Here are two fallacies that often strike new real estate investors. The first one bugs me only a little – the second one bugs me a lot.
The first fallacy is the one peddled by late-night infomercial stars. It’s the idea that it’s really not that difficult to find an old house, buy it for much less than it’s worth with no money down, and sell it for big bucks. It’s true that some deals of this sort do happen, but they’re very rare. If you start your real estate career thinking you’re going to get 50 deals like this on the way to that new Bentley, you’re actually on a fast track to disappointment. (And if you really have done 50 deals like this – and have documentation, and don’t charge $1 million for people to see it – call me!)
The second fallacy is much more insidious and hits people who are much too smart to be fooled by the first one. I’ll call it the Every Dog has its Day fallacy. This means that any property you buy, no matter how big a loser, will eventually make money for the owner. This view is underscored by two other views, both also erroneous:
- All real estate rises in value over time.
- When you own rental property, your rents go up over time, while your expenses stay the same.
We know in our hearts that this assumption is wrong, but still fall for projections that show it.
It’s certainly true that most real estate rises in value over time. However, that’s not true everywhere. I’ll give you two examples: Detroit, Michigan, and Buffalo, New York. Right now in Buffalo, there are almost 800 houses listed for sale for $50,000 or less. 45 of those are listed for less than $10,000.
Why do you think Buffalo might have these wonderful deals? It’s because Buffalo has been one of America’s fastest shrinking cities over the last 50 years. The population is less than half of what it was at Buffalo’s peak in 1950. This, coupled with the reason for the decline (there are no jobs to be found), has resulted in a huge drop in real estate values over decades. Almost anyone who put their money in Buffalo over that time lost much of it. By the way, this also means Buffalo rents dropped over the past few decades, so those Buffalo investors lost money every year on their way to eventually selling at a loss.
Detroit is in a similar way, with 6,900 homes for sale for $50,000 or less; 3,200 for less than $10,000; and a population less than half what it was in 1950. Detroit’s motto, translated from Latin, is “We Hope For Better Things; It Shall Rise From the Ashes.” I sure hope they are right!
This extraordinary hovel can be yours for $100 in Detroit. Make an offer!
Thankfully, there are few true disasters like Detroit and Buffalo around the United States, although there are many cities where prices have risen only a little, stagnated, or dropped even before the real estate and mortgage crashes. Even elsewhere, however, you might lose money over time because of the “expenses never go up” assumption.
Suppose you buy a property for $100,000, with rents of $1100 per month. Your expenses are as follows:
· Monthly mortgage payment: $480
· Insurance: $75
· Taxes: $200
· Allowance for maintenance: $100 (0.1% of purchase price)
· Allowance for vacancies: $55 (5% of rent – assumes a 5% vacancy rate)
· Utilities: $100
· Legal, accounting, mileage and so on: $50
Obviously these numbers are going to vary widely for different properties. It’s worth noting, however, that poorer communities usually have relatively high property tax rates. They have to provide the same services as wealthy towns but with smaller tax bases.
For this example, however, your monthly expenses are $1060, which means you’re making a profit! Congratulations! It’s a very small profit, but should be much higher a few years from now because according to the second assumption, your rents are going to rise, and your expenses will stay the same. Five years from now, your rents will be more like $1300, which means you’ll be making $240 per month in positive cash flow, which is excellent. And, of course, you’re building equity.
So many new investors fall for this. The truth is that every one of those expenses is going to go up except for the mortgage payment (assuming a fixed rate loan). If they go up by more than about 9% per year, your monthly profit will decrease, even with inflation in rents. And that can certainly happen. In particular, property taxes, utilities (mostly heat and water/sewer, the two utilities most often covered by landlords), and insurance have all risen by 10% or more in many communities over the last five years.
The pinch will be even greater in communities experiencing rent stagnation or deflation. If your rents stay the same and expenses go up even a little, your profit will fade and disappear.
That equity growth that was going to save your bacon? That won’t happen, either. If your monthly cash flow stays the same or decreases over a five-year period, your property will be worth about the same, or even a little less, at the end of that time. Yes, you’ll have added a bit of equity through the principal portion of your mortgage payment, but not enough to make a major difference.
None of this is intended to turn you off real estate investing. Many thousands of people have done very well with their property investments – yes, even some in Detroit and Buffalo. They avoided losses by being very, very careful about where they bought. They looked for towns and states that were growing, particularly in employment, a leading indicator for housing growth. They avoided towns with a history of high property tax increases. They looked for houses in neighborhoods where people wanted to live. And, they sought out properties where they could reduce expenses by taking responsible steps to lower maintenance, utility and insurance costs.
Finally, they made sure they could sell on their terms by making sure they had enough cash to handle emergencies and daily living.
Tags: equity, housing, inflation, landlord, rental-property, stagflation, tenant
In Frank Sinatra’s famous tune 
Last week I made the case against real estate as an investment class. My recent change of heart is due to the ridiculous amount of market tinkering the Fed, the Treasury, and the central bankers around the world are doing to “support the real estate market”. All the bad loans, the foreclosures, and the schizophrenic Hank Paulson with his “on again - off again” bailout schemes, is putting the banks on hold…not knowing quite what to do with the growing REO on their books.
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