Investing Versus Flipping Chris Brightman, Research Affiliates

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Key Points

  1. High stock prices, just like high house prices, are harbingers of low returns.
  2. Investing in price-depressed residential rental property in Atlanta is like investing in EM equities today—the future expected long-term yield is much superior to their respective high-priced alternatives.
  3. Many parallels exist between the political/economic environment and the relative valuation of U.S. and EM equities in the periods from 1994 to 2002 and 2008 to 2015.
  4. Our forecast of the 10-year real return for U.S. equities is 1% compared to that of EM equities at 8%, now valued at less than half the U.S. CAPE.

I have the good fortune to live and work in Newport Beach, California. Among the global investment community, Newport Beach may be known as home to PIMCO (and, of course, Research Affiliates). Locally, however, the business of Newport Beach is real estate finance. Many of my local friends have made a bundle in recent years flipping houses in Orange County (the OC). I have also purchased some houses over recent years, but as an investment rather than as a flip. In this article, I explain the difference between investing and speculating by sharing my personal experience investing in residential real estate.

A Fireside Chat

This story begins four years ago when Dave, a longtime friend and real estate investor from Atlanta, was visiting my wife, Donna, and me in Newport Beach. Sitting by the fire pit in our backyard after dinner one evening, sipping a nightcap, we chatted about business.

Dave explained that the residential real estate crisis had hit Atlanta hard. Countless thousands of homes had been foreclosed and were owned by banks across the sprawling metropolis. The best bargains, he explained, were houses in the older and less wealthy areas of the city. The big private equity firms (BlackRock, Starwood Waypoint, and Colony Capital) were starting to gobble up foreclosures and bid up prices in the easy-to-value suburbs, but they were ignoring the less homogeneous urban areas, some of which then, as now, may seem unsafe, but many more are solid working-class neighborhoods.

Dave was buying vacant single-family homes out of foreclosure in decent neighborhoods for $10,000 to $20,000, investing another $10,000 to $20,000 in renovations, and then renting the renovated properties for $800 a month. His problem was that he couldn’t sell the houses—not for any price. Credit was then, and still is, unavailable to most of the folks who live in Atlanta’s lower income neighborhoods.

Before the housing crisis, banks were fighting each other to lend money, to buy houses at ridiculous prices and on ridiculous terms. As a result, after the crisis, Dave owned many properties across Atlanta, all leveraged to the hilt. Even though he was comfortably solvent and current on all his properties, he couldn’t get another dime out of any lender to buy rental properties.

How do you know, I asked, that these houses are sensible investments? Houses in Detroit are cheap too, I observed. Unlike Detroit, with an aging and shrinking population, Dave explained, Atlanta is a vibrant growing city. How do you know the price is right? Are you kidding, he asked? I am buying houses at a small fraction of replacement and renting them at 25% of my cost. I get my money back in rent in four years!

Over the coming days, Donna and I talked about getting into the residential real estate business. Our alternative investment opportunities in the U.S. capital markets at the time, much like today, were 2% bond yields and 2% dividend yields. Investing in houses seemed an attractive alternative. Thus began our business of investing in houses in Atlanta. We are still buying there today.

Relative Value of Houses

Let’s compare the housing market here, where we live in the OC, to Atlanta. The best bargain we can find in the OC is a three-bedroom, two-bath house that sells for $500,000. Yep, for those of you unaccustomed to California real estate prices, the cheapest houses in OC fetch half a million dollars. We could rent one of these houses for $2,000 a month.

As shown in Table 1, the prices in the OC are—to anyone who doesn’t live here—insane. If we were to invest in a house today as a rental property in the OC, our net annual rental yield (annual rent minus taxes, insurance, and property management) would be about 3% before tax. Of course, we can reasonably assume that home prices rise with inflation, so this is a real yield. Not bad. But California and the IRS tax even the inflation portion of the return.  This yield is then mostly taxed away, at higher rates than in Atlanta, to deliver less than 1% real return, after income and capital gains taxes. I don’t like this investment. House prices can go down as well as up. The high prices in the OC seem risky to me.

Instead, we buy houses in Atlanta. Today, we buy renovated “three/two” houses (three bedrooms and two bathrooms, in the parlance of the trade) for $80,000, and then rent them out for $850 a month. As shown in Table 1, our net pre-tax rental yield is 9%, and approximately 5% after tax. I have strong conviction that buying rental properties in Atlanta at a 5% real after-tax yield is a far more sensible and safer way to accumulate wealth for our retirement than buying rental properties in the OC with an after-tax yield of 1%.

Investing vs Flipping

Flip That House?

Now, to some of my house-flipper friends in Newport Beach, the OC seems the better bet. The OC is local, prosperous, and safe. House prices have been rising rapidly for many years; they’ve even recovered the full damage wrought from the 2008 global financial crisis. Atlanta, in contrast, seems far away and scary. They have a point; the urban neighborhoods of Atlanta have a very different socioeconomic profile than Newport Beach and must deal with the corresponding issues of a less educated renter base, a less prosperous population, and a higher crime rate. I can confirm that Donna and I don’t feel quite as safe when wandering the streets of the neighborhoods in Atlanta where we search for houses as we do during evening strolls through our quiet neighborhood in Newport Beach. That’s, in part, why a comparable house costs $500,000 in the OC, but only $80,000 in parts of Atlanta.

When my local house-flipper friends ask how I can be sure that house price appreciation in Atlanta will outpace house price appreciation in the OC over the coming year, I respond that I have no clue about the prospects for short-term price changes. If I had to guess, I would pick the OC as the hotter market. But I am not flipping houses, I explain. I am investing to build long-term wealth.

When my local house-flipper friends ask how I can be sure that, when the next housing crisis comes, house prices in Atlanta will decline less than houses prices in the OC, I say that I expect and hope that they will decline more. For savers like me, price volatility is opportunity not risk. Three years ago, we were buying houses in Atlanta for less than $50,000.

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