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Warren Buffett Would Make This Investment If He Could

June 14, 2012 | About:
Josh Zachariah

Josh Zachariah

36 followers
Earlier this year Warren Buffett was quoted as saying he would buy a “couple hundred thousand” houses if it were logistically possible. He continued to say that if held for a long period of time they would outperform stocks.

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.

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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?

Cheap Money

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.

About the author:

Josh Zachariah
I credit my father and Warren Buffett for molding me into the investor I am today.

Rating: 4.3/5 (32 votes)

Comments

Adib Motiwala
Adib Motiwala - 2 years ago
Thanks for this post. Few questions

1) is property tax so low in that area? Its about 2.5-2.75% where i live in Dallas,Texas.

2) if i bought this property with 100% cash, then my after tax return would be 6% or 9% pre-tax (33% tax on $9000 op income). So the better return is coming from leverage. Its not fair to compare the 18% post tax levered return to the return from an unlevered equity portfolio is it ? Maybe the 9% pre-tax unlevered is the right comparison.

3) If someone buys with cash, what would be closing costs? would they go down since you don't need a mortgage

Arpan
Arpan - 2 years ago
Thanks for sharing the info.

The question I have is:

How do you account for the monthly mortgage payment? With each payment, your equity builds up, and so your overall ROE is reduced. You arrived at 18.3% by simply taking the NI/Down Payment, but you excluded the $5,400 annual addition of equity. If that is included, then return falls to less than 15% in the first year.
Josh Zachariah
Josh Zachariah premium member - 2 years ago
Adib

1.) Yes it is quite low, California has property taxes fixed at 1% of assessed value and not to exceed 2% per year. Unfortunately our school systems suffer as they are the beneficiaries of property taxes.

2.) In regards to paying cash that is an entirely different animal. My father paid cash for a foreclosure but paid close to $40,000. The property required some $10,000 in repairs whereas mine needed only a $110 carpet clean and some window washing. Foreclosures can't be financed so they generally sell at at a deep discount because you must pay cash. In such a situation, 20% returns are possible. In my father's case he should earn a comparable return.

The downside in financing is the time and possibility of the deal doesn't go through. It took me ~ 6 months to finally get a house. It took 3 months from my offer till I got the keys and this is an average time for short-sales. In a short sale you deal with both the previous owner and the bank and the bank must authorize any offer and this is what generally holds up the process. Some banks are quicker than others, if I remember correctly the average time to close for a JPMorgan Chase short-sale is 4 months and some are higher yet.

3.) Yes the closing costs would certainly be lower by paying cash. There would be no financing fees, there would be no appraisal costs (mine was $500) and if you bought at auction you wouldn't get hit with broker/agent fees but auctions may have their own additional costs.

Arpan

Yes you're very right in that regard, capital builds up and it raises the denominator in return on equity. But keep in mind of the $5400, $3400 is interest and that gets deducted from revenues. $2,000 is what gets added to the capital base. Also keep in mind you get cash flows early. Presumably you'd be reinvesting that money and getting a return on that. Income taxes and property taxes get paid later so you can earn interest on that money in the meantime.

So yes return on equity may decline based on cash flows. But then if you consider Robert Shiller's findings that over the long-run house prices have an inflation adjusted appreciation of 1-2% per year. If you're leveraged with assets 5x that of equity then 1% gain in the price of the house would yield a 5% gain in equity.

But in the event (rare) that house prices don't appreciate the additional capital you add to principal will bring your return to equity down about 1-2 percentage points a year which is still a very good investment.

Thanks for your guys' questions!
shareholdr
Shareholdr - 2 years ago
Your article assumes you can get a tenet in a home that costs $100,000 to pay 2x your monthly mortgage payment. Is that realistic?

Josh Zachariah
Josh Zachariah premium member - 2 years ago
Shareholdr,

That's exactly what I'm getting, I can show you the lease if you don't believe me and refer you to craigslist listings for rentals. The reason for rent being double the mortgage has to do with the fact people don't have credit to qualify for buying a home even if they had the money. People are being foreclosed on because they can't (or won't) pay their mortgage for a house that was purchased for $400,000+ and is now only $100,000 They have no choice but to rent once they have gone through bankruptcy or even a short-sale. So that's why you have such a situation, I should have clarified to make sense of the conundrum.

In San Jose/San Francisco many people have money and credit and so you don't see rents exceeding mortgages. In the Silicon Valley (greater San Jose) you have a situation where tech entrepreneurs are doing IPO's and raking in huge amounts of cash and are spending it in areas such as Palo Alto and Los Altos. I have a friend who is a doctor and recently paid $2 million cash for a house in an upscale neighborhood called Saratoga because the competition for houses is so intense.

Dr. Paul Price
Dr. Paul Price premium member - 2 years ago


No mention of the very real depreciation charges nor any allowance for deadbeat tennants, unoccupied periods and/or agent fees or your own time and labor.

Now and then you'll need a need roof, furnace, A/C etc. Finding good tennants that pay as promised in an area like Stockton might be challenging as well.
Josh Zachariah
Josh Zachariah premium member - 2 years ago
Hi Stockdocx

Depreciation is same as repairs. I budgeted $1,000 for repairs and it is a fair estimate for reinvestment in the property. On a given year you won't spend that kind of money, but yes there will be water heaters and other high ticket items that need replacing.

I also did deduct a month for vacancy. The $1,100 I'm renting it for is well on the low end of the rental market. The appraisal estimated rents to be between $1100 and $1300 in the neighborhood. The reason I priced it so low was so I could rent it quickly to a high quality tenant. I've screened hundreds of tenants to know what a good one looks like and I had several decent tenants apply.

I appreciate the questions and comments
Charteroak_2000
Charteroak_2000 premium member - 2 years ago


I would imagine there are similarities to Detroit ?
Josh Zachariah
Josh Zachariah premium member - 2 years ago
Yes, there does look like some opportunities in Detroit also. But Detroit does have its own risks. From what I've read there are some neighborhoods where less than have the homes are occupied and its created a problem for the city as far as offering services so the city has asked residents to vacate. I had read this some time ago, but it may have changed since then. But if you live in the region i'm sure you would have a better understanding of the market.

zillow.com is a good place to see both going rents and actual sale prices of homes in the same area.
quantumwell
Quantumwell - 2 years ago
Congratulations Josh. Buy-and-hold real estate is a steady ( or slow) but safe way to accumulate wealth. I am a real estate investor in bay area so I can say that quite a few places such as Stockton, Merced or even Sacramento can find those deals.

However, the reason you can get 15 -18% return is because you actively manage the whole deal. (vs have McDonald CEO works for you if you own MCD.) You need the knowledge to find deals, get financing, know how to find qualified people to do repairs, maintenance. Most importantly, know how to find good tenants and have the temperament to manage them. ( or find a good property manager and know how to manage your property manager or else you will be manged by him/her.) Real estate is not liquid at all so you will be in for a long while.

On the other hand, you will have tax write-off on many deal related expenses, depreciation on the property, and then you can do 1031 exchange so taxes can be delayed when selling.

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