Real Estate Opportunities For The Next Decade (Part 1 of 3)

Real estate investors typically have longer investment time horizons than investors in publicly traded equities, bonds and funds. While it is possible to buy and sell a stock within a few hours, and typical to liquidate these investments within several months, real estate investments are typically held for a decade or more. Consequently, it makes sense to look at the long term when considering real estate investments.

Before addressing current opportunities revealed by this analysis, I’d like to provide a specific example of how I conducted this type of analysis decade ago and how it is benefiting to investors right now.

The idea behind fundamental investing is to identify opportunities with limited risks of loss and potentials for large gains that have not yet been fully recognized by the broad markets. In order to do this, we have to construct several plausible scenarios of how events might unfold. We have to identify these scenarios well before they are generally recognized. By the time events make national news, it’s too late. Looking at the world from the perspective of Austrian economics gives us an enormous advantage in this respect.

These advantages are epitomized by a newsletter article that I delivered to my clients in August 2002. At the time, I, along with most Austrian school scholars, recognized that we were in the midst of an unsustainable housing boom, but:

Many commentators think that the housing market will remain strong. A June 25 [2002] article in the Washington Post reports that the chief economist at the National Association of Realtors said: “There is no bubble, I’m as sure of that as I can be sure of anything.” In April, Alan Greenspan testified that a housing crash wasn’t likely to happen, mostly because purchases aren’t being made as speculative investments. A June 18 report on CNN Money reported: “economists say that the post-boom is unlikely to play itself out so darkly. Inflation remains low and the economy is poised for a turnaround.”

These analysts base their opinions on the facts that developers are having difficulty keeping up with the demand for houses and that mortgage rates are near their 30-year lows. Housing prices have not dropped since 1994 and a wave of immigrants in the 1990’s recently entered the house buying market.

I didn’t buy into this hype, all of which eventually proved to be wrong. In fact, the market for single-family homes tanked and the National Association of Realtors subsequently fired their chief economist because his forecasts proved to be so bad.

Simply knowing that the housing market was poised for a crash, however, was not enough. I had to come up with a way that my real estate investor clients could earn money from this knowledge. Since it wasn’t possible to short single-family homes, I had to find another real estate investment that would benefit from this trend. I considered what other events would occur as the housing market collapsed and finally came up with my answer, which I included in the same newsletter article:

The precarious financial structure will eventually collapse. Employment has peaked in the various industries in exactly the order that Austrian Business Cycle Theory would predict. As people encounter financial distress, they will find it easier to sell their highly mortgaged houses than to continue to pay for properties in which they have minimum equity. This will cause housing prices to fall. Although this probably won’t occur for several months, it is wise to start planning for it now.

The best investment strategy in this environment is to purchase apartments. As homeowners sell their houses, they will be looking for other places to live, and apartments are the obvious choice.

I went on to identify specific sub-markets where rental apartment investments were particularly attractive.

Those who followed my advice made out pretty well. Reis, Inc. provides the following chart, indicating apartment rent and vacancy trends over the past five years. Rental rates dipped in 2009, with a commensurate increase in vacancy, but overall performance has been good, particularly in comparison to other real estate investments.

Apartments have now become the most sought-after property type nationwide. Investors in the sub-markets that I recommended in 2002 have outperformed the national averages by a wide margin. Some of the leading developers of retail and office properties are now moving into the apartment business, despite their lack of expertise in the property type. We have seen a mass movement out of homeownership and into rental apartments and even student rentals of the McMansions that were built during the housing boom.

All of this has been great for those who received, and heeded, the advice in my newsletter a decade ago. The more important question is: what property types can you invest in now that will produce comparable results in the future? I’ve identified two real estate investment strategies that will make you money in the next decade. I’ll reveal these strategies next week.

Doug McKnight has been a commercial real estate appraiser for 23 years. He previously served as a director for the national appraisal firm Marshall & Stevens. He is currently the managing director of CapStruc Advisors and is working on a book on the value of assets. Contact him at: doug.mcknight@capstruc.com.