Well – I’ve got to tell you that I am in a strange circumstance with the statement which is the title of this article. After all, I am a rather outspoken proponent of real estate as an investment vehicle and have been for years. What am I doing – shooting myself in both feet at once?
Maybe I am, you decide; but, I have to be honest with you about what I see, and not all of it is rosy. The real estate investment game was easier 10 years ago than it is now. Financing was easier, but more importantly the Cash Flow was easier – and unfortunately, I see this trajectory continuing and as such I am sad to inform you 10 years from now this business will be even worse.
Let’s talk about this…
Let’s Agree on the Basics
Generally speaking, all of us agree that real wealth in real estate comes as a result of holding property long-term. I’ve spoken to many investors, and even those who practice the disciplines of fix and flipping or wholesaling generally agree that the end-game is to hold property long-term in some shape or form.
There are two reasons why so many of us agree on this. First of all, while investors can and do make a lot of money by utilizing all types of techniques techniques, in the end we want to retire! But, when we do, we would rather the income to continue coming in – we want Passive Cash Flow.
You nubies out there – listen up:
Seasoned people understand that while business is about money, life is not. Life is about freedom. LIFE IS ABOUT TIME – the most priceless commodity! As such, passive cash flow from property owned becomes important to us at a certain juncture in our careers.
Having said this, it would be wrong to say that equity is completely unimportant. If our buildings appreciate in value, than we gain the option of bridging this equity in some way in order to acquire more building which will throw-off more cash flow.
So, as you can clearly see, the theme of Cash Flow + Equity seems to run through the entire life cycle of our investment objective. As such, if it becomes evident that either one or both are under pressure or in danger, then it becomes necessary to admit that the entire business model may be in danger…
This, my friends, is indeed the case, and I am about to tell you why…
About Cash Flow
Cash flow is income minus expenses. Are your expenses going up every year? Mine are – garbage, water, sewer, property taxes, and don’t even get me started about the fire insurance – those guys will rob you blind and you have no choice but to let them. All of the expenses are going up like clock work indeed my friends.
So, if the expenses are going up, then the income has to go up as well, otherwise cash flow suffers – right?
Question: Can income go up every year?
Answer: Sure, you can charge more rent every year!
Question: Are you sure about that?
Answer: Sure – as long as people can afford it…
Question: Why wouldn’t people be able to afford it?
Yesterday I took-in an application for rent. This particular applicant works full-time, and her pay before withholdings is $1,300/month. She earns a bit over $8/hour…minimum wage in my State is currently $7.70.
Now – you tell me how much rent this single mother can afford on $1,300 gross. My rental guidelines stipulate income of at least 3 x Rent, in which case the most she can afford to pay is about $400/month. Unfortunately, this places her and her daughter in the kind of neighborhood and dwelling that none of us would want to raise a child in. In her own words, she is “trying to get out of there as soon as possible.”
How much is my apartment? It is $615/month. So, why would I consider her application? Because she has recently qualified for Section 8 housing subsidy which will pay for this apartment…
The minimum wage in this country is such that a person working full-time can no longer afford the basic human dignity of a roof over their head. And every time we talk about improving this situation businesses big and small revolt saying that they will have to pass the cost onto the consumer or go out of business.
I can certainly understand why a pizza chain can not raise the price of pizza. The same very people who earn minimum wage are the ones buying their pizza, and they can not afford to pay $6 more for a pie. And should the business have to eat this cost, then it may not make sense to be in business – I get what the problems are.
There are no easy solutions and our politicians aren’t even attempting to deal with the fundamental problems in our economy. What are those problems?
Do you know how much businesses spend on compliance with federal, state, and local regulations in this country? Who knows, but I would be surprised if it’s anything less than $300 billion per year; likely more! Do you think that this cuts into their bottom line? All we are doing is take the money out of the economy in order to re-rout it through the government to put it into the hands of people who are then going to deploy it back into the economy. Is there an obvious extra step there which shouldn’t be there, or am I wrong? Not top mention that some of it gets “misplaced” in the process…
Do The Math
According to an article by Tami Luhbi published in CNN Money on February 27, 2013, “An estimated 3.6 million people were paid hourly rates at or below the federal minimum in 2012, down from 3.8 million a year earlier.”
For the sake of this argument, let’s just take this number to a cool 10 million people. And further, let’s say that we managed to cut the capital needed for regulatory compliance by a third, and in doing so we freed up $100 billion of spendable cash flow in the private sector. And let’s say that this newly found cash flow will be reallocated into compliance with higher federal minimum wage standard – what would we be able to raise the minimum wage to?
I haven’t done proper research cause I don’t have time for that, so I am likely overestimating everything – perhaps you guys can check this out. But, let’s assume that 10 million workers are either below, at, or slightly over the minimum wage. If $100 billion was deployed in the form of minimum wage to 10 million full-time workers, then each worker could earn an extra $10,000 per year, which spread over 52 weeks at 40 hours per week would constitute an increase in their pay of over $4/hour.
In the State of Ohio this would bring us close to $12/hr and monthly income of over $2,000. In Ohio, a person could afford to live with decadency, in a clean, functional, and convenient rental unit (just like mine J ) without needing a handout. And I have to believe that my applicant would much rather show her daughter that they can make it on their own – just saying…
Back to Real Estate
While we know for a fact that all of our costs have been and will continue to go up, how much confidence can we have that our rents will continue to go up accordingly in the environment that I just described?
Rents go up because people’s income goes up. One can’t happen without the other…
So you see, the passive cash flow that we are all striving and fighting for is under pressure and drying up due to macro-economics every year. Sure, there are zip codes in this country where this is not a problem, but most of us don’t live there. And this is one of the reasons behind my thesis – real estate is loosing its’ mojo as an investment vehicle…
What About Equity?
When I refer to a “portfolio” of income-producing property, I am referring to those of us who want to own 50 units or more. While I know that some people prefer SFR for their long-term holds, as the numbers go up it becomes increasingly difficult to manage a portfolio of this many units if all are singles. As such, most people who will own 50, 100, or 500 units will do so with apartment buildings / commercial space, and not SFR.
Well, when we talk about equity what we are really talking about is building value, which in an apartment building is a function of income – the more the NOI the more the thing is worth to an investor. That’s it!
Question: If you can’t increase the income for the reasons discussed in this article, how are you going to build value long-term…see what I’m saying?
We have grown to believe that true wealth in real estate is accomplished by holding property long-term. I believe that I’ve stated a case for why this belief, which indeed has been the reality in the past, may be in jeopardy going forward. What are your thoughts?
P.S. – a bit of good news
Having sufficiently unnerved you, I must now tell you that as bad as things may get I believe real estate to remain the BEST opportunity for the foreseeable future, and here’s why:
LEVERAGE – we use OPM (Other People’s Money) to buy real estate and we use OPM to pay off real estate. As such, having bought the property with nothing or very little out of pocket we are guaranteed to win, presuming we’ve bought the right kind if thing…
Photo: Eric Constantineau