The peninsula in particular.. there can be no sprawl... whats built on is basically built on.. the only real development comes from Tear downs.. Like the Barron park neighborhood I lived in in the 80's it started early 80's and when I go back now its just insane the amount of homes that have been torn down... The peninsula in my mind will become more like other parts of the world were real estate is not sold its handed down to the next generation thereby reducing inventory even more and keeping prices in the stratus... with the bay on one side and the coast range on the other.. Stanford taking up a huge area.. and super tight land use laws.. there is not going to be any crash coming soon on the peninsula... Now east bay and other CA areas this is not the Case we saw that with the GFC.

Originally posted by @Minh L.:

@Kevin D. , it's four 2-beds. When you can borrow at 2.75%-3% and get a 5% CAP, it's positive leverage. Maintenance on a 2-beds renting $2,500/month is the same as a 2-beds renting for $400-$500/month in mid-west state. I would easily argue it's less on the $2,500 unit due to less extreme weather and better quality tenant, but that's another story. Utility usage is likely less here compared to the mid-west. Insurance is the same for the two. 5% for property management is $125/month for here compared to 10%, which is only $50/month for the mid-west. Vacancy here is so low that it's not even funny. Once you factored in all of these, the expenses here are much lower compared to the mid-west. If a 50 to 100 year old building in the mid-west is selling for $25k-$30k and renting for $500/month, what's the likelihood of appreciation on that building in the future. If a tear down shack on the Peninsula sold for $50k in the 1970's, now selling for $1M bucks, what's the likelihood of that shack continue to go up in value in the future? If you look at history, you will have your answer. Real estate is about location, location, location. Why do you think people pay $3.5M for a 2,000 square feet Eichler house in Palo Alto when that same house can be bought for $50k in the mid-west? :-)

 Thanks, @Minh L. Your input is always fascinating. I'm not doubting your numbers, just playing devils advocate for my own edification. I am trying to separate the cost of homes for use as a primary home (which doesn't have to make sense) versus buying homes for investment. A 10k gross, even if we disregard maintenance and compute 0% vacancy, still doesn't seem to give us the numbers to make the investment worthwhile. A 1.5m loan is unlikely to get us a 3% loan rate even if we somehow manage to convince the lender that it is a primary home.

What I'm getting to is this: why compare a 2m home with a 50k shack? Why not compare a 2m investment here with a high quality 2m investment elsewhere that has a ROI many times the one in the Bay Area, where it's value isn't dependent on appreciation but on cash flow? How do we know that the appreciation is not dependent upon the low interest rate and speculation that is unsustainable? Isn't appreciation based on cash flow the more reliable indicator?

@Minh L. I have no doubt that you'd reach 8 figures in 10 years. Even if Bay Area properties do not  double in this time frame, you'd be making other investments to help  achieve that. So congratz Bob and J Martin on your future cruise trips. As for significant others, maybe Minh has some cute relatives, Ha!

But Minh, your numbers for Midwest is a bit too pessimistic, with a $50k SFR, you can get $600-800 while paying 0 utilities. Of course you'd still need to pay for maintenance.

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