More Real Estate

The first signs of real estate dipping appear to be in San Diego. Eighteen months ago, there were 2,916 homes for sale in the county. Today there are 13,204 homes for sale.

My new landlord admitted to me that he overpaid for the building (pictured above). I was somewhat surprised to hear this from a recent buyer, but pleased nonetheless. Nobody wants to have a moron for a landlord.

He told me that he did a 1031 Exchange, which is the buying of one property from the selling proceeds of another within a period of 45 days (I think this is the number), all to avoid paying capital gains on the sale. Let’s clear one thing up, you can’t really avoid paying capital gains tax – all you can do is defer it. Right now long term capital gains are 15%. There is no guarantee that they will stay that low. In fact, in 2013, they are already scheduled to rise above 20%.

The scary thing is, in the last 4 days, I have heard 4 separate people tell me about 1031s. No one wants to sell their appreciated real estate and cash out. Again this is redolent of the 2000 stock market where seemingly nobody sold at the top.

I maintain that my landlord would have been better off taking his capital gains – assuming they were long term (over 1 year). After paying the 15%, he could have put the remaining 85% in some fixed income securities. Even if he went for the boring 10-year Treasury Note, he could get just over 4.1 % after commissions.

In a previous blog, I showed that the landlord will earn at best a 3.7% yield on his investment. So compare that yield to 85% of the 4.1% 10-year note which is 3.49%. So this whole tax deferment is for a gigantic .21%. Furthermore, the landlord could easily improve on his fixed income yield by putting part of his wad into high yield (junk) bonds – which currently are paying around 6%.

I just don’t see what is so bad about realizing capital gains, taking some time off from landlord duties, and waiting a couple of years for a better reentry point in the market.

This brings up a few points about renting that I haven’t seen addressed anywhere.

It seems to me that most landlords don’t have large mortgages, if any at all. Most seem to have owned the properties for some time and so much, if not all, of the rent they collect (net of operating expenses) flows into their pockets as income.

So in terms of renting apartments, these un-mortgaged landlords essentially have very low costs structures. This helps explain why rents haven’t risen in the last 5 years.

Another thing that I keep hearing it that now is a good time to invest in apartment buildings. The theory being that at today’s prices, soon first time buyers will be unable to afford homes and will be forced to rent. First of all, I have been hearing this for 5 years straight – all the while starter homes have gotten more and more expensive.

Apartment building sales prices have risen, in fact to astronomical levels. By this I am using the metric of “price to rent roll”. Today buildings are trading around 20 times annual rent. (Remember my building, the landlord paid $1,000,000 and that is roughly 20 times the $48,000 in gross annual rent he will collect this year.)

Historically, rental buildings have traded at 10 times annual rent and even lower than that. Only a small amount of this multiple expansion can be explained by lower interest rates. At some point, the gap between rents and sale prices will have to narrow. Most real estate perma-bulls think rising rents will do the trick but I fear this is just more wishful thinking on their part. As I addressed above, I think many landlords have little to no mortgages and will only be forced to raise rents to the extent that all landlord costs rise, e.g. rising property taxes. Anyway, here is a good article that defies the conventional thinking of “rents have to rise”.