Apr

5

For SaleA person buying property for investment is doing three things simultaneously, even if he doesn't admit it:

1/ Running a real estate business, including headaches, deadbeat tenants, vacancy between tenants, etc., for which costs and lost rent should be included in an analysis, as these are not minor costs.

2/ Speculating on the value of property going up or down.

3/ Speculating on the value of the dollars borrowed for purchase going up or down.

The third one is often overlooked. Picture buying an apartment for $100K cash (in real estate terms, that means writing a check for $100K, no loan involved). Then picture that with inflation, after X years the value of the dollar went to 1/2 with no change in the value of the property. Selling it would yield $200K, which after taxes on the $100K "profit" would yield a loss of $50K in future dollars, or $25K in present dollars.

As an alternative, picture buying with 10% down and 90% borrowed. After X years the proceeds of the $200K sale go $90K to the bank (assume no amortization, for simplification), $20K to pay back the $10K down payment, $50K to taxes, which leaves $40K profit (in future dollars).

The interest on the loan makes things more complicated, of course. It means likely not paying taxes on other, similar deals that made a profit at the same time, so the above deal maybe should show a profit of $90K in future dollars. It also means that instead of choosing between paying $100K "cash" or $10K down and investing $90K, another option is buying 10 apartments for $10K down each.

Of course the interest payments are a cost, which need to be looked at. One good way to do this is to compare the interest rate to the "cap rate" for the property. The cap rate is the annual income divided by the property price, which is just the income from the property. It is, or should be, figured including all costs, including tenant hassles, but not include any interest costs. If the property is making 8% and the money costs 6%, that is a good sign, and will make the return on the 10% down payment really high. If the cap rate is 4% and the money costs 6%, the deal will lose money steadily, but perhaps be bailed out by a sale at an increased price. This is exactly what most deals look like, especially in recent years: they lose money steadily until sale to someone else who does the same thing and hopes not to be the owner when prices drop. This time around it may be a little different, as the loss to the "last" owner is increasingly spread among all taxpayers, but that's another story.

As much of the price increases lately have been due to inflation (narrowly defined by me as a drop in the value of money), and only some is due to an increase in the value of the property, buying with a loan is also a gain from shorting the dollar: profits are made from that "option" trade if the inflation rate is higher than the interest rate, which in effect makes the interest on the loan a negative number. This has made many people rich, who either aren't aware of this or won't admit it, preferring to think they made the money from choosing better paint colors.

As prices are dropping now, it strikes me as sensible to wait at least one or two years before buying. When cap rates are higher than interest rates, that's the time to buy, as everyone will be saying "I got burned, don't bother with buying property".


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