When evaluating market areas for prospective real estate investment, the most common element that people examine is the price history. This makes sense for many reasons. In most cases, price data is what we can most easily find about a market. Price appreciation is also the primary source of value for many people who depend on buying into a price escalation to realize the profits from their real estate investing activity.
However, in order to adequately incorporate the impact of price trends on our investment portfolio value, we must understand the importance of stability vs. volatility on our investment returns. The reason why this is of such importance for investors is because the returns you will be able to generate from volatile markets are critically dependent on “when” you buy and “when” you sell.
To illustrate this situation, we will be departing from the traditional orthodoxy of simply showing price appreciation over long timer periods to show the full picture of how market ROI profiles differ based on “where” you buy, “when” you buy, and “when” you sell. Understanding this picture is a critical component of making informed investment decisions.
What this analysis uncovers is the importance of including leverage and cash flow into our assessments of relative opportunities between real estate investment markets. The most impactful insight that is generated by this analysis is the effect of carrying an investment property that generates negative cash flows. The reason why this matters so much is because a negative cash flow must be offset by positive leveraged appreciation just to break even. Conversely, a positive cash flow investment property can be carried through price disruptions without adverse impact.
When operating in cyclical markets, investing success is a matter of exceptional timing since positive appreciation is needed to compensate for negative cash flows. This means that you need to buy at the bottom and sell at the top. Conversely, when investing for cash flow, success is a matter of exceptional patience. The reason for this is because over the long-term, real estate tends to appreciate at the real rate of inflation. By generating positive cash flow to pay for the costs of carrying the property, you can leverage this inflationary appreciation through the mortgage on the property to generate long-term returns.
To illustrate this principal, we have created three comparisons of major markets from the Case Schiller index. Each analysis incorporates the price index movements from Case Schiller, Rent to Value ratios based on market average prices & rents from Zillow.com, a 30 year amortization of a 5.5% fixed rate loan, and expense ratio forecasts that are adjusted based on the relative carrying costs of the respective markets. The comparison pairs we will be examining are San Francisco versus Atlanta, New York versus Denver, and Las Vegas versus Charlotte.
Next Article: San Francisco versus Atlanta
