There are several reasons why people buy anything at all. It is not my intention to explore all these reasons for that is a topic more pertinent to psychology than to investing. We will explore the reasons why I buy anything because, well, this is after all my blog and I will do whatever the hell I please.
The first reason is consumption. This includes food, clothing, rent, gym membership etc. These are things I need for living. This has been the bulk of my spending so far. We will no longer talk about consumption on this post.
The second reason is investment. An investment is basically something that will pay off over time. It usually never pays off immediately. This comes under the category of buying machinery for a manufacturing plant, or investing in a company that will develop a wonder drug, or taking a loan to pay your tuition for that engineering degree. These are all investments. It is called an investment simply because it is expected to produce value in the future.
The third reason is for generating income. This is the topic of this post. And it is in this context that we shall discuss U.S. Real estate. While I was living in the United States there was a housing boom going on there. Simultaneously in my own province in India, there was a bubble in land prices. U.S. houses as well as Land in Andhra were touted as investments. The reason they were cited as investments was that the value would go up over time. Nobody bothered to explain to me why their value would go up over time. Nobody seemed to have any clear idea either. We kept hearing vague generalities such as “They are not making any more land” or “the population rises, but land does not increase” or some such nonsense. Nobody explained why that was a sufficient reason for land prices to keep going up. After all population had been going up for a long while. So why were land prices going up like this only now? What changed? Nobody had any coherent answers. They had plenty of made up answers. Land prices were going up like crazy even in far flung villages. This topic itself is a more an area of research more for psychiatrists than for investors. So I will not cover it here. Go to google and type “indian real estate bubble” or “U.S. housing bubble” to get all the info you need.
First, I ask myself the question, Why is land valuable? How must we determine it’s value? To me land is valuable if I plan to do something with it. Someone must have plans to use it to produce something of value. If the land just sits there, it has no value. So if you hope to make money out of the land, you must either do something with it such as grow food, build a factory that produces goods, build an apartment building and rent it out to tenants, or build an office building and rent out office space. Either you must do it, or you must sell it to someone who plans to do something with it. Someone who plans to produce value with it. If you just want it to sit there, it’s value is zero, nada, nothing. Unless you are one of those people who get’s value out of gazing at empty land. I assure you I am not one of those people
Next question, How would I value land? Here is where the question of Yield comes up. How much can I generate from that land? Suppose you bought some land and a house on it and you rented it out. In how many years do you expect to get your money back? To me the answer is under 20 years. If I get my money back in 20 years, then it is a good deal. If you get your money back in twenty years, the rental yield is then said to be 100/20 = 5% per annum
Given this information, let us try to evaluate the rental yields in A city in India called Hyderabad. This will illustrate to you exactly why I believe Rental property in Andhra is a bubble.
Price of home in prime area with clean title = $500,000.
Tax on that home = 8% * $500,000 = $40,000
Total home price = $540,000
Yearly rent on said property = $7200
Maintenance cost on said property = $1200 per annum
Total income = $6000 per annum
Tax on that rent will be assessed at 33%. Remember anyone who can afford a home like that probably is in India’s top tax bracket and already pays 33% of his/her income in income taxes. Thus the extra $6000 he/she makes on this will be taxed at the same rate
Tax on rental income = 33% * $6000 = $2000 per annum
Actual rental income = $4000 per annum
Rental yield = $4000/$540,000 = 0.7%
You will get your money back in 135 years if you invest in rental property. 125 years back was 1877. There was no aeroplanes, the sun never set on the british empire, the british ruled India, Adolf Hitler was not yet born, China was still under Manchu Rule, the boxer rebellion was 20 years away. Do you want to take bets on what the world will be like in 125 years? Exactly! That is why the Real estate market in Hyderabad is a bubble. Either House prices must come down or the rents must go up. Either the real estate prices are too high or the rents are too low. You can’t have it both ways. But rents are not too high. People are already unable to make household budgets balance and rent is a big component of that. So rents cannot go up any higher. Then we must conclude that the House price is too high. Personally, I think the house prices will not come down. The real estate lobby in India consists of powerful politicians and bureaucrats who will never let house prices fall. Thus rents will have to rise. And the way to do this is by devaluing the Rupee, i.e. printing more rupees and causing inflation. Thus the house price will remain at $500,000 while the rents, food prices, clothing prices all go up astronomically. This is exactly what is going on in India right now with the Rupees precipitous fall against the U.S. Dollar. To be fair, no one in India buys real estate for the Yield. They buy land as a hedge against inflation because the Indian Rupee is a really shitty currency. The Land helps them preserve purchasing power. The average Indian pays such a large premium for land simple because it is an inflation hedge. You could argue that they could buy precious metals, and in fact Indians do buy a lot of Gold. Land is just a way to diversify their savings beyond Gold. So in this context, Real estate in India may not really be a bubble.
Singapore also has the problem of very high house prices, but the yields are a little better at 1.6%. Basically in Singapore you will get your money back in 64 years. Ofcourse this is only for the property in areas like Orchard where foreigners are permitted to buy. This is not the case in the HDBs. The Rental Yields in HDBs are more respectable at 5%. But since I am single, with no plans to marry, the HDBs are out of my reach. Here is my analysis of HDB yields
Average HDB flat price = $400000
Yearly rent = $22000
Yield = 5.5%. Get your money back in 18 years. Very respectable
Now, let us get to the meat. U.S. real estate. In some areas the yields are spectacular. According to part of this article http://www.planbeconomics.com/2012/01/29/14-of-top-20-cities-for-gross-rental-income-now-in-us/, the house price to rent in JacksonVille Florida is 1.2! This means you get your money back in 15 months! This is incredible if it is true. This needs further investigation. The place I lived in the U.S. was texas. This state has very high property taxes at 2.4%. This prevented house prices going too high and consequently Texas never experienced the housing bubble. In Austin,TX and Dallas, TX, the rental yields are close to 10%. This I have confirmed with friends, This is incredible. And it makes me a bit suspicious. One thing every veteran investor knows is that if it sounds too good to be true, it probably is not. Why are house prices so low relative to rent. I got a few answers after interrogating friends
1. Banks are not lending like they used to: Earlier, everyone with apulse got a home loan. Not anymore. So forget about taking a loan to buy a house. You have to put 100% down or close to it. If you put less than that down, then you need a very good, high paying, stable job for the bank to lend. Basically, banks are willing to lend to people who don’t need the loan. Why does this not surprise me?
2. People do not have the money to buy the house: Most Americans live pay check to paycheck inspite of very Good salaries. Thus they earn enough to pay the $700 monthly rent, but they do not have the $30,000 needed to buy the apartment or Condo outright. This I know to be a fact. That the normal American is not a competitor. It is common for an American to make $3000 a month and still have no savings.
3. A lot of these properties belong to the bank. These were the result of fore closures where the person who borrowed from the bank could not keep up the monthly mortgage payments and so the bank seized the property. The banks want to get these properties off their Book ASAP. They are not in the property management business. They would rather sell at a loss and get them off the books rather than hold them or manage them. Banks do stupid stuff like this all the time and apparently this is standard practice for banks. Okay, so this makes sense.
But I still have a few more questions
1. Why are international investors not buying? Actually international investors are buying. Miami is full of brazilian buyers. Phoenix full of Canadians. Homes in these cities do not offer such fantastic yields. The Fantastic yields are in second tier American towns such as Lamar, TX where Foreign investors do not venture. Foreign money sticks to the Big American cities like Chicago, NYC, Miami etc.
2. Why are property management firms not acquiring these properties and making a killing? I am not sure of this reason. Are they restricted by law? Do they not have the money? Are the properties too spread out? Property management firms probably do not like to buy one house here and one there. They like to buy in chunks. This could be the reason though I am not sure. I need to investigate this reason.
There are several other questions
1. If I buy a house for $30000 that rents for $6000 a year. Will the state assess property taxes on $30000 or more. This is a real query because at one time houses in atlanta were selling at $12000, but the state assessed taxes as if the houses were worth $90000.
2. maintenance costs?
3. You cannot manage the house yourself since you are a foreigner. How much will a real estate agent charge? how to find a reliable real estate agent who won’t cheat you?
4. Tax rates on the rent?
There are several other questions which I need to think of before buying. But it looks to me that U.S. residential real estate in second tier towns such as JacksonVille, FL and Lamar, TX is definitely worth investigating