Let’s not mince words about it — The local real estate market in the Bay Area is going absolutely ballistic right now. Back in 2012, when I first started buying properties locally, I thought that each and every open house was an insane mad house with too many eager buyers wiling to do whatever it took to secure a deal.
Over the next few years, the flurry of interest has remained strong, but during the end of last year, I had this strong feeling that things were starting to taper off a little bit. When I was looking for properties to buy last summer, yes there was interest in the air, but it really did not seem like I had to overbid significantly to win Side Hustle #1, Side Hustle #2. In fact, most recently with Side Hustle #3, we won the deal at $10,000 BELOW listing. As short back as this past November, there was almost zero interest for these types of properties. For SH #3, I think we competed with just 3 other buyers, and I even had difficulty finding anyone who wanted to partner up on this deal!
The Fear Of Missing Out
How times have changed. Right now, properties in the Bay Area are flying off the shelves again. I have friends who are struggling mightily to win ANYTHING, and have now acquired the most dangerous psychological condition that exists with investing:
The Fear Of Missing Out (FOMO).
Like with anything in life, when you’re repeatedly told, over and over again, that your best is not good enough, it will make you hungrier and want to try even harder to succeed. With investing it’s no different, but a tad bit more simple — Throw in more money and remove even more contingencies in your offer.
When that doesn’t work, well, toss in even more funds… Which is exactly what is happening today. Have you heard of the Escalation Clause? Neither had I, until I found out that’s what some people are resorting to these days. In a nutshell, it works like this:
I’m willing to pay $X for your gorgeous home! However, if Buyer MB (money bags) comes along and offers $Y more, I’m willing to outbid him and pay $Z extra!
Can you say, crazy? These days, it doesn’t even make sense why a seller’s agent deserves to get paid for a transaction… In a SCORCHING enviornment, it’s a complete seller’s market and the house will sell itself! Even I (someone with no experience and no real estate license) think I could sell a home for over listing right now, easily! 😉
The Start of Buying Season
In a previous post, I argued that cash flow is NOT always king, and that appreciation (to build wealth) is also important. In that article, I used a specific example to illustrate my point, showing how much interest a desirable property can receive in the open market.
Here is that property again, from Redfin:
As mentioned previously, this particular property has a lot going for it. It’s located in a very good school district, is a single family home, is strategically centered around many high-tech jobs, and provides nearby access to many major freeways.
The listing price was reasonable, and if you had asked me earlier, I would have guessed that the property had enough potential to sell for about $700,000. Anything higher than that, I think the numbers just don’t make any sense, since renting would obviously be cheaper than buying.
Here are the numbers at $700,000 purchase price:
At $700,000 purchase price, the cash flow numbers don’t look attractive, but the total monthly payment isn’t world’s apart from what rent would fetch out in the open market. As a homebuyer, you could argue that this deal makes some sense because at least if you purchased as an owner occupant you would be building up equity (paying down principal) every month. Further, because the house has all the characteristics of a Class A property, you could easily argue that it has a good chance of appreciating further into the future.
For an investor, all I see is a lot of RED. If I was looking at such a property for a Buy and Hold, I would never even consider it; there’s no layer of protection offered, and another market crash would easily wipe out all your equity. Further, the above analysis assumed a massive downpayment of $175,000, which is a huge sum of money to be depositing into a cash flow NEGATIVE investment.
Market conditions will always dictate what moves you can make as an investor, so always stay open-minded and fluid. But even early on in late 2012, I realized that cash flow was tough to find in desirable single family homes. Ever since I started investing in Bay Area properties, my “sweet spot” strategy has always been to purchase quality townhouses for under $500,000. Above that price point, the cash flow numbers rarely (if ever) work out… The combination of: higher mortgage payment, increase in property taxes, and rent ceiling (market rent can only be set so high…) creates a sort of triple whammy that all serve to minimize cash flow.
The Continuation of Buying Season
The numbers crunched above were realistic numbers and what comps were selling for at the conclusion of 2014, and even into early 2015. Now that buying season is ramping up, the landscape has changed yet again.
To continue my point regarding the absurd overbidding that is going on in the local market right now, here’s an update on that Bay Area home in Milpitas — After all was said and done, that $675,000 single family home ended up selling for $782,000.
That’s right… In 2015, 3 years after the recovery (bull run) started, we are STILL seeing properties selling for over $100,000 above list price… And we aren’t talking about Palo Alto or Mountain View here… This is happening in the lower-tier cities such as Milpitas!
If you thought the numbers looked bad at $700,000, here they are at $782,000:
The divide between monthly payments and market rent just keeps getting wider and wider… We are talking bout a difference of over $700/month which is NOT chump change. At this point in the housing cycle, as a homeowner, you are paying a hefty premium to be able to call a property your “own home”. It is far cheaper to rent than it is to buy today!
As an investor, upon seeing these numbers, I would run for the hills… Or at least seriously contemplate selling my own properties. If the market has not reached fever pitch yet, look out below when it does!
The Fear Of Missing Out and the irrational exuberance it brings along is something we must all fear.
Although mortgage lending is still pretty tight today, lenders are loosening up, and are giving people far too much credit by pre-approving loan amounts that they are not qualified for. Sure, it feels good when the bank tells me that I’m pre-approved to buy up to $700,000, but even I know that I’m ill-equipped to take on so much debt (at least without having someone else paying it off for me, which I can’t anymore today because cash flow numbers no longer work!).
It’s always important to take a step back and analyze for ourselves what is going on behind the numbers. Ignore the bidding wars. Ignore the open house crowds. Ignore all the insanity surrounding you!
It is possible to make money in an upmarket (greed), but you make far, far more in a downmarket (fear). Why take unnecessary risks? What goes up will always come crashing back down again, eventually.
Recently, I spoke to another investor friend of mine and he offered me this advice:
“Why not take all your cash/stock options/bonuses and invest out-of-state? That’s what I’m doing with my money. No way am I going to get suckered into overpaying $100,000 for a junk home in the suburbs that needs major updates when I can go out-of-state and pick up some cash cows that have only appreciated maybe $5,000 since 2012.“
Perhaps the above statement is oversimplified (out-of-state investing involves work too!), but I do understand the angle where he is coming from. Yes, to me it makes sense that if your own financial situation is abundant (and so are all of the houses around you), that you try and locate a marketplace where assets are reasonably discounted (relatively speaking).
And that’s what I tried to do myself in 2013 when I first went out-of-state to purchase turnkey properties. I can verify what this guy is saying too, because I know very well that my own out-of-state investments have experienced hardly any appreciation since I closed escrow in 2013/2014. But hey, if you’re looking for cash flow and don’t care for appreciation, then the downside risks of going out-of-state may be significantly less if you buy right.
I’ve admitted that I’m a fan of appreciation, but c’mon at $782,000 (and $100,000 above listing), even I have my limits! Appreciation is most potent when you buy at market lows, not when you are setting all-time-high records. To expect even more appreciation above this new benchmark would be tough and unrealistic; you’ll most likely need to wait out many more years for earned income to catch up to support this level. This sale will no doubt raise comps, but you’ll need a lot more comps to come up to justify this premium!
With markets like the Midwest, unlike the Bay Area, your increase in buying power will actually help make a positive difference; By going out-of-state, you’ll be able to gobble up a ton more properties that actually cash flow!
Many Bay Area investors have indeed adopted this approach and some have been doing this since the local upswing first resumed in late 2012. I know a few investors who have planted deep roots in Texas, purchasing as many at 15+ SFH over the last 3 years. I can’t deny it, part of me occasionally thinks about liquidating my Bay Area stock and using the capital gains to outright buy homes in other parts of the country. Thanks to things like 1031-Exchanges, there are conceivable ways to do it without incurring a massive tax hit.
I only have a few datapoints of my own (from my experiences in Chicago and Indianapolis), but yes, you can definitely go out-of-state and make good money (cash flow). Of course, you most definitely won’t secure the same quality of tenants as the Bay Area, and it will probably force you to take a more active hands-on management style approach, but I’ll save that article for another day…
Or, you can take the path of least resistance and do what many other investors have elected to do — NOTHING. If you feel that real estate is expensive, stocks are expensive, and just about everything else is overpriced, there’s absolutely nothing wrong with stashing cash and sitting on the sidelines while you wait for a better opportunity to strike. In fact, this is basically the option I’m electing to take. As mentioned many times before, it’s just simply more fun to be investing in a time of fear as opposed to greed.
Since the start of 2012, I’ve gone head-first in my assault to buy up assets. It’s now spring of 2015 and the markets are very frothy again. I’ve made enough moves to be content with where I am today. Rationally speaking, it makes very little sense for me to keep investing in this type of market environment. Too much risk and not enough reward.
The Fear Of Missing Out is a very dangerous poison that we should always be conscientious of. Most won’t realize it until after the fact. I let the numbers be my guide, so when they don’t work, neither do I…
It’s not a fun time to be an investor right now. But things will turn around at some point, they always do.
Happy Investing! Please tread carefully! 🙂