Why Real Estate Advice Is Dangerous: Hyperlocality

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Everyone seems to have a gut reaction about real estate as an investment, and those opinions clash violently. I used to wonder about this – at family gatherings, my intelligent cousin would try and convince my equally intelligent uncle from across the country why real estate was an excellent bet, and my uncle would maintain that it was a risky money sink.

How can incredibly thoughtful, well educated people differ so strongly on what should be an arguably objective topic? It wasn’t like they were just arguing over their risk tolerance. They were arguing over the actual performance of the housing market! Isn’t there data to support one view over another?

There is, and it explains why this blowout occurs, with implications on who you should and should not take advice from.

Real estate is hyper local. And because we tend to absorb data about real estate through osmosis (driving around, hearing stories from our friends on how their home has sold, etc.), we are a reflection of the performance of the specific places we grew up in.

What’s more, real estate has gone through a tectonic shift in the last 10 years, specifically with the subprime crisis. That major exogenous force – and the ensuing gangbusters recovery in many areas of the country – are perhaps once-in-a-lifetime experiences, which create not just a difference between different geographies but between different generations. If you are under the age of 35, you have a very different subset of data you are drawing from compared to older generations.

 

Real Estate is Hyper Local

As it turns out, real estate performance is hyperlocal. Buying a share of Microsoft is buying a share of Microsoft. But buying a house yields hugely different performance depending on where in the country you live.

US Housing Price Appreciation – Last 10 Years (2005-2015)

Two Strategies - 10 year

Chart from Brian Larrabee

 

US Housing Price Appreciation – 5 Years (2010-2015)

Two strategies - 5 year

Chart from Brian Larrabee

 

It makes total sense that sitting in California the last few years, you are desperate to get in on the gold rush, with your broker warning you to “get in before you are priced out!” And it makes total sense that your Aunt and Uncle in Connecticut or Arkansas give a giant yawn when you talk about it. Why is their nephew so crazy about houses? The stock market has done way better for them!

The hyper local focus goes even deeper. Check out this chart of North Texas 2015 Appreciation, spanning from Denton County to Ellis County, the area which surrounds the Dallas-Ft Worth Metro. Oak Lawn residents (red – zone 17) aren’t going to have the same opinions as their neighbors in Oak Cliff (green – zone 14).

 

texas

Graphic from Dallas Morning News

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Even Strategy Is Hyperlocal

Two areas can both have shown strong performance for real estate investments, but the approach that worked may be different. In the bay area, it is common to bank on appreciation to make you money, and that means that the carrying costs of the house (property taxes, maintenance, etc.) often exceed how much you can generate in rent. However, in other areas of the country, appreciation is much lower so investments only make sense when there are high rent to property value ratios. This is why your Aunt might think you are foolish to be investing in a San Francisco property that is negative cash flow.

top 10 appreciation

top 10 rent to value ratio

Charts from Bigger Pockets’ 2015 Real Estate Market Index.

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Takeaways

Approach the advice of folks who live in a different geography with caution.

Take care to view your appreciation estimates in light of the incredibly unique events of the past decade (the subprime crisis and subsequent recovery). Realize that folks from different generations have different subsets of data to work with and that the run-up in real estate on the coasts in the last 5-10 years is partly driven by a once-in-a-lifetime subprime crisis event.

Go extremely local in your research and focus on the drivers for growth in your chosen neighborhood, district, and state.

Real estate can be an extremely lucrative investment, but its performance is highly tied to hyperlocal conditions.

 

 

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2 Responses

  1. Maxime says:

    Hi,

    My name is Maxime and i’m from belgium. (28 Years of age – 9 to 5 Job 🙁 )

    I ended up on your page by pure coincidence and find it fascinating.

    I was wondering if perhaps you would have some piece of advice to hopefully get me to where i wanna to be.

    I own a property in Brussels (500.000 $) with positive cash flow and made some money by selling the large garden in the back. (90.000 $)

    My initial idea was to use the money to buy another piece of property that pays itself with the rents i collect (Pay off the mortgage) from my tenants and get “rich” over time. But at the same time, i fear i will not be able to progress at a good pace if i decide to do so.

    I literally read any book i can lay my hands on as far as real estate in concerned, but i don’t necessarily feel that i am using my time efficiently.

    The way i see it is, low interest rates = Best time to use the money i have to buy some real estate as long as i can pay off the mortgage.

    do you reckon this is the path i should be taking or is there any other investment i should be looking at?.

    I hope that everything i am saying makes sense to you.

    Looking forward to hearing back from you.

    Max

    • JP says:

      Hey Maxime,

      It sounds to me like you’re already well on your way to FI. There are two interesting components to your message. The first is determining whether real estate/investment properties is the fastest way to get you to your goal of financial independence vs other investment opportunities available to you (like stocks, bonds, starting a business, etc.). And the second, related, is whether the low interest rate environment is a tipping point to making real estate the best choice for you over other investment opportunities.

      Cheap leverage is pretty much always a good thing. You get to borrow money for a relatively low cost and hopefully put it into something that generates higher returns than what you have to pay in interest, so you get to keep the spread. But if you get a mortgage, you don’t have to necessarily deploy those borrowed dollars in a house. You can, for example, refinance a fully paid off house and take the money and dump it into bonds, for instance, or stocks depending on your risk profile. I write about that here.

      As for whether buying more investment properties is the best strategy for you, I’m unfortunately not well-versed enough in the market in Belgium to have a stance. What I will say using my US-centric example, is that you can compare whatever the expected IRR on your investment property is to what you can get in the stock and bond markets you’d be willing to invest in. For the US, the Standard & Poor Index has yielded a 10.6% CAGR from 1926-1995 and a slightly lower 8.2% CAGR from 1995-2015. So my view is when I look at an investment property, if I think I can do better than an 8-10%+ return year on year, then I would strongly consider it. The calculation of the investment property’s IRR will take into account the cheap leverage you’re able to obtain as an advantage and will tell you whether it’s worth proceeding. There are numerous investment property IRR calculators on sites like BiggerPockets.

      It also depends on what your personal preferences are. Do you like doing the work of a landlord vs more passive strategies like dumping your money in index funds? As a retiree, I value the steady cash flow of investment properties and the diversification into a different asset class (real estate). So I find this very appealing. What else are you invested in and do you have a timeline for when you’d like to retire/be financially independent?

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