Are we heading for a 'bubble' in Orlando Real Estate?

[Chris Romany]

In reviewing the latest Orlando Real Estate statistics, there is a concern that house prices are rising so fast that they are becoming out of reach for the average citizen. If this continues, banks' loan business will eventually falter and there will be pressure on them (and the government) to ease lending criteria further (they have already dropped credit score requirements to 580 in some cases). 

Does this sound familiar (2005/2006/2007)?

What do the voices of BP think?

[George Gammon]

@Chris Romanythanks for bringing up an important topic.  I'd like to expand it a bit further and point out housing prices across the nation being high (see case shiller inflation adjusted home index and compare current level to historic norm).  But my post pertains to Orlando as well.  

I'm new to BP but I'm not new to macro econ or real estate investing and I must say, after reading a lot of posts on BP, I'm astonished by 2 things...  A.  How well many real estate investors study the impact of micro econ and B.  How most real estate investors totally ignore macro econ.  And ironically, there's a very strong argument for the macro playing a much bigger roll in price appreciation or depreciation.  

As you point out, lets look at the last crash.  At a very basic level what caused it?  homeowners not being able to make their payments.  If homeowners would've continued to make their payments we wouldn't of had the defaults that caused the domino affect we all remember well.  

So then the question becomes "why were homeowners unable to continue making their payments"?  because everyone lost their jobs? No...that was a result not an initial cause.  The answer is because interest rates had been artificially low for several years and when interest rates started to rise the loans adjusted, increasing the mortgage payments, making those payments unaffordable for a large amount of borrowers,  regardless of whether or not they were subprime, granted subprime was a huge part of the problem.  (if you have an adjustable rate loan right now just run the math on what would happen to your monthly payment if interest rates normalized and increased by 5%.  Many properties owned by investors far from "subprime" would become cash flow negative).  Now, if you recall, the theory was if you couldn't afford your monthly payment anymore you could just sell and no one's hurt.  The reason that didn't work is because demand evaporated overnight and prices plummeted locking the homeowner/investor into a position where they couldn't sell or make their mortgage payment.  Why did demand vanish?  Because when you keep interest rates artificially low it pulls demand from the future into the present.  In 2007 much of the demand from the future (2008,2009,2010,2011) was pulled into the present/past (2003,2004,2005,2006).  Combine that with the fact that monthly payments increased, therefore the price of home that people could afford decreased (if you can afford a $950 a month payment you can afford a $200,000 loan at 4% interest and only a $160,000 loan at 6% interest), and you've got no demand.   

As we all know the fed just started a tightening cycle (whether they continue to tighten remains to be seen), the same thing they did in 2007 that pricked the bubble.  So what's different now?  1.  Interest rates were far lower for far longer from 2008-2016 compared to 2003-2007... 2.  As a result far more demand was pulled from the future than before and malinvestment was enabled for much longer... 3.  Labor force participation is much lower (lowest level in decades) and wages have been stagnant, adjusted for inflation, so fewer people working at the same rate of pay, reducing aggregate purchasing power... 5.  If we go into another recession (many economic indicators show we're already recession) the fed is out of ammo.  Interest rates are basically zero already.  This means that we have exhausted all traditional methods of softening a blow of recession.  Just think what would've happened in 2007/08 if interest rates were already at zero...we most likely would've gone into a massive depression... 6.  Hedge funds now own a significant amount of homes, many just like the rentals us small investors buy.  Whats my point? What happens to the supply/demand balance if they have to liquidate their real estate portfolios?... 7.  "Lending standards aren't as low."  That myopic view may be misleading.  Look at auto subprime, student debt subprime, oil subprime.  Remember the only reason subprime housing debt was a big deal was because it was colateralized and sold and made the banks freeze when it went bad.  People may think that bad housing debt affects only housing and bad car debt would affect only car sales.  Not true.  The type of debt is irrelevant if it causes banks to freeze up.  Subprime car debt could crush the housing credit/demand just like housing subprime crushed car credit/demand.  I could go on but hopefully that shows the importance of the macro environment on housing.  

My goal is not to promote a bearish narrative.  I actually currently like US rental properties as an investment.  But only under certain conditions and only if you factor macro as well as micro into your decision making process.  An ignorant investment that makes money is still an ignorant investment and over the long term ignorant investors lose.  

Taking the macro into consideration here's my current strategy in the US.  This applies to Orlando as well as any other market you know well and are comfortable with the micro conditions.  

1. Only buy something where you can add value and be all in for the LTV of a current cash out refi. As soon as the rehab is done take out your equity and lock it into a 30 year fixed. If the market goes up that's great and if it goes down your equity is protected and you'll have cash to buy after prices have fallen. You get paid (the positive cash flow) to hold cash and see how everything plays out AND you participate in the upside if the market continues to rise.

2.  Only buy something with a 1.3+ R/V ratio.  This will ensure you're cash flow positive and you have staying power regardless of which way the market goes.  

I personally wouldn't buy anything unless I could fit it into that strategy because the risk/reward doesn't make sense when compared to cash.  

Having said all that I could lay out a strong argument for US housing prices, including Orlando's, going  higher.  I'm happy to expand on that if anyone would like me to but this post is long enough;) 

I hope that helps your decision making process Chris, 

George