Feature
by Jim Forbes
If you were thinking that the year 2002 would bring some good real estate buys after the collapse of the dot-com bubble, you were wrong. I know I was wrong.
Instead, the decline in the stock market has pushed real estate prices higher. Everywhere I search for something to buy, even along the entire West Coast, as well as San Francisco, brokers say the same thing—rents are dropping and prices are rising. Go figure. Well, I’ve been figuring and I conclude only one thing—people are desperate to invest their money.
Look at the alternatives. Stash your money in a passbook account and you get 1 percent. True, you won’t lose any principal, but 1 percent on your money is not too exciting. At this rate, you could have $10 million in the bank and receive an income of $100,000. In San Francisco, for a family of four with private school tuition, health club dues and a mortgage, $100,000 just doesn’t cut it. To break even after taxes, the average upper-middle class San Franciscan would need about $25 million in the bank—and that’s cutting way back on vacations.
Clearly saving your money isn’t an option. How about the stock market? Okay, enough said on that topic. Now what’s left? There are bonds. I’ve heard WorldCom bonds are trading at a discount, as are those at Enron, Global Crossing, Adelphia, and soon at many other corporations once they admit what their corporate officers and board members already know.
What about municipal bonds? Depending on the municipality, yields are as high as 5 percent. Even California bonds pay in the high fours and have an A rating. This rating should remain if Governor Davis can figure out how to plug the $26 billion deficit and George Bush’s energy friends don’t figure out another way to scam the state with fraudulently high costs for energy.
However, bonds are basically boring and, despite their low yields, risky. Definitely risky if the whole economy is headed into the tank.
So what does that leave? Real estate. Of course! I should have thought of that. Real estate. Okay, let’s look at the numbers. If you assume rents have bottomed out—a distinct possibility in San Francisco—apartments in the safer parts of town are selling about 11 to 13 times their gross income, which translates to about a 5 percent cap rate. Stated another way, if you buy a building with no debt at all, you will earn 5 percent on your investment. This is approximately the amount you would receive if you commit your money to the federal government for thirty years, and it is a heck of a lot better than the saving account’s 1 percent or the negative 98 percent you might get from the stock market.
Now if you borrow on that piece of real estate, you could still have some cash flow. Why? Because interest rates are at an all time low. Borrowing at half a percent higher than the going cap rate in San Francisco is historically about par, if not a bit cheap.
To borrow at 5.5 percent for a property with a cap rate of 5 percent is the approach you should take. The net result is cash flow of about 3 percent with a 50 percent down payment, or you can break even with 25 percent down. Again, this sounds about right for San Francisco apartments. The absolute result then is that these historically low 5.5 percent interest rates have pushed the brick and mortar value of real estate to an all time high.
Consequently, there are no less than two reasons why real estate prices are rising while rents are dropping or at best staying flat. First, there is no other place to invest that seems as safe; and second, borrowing rates are incredibly cheap, making acquisition easier.
Both of these reasons make me laugh, and leave me a bit confused. If you consider the first reason, owners are willing to have commercial tenants from the same companies whose stocks the property owners themselves don’t want to own; or they are willing to have residential tenants who are employees of these same pharaoh companies. Either way, I see the problem that investors are having with equities will probably circle around and bite them with real estate.
In terms of low interest rates, these are transitional. Once government borrowing increases because of a drop in tax revenues or another middle-east war, we could see rising interest rates without a corresponding rise in real estate values. Further, low interest rates enable people to hold onto buildings that they should either sell or give back to their bankers, which is an artificial way to keep prices high and supply low.
In addition, the economy is getting a push from refinance proceeds as people pull money out of their homes without an increase in mortgage payments. Yet this is also temporary. Eventually excess equity will dry up and the slow down in the economy that we should feel right now will finally be felt. Indeed, when it comes to bubbles, a very good argument can be made that the Bay Area real estate bubble is not even leaking, let alone popped. What worries me is that when the bubble does burst, it is going to hurt a lot more than the stock market collapse.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. Jim Forbes is president of Urban Properties, a real estate investment and brokerage firm. He can be reached at 415-922-8998 or at his Web site. © Copyright 2002.