A Tale of Two Cities: Bubbleville vs. Bargaintown

It was the best of times to buy real estate. It was the worst of times.

First, the worst …

In Oakland Park, Florida … not far from where I live … you can buy a 35-unit apartment building for $4.5 million. For that price – if you bought this property with 100% cash – you’d get about $184,000 in net operating income (NOI) per year.

NOI is the money you have after deducting rents lost because of vacancies (2%, according to the sales sheet for this property) and paying operating expenses (such as insurance, property taxes, property management, utilities, maintenance, and grounds care).

That works out to a yield of about 4.1% on your cash. Or, you could simply buy a liquid, government-guaranteed, 13-week T-bill and get a higher yield … about 4.5%.

So why buy the apartment house instead of the T-bill?

Well, for the appreciation, of course. T-bills don’t appreciate. But, then again, how much appreciation can you expect from a building with a lousy 4.1% yield … especially when area properties have already tripled in value in the last six years?

Not much, I think. But here’s the real killer in this deal …

You usually don’t buy properties with 100% cash. Not even Donald Trump does that. You use leverage. Leverage is the thing that lets you put money to work at higher rates of return. But that’s if – and only if – you buy an asset that generates a lot of income relative to the price you paid.

So, say you have $100,000 in cash and you use it to buy a $100,000 property, all cash. If your NOI is 4% and the property appreciates 6% in a year, your total return is 10%.

But if you use that same $100,000 as a down payment to buy a million dollars worth of property, you can make a lot more money (as long as the property pays for the $900,000 loan and all operating costs). If the property appreciates 6%, you’ve made 60% on your money.

How? Well you put $100,000 down and get a 6% return on $1 million. That’s a $60,000 gain on your $100,000 investment. And that’s 60%.

If you pick up another, say, $20,000 in net rents (after expenses and loan payments), that’s another 20% on your $100,000 investment. Total return in the first year: 80%.

But again … that would only work if the property’s rents were high enough to pay for the $900k loan, cover all other carrying costs, and generate some net rents to boost profits and create a cash cushion (margin of safety). But that isn’t happening anymore in the bubble markets.

Take our Oakland Park property again …

Forget 10% down. Let’s say you put 25% down to buy the building. You’d end up with a loan of $3.375 million. With a 25-year commercial loan at 6%, that works out to annual payments of $261,225.

But this property only has a net operating income of $184,000 a year. So you have negative cash flow of over $77,000 a year!

And that’s after a hefty 25% down payment. And it also assumes the miniscule 2% vacancy rate claimed for this property … and that the operating costs weren’t under-reported in order to beef up the meager NOI.

Truth is, you’re probably really looking at a negative NOI of $85,000 to $90,000 a year here.

And, by the way, this property was on an Investor’s Wholesale List! If that’s the “wholesale” price, you don’t even want to know what retail would be.

That’s how it is in the bubble areas. Real estate agents have turned into agents of the unreal. The prices at which they’re listing properties have nothing to do with the real world.

And South Florida isn’t the only bubble market.

In California, only 14% of residents can afford the median-priced home. That’s down from 19% a year ago. If you’re selling one of these properties, you just lost a quarter of your market. In parts of Northern California, it’s worse. Only 7% of the state’s population can afford a median home there.

In Boston, the median home sells for about 300 times the monthly rent! You can’t cover your mortgage and expenses at those ratios. A lot of recent homebuyers and investors are now learning this the hard way.

The Providence Journal reports that foreclosures shot up 34% in Massachusetts. In some of the pricier counties, they’re up 40%. And if interest rates continue to climb, the slew of ARMs could send the foreclosure numbers higher still.

But it’s not all bad news. Just as there are bubble markets, there are still some excellent bargain markets in the U.S. today.

In fact, thousands of homeowners and investors are fleeing the bubble markets and heading to the bargain markets … and they’re helping create the Next Great Real Estate Bull Markets in the process.

Deep Value, High-Quality-of-Life Cities: The Next Great Bull Markets

Now … let’s take a look at Bargaintown.

A bargain is NOT a cheap price compared to what you’re used to. A bargain is a property that (1) sells for less than comparable properties in the area, (2) produces good income relative to the purchase price, and (3) is located where the market is in the early stages of steady appreciation, bolstered by a high quality of life, diversified economy, and rising population and employment.

You have these characteristics in spades in select markets in Texas, North Florida, Georgia, North Carolina, and New Mexico – to name just a few.

For instance, The Houston Chronicle reports 48,000 residential housing starts last year, an 18% jump from the previous year. Yet Houston is still priced at a fraction of the bubble cities – relative to the average household income and relative to rents.

In another Texas city, I recently bought a multi-family property in an up-and-coming area for 20% below comps and at just 82 times the monthly rents. That’s far better than the properties in Boston, which are going for nearly 300 times their rents.

And this city has a temperate climate (a big plus for the millions of baby boomers who will be retiring soon). It’s also culturally rich, with a major university, tech industry, diversified local industry, and growing jobs and employment. And it’s consistently rated among the top two or three cities in the country in national quality-of-life surveys.

In this same neighborhood, I also just missed out on a 24-unit apartment building in a B area, with $144,000 in monthly rents and selling for just $850,000. (The deal was an “REO,” owned by a bank. Not surprisingly, it was snapped up in a heartbeat.)

But compare this deal with the bogus “wholesale deal” we looked at in Oakland Park, Florida.

The Texas property had a net operating income of about $65,000 (after taxes, insurance, property management, maintenance, legal and accounting, and a 5% allowance for vacancies). If you put 25% down and took out a 25-year commercial loan on this property at 6%, you’d pay about $49,000 in yearly mortgage payments (principal and interest). That would leave you with positive cash flow – on a leveraged property – of about $16,000.

As a percentage of your $212,500 down payment, that’s a 7.5% yield – after all operating expenses and your loan payments!

Remember, the Florida property would only produce a 4.1% yield if you bought it all cash! If you used a 75% mortgage, you’d be hemorrhaging cash to the tune of about $85,000 to $90,000 a year.

And if our Texas property goes up by 6%, you would gain $51,000. Add the $16,000 in net cash flow and another $6,000 in amortization (the reduction of your loan balance), and your total gain after one year would be $73,000. That’s about a 34% return in a year on a property that pays for itself.

More importantly, you’re in a market where the prospects for appreciation are excellent.This Texas city is just starting to move upward. It hasn’t tripled in value in the last five to seven years, as many markets in California, Florida, Massachusetts, New York, and other parts of the country have. In fact, it was up only about 7% total between 2002 and 2005, even while the bubble markets exploded.

But that was because the tech crash kept prices cool in this Texas city. Now that’s changing in a big way. This city is getting hot.

It’s starting to attract out-of-state buyers (including many bubble market “refugees”). And its solid economy, high quality of life, population growth, job growth, and still-affordable real estate all indicate that it’s in the early stages of appreciation.

I would expect this city to appreciate much better than the long-term 6%-a-year average. In my view, you could see 25% appreciation in the next two to three years.

A 25% rise would basically double your money (if you put down 25%). Add in the net rents and amortization, and you could be looking at leveraged gains in the neighborhood of 125% to 150% on a property like the one we found … even while the bubble markets deflate.

And you could do it with much lower risk than you’ll find in a bubble market, because you’re buying a property that kicks off plenty of cash to pay the loan and all expenses while steadily piling up a cash cushion.

And this is just one example. There are many other value-rich cities in the U.S. that are just beginning their bull markets. Not only do they have good values and solid growth fundamentals working for them … the deflation of the bubble markets is actually working in their favor, as retirees and investors seek the once-promised land of properties that are affordable for homeowners and actually cash flow for investors.

“Property in land is capital; property in the funds is income without capital; property in mortgage is both capital and income.” – James Mansfield

(Ed. Note: Justin Ford is the editor of the Main Street Millionaire real estate investment program.