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Tuesday, August 14, 2012

How To Make Money In Real Estate?

One of the most common responses to my posts correctly points out that I am generally pessimistic. While I have harped on the numerous flaws of the system, I seldom offer any solutions. This is my reply to these complaints.

There are solutions. In a supposed free market economy, the government's role is to provide the framework that the private market can thrive upon. Unfortunately, the market has been hijacked by politicians with blind ambitions and the insatiable greed of Wall Street. This deadly combination makes it impossible to plan any sensible political or free market solutions. In my opinion, we are moving further and further away from rebuilding a solid foundation for the real estate market. It is an exercise in futility to attempt a fix.

I am not hypocritical nor do I have delusions of grandeur about saving the system. Just like Wall Street, the motivation for all of my analysis is profit, I'm constantly in search of that special angle that hopefully helps me to make an extra buck. As economists and analysts toil over meaningless fluctuations, it is becoming obvious to me that fundamentals are currently of little relevance. In other words, we should not count on the traditional way by buying good properties, generating income and then counting on some appreciation to augment the gains.

The market is not driven by data but by how policy makers react to the data, a constantly moving target. Investing in real estate is an exercise of hit and run, betting on bubbles and the bursting of bubbles. The dumbest idea would be a long term buy and hold strategy, which is just another way for Wall Street's wily practitioners to collect fees from the lemmings with little regard to performance.

Little Bowden housing estate A relatively new housing estate on the eastern edge of Market Harborough
English: Little Bowden housing estate A relatively new housing estate on the eastern edge of Market Harborough. (Photo credit: Wikipedia)
In hindsight, the biggest gains in real estate history barely qualify as having been derived from real estate. They were derivatives of derivatives derived from default probabilities of interest payments of sliced and diced tranches of real estate loans secured by pools of addresses and borrowers with little regard to their qualifications. Because they were derivatives, the size of the bets could be leveraged to infinite times the underlying assets. These huge bets were made possible by Wall Street casinos matching gamblers like John Paulson against AIG and others who may not even have known they were participating.

Most of us are not so fortunate to have Golden Sachs package a perfect pool of junk loans, but there are plenty of other lucrative avenues. Retail investors who shorted the subprime lenders such as New Century, Novastar, and Fleming were handsomely rewarded when they all ceased to exist. Then there are the builders. All the builders' charts look the same. Here is a chart of D.R. Horton (DHI), the largest listed homebuilder:

The path of DHI's stock price since the Nasdaq bubble topped out.

DHI was just bouncing along in a trading range when the dot-com bubble burst. Then Greenspan decided to inflate the next bubble and DHI went from under $4 in 2000 to over $40 in 2005, a greater than 10 fold appreciation in just 5 years. If you were smart enough to recognize the bubble as a Ponzi scheme, you would have bought during the early years and let Greenspan do the rest. Then when it became obvious that the Ponzi scheme was too large, you'd have taken your profit on the long side and shorted the builders along with the subprime lenders. You would have pocketed profits in the triple digits, annualized.

By comparison, had you invested in the real estate market during this period using "fundamentals", a single digit return would be considered good. Many are still underwater with their investments. Now they try to convince themselves that real estate is for the long term, hoping for the next bubble to bail them out.

What lessons should we have learned to guide our real estate investments in the future?

1. There are far better avenues to invest in real estate than physical ownership, skipping the laborious task of operating income property.

2. Politics and public policies, not the free market, dictate future value. There is no need to discuss the merits or morals as logic seldom prevails in politics. The current sentiment favors a re-distribution of income from lenders to borrowers. As Wall Street funds move into foreclosed homes, converting them to rentals, the most likely political outcome will be a re-distribution of income from evil landlords to poor tenants. Wall Streeters should not be celebrating rent increases, they should rather be worried about rents going too high.

3. Real estate has traditionally been a long term investment, with little consideration for an exit plan at the time of purchase. This is no longer the case. Real estate is not liquid and it is proven that it can be a trap, evidenced by the many investors who are holding rentals today and cannot get out. They may be under water in their mortgage but may have enough other income to keep feeding the negative cash flow. However, they do not have the funds to sell and cannot just walk away, because the laws do not favor an investor in the same way as they do a homeowner. To avoid the same trap, there must be an exit plan at the time of purchase.

4. Physical real estate can only be profitable through income and price appreciation. Given the current uncertainties, I believe that it is imperative that real estate investment vehicles can be profitable in both appreciating and depreciating markets. For example, DHI can easily double if Bernanke is successful in re-inflating the housing bubble, or be cut to pieces if the current optimism turns out to be nothing more than a head fake. Just like in craps, you can bet on the "Come" or "Don't Come" line and shoot the dice.

In conclusion, I have never seen such unfavorable conditions as now. The easy days are gone. Investors can no longer buy a couple of rentals and expect them to provide a nice retirement nest egg in 10-20 years. Physical real estate has always been considered a safe and conservative investment but that is simply no longer the case. Stocks of builders, building suppliers and interest rate ETFs (such as TLT or TBT) offer much better risk/reward ratios if only for the reason that exiting these investments is much easier than having to dispose of actual real estate.

Finally, as to the question "How to make money in real estate?": I am still searching for the ultimate answer, but buying physical real estate for long term holding purposes is not likely to be on the list.

Chart by: BigCharts

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