Market Report: May 2005

Growth or Income? by Jim Scott

Last week in our local paper there appeared a story on the speculative mania surrounding downtown condominiums and other single-family properties. The story featured, in case you missed it, how many new investors were profiting from the residential speculative market. To be sure there are will be many success stories; those of us who stood on the sidelines waiting for the inevitable correction missed the opportunity. Buying and holding San Diego single-family properties has been a traditional way to increase personal wealth. But betting solely on growth has pitfalls and our past is littered with victims who pursued that strategy too late in the market cycle. Good investing in real estate is no different than a successful stock strategy; you need the correct balance of growth and income financial positions. If you made some short-term speculative profits in real estate during past few years it may be time to shift those gains into the income side of the equation. Our real estate culture is imbued with a sense of special entitlement; we possess the San Diego premium and therefore the rules do not apply here. But as I like to remind readers, the business cycle is not extinct.

The Lost Art of Finding Real Estate Income

This is the real problem. Saavy investors are all chasing yield, whether in financial or property markets. The markets and investors are awash with cash and have buckets of cheap money for loans. All of this money is out there trying to buy what little product there is available for purchase.  The investment scene in San Diego is even more inhospitable to buyers.

Prices of investment real estate should have some relationship to the net income generated by the property. As an example, apartments traditionally sold for about seven times their annual gross income. This easy formula, which always produced a small positive cash flow, was washed away by the inflation tsunami beginning in 1976. During the Ford and Carter administrations local commercial and apartment prices added a twenty percent pricing premium, changing sales to nine or ten times annual gross rents. Negative cash flow became the norm as investors counter-balanced monthly losses with future appreciation gains.

Since it was the only game in town investors had little choice but to pay up. It was then the traditional divide between growth and income based investments disappeared. It became acceptable to earn little or no income from investment property because of the prospect of lucrative appreciation rates. Negative cash flow was OK. As an example North Park apartments, selling for around ten thousand dollars per unit in 1974, easily fetched four times that amount by 1979, even though rents increased only about 25% during that period.  (The price of homes roughly doubled during the same years)

After 2000, the era of cheap money and lackluster financial markets further diminished the prospect of obtaining real estate income from San Diego area investments. It seems as if everyone was betting on the come concluding that cash flow was now obsolete—appreciation was king. Looking back it appears those who bet on appreciation based products fared better. As always the story is more complicated than it appears.

Risk and Other Hidden Costs

Buyers are drawn to the appreciation market primarily because they can. Participating in commercial ventures takes far more capital to become a player. Speculating in homes and condos is accessible to most people since down payment requirements are so low. The only way to mitigate the risk is to either have more capital or to pool resources. The latter is the more practical path to gain access to a different kind of investment strategy. I am now piecing together a tax-deferred transaction involving turning four small properties into one cash-producing larger property.

While the current speculative boom is attractive it carries a huge risk. No one really has any idea of what will occur when the 92103/92101 condominium market becomes fully built out or converted in two or three years. It is easy to assume all is well when a future project is sold out two or three years ahead of the completion date. That begs the larger question; are they really sold or are the units just being held for sale upon completion? The lesser question concerns the financial staying power of the speculative community. If you think that is not important, call me and I will fill you in on the ugly details of the 1990-1995 residential market.

I think it’s time to start hedging bets and moving money away from risk and toward safe income.  Real estate is still the best place to have capital but the day when money is thrown at any product with nothing but upside is coming to an end. It is time to reposition real estate assets. If you would like me to evaluate your real estate holdings and discuss future strategies, call.

Click here to see Jim's past Market Reports. You can also download Jim's 26 page research paper on San Diego County apartments.

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