Before buying any property, always ask yourself, "Why am I buying this?" This seems obvious, yet many buyers later regret not asking this simple question.
The best reason to buy property today is for cash flow. There has never been such a perfect combination of low home prices, low interest rates and high rents. It makes a lot of sense today to buy a home if it's cheaper to own it than to rent it. There are many areas in the country where this is possible, and both home owners and investors should take advantage of this rare opportunity to increase cash flow.
However, in high priced markets along the coasts, the opposite is true. It's still cheaper to rent than to buy, which means there may be more price adjustments on the way. Low interest rates have made it possible for people to afford more expensive homes, but what will happen when rates creep up? They have been held artificially low since the Fed started buying mortgage backed securities, but that program is now over. Even a half percent increase in rate can price buyers out of the market.
Take a look at Walnut Creek, California. In 2006, the median home price was $729,000. Today, it's $526,000. The federal tax credit boosted the values up a bit from a low of $510,000 last year at this time, so some buyers think the upward trend will continue. But they may not be considering that the average income in Walnut Creek is $82,000. An affordable mortgage should be only 3 times the annual income, not 6.5. For Walnut Creek to become affordable, the median home price would need to be $246,000. When interest rates rise, but incomes don't, the result is a downward pressure on prices.
Compare these numbers to Dallas, Texas, where some neighborhoods have a $90,000 median income, $135,000 median home price and $1450 median rent.
If you were to rent in Walnut Creek, a $526,000 home would lease for about $2000 per month. That's $1000 less than the mortgage, taxes, insurance and basic home maintenance would have been. Even with tax deductions, you'd still pay less to rent and would not be subjected to the risk of potentially further declines in prices.
However, even if it is more expensive to buy than rent in places like Walnut Creek, it still might make more sense for some people. These buyers may be seeking stability, tax relief, or a chance to renovate to their liking. As long as they plan to stay put for a minimum of 10 years, they could find themselves ahead of the game.
The government is attempting to create inflation to combat deflation. This is done by expanding the money supply. Even if the median home prices dropped another 20% to $420,000 during this deflationary period, it could experience huge gains once inflation kicks in. With just 5% inflation, that home could be worth over $700,000 10 years later.
Leveraged real estate has always been the best hedge against inflation because you can pay your loan back in less valuable dollars. You don't have any more spending power, but at least you've kept up with times. This means you've got to be able to hold on to the property for an extended period of time to reap the rewards.
If you're buying investment property, once again, you must ask yourself, "why?" Income that far exceeds expenses is a great reason. Selling the home for profit after making improvements also works. But buying on speculation, simply hoping that prices will rise again can be a huge mistake – especially if the property has negative cash flow at the get-go.
If you bought the $526,000 home in Walnut Creek as an investment, you'd put $125,000 down and then pay $12,000 in negative cash-flow. In the long run, the prices very well could go up, but then you'd have to add up the cost of lost funds along the way.
Whereas, had you bought in a cash-flow market like Dallas, you could have bought 4 properties with $125,000 down. The cash flow would be $300 per property per month, or $14,400 annually positive cash flow.
One strategy would be to take all that cash flow to pay off the 1st home in 8 years, and the 2nd home 4 years after that. That means in 12 years you'd have $31,200 in annual cash-flow, 2 houses paid off (valued at $300,000 not including inflation) and 2 more houses that could be paid off in 4 more years. (For a total equity position of $600,000 and $48,000 annual income, not including inflation.)
Compare these numbers to the Walnut Creek home that may or may not have inflated to $700,000 in 12 years. Subtract the $140,000 paid to negative cash flow so the real value to you is $560,000, but the loan would still be over $400,000. That's a $160,000 equity position and still a negative cash flow position.
The difference between the high priced markets and the cash flow markets is significant. And all this, just because you asked, "Why?"
