One of the most impactful news items heading into 2011 is the announcement by Bank of America that foreclosure activity is being suspended1, and the decision by government agencies to increase scrutiny on the foreclosure process. In the wake of this announcement, nobody completely knows how long this increased scrutiny will last, how intense it will be, and what impact it will have on market activity.
One thing that we know will occur because of this move is that prices will be temporarily strengthened as the inventory of foreclosures is artificially constrained. During this time, people will be held out of the rental pool while they are living in a house (without paying rent) until the foreclosure process rolls through. The impetus behind this is quite clear, since the politicians in charge of government policy are attempting to curry favor with their constituents by helping people
to stay in the houses that they cannot afford.
Over time, this decision will play out and the market will regress back to equilibrium. In many markets, this will take the form of short-term price stabilization or increase, followed by softening of the market prices as the foreclosure inventory that had been held off the market comes back on. In conjunction with this, there will be people moving out of the ‘owner’ population and into the renter pool. This will strengthen rents as the population of renter’s increases faster than the supply of rental properties. This will remain true even if investors purchase some of the foreclosed properties because the displaced owners will become renters, but less than 100% of the foreclosed properties will be purchased for investment.
In some markets with low land values, the wave of foreclosures has pushed market prices below the cost of construction. Fundamentally, this means that buyers have ‘built-in’ equity since the low prices have ground new construction to a halt and future demand increases will push market prices up toward replacement cost before new construction begins. This Regression to Replacement Cost is expected to be an upward force on future market values in some areas. Conversely, in markets such as California and New York with high land costs, there is considerable room for price compression since the values exceed replacement cost by a very large margin. It is not likely that land value in these markets will compress to zero, but whenever land value makes up a high percentage of your total market value, there is more downside risk exposure.
In the end, the only situation that can create a fundamental market recovery in real estate is if there is an increase in the number of people who can pay their bills. With national unemployment in excess of 9% with a broad unemployment rate exceeding 16%, there is considerable slack in the labor markets that will stand in the way of a fundamental recovery. It is likely that real estate will lag the overall market recovery, as there need to be more people who are employed and paying their bills before there can be a sustainable increase in the number of people purchasing homes. For astute investors, there continued to be tremendous opportunities available to purchase properties in healthy economic areas for prices below the cost of construction.
Breaking Down Return on Investment by Market
It is most decidedly true that “all real estate is local” and that the commonly referenced “national real estate market” does not exist. One of the unique features offered in this forecast book is a detailed prediction for each major investment market that outlines the key ROI components. These components are the base value appreciation, leveraged appreciation, and cash flow from rental income.
Value appreciation represents the simple increase in property values for a market area. Leveraged appreciation represents the extent to which you realize additional return on investment because of the mortgage loan that allows you to purchase much more property than would have been possible with cash alone. Leverage opportunities vary, based on markets. Cash flow represents the rent revenues you receive from tenants, less expenses for the property. These factors combine to generate the total return on investment for properties in a given area.
Another Form of ROI is “Return on Inflation™”
Jason Hartman created the term “return on inflation,” which is a distinct advantage of investment real estate in that it offers the opportunity to generate a return on inflation. Broad price inflation results from increases in the money supply by the Federal Reserve. This ends up generating more dollars chasing after the same amount of goods and services, which inevitably precipitates an increase in prices. By borrowing money to purchase your property with a fixed-rate mortgage, it allows investors the opportunity to realize significant benefits when inflation rolls through the economy.
The way that this phenomenon unfolds is when the increased flow of dollars throughout the economy increases the nominal value of the property. The real value relative to other assets may remain unchanged, but the fixed-rate mortgage that was used to acquire the property will have its payments remain flat while the value goes up. In this case, the investor realizes all of the increases in value while paying exactly the same amount to the bank each month. We refer to this effect as “Inflation Induced Debt Destruction.” The impact of inflation reduces the real value of mortgage debt.
In addition to this, rents are likely to be pushed up by inflationary pressures as well. This will result in larger cash flows that increase profitability for investors. The driver of this increased profitability is also the fact that interest payments remain fixed and revenues grow faster than expenses. Thus, investors can generate real returns from inflation through the prudent use of leverage. This is the fundamental strategy behind our ROI predictions.
The Young Wealth Team
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