How Market Timing Affects the Success or Failure of a California Real Estate Investment
Real estate markets are generally cyclical—they go up and they go down over time. If you are near the bottom of a downward-trending buyers’ market, when real estate prices are heading into the abyss, you may be able to get a much better deal than during an upward-trending sellers’ market, when real estate prices are shooting to the moon.
When a real estate investor enters and exits a real estate market, it is critical to overall investment returns. A real estate investor cannot change market timing, however it is possible to spend a considerable amount of time and resources measuring it to determine the best time to maximize profits over the long-term or within each real estate bubble.
Many years ago, real estate markets were somewhat slow and steady giving real estate investors plenty of time to gauge their directions and make prudent investment decisions based on long-term market trends. Today, real estate market have been upended by short-term real estate bubbles caused by mortgage-backed and rent-backed securities originating from Wall Street, as well as capital flight out of the stock markets and into tangible assets. For this reason, it is critical for a real estate investor to move quickly, read each artificially-fabricated short-term bubble, and invest accordingly.
Buying a poorly-maintained distressed house in a lower socio-economic neighborhood directly violates the rule of location. However, that is exactly what a large number of real estate investors have done in response to the Federal Reserve Bank's (FED) quantitative easing programs. Real estate investors feared inflationary pressures caused by the increase in the FED's balance sheet from $800 billion a few short years ago to $4 trillion today.
Real estate rules tend to be effective during long, slow upward-trending sellers’ markets where economic growth is the backbone of real estate price appreciation. However, when central banks (i.e., FED) introduce new and untested stimulus techniques into the market trying to jump start a sluggish economy, the rules tend to go out the window.
If appreciation in value seems to be many years down the road, cash flow may be the main objective for investors to invest in real estate—along with wealth preservation strategies. Rental houses located in lower socio-economic neighborhoods may have the potential for huge cash flows—if purchased near the bottom of a downward-trending buyers’ market. Although, some investors may decide to keep their money in the bank, especially if inflationary pressures are low and they believe they can obtain higher returns in the stock markets or other investment entities.
As the real estate market moves from a downward-trending buyers' market to an upward-trending sellers' market, real estate investors tend to move their real estate assets from cash flow generating properties into more expensive single-family homes that are leveraged and will have a better chance of significant price appreciation. In other words, real estate investors may find themselves moving their equity into other property locations that are more suitable to capturing anticipated price appreciation in the real estate markets.
Overall, during a downward-trending buyers’ market when the economy may be heading into a deep recession, less expensive single-family homes may be less risky than more expensive single-family homes. As the market turns upward, more expensive single-family homes usually have a greater percentage return, and less perceived risk, than homes located in lower socio-economic neighborhoods.
California and U.S. Economies
As the California and U.S. economies fall into a recession, many people will begin to look at food and shelter as their primary concerns. Single-family homes located in lower socio-economic areas tend to rent well during these types of downward-trending real estate buyers' markets. There are usually more people who can afford to pay $1,000 per month in rent, than those who can pay $2,500. Of course, the location of the property in California can have a huge impact on prevailing market rents. For example, a home located in California's central valley may rent for $1,000 per month, while the same house located in the San Francisco Bay Area will rent for three or four times that amount. Location, location, and location.
There are usually considerably more lower socio-economic tenants available to rent homes in the lower rental price range. Many tenants who have lived in higher socio-economic neighborhoods in the past may find themselves moving into lower socio-economic neighborhoods because of economic factors. In fact, during a tough economy there may be a general lowering of the standard of living for many people around the country.
As the California and U.S. economies continue to decline, home values may decrease to a point where home loans are greater than home values. This is what is known as being “underwater.” People start losing their jobs and may eventually lose their homes to a short sale or foreclosure. Former homeowners will be forced to become renters. This drives up the demand for rental housing, which usually bodes well for landlords, because rents usually increase and decrease as a function of supply and demand of suitable housing in a local geographical real estate market. Greater demand along with the same supply, usually equals increased rents-as long as tenants continue to have the purchasing power to pay the higher rents.
If you did not sell your property at the top-of-the-market, you have probably ridden the downward-trending buyers’ market downward over the last several years. You have been collecting rents and waiting for the market to come back around. Historically, time has healed downturns in the real estate market. If you can wait out the market, you will usually have a good chance of recouping your equity over time.
If you are facing an upward-trending sellers’ market, prices will generally rise because of intense competition for homes, especially if they are located in the higher socio-economic neighborhoods. There may be a “frenzy” of owner-occupied buyers making emotional, and often bad, purchase decisions because of pressure coming from other owner-occupied buyers—who are making emotional and often bad purchasing decisions. New listing information is critical during this type of market. As a real estate investor, you want to be a seller and not a buyer during this type of market.
During an upward-trending sellers’ market, the best single-family homes are usually sold long before they reach the multiple listing service (MLS) and good deals are few and far between. It’s tough to get a good deal when there are multiple offers on each property—driving prices upward and creating a sense of urgency that is not in an investor’s favor.
As a real estate investor, you need to have made your purchases near the bottom of the downward-trending buyers’ market, so you can ride the next upward-trending sellers’ market to the top and then sell, pay your capital gains taxes, and put the money in the bank—or do a 1031 exchange tax deferred exchange and move your equity somewhere where it will be safe.
As mentioned earlier, time usually heals, and over the years this has generally been true. You only lose if you sell at the bottom of a downward trending buyers’ market. I like to buy when everyone else is selling and sell when everyone else is buying. This is exactly opposite of the crowds. So when the news media is in the doldrums and crying in their beer, that’s when I break out my checkbook and go shopping. You either find the deals or you make the deals—and there are usually a large number of single-family homes on the market. New listing information is not as critical during a downward-trending buyers’ market because quality homes tend to stay on-the-market long enough to find them. Once a seller makes one price reduction, it’s much easier to make another. Homes that are over 60 days on-the-market (DOM) seem to be where I find some good deals.
I usually track a real estate market back in time to see where it is trending. Based upon this information, I usually try to buy single-family rental properties somewhere near the start of the next upward-trending sellers’ market. This is not always easy to predict. You must look at prevailing wages in the local market area, median home prices, and prevailing loan interest rates in an attempt to determine how far down the downward-trending buyers’ market will actually go.
The real challenge is determining a real bottom of the real estate market as opposed to a false bottom. You will usually know that a real estate market has bottomed out about six months after it actually happens. With this in mind, some real estate investors use a continual buying program that is similar to long-term investors in the stock market. When they think the real estate market is nearing the bottom, they start buying rental homes on a continuous basis throughout the bottom of the trough.
A real estate investor using this strategy is trying to buy as low as possible and then wait the least amount of time before the next top of the upward-trending sellers’ market. In other words, he wants to buy the asset as cheap as possible and then keep it for the least amount of time before selling it for a profit.
If the real estate investor buys a single-family rental home too soon, he may pay too much for the home and have to wait a long period of time before the top of the next upward-trending sellers’ market. This can reduce your return on investment, especially taking into account the time value of money. Money in your hands today tends to be worth a lot more than it will be in the future.
If the real estate investor waits too long to acquire the single-family rental property, he may pay too much for it as prices move upward. However, he may not have to wait as long to reach the top of the next upward-trending sellers’ market.
If he misses both of these opportunities, he will pay too much for the single-family rental home and this will reduce his return over the asset holding period. However, during an upward-trending sellers’ market he may be able to increase his return by performing a rehab when he nears the top of the next upward-trending sellers’ market. If the market is extremely hot, the real estate investor may be able to sell the property at or near top-of-the-market prices without performing a rehab at all.
Investors may swoop in near what they think is the bottom of a downward-trending buyers’ market and purchase foreclosures at perceived “rock bottom” prices. Investors may convert these single-family homes into rental properties, hold them as long-term rentals, ride the real estate market upward over time, and then sell the homes to owner-occupied buyers at the top of the next upward-trending sellers’ market.
The other option for investors is to perform a major rehabilitation of each foreclosed property and then flip (sell) them immediately to an owner-occupied buyer at prevailing market prices. This tends to work fairly well during an upward-trending sellers’ market, but can be disastrous during a downward-trending buyers’ market.
Prices of homes will generally adjust downward during a downward-trending buyers’ market. Many more buyers may now qualify for FHA-insured loans on homes they could not have afforded a few short years earlier. High loan-to-value FHA-insured loans allow first-time home buyers to purchase a home with a small down payment and generally easier loan qualifying criteria than conventional loans. They have increased their loan costs in recent years, however, so keep that in mind when considering an FHA insured loan.
You may be in competition with owner-occupied FHA buyers. I have found the best deals come from foreclosures that are in such disrepair they do not qualify for FHA-insured financing. When you find a property that doesn’t qualify for FHA financing and it is over sixty days-on-the-market, you may be able to negotiate a really good deal for the property. The number of owner-occupied competitors is diminished and only investors with cash or some type of conventional financing (with usually 20% down payment or more) will be able to purchase the single-family home.
Single-family homes tend to be the most desirable property type, with halfplexes, townhouses, and condominiums following on the desirability continuum. If you own single-family rental homes, tenants will generally pay higher rents to live in your single-family homes than other property types. Therefore, in a downward-trending buyers’ market apartment owners initially benefit by an increase in market rents, however, single-family homes may later “steal” the apartment owners’ tenants. Tenants living in apartment buildings may be induced to move out of their existing apartments and into these more desirable single-family properties.
Real estate investors have a little different scenario than owner-occupied homeowners. Homeowners may consider selling their home at the top of an upward-trending sellers’ market and becoming a renter during the entire downward-trending buyers’ market. The homeowner could then buy at the bottom of the market and leverage the purchase (with a loan) to increase the return through price appreciation—while riding the real estate market back up again. Most homeowners have a difficult time becoming a tenant after having been a homeowner for any length of time. Of course, the homeowner could also consider paying off his home and not worrying about real estate markets altogether.
Real estate investors generally have different alternatives than owner-occupied homeowners. They can buy and sell, not based upon their own home and where they live, but strictly by market timing. As mentioned earlier, when the real estate market nears the top of an upward-trending sellers’ market, many investors opt for a 1031 exchange and move their equity into another market that has not yet peaked. One of the decisions investors must make is where to move their money? If all the real estate markets are at or near their peak, where do you place your money to experience the least amount of loss in value? The answer may be to cash out completely, pay your capital gains taxes, put the money in the bank, and wait for the next bottom of a downward-trending buyers’ market. These are normally 5 to 10+ year cycles so you could be waiting a long time.
If it is advantageous, some investors play the stock market during this period. If not, they may keep liquid bank deposits waiting for the right time to move back into the real estate market. They may also look at buying businesses that derive good cash flow. It really depends upon the investor’s experience and perceptions of risk.
Market timing is critical to long-term real estate investment success. Getting in near the bottom of the market and getting out near the top are crucial to capturing profits from real estate investments. Cashing out and paying capital gains taxes may be a tough pill to swallow for an investor, especially with federal and state capital gains taxes being so high—compared to rates in the past; however, liberating this equity into cash may be the best way to achieve long-term wealth preservation.