Re-Learning to Count

 One of the pervasive concepts that continue to float through the marketplace of investments and ideas is the notion of a “National” housing market. Many people simply assume that the Case-Schiller composite index of the 20 largest housing markets is a reasonable proxy for the total real estate marketplace. The problem is that this perpetuates a standpoint of ignorance, since real estate is not an efficient asset like stocks or bonds. The price for a share of stock or for a 10-year government bond remains the same throughout multiple global markets. However, real estate is fragmented and localized. This means that aggregating markets into a ‘national average’ does not tell the complete story.

The reason why this methodology has become so popular is because it resembles the way that stocks are tracked. Most investors follow the S&P 500 index or Dow Jones Industrial Average as a reasonable proxy of the stock market performance for a given day. For the most part, this is completely appropriate in the world of stocks since most stocks are purchased with cash and most stocks pay low to zero dividends, the primary dimension of value for stocks is market value movements. The danger of applying this methodology to income property investing is that it ignores localized effects and does not comprehend the multiple dimensions of income property investing. 

To further understand where this mindset came from, let’s analyze two periods of time for the Case-Schiller index. Those two times are May of 2005 and May of 2010. The former represents the height of the housing boom and the latter represents the depths of the housing bust. However, before beginning this analysis we should discuss the taxonomy of market indexes for a moment.

Any time that assets are aggregated into an index, they must be weighted. This is done to give more strength to movements in assets with a large market presence than assets with a smaller one. The reason that this is done for stocks based on market capitalization is to create a proxy for aggregate market activity. However, any given day tends to have ‘winners’ and ‘losers’ in the stock market, regardless of what is happening with the indexes. This phenomenon is even more relevant for real estate.

Let’s start by examining the Case-Schiller markets at the height of the housing boom. Analysis of the Composite-10 and Composite-20 index shows a weighted average growth rate for national real estate that is heavily influenced by California and New York, since those are the markets with the greatest population and the highest aggregate market value. During a ubiquitous bull market, this blunt approach still serves as a reasonable proxy for market appreciation because of the highly correlated rates of appreciation across multiple markets. Smaller markets like Dallas, Texas or Denver, Colorado are frequently lost in the mix because their population base is not sufficient to move the national average relative to New York and California.

By looking forward past the housing bust to 2010, we see a dramatically different picture. The ‘big’ markets that drove all of the upside profits are now driving massive downside losses. Thus, the index shows persistent negative movements that are driven by large bubble markets while smaller housing markets such as Dallas and Denver remain largely unnoticed. In the current environment of wildly divergent real estate markets, the use of an aggregated index to communicate value movements for real estate is not remotely appropriate.

Prudent investors realize that nobody buys an index when it comes to income properties. Individual investors purchase individual properties in unique segments of single markets for each of their investment transactions. This renders the overall market aggregates nearly meaningless, since the returns from my single income property is dependent on the fundamentals of the particular area it is in.

This concept also punctures the ‘foreclosure hangover’ fears that currently grip many investors. It is certainly true that there are many foreclosures that have not yet hit the market. However, most of those foreclosures are occupied by tenants. When the foreclosure inventory is eventually liquidated, those people will still need somewhere to live. This will place upward pressure on rents since housing construction has been at a dead stop for the last two years, and builders will need to see sustained demand before they will be able to raise enough capital to begin building again.

This is a perfect example of how the multiple dimensions of income property investing benefit people who are educated. Home flippers fear the introduction of foreclosures since it suppresses market prices. Income property investors welcome the addition of more people to the rental market, since it enhances cash flow. Consider that long-term investors lock-in their cost of capital with a fixed-rate mortgage when they purchase a property. By renting it out to a tenant, they generate cash flow that pays to systematically liquidate that mortgage. In addition to this, the impact of depreciation and mortgage interest deductibility helps to shield them from taxes. In this way, income property investors can actually benefit from the release of foreclosure properties onto the marketplace while uneducated pundits opine the “unfavorable housing market” while educated investors cash monthly rent checks of increasingly larger size.

Action Item: Become educated on the multiple dimensions of income property investing. Learn to view the financial media with a critical eye and recognize the agendas that drive their evaluation of stocks, bond, and real estate markets. Use the dimensions of income property investing to create a lifetime of wealth and prosperity. (Top image: Flickr | Teosaurio)

The JasonHartman.com Team

"The Complete Solution for Income Property Investors"