How to Predict Real Estate Prices – David Campbell | PREI 043
Is it possible to learn how to predict real estate prices?
Learn why property values and price trends are so important. If you can see where a market has been, and where it may be headed, you can lower your risk and improve your results.
We welcome back my good friend and successful real estate investor, David Campbell, to discuss market drivers, inflation, currency and other factors that investors should be aware of.
Enjoy the show!
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How to Predict Real Estate Prices – David Campbell
Welcome to Passive Real Estate Investing. I’m your host, Marco Santarelli. On today’s show, I have my good friend, David Campbell back. David is a good friend of mine and the founder of Hassle-Free Cashflow Investing. David started investing in real estate part-time while he was working as a full-time high school band director with zero net worth. Within six years and before the age of 30, David became a financially independent millionaire through part-time real estate investing. David has been involved with new home construction. In fact, he was one of our new home builders in the state of Texas for a number of years. He’s been involved in land development, commercial real estate and he has been focused as a professional mortgage known investor for over a decade now.
David, welcome back to the show.
Hey, Marco. Thank you so much for having me back. I love talking with you and your listeners. I’m excited to see what we learn today.
I’m excited too. I think we have a great topic. I’ve titled it, How to Predict Real Estate Prices, which is of interest to most, if not all, real estate investors. What do you think?
I think your title is very specific about real estate prices rather than real estate values, because values and prices are two different things. As an investor, when were focused on profits, it’s the increase in prices that makes us money, not necessarily the increase in value.
You’re jumping in, that’s great. Break that down, define value, define price, because for a lot of people, they think they’re one and the same. I know what you’re talking about but a lot of people are saying, “What’s the difference?”
Value is the usefulness of a particular item. For example, the usefulness of a gallon of gasoline is pretty much constant. It gets you from point A to point B by creating a certain amount of energy when it’s burned. The price of gasoline fluctuates every single day because of different variables. It could be the supply of the gasoline. It could be the demand for that gasoline. It could be the supply of the currency, which is used to purchase that gasoline, or it could be the demand or the velocity of that currency that’s used to purchase gasoline as well.
Everything you’re talking about comes down to two or three fundamental things. One is supply, and supply could be measured on many, many different things. Second is demand. The third, we’ll get to hear in a moment because we really haven’t jumped into talking about real estate specifically. Before we go down that road, I always want to start off my episodes with people talking about them. I’d like to just ask you the question, how did you get involved in real estate? Maybe you could just take a minute to talk about that, if you don’t mind?
Sure, Marco. When I was a high school band director, I started in the mid to late ‘90s. I was getting my first paycheck and I still qualified for food stamps. I realized that even though I was an educated, smart, college graduate, I set myself up for a financially humble lifestyle. At that time I knew that I wanted a little bit more for myself. I wanted to have a family. I wanted to be able to support that family in a very comfortable way. I started looking for financial vehicles that were more powerful than trading my time for money, particularly in my teaching profession. Someone else was telling me what my time was worth and there was nothing that I could do to be a better or candidly worse teacher to make my income go up or down.
I was looking for another vehicle. The vehicle of real estate and mortgage investing, those two vehicles really resonated with me. I started out buying real estate and that went great. After six years, about a dozen real estate deals, I was able to be out of the rat race. Getting out of the rat race is easy when you’re expenses are low. Once I was out of the rat race, I was able to focus on creating a real estate development company and that expanded into also starting a private lending business. Then, just through my personal investing plus the success of those two business units is where I am today.
You’re quite the success story, especially becoming a millionaire and financially independent before the age of 30, which is what a lot of people aspire to do, kudos to you.
Thanks. Now, I’m over 40. There’s a lot of water under the bridge in the last decade. Now, I’ve been doing real estate full-time much longer than I’ve done anything else. There’s a saying that once you’ve done something for 10,000 hours, you’ll become an expert in that particular niche. It’s so true. When people are just starting out in real estate, there’s a lot what they don’t know, they don’t know. There’s a whole vocabulary that they think they might know what it means, but when you start using that vocabulary in a way to make investing decisions and financial decisions, that vocabulary means something different. For example, we started out with the word prices and the word value. A lot of people think they know what the word price means and what the word value means, but today we’re going to talk about those words in ways that might help people think about money in a little bit different way.
This is why educating yourself is so important and I harp on it so much, because the more you learn, the more you build up your financial IQ. You start to understand the differences between these different phrases and terms. You can talk the talk and you understand the lingo and the language. You understand the difference between value and price etc. There’s another saying David, I think it’s something like this, “You became an overnight success but that overnight success was ten years in the making.”
It’s so true. No path is without pitfalls and turns. When people look at my breath of experience in real estate in some senses, a savvy person should say, “You have ADD, you’ve done too many things in real estate, pick a niche and work that niche.” What I like to believe is that different vehicles and different strategies for investing change depending on what’s happening in the global economic cycle. It should change the vehicles that you choose to invest in that will change depending on the benefits that you are looking for from those financial vehicles. If you are trying to create wealth, for example, you’re trying to create equity, then you might be investing in highly leveraged real estate for appreciation and for amortization. If you want cash flow on a monthly basis, you’re probably going to be more interested in mortgage investing. If you want security because you’re trying to protect your net worth in a potentially volatile economy, then same thing, you want safety first type of mortgage investments rather than going out to buy a whole bunch of properties at the sellers’ market.
You have to adapt to the time and the market in the real estate cycle. If you’re the number one manufacturer of typewriters and you don’t change, you’re going to be run over by the PC and the word processor. You have to be able to adapt to the changing times.
That means a lifetime of continuing education. I really applaud everyone who’s listening to your show today because they’ve made their own commitment to continuing education and by doing automatic download on your iTunes feed, it’s awesome. It’s a free subscription to the one of the most educational resources your listeners can tap into.
On that note, here’s the overarching question, how important is it to be able to predict real estate prices? Because after all that’s going to be the theme of the show. Before you answer that, I know that our clients are aware of this, that we put a focus on cash flow primarily. Secondarily, there is the amortization of the loan and then we look at tax benefits. These are all wonderful things about real estate. Back in 2003, 2004 and 2005, so many people were focused on appreciation. They were looking at how much can I grow the price of these assets over the years through appreciation? They were focused on what I refer to as speculation. That’s not our philosophy. We don’t focus on the price of a property and how much appreciation there is. Although, it’s nice to have, it’s important. Sometimes I refer to it as icing on the cake. We always focus on cash flow first. Let me throw this over to you. Answer the question, how important do you think it is to be able to predict real estate prices?
I would say in the short term, being able to predict real estate prices would help you find an entry point into the marketplace. Over the long term, predicting real estate prices is a lot less important. For example, my parents bought a $50,000 home in Southern California in 1970. 40 years later, they sold it for half a million dollars. I like to tell the story. What if they had overpaid for that house by 50%? What if they paid $75,000 at that time where everyone was paying $50,000? They look like fools but wouldn’t they be pretty smart if they had loaded up on a hundred of those overpriced houses and hold them for 40 years? They’re going to be multi-millionaires by overpaying for property.
You’re going to overpay for every property that you will ever buy, because if someone was willing to pay more, they would be the owner of that property instead of you. How to predict real estate prices? How important is it? I think it’s important in helping me decide which part of the market cycle we’re in, whether we’re in a buyer’s market or a seller’s market. That generally helps me decide which types of asset classes I’m going to be involved in, because I’m a market cycle investor. I want to buy when it’s the time to buy and I want to sell when it’s time to sell. If you’re just going to buy and hold forever and not churn your portfolio, then I think predicting real estate prices is a lot less important.
That’s not to say that this show is not important or less important to people who are long term buy and hold investors.
Understanding the concept and understanding how to use the tool, I think is vitally important for every investor so that they can make educated decisions and decide whether that tool was relevant for their own portfolio or not. Having the information is of huge importance to every investor, so they can understand when they are seeing prices move or not move that they understand why that’s happening and so that they could also sound intelligent when they’re talking with other investors. When you understand the vocabulary, you’re going to attract other people to your life that understand the vocabulary. You’re going to get a more intelligent and more successful sphere of influence of people to do business with.
It sounds like you can hedge your risk, if you will, if you focus on cash flow and you focus on a long term investment horizon because the price of real estate will work itself out over time, because assets prices go up mostly because of inflation. You’ve got cash flow every month every year to hold and carry that property over time. If you invested in a different market maybe you would’ve made more in terms of appreciation. Overall this should work out. You’ll end up with an asset that grows equity through appreciation and through amortization. You’ve got the cash flow and you don’t need to worry or try to time the market. Would that be a fair assessment?
Yes. A lot of real estate wounds are healed with time, so if you make a mistake in real estate in your positive cash flow, time heals most wounds in real estate. Some people, depending on where they are in their personal life, maybe they’re 60 or 70 years old, they might not have enough time for the real estate cycle movement to heal those wounds. It becomes even more important to understand how to predict real estate prices when your time frames are shorter.
I think that’s more true if you’re in a market to flip than to buy and hold, because you obviously want to buy in a market that’s stable or appreciating if you’re looking to flip because you increase your risk if you’re buying in a declining market. You have to buy better.
You want to be a momentum investor. You want to buy with the trend. The long term trend, prices are generally going up because not the value of the real estate is going up, but because the currency in which the real estate is denominated, that currency is devaluing because of inflation or increased supply of currency and reduced demand for that currency.
I think where that plays in heavily is in the value of that mortgage underlying the acquisition or the property. In other words, you have a 30-year mortgage on a property and as time goes on, that mortgage becomes worth less and less because you still pay it every month in a fixed amount of dollars. Over time, the purchasing power of that dollar goes down so you’re actually paying it every month, every year for the same amount. The value of that loan becomes worth less. I don’t know if I’m making sense. I know I’m making sense to myself David, but maybe to the listeners, they’re not following on this.
In other words, if you have a 30-year mortgage today and your monthly payment is $500 a month, that might seem like a substantial payment. Maybe it’s half of what your monthly rent is at $1,000. If you fast forward ten or twenty years from now, that $500 monthly payment hasn’t changed, but that might seem like a very small payment in relative terms because now that property you just purchased may be two or three times the price you bought it at, originally. Your rent might have gone up from $1,000 to let’s say $2,000 a month, so now it’s much less significant.
Let me try to say the same thing in a different way, so that your investors can have a different way of looking at this same concept. I believe that when you’re buying real estate that the mortgage is the asset. The property itself is just an excuse to create income to support that mortgage. Let’s say, you were to buy a $100,000 property with an $80,000 loan, so 80% loan-to-value. Let’s says, there’s a widget. That widget is priced at $20,000. If the value of the property goes up and the value of that widget stays the same, then you’ll be able to sell that property in half more widgets. That’s the exchange of value. We removed currency from the conversation and we’re just talking about how many widgets per property. If you can rent away the property and make it nicer, cleaner and more people want to use that property or it’s gentrified or the utility of that property goes up, you’ll be able to trade that property for more widgets.
Let’s put currency in the equation. Let’s say, the price of a widget goes from $20,000 to $40,000, and the value of the widgets stay the same, and the value of the house stays the same. That means the price of the home is going to go from $100,000 to $200,000. Your value didn’t increase but the price doubled. The price of the widget doubled. The price of the house doubled. Now, you sell that $200,000 home, you got a $100,000 capital gain. Let’s say, you give $20,000 of that capital gain to the IRS. Now, you’re left with $180,000 and you try to go by widgets with it. You paid five widgets for the property, but now even though your home doubled in price, you can’t buy five widgets anymore because of the tax bite. The increase in the price of the property less the taxable bite means that you actually lost purchasing power. Many people don’t see that. They say, “Hey, my property went from a 100 to 200. I hit a home run.” When you look at the purchasing power, did you really?
The way that you make money in real estate is with that place holder of price, that place holder of value, which is the mortgage. Let’s say you bought that $100,000 property, $80,000 mortgage, when you resell that property and you sell it for $200,000 and you pay off that mortgage. Assuming that you had an interest on the mortgage to make the story easier, you’d be paying off that mortgage with two widgets. You’re not going to pay them $80,000. You’re going to pay them two widgets. Then, you sold it for five widgets and then you paid your mortgage off with two widgets and you’ve got one of your widgets that is your own money coming back to you. Then there’s money left over. That money leftover is real profit in terms of purchasing power.
That increase in purchasing power is the thing that we really want as real estate investors. The thing that gives us that increase in purchasing power over time is the diminishing value of the debt. The diminishing value of the debt is what makes us a profit in real estate.
What you just said is why real estate is so powerful and why leverage is the tool that allows you to create that wealth. You can’t do that with any other asset class. I call real estate an asset class, some people don’t. You’re right David, that leverage is so powerful. That’s what ultimately ends up creating wealth.
If I could buy bars of gold with financing and stick them in my basement that seems like a good plan until I have to go pay the mortgage on the gold. If I could find someone that would rent my gold on a monthly basis, that would be a pretty easy business model. That doesn’t exist. The only business model I know where someone else would give you the majority of the money to buy the asset and then pay the interest cost on that loan, plus the profit margin on your equity is real estate. There’s no other investment vehicle where you can buy with such leverage and margin and get the cash flow to pay for that margin.
You also pointed out the relativity of things. I’m not sure if I can clearly explain this, but what you buy something for today on a per dollar basis, years from now as long as the rate of inflation is consistent, your purchasing power will diminish. The value of your property will go up. That $100,000 home today, whatever you make on it without financing, is not going to be as attractive as if you had leverage on that property. Five or ten years from now, all real estate will be more expensive not just the $100,000 property you bought. You might now need to spend $200,000 to get the same property in ten years from now.
You need ten times as much to put down or ten times as much to invest. When you factor in the financing, where you can only put down 20%, 25% of that purchase price, now, you’re building true wealth because you’re using other people’s money and other people’s rent to pay off that mortgage. I think another way of saying what you just said is, if you want to make $10 million in real estate, go out and get $10 million worth of debt today.
Correct. There is $10 trillion mortgage piece of a Zimbabwe currency in my pocket. It’s in my wallet. It’s just a good
reminder that in the ‘70s, that $10 trillion mortgage note from Zimbabwe currency, would’ve purchased the entire city of Orlando. Now, fast forward in today’s money, that $10 trillion note buys you lunch and that’s it. If I was able to borrow $10 trillion in the ‘70s and just hold on to that debt and let the income from all that property in Orlando to just service the interest on that note. Then today, I’m going to pay that bank off, I just have to take the banker and buy him a Big Mac. Now, I own all of the city of Orlando, free and clear.
The thing that changed was the price denomination and the value of the underlying debt decreased. I think what’s interesting is looking at supply, demand and capacity to pay. Those three things we’re looking at supply and demand of the commodity of real estate, and we also look at the supply and demand of the currency that’s used to purchase that real estate. Those are two different independent gears moving side by side. Supply and demand of property, supply and demand of the currency used to purchase that property. Those gears are moving independently at each other.
What’s interesting is a lot of people forget that capacity to pay is a huge part of predicting real estate prices, because if you’re a family and you’re using 100% of your income to pay a mortgage, you can’t pay more, even if you want to. Even if you say, “I really, really want to buy this house, Marco.” If you’re using all of your money already, you can’t pay more. That’s where a lot of markets are easy to look at. Can the price go up? Can the price continue to go up? The easy thing to look at is census data for median income and census data for median home price.
If you look at the median income and the median home price and you figure out, can the person with the median income afford the median home? If the answer is no, prices can’t go up, they just can’t. Even if supply and demand and any of the factors, they can’t go up unless the incomes go up. That’s a great way to pick undervalued markets, because if you find the situation where people are only using 10%, 20% of their household income to pay for real estate, that’s very affordable. People can afford more than 10% to 20% of their income. People are using more than 45% of their income for property, they can’t. They can’t afford to get the mortgages or even if they could potentially afford them, they can’t get the loans that are over 45% DTI.
What you’re talking about here are affordability ratios. It’s something very important to look at. What I did as an exercise last night, I just pulled some current information, at least as current as I could possibly find on median prices and median household incomes on five different markets. Three of these markets are ones that we operate in, where we actually have investment property available for sale. Two of them are markets that are priced out of the affordability range. One of them was a market that we used to be in twice over the last twelve years. We were in and out of it because that market cycle had gone up. It had appreciated, it had become unaffordable. We stepped out of that market. It come down, it became affordable, it made sense again financially so we went back into that market. That market cycle turned around after it hit a trough. Once again, it became unaffordable.
The first market was Dallas, median price of about $150,000, median household income of about $59,000. Your affordability ratio is 2.6. All I did was just divided the $59,000 into the $150,000. That’s a relatively low number. That’s an affordable market. I took a look at Kansas City. Again, about a $148,000 median price, the median household income is about $58,000. Again, we have a 2.6 affordability ratio. Now, I looked at Birmingham, it was little higher than I expected. Median home price of a $134,600, the median household income of about $49,500, so it’s a 2.7 affordability ratio. Anything up to three is very affordable. As you get to the three to five range, it becomes less affordable. If it’s over five, it’s unaffordable.
Here’s something that’s interesting. Phoenix has gone up quite a bit over the last two years. Now, the median home price there is $185,000 and the median household income is about $52,500. It’s a 3.8 affordability ratio. You can still find deals in Phoenix, but they’re not as plentiful and also the numbers don’t work as well as they used to. David, I just want to point out one more market for comparison here because a lot of people can relate to markets like New Jersey, New York, and Los Angeles, these higher priced coastal markets or sometimes what I refer to as bubble markets.
Up in Los Angeles, I’m talking within the MSA, the Metropolitan Statistical Area, you’ve got a median household price of $455,000, yet the median household income in that area is only $56,000. That gives you an affordability ratio of 8.1. Taking these all back to what you’re saying, is markets like Dallas and Birmingham have a much higher potential for price appreciation than a market does like Los Angeles that has an 8.1 affordability ratio.
You got it, that’s correct. People often will say, “I want to invest in the hot market where prices are high, because they’ve always been high and will continue to be high.” I don’t think that’s necessarily true because even though they’re desirable and there’s demand for the product and there’s a restriction of supply, the capacity to pay isn’t there. People can’t pay more even if they wanted to.
There’s got to be a breaking point at some point where people can’t afford to buy anymore. What does that do? The next logical step is that lack of affordability drives down the demand. With demand drying up, less people are buying, that just starts pushing prices down because if sellers want to sell, they have to come down to meet what demand there is. Correct?
That’s correct. What’s driven market cycles, market prices up and down in the past, a lot of times has been the supply of currency in the form of mortgage financing. Because if anyone can get a loan, like in the case of 2003 to about 2007, when stated income loans are so easy to get, you just have to fog a mirror and you can get a mortgage in 2006. Because that supply of money was so available, that meant more people had capacity to pay, more people than ever could afford to pay a mortgage, so they did. They got these mortgages. When those mortgages were negative amortization, with these teaser interest rates that were really low, again that increased capacity to pay.
When a whole bunch of people have an increased capacity to pay, that makes demand go up, which then pushes the price up. That was a big driver of the American real estate market in that 2003 to 2008 timeframe. Then at the end of 2008, 2009, 2010 and 2011 lenders got really shy and they pulled back and they said, “We’re not giving loans to unqualified borrowers anymore.” That dried up the supply of currency, which dried up the capacity to pay, which dropped the demand for housing, which meant prices had to go down because there were fewer buyers and more sellers. When the lenders started coming back into the marketplace again in 2013, 2014, they may start seeing that market cycle or that market pricing starts to increase because capacity to pay increased.
It’s not that we have a whole bunch of more people and a whole lot less houses, that’s a very simplistic model to say, “We have more people and less houses than all,” then of course, the prices go up. A natural part of the supply and demand push and pull is that as there is more demand for housing, builders add more supply. There’s always just a little push and pull, more demand and supply, and then builders build more. They always overbuild. Then there’s too much supply for the demand. They have to wait for that supply to get doubled up through population growth. Prices come in the equilibrium again, that time builders have gone out of business and they can’t keep up with supply anymore and then prices go up. It’s a very complex moving model, but if you understand the variables of supply and demand of the product, supply and demand of the currency and then the capacity to pay, those five things are the things that are going to help you figure out where prices are going.
That also illustrates why the permits being pulled for new home construction is a lagging indicator for a real estate market, is because the builders follow the increase in demand. When they see the increase in demand, they go out and pull permits. They start building and when the demand rise up, they still have construction going on and permits that have been pulled. Even though the trend may be upward, the demand may have already dried up. You can’t just look at the number of building permits or the number of homes being built by new home builders as an indicator of where that market is going, because unfortunately in most cases, it’s a lagging indicator.
Absolutely. I think the leading indicator for supply is going to be the supply of finished vacant lots or finished single family home lots. I’m on a home building company so this is a very personal topic for me, which I studied a lot. When there is high demand for housing, builders are going to build but when you build a house, it only take four to six months to build a house. To take a piece of raw land and tell the place where you can start building a house, that can take years, especially in more highly regulated, governmentally involved marketplaces. Years and years and years to take raw land until you’re ready to put a house on it, because of zoning changes, environmental impact changes, getting utilities set up to your site, getting the roads and the infrastructure put in, that’s a very slow moving process. Lot creation is a very slow moving process.
Home building, which is what the census people track is we need a pool of permit to have a home ready in three to six months from now. I would like to say, as a home builder when the demand was lower, let’s say a couple years ago, we were building more houses. We were pooling more permits when the demand was lower because the land availability was there. Now, that land availability has been doubled up and there aren’t very many lots to go build on, we’re building fewer houses. We’re building fewer homes. However, it would look like that there’s less demand now because we’re pulling fewer permits. That’s actually not true. There’s more demand than ever and fewer houses are being able to be built because the supply of lots can’t keep up.
Taking that one step further, sometimes you have to look at things that you normally don’t think about. For example, environmentalists, they sometimes get in the way of the permitting process and the political process in freeing up available land or rezoning of land to create more supply of land to build on. This is one of the issues that we see in California here, is there are groups that get in the way of the free market where we can create more available land to build new housing. Because that is being weighed down, like a ball in chain, we here in the state of California, can’t keep up to the natural growth and demand for housing. Therefore, that lack of supply pushes prices up. I don’t know if you’ve heard of that but it seems to be a pretty big problem here in Southern California.
Also the supply of water is a big issue for the desert communities, where you go out to say, Las Vegas and you see land for days. You think, “What would ever make the prices of real estate go up here because there’s so much availability of land but it’s the middle of the desert.” You can’t get a lot of water out there. Now, municipalities have to make sure that they have a supply of water available to meet the demands of the homes being built. If you don’t have enough water, then you can’t build there. You can’t turn that desert land and attract homes because there’s no water to do it.
David, what would you say are the top three factors or the most important factors when it comes to supply and demand? I will just first of all say that for me, jobs and migration rates into a market weigh heavily into the supply equation. What would you say are the top three most important factors?
In determining the supply of real estate and the potential future supplier of real estate, I want to look at the availability of land. Is there land to develop? If there is no land to develop, you can’t add more supply. Things that can cause restrictions of land would be natural geographic barriers like oceans or mountains. The other would be governmental restrictions on supply, like you were mentioning earlier, environmental groups. I live on a beautiful farm and there’s an endangered species of butterfly that lives on our neighborhood. There’s no way anyone could develop any of these farms and detract homes because it would remove the habitat for this endangered species butterfly. You might look out and say, “Wow, there’s land for days to develop here.” No, there’s a governmental restriction on the ability to develop because of environmental concerns.
The third thing I would say predicting supply is the cost of construction relative to market prices. There are times in the market cycle where the market is begging for more supply but home builders look at the current housing inventory and say, “I can’t build because it’s cheaper to buy an existing home than it is to build one.” If a builder says it’s going to cost me a $100,000 to build a home here and when it’s done I could sell it for $90,000, nobody is going to build. You have to wait at different parts of the market cycle where replacement cost is under the current pricing. If you look at the marketplace and say you know what, it is still affordable to build new and there are lots of builders building new, then you can see supply coming in. When prices compress and the prices compress below replacement cost, nobody can add supply to that market place in a cost effective way. Prices would have to go up above the cost of construction before more supplies are going to come in to the marketplace.
That’s exactly what happened after 2007, 2008 and that is the reason why today 80% to 90% of our sales are newly refurbished turnkey homes. They’re not newly built homes. They’re not new construction. Although we do have some, like in some markets in the state of Texas, a lot of the properties we sold with you when you were building single family homes in Dallas-Fort Worth. It made sense in those markets to build new construction. Still today, we don’t see more than maybe 10% of our clients, our investors, purchasing new construction because it’s just not out there.
It’s peppered around the country, but it’s not common, at least not yet. The day will come where the numbers make sense and the economics are there for builders to profit in other markets. That supply of new inventory doesn’t exist. A minute ago, I don’t know if I had made a mistake in saying that jobs and migration played into the supply side of the equation. What I meant to say is demand. Let’s shift gears here for a minute, what would you say are the most important factors for the demand side of the equation?
The demand side of the equation is on the utility side. People need a place to keep themselves warm and dry. When there are more people interested in that utility, then that’s going to increase demand. The demand also shifts, what I called, move up buyers and move down buyers, is influenced by capacity to pay as well, but those go a little bit hand in hand. As more people move into the market, then there is more demand for housing. As households are created, then that creates more demand for housing.
Household creation is slightly different than population growth because when you’re looking at a family where there are lots of young children, then the number of people per household is large, so you need less houses. As that population ages, then the people are creating more households, then you’re going to see a shift. If you’re really a demographer, you could look at a marketplace and say, “There’s a population segment that has a lot of young families. There’s a gap when those young families start creating household formation, there’s going to be a higher demand.”
What we’re seeing now with just generational expectations, there’s a lot of younger people that don’t have meaningful work or career work. There are a lot of people sleeping on couches. There are a lot of young college graduates who are still living with mom and dad. They want housing, everybody wants a nicer house and a bigger house, that’s demand, right? If you’re giving out free houses, everybody would take one. The capacity to pay is limiting the people’s ability to enter into that home purchasing market. When that capacity to pay changes, the question is, are there some sleeper demographics there, people on couches, people living with mom and dad, late to launch demographics that are going to increase demand for housing in the near future.
The other is the opposite. Is the population aging in such a way that people are not buying houses or what kind of houses are they buying as the population ages that will change? The other thing is looking at population shifts, just influx of population. There’s a general trend happening where people are moving from the Midwest and the north, they’re moving to the west and to the south. There are moving companies that publish national trends of moves that say, “How many people have moved from point A to point B versus in reverse?”
A really cheap and easy way to see demographic shifts is you can say the price of U-Haul truck from Los Angeles to Dallas and then price that same truck in return from Dallas to Los Angeles. Based on current market trends, it’s significantly cheaper to go from Dallas to Los Angeles, one-way than vice versa. That’s because there are so many people that want to do that Los Angeles to Dallas one-way move and not as many people that want to do the reverse. They incentivize the prices for people who are willing to bring those trucks back to Los Angeles.
That’s the U-Haul report. We just published that on our blog not too long ago, maybe two or three months ago. It’s very interesting. It shows you where people are moving to. They rank all the states in order. Texas was, I think, the first or second on the top of that list as far as where people are moving to. Interestingly enough, places like the Rust Belt up in the north east, parts of California where it had a pretty strong negative net migration out of state. Those are interesting studies.
There was one other thing I want to mention about demand. Pent-up demand, you were talking about some demographics. I think millenials because of the lack of capacity to pay that comes down to lack of jobs or lack of career type jobs. A lot of these millenials are staying at home creating larger household sizes. The day will come where there’s going to be a boomerang effect. I think, these people will eventually move out of the home and create demand. That could be a demand for apartments. It could be a demand for starter homes.
If you can get on top of that trend now and see where they’re going to be moving to or what they’re going to be buying, as far as product type, I think you could position yourself as real estate investor to take advantage of that coming wave. I don’t think that’s going to be for a while, maybe five to ten years down the road. That’s just another variable that plays into that demand equation.
Also looking at density and the changes in density can also impact the supply for a moment. For example, in the South Dallas market in the ‘20s and ‘30s, people were building starter homes on half acre. Time happened and those homes became functionally obsolete because they were 900 square foot homes, three-bedroom, one-bath on a half-acre. That becomes functionally obsolete. The people left those neighborhoods in favor of three-bedroom, two-bath, two-car garage, 3,000 square feet homes and 2,000 square feet homes. There were people that left those neighborhoods behind in favor of gentrified neighborhoods.
Then you see the full swing come back once those houses have come to the end of their utilitarian life. They’re more valuable as dirt than they are as a structure. People scrape those structures and they aren’t building 900 square feet homes on a half-acre lot. They’re either going to split that lot into two. Now, you have two households or maybe four. Now, you have four households. Or they take this $50,000 Junker house, they scrape it and then they put McMansion on it. That becomes a half a million dollar McMansion on a half-acre lot close to the city center.
That’s an interesting way to also look at changing demographics and different types of supply. When you’re looking at what is being supplied to a market place, that is also important just to look at the supply, what is being supplied and the demands, I think. Not just the demands but what are people demanding based on shifts of demographics.
That’s a good example of highest and best use as well. What would you advise investors that are looking or at least trying to look at this whole supply, demand and capacity to pay scenario in order to be able to predict real estate prices? I’m sure for a lot of people that sounds rather complex and if it’s new to someone, they’re probably feeling somewhat overwhelmed because there are all these variables. Where do I find that information? How do I piece it all together once I have it? If you were to simplify this, what would you boil this down to as far as what to focus on, so you have at least a finger on the pulse of the market?
Great question. To make it simple, you just want to find the trend and invest with the trend. If you’re living in a marketplace where you’re fighting the trend, you probably want to invest outside of your local marketplace and somewhere where the trend is moving in the right direction. Where do people want to live? That’s additional demand. Where is the supply going to be restricted because of the various things that we talked about? If you can find those two magic equations, you’re heading yourself in the right direction.
Capacity to pay is a pretty easy thing to do, just by taking the median home price divided by the median income and you can see that multiplier. The lower that multiplier is, that’s the affordability ratio that you talked about, the more likely it is that prices could depreciate in the future. The higher it is, the more likely that market is in a bubble and it’s going to correct until that ratio is more affordable.
The other thing is looking at currency. That’s a little bit more complex, in terms of what the supply and the demand of currency is. An additional part of currency is velocity. The velocity is how quickly money moves. Consumer confidence is one way to look at or anticipate velocity of money. If you earn a dollar today and you stick it in your savings account and you don’t spend it, because you think that you’re going to lose your job and you want those reserves, then that makes velocity lower. If you have a high confidence in the future of the economy, you earn a dollar and you immediately go out and spend it, that’s confidence in the economy, that’s consumer confidence. That dollar gets spent more quickly. The more quickly that dollar gets spent, the more supply of currency there is in the marketplace which tends to push prices up. The more money there is, the more people have to use it.
Right now, what’s happening in the economy is the government has created an unprecedented amount of money. The actual money supply is gigantic. It has increased several folds in the last decade. The people have slow velocity. They aren’t spending the money. They get the money and then they don’t spend it. It just sits in an asset like a stock market, or it sits in an asset like precious metals or it sits in an asset like real estate. Once it’s in that asset and it doesn’t move, that makes velocity low.
When we see increased consumer confidence that means money is going to trade faster which means prices can go up. When we look at decrease in consumer confidence, money is going to move slower. People are going to hoard cash instead of spending cash and that will move prices lower. That’s what happened in the 2009, 2010 real estate crash. Not only did the banks pull in the money, they weren’t lending it because they didn’t have confidence. The banks didn’t have confidence they were going to get paid back, so they pulled the money out of the circulation. The consumers, when they had money, same thing, they pulled the money out of circulation to say, “I think I’m going to lose my job, so I’m going to just sit on this savings in case I need it. I’m not going to take that vacation. I’m not going to buy that extra big TV. I’m going to sit on the savings. You can also track on a nationwide basis or a local basis on what that consumer confidence is like. That’s a good predictor of what’s going to happen to the price, up or down.
I think just to be clear for the listeners, when you talk about currency, another way to look at that is just the amount of credit that’s available. You refer to it as currency, but really that’s anonymous to the amount of credit available to borrowers, not just through institutional lending organizations like your local bank, but even portfolio lenders. We’re seeing a lot of them today that are coming out. This is essentially private money outside of the institutional environment. They’re providing all kinds of loans. In fact, we’re starting to see stated income loans again. We’re starting to see asset based loans, which are not so much based on the borrower’s ability to repay, in other words their income, but it’s more based on their credit and the asset that they’re purchasing. We’re seeing a lot of that coming out today. That credit is increasing which means that the capacity to pay is also increasing. That’s going to drive more people into the demand side of the equation which will increase the velocity of the money, which will increase prices.
One other comment from an economic perspective here and maybe political, but these negative interest rates that we’re all hearing in the media right now which has not come to America yet, but I have a feeling that within the next twelve months or so, we’re probably going to see negative interest rates here. One of the reasons to have a negative interest rate in your checking counter savings account is to prevent people from parking their cash, their currency in the bank. They want you to take that and put it into the economy to spend it, to drive up the stock market, to put it into other assets.
It doesn’t make sense to keep your cash in the bank because you’re paying the bank to hold it. It doesn’t make sense to keep you cash in you mattress because inflation will eat it away even if it’s just nominal inflation, headline inflation, what the government tells you 2%, 3%, 4%. It really pays to keep your money moving and keep your money working for you. The best way to do that obviously, is through income producing real estate. That’s my commentary on your comments there, David.
People could put their money into the bank and earn a rate of interest that’s significant to them. They had peace at night knowing that their money was safe. You wouldn’t need to be into income real estate. Everybody would just have money in savings accounts. As bank interest rates savings, as they push those interest rates down and they pay less and less for interest, people who have a need for income are pushed to alternate assets like real estate, like mortgage investments, being a private lender and notes.
Being in the stock market is a pretty scary place to be, in my opinion, because the people that are currently buying big parts of the market, I’m talking about institutional investors, giant insurance companies and giant retirement plans like state teachers retirement plans and hedge funds. They would rather be in a safe treasury bond. They don’t want to be buying the shares of Apple and shares of Motorola. They want to be in a bond. As those bond yields dip below inflation, then they’re stuck. They have to take the money out of bonds into a riskier asset class like stocks or equities.
A scary thing that could happen is as interest rates go up, the people who would rather be in bonds are going to sell their equities and breath the sigh of relief and say, “I don’t have to be in that risky equity anymore, let me go to the safety of bonds which is where I wanted to be all the time.” That change in interest rates or a significant increase in interest rates could very well result in a significant decline in prices as people shift away from equity positions to debt positions as lenders. That’s just something that I would caution people about who are stock investors while the market is in an all-time high. Can it go higher? Maybe, but I don’t thinks so.
Anything is possible, but there’s so many economic factors confounding at the same time that say there’s a potential risk for staying in a stock market. Simultaneously, someone can go get a 30-year fixed mortgage at 4% to 5% to go buy a piece of property lift. If you could go buy a property paying you a 6% yield and you could borrow most of the money at 4% to go buy that property with, how much money do you want to borrow it for to invest at 6%? A lot, how much can I get? Load me up with that.
I think there’s a growing concern with the equities market, particularly in stocks. In the last few weeks, I’ve had two investors approach me and talk to me about their positions. We’re talking very, very significant positions in the stock market. They realized that they need to start divesting, maybe not entirely, but at least a very measurable portion of it. Unfortunately, we don’t have a free market. If we did, the stock market would’ve corrected a long time ago and it probably would’ve been in a pleasant, nice, orderly correction. I think, at least this is my fear, the stock market is poised for a massive correction. Nobody can predict when. I don’t have a crystal ball. Personally, I think we’re going to see something fairly significant in the next twelve months.
If you’re heavily vested in the stock market and this is not financial advice, by any means, but me personally, I wouldn’t be in the stock market right now. If I wasn’t in it, I would start divesting just to, at least, hedge my position. If not, just completely shift and move out of that asset and into a safer or income producing type of investment, instead of speculative investment that’s based on nothing more than capital gains and lacks dividend payments these days.
I pay attention to the stock market because it influences the wealth factor, the wealth feeling which is also consumer confidence. As the stock market is plummeting, wealthy people feel shy. They don’t spend as much because their 401K plan is down and they think “The stock market is down twenty points. I’m going to have to work an extra ten years to retire.” They start spending less. When I am looking at the correlation to real estate prices, I think if there is a significant correction in the stock market, which I think is coming, then the median income in up. The people have discretionary income and the people who are heavily invested in the stock market or that move up buyer, the median income and higher, I think they are going to feel the pitch. I think that those buyers might not be moving up. They might buckle down and move down a little bit in their home purchases. They might just buy laterally rather than buying a bigger home. They just buy a home consistent with what they currently have.
That’s a very fair assessment and prediction. Only time will tell. We’ll find out soon enough. David, we’ve been running one hour on this recording here and I think maybe we should start wrapping it up. Is there anything else that you want to share with our listeners before we bring this to a close?
Hey, Marco. I want to say thank you to all of your listeners who are listening today because they make the show worth doing. I want to say thank you so much for being a great friend and for running so many awesome resources and investment opportunities to the world. I think you’re offering a great service.
Thanks for that, I appreciate it. David, tell our listeners how they can find you and learn a little bit more about what you’re doing.
My blog at HassleFreeCashFlowInvesting.com has a ton of great educational resources available for free. Lots of e-books, videos and blog articles that have been named one of the top 100 real estate investing blogs in America. I just want to encourage listeners to pop on over to that site and start up a conversation or just read some blogs or download some great free content.
Awesome. David, as always it’s great having you on the show. I appreciate your time. We’ll look forward to having you again sometime in the next couple of months.
All right, David. Thanks again.