As someone active in the real estate investment I could not agree more. Buffett should have qualified his statement by saying not all real estate markets are equally compelling. The San Jose/San Francisco bay area is not nearly as attractive a market as that of Stockton, Calif., 90 miles east.
I recently purchased a house in Stockton (a link to the listing). Below I have expected expenses and returns based on the purchase. The house was rented out for $1,100 a month which was at the low end (to a good quality tenant I might add) and a vacancy allowance of one month deducted from the year’s earnings.
Keep in mind the 18% return on investment is after tax so it can’t be compared to a 18% pre-tax profit on a stock portfolio gain. If you were to employ a property management company that would take 10% of the rents then you’re looking at a 15% return on investment. Its easy to see why Buffett would get so excited about such an investment.
The Risks of Markets Like Stockton
There are some that would say, "Why Stockton?" Stockton has the highest murders per capita in the nation, the city is near bankruptcy and the unemployment rate looks more Spanish than it does American.
Yes, the city may go bankrupt, but your average citizen is not going to be a big loser. The losers are likely to be the pension holders and retirees receiving benefits who may not even live in Stockton. It would also be the distant lenders who had bought Stockton’s municipal bonds and now have to take a haircut on their bonds. After bankruptcy the city would face higher interest rates, but this would be a burden primarily for financing city expenditures.
The real estate company I work for has some 30 houses spread about some of the rougher parts of Stockton. I feel much safer in Stockton than in an urban city like Oakland, Calif., which has similarly high murder rates. Still, the high crime rates could lead to an exodus of people who would seek safer neighborhoods. At the same rate we do have tenants in Stockton that commute to places like San Francisco because rents are so much more affordable than in that region where rents continue to climb.
Stockton is in bad shape economically. But all bad times come to an end as do all good times. If you can make 18% in the bad times who knows what can be made in good times? If house prices are temporarily depressed by a glut of homes, when that glut of homes gets purged how much do house prices go up? Further, if the cost of renting a home is double the cost of a mortgage, when does this imbalance equilibrate?
A second sweetener to buying a home is getting money at 4.75%. We’ve been so lulled into this low interest rate environment we’ve forgotten how good a deal at 4.75% is (4.75% is what property investors would pay). Assume, however, rates increase to 10%, and the monthly payment goes up to $760. That’s still below the $1,100 rent.
This is why Stockton is so much more attractive than the San Francisco/San Jose region. Just estimate a mortgage for any house in that region, and the going rent is likely to be less than that monthly payment. Las Vegas, Phoenix, Riverside and other cities also have very beat up house prices but a rental market that is not nearly as beat up.
What May Unfold
Eventually investors will open their eyes and plow capital into cities like Stockton and others that have been neglected but yield a good return based on today’s depressed rental rates. Many private equity funds are trying just that but are finding it difficult to buy enough homes, as Bloomberg reports.
Should houses get bought up as investment property, rents would naturally come down as the market grows saturated with rentals. However, prices will see upward pressure as the inventory of homes is whittled down. In this scenario it’s a win-win situation no matter which way you see it. If the residents of Stockton can pay less on rent, then they have more money to spend elsewhere in Stockton, providing a needed boost to the economy. The only person that loses is the one that overpaid for investment property five years ago and is stuck with a higher cost structure.
Unlike stocks, there is no “catalyst” for investing in real estate. You make your return by sitting and earning rents. You may get bailed out by a rise in house prices, but its not something to count on. I welcome any questions anyone may have about property management and real estate investing and will try to answer them as best I can.
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About the author:
Josh ZachariahI credit my father and Warren Buffett for molding me into the investor I am today.