Revenue multiples, anyone?
Do you know what a rent multiplier
is? Are you afraid that California real estate prices have peaked and
not sure what to do or where to invest? We’re
going to cover these topics and more in this special edition of the Whitwell
Report.
As you probably noticed, I took a
few months off from the newsletter to focus on my day job: running Tierra
Capital, L.P. Tierra Capital is a real estate investment firm that focuses on
land, apartment buildings, condominiums, and mixed use assets in Texas and Florida.
This weekend I am writing from Los Angeles, where I was asked to participate in two real estate seminars organized by two successful Los Angeles-based realtors. Their investors are stressed out because they recognize that the wonderful 20-25% per annum gains they have seen in California the last several years are unlikely to continue much longer.
“Rent multiplier” is a real estate
term that was used quite a bit in the presentations by the realtors this
weekend. The funny thing, though, is
that the audience had no idea what this meant – even after one realtor tried to
explain the concept with a technical sounding formula.
The “rent multiplier” is the number
of dollars you have to spend in order to get one dollar of rent per year (gross
rent, before expenses). For example,
let’s say you buy a home for $120,000 that rents for $1,000 per month ($12,000
per annum). It has a rent multiplier of
$120,000 / $12,000 = a rent multiplier of “10”. Said differently, for every ten dollars you spend to buy that home, you
will collect one dollar in gross rents each year.
By way of context, the multipliers
in Texas, North Carolina and Oregon tend to range around 8-12x on
average – but in California, they are nearly 30x! This means that for every $30 dollars you
spend on a
A better way to measure the
performance of a potential investment property is to measure the actual net return
you expect to get as a percentage of the purchase price assuming you buy using
all cash (no debt). This calculation
takes all expenses into account and in the real estate world is known as the
“cap rate.” If you buy a home for
$120,000 and you expect to pocket $9,600/year before taxes, then your cap rate would be $9,600
/ $120,000 or 8%. The cap rate is a
realistic measure of the underlying profitability of the real estate investment.
Whitwell Rule #1 – it is extremely
important to understand how to measure the profitability of your real estate
investment before the effect of leverage.
Why?
Let’s answer this question by first reviewing
the two reasons why people use debt to help finance the purchase of real
estate: (a) to reduce the cash needed to buy and (b) to increase the
“profitability” of the investment.
To understand the latter point,
let’s look at an example. If we buy a
$120,000 house all cash, our return might be 8%. However, using bank financing, we might only
have to put down $24,000 in cash and can get a loan for $96,000 from the
bank. Let’s say we have to pay the bank
$6,000 in interest, well then that leaves us $3,600 in profit. By using leverage, the dollars we get are
fewer but as a percentage of cash we invest, the returns are much higher
($3,600 / $24,000 = 15%).
Because the returns are higher and
because cash is a scare resource, it is common for people to use a lot of
leverage when buying real estate. Using
debt in situations where the underlying profitability of the property is strong
has great advantages. Using leverage as
the primary means to achieve high returns when the property itself is not that
profitable is a formula for disaster!
Whitwell Rule #2 -- Focus on the
underlying profitability of the property first before being romanced by higher
return figures produced with leverage.
Whitwell Rule #3 -- Focus on cash
flow.
Hint: almost nobody in California real estate is paying any attention
to cash flow – this is because the prices have been bid up so high that they
make no sense if you look at the cash flow.
This whole scenario should remind
you of the tech stock craze, when, we briefly believed that cash flow and
earnings were unnecessary in tech companies because “they are special” and
“there is tremendous future growth potential”.
I love California– the people, the weather and the land, all three of which are beautiful, but we all lost too much money in the tech bubble crash to fool ourselves into thinking that California real estate will always go up. Indeed it fell nearly 40% in the early 1990s, but many speculators believe ‘this time is different.’ Sound familiar?
There are two additional signs that California real estate is living on the edge:
Whitwell Report Sign of Caution #1 –
according to recent reports, over 60% of all California real estate mortgages being taken
out to buy these price-inflated homes are floating rate mortgages. This trend is increasing system risk since
further increases in interest rates could boost mortgage bills and put many careless investors into hot water.
Whitwell Report Sign of Caution #2 –
almost 80% of Californians living in
By the way, the average cost of a brand new home in Austin, Texas is only $160,000 – and in Austin, we do not have state income taxes, we do not have earthquakes, and the overall cost of living is substantially more affordable than Los Angeles. Sell Los Angeles and buy Austin.
The best way to buy real estate is
when the rental cash flow covers the cost of owning the property so that you
can afford to hold it for long term appreciation. If the market happens to go up substantially
in a short period of time, then that is cause for celebration – but this should
not be the premise upon which to buy real estate. If you buy real estate in California right
now, it is risky since “the carry” (the net cash cost of ownership, including
the cost of any debt) is negative and the only reason people are buying is that
they are hoping to get extraordinary price appreciation in short periods of
time.
Austin, Texas continues to win national
attention for the quality of life, its outdoor beauty, its intellectual
and artistic community, and the vibrancy of its economy (a small tech
company was founded that is still headquartered there called Dell).
In the next Whitwell Report, I will
share with you some fun and exciting (and surprising) facts about
Austin and about Texas in general.
If you own California real estate, count your blessings
for having enjoyed such a spectacular market the last couple years and do the
smart thing: take your money and run. If
you live in
A friend of mine who runs a real estate investment fund in Los Angeles is actively selling his portfolio. He has made great returns for his investors but prices have now reached such an insanely high level (relative to cash flow) that he feels compelled to sell.
Should be very interesting to see
how things play out in California. Don't be left the last person standing when the music stops.
Make It Happen!
Stefan,
Hisashiburi desu! Based on my discussions with him, my younger brother just did this - sold their Bay Area home and are moving to Colorado. Not quite Texas, but the comparisons have made him a believer that its just crazy to try an keep your head afloat in such a heated bubble housing market such as the Bay Area.
- Jonathan
Posted by: Jonathan | Apr 23, 2006 at 07:29
Stefan, glad to see you're back!
Posted by: matt | Aug 07, 2005 at 23:29