Wednesday, January 19, 2011

The Glass Ball - The Future of Real Estate

In 2005 I shut my real estate lending/investment company down.  Almost everyone told me I was crazy except for my Dad.  Real estate was "going through the roof."  It was the second time in my career I "pulled the plug" and was told I was nuts - years later my critics asked if I was prophet - how I knew the bubble was about to burst.

Am I a prophet?  Hardly.  It was extremely simple and easy to know.

Capitalization Rates aka "cap rates" are the single best measurement of both the value of a given investment as well as where we are in the investment cycle. It is a simple ratio that takes the Net Operating Income (NOI) i.e. the cash that a property produces and divides it by the investment in the property.  It has been called a measurement of "cash on cash return" - what return you would get if you purchased a property for cash.

Read more about capitalization rates:

What does this have to do with being able to see the future of where real estate prices are going?   All markets cycle.  They go up.  They go down.  They Go up.  They go down.  By looking at the relationship to interest rates and cap rates you can get a very good idea where you are at any given point in the cycle.   When interest rates are lower than capitalization rates, you are somewhere in the Fear/Buy zone.  People are afraid which makes them sell and it is a buyer's market.  When interest rates are higher than capitalization rates you are somewhere in the Greed/Sell zone.  People are over confident and the market doesn't warrent the over confidence - it is the time to sell.  How far they deviate tells you how far into the respective zone you are.  The further you are into either of those two zones the less stable prices are.  When prices drop so far that there is a tremendous "spread/profit" to be had by purchasing property, there will be a strong correction and prices will go up.  When prices are rise to the point that cap rates are significantly higher than what properties are yielding, there will be strong corrections to bring prices down.

Extremes are driven by either greed or fear.   Both create amazing opportunities.  When the market is in the "greed zone" it is an amazing opportunity to sell.  People are paying more than works economically and that is a very good time to "go to cash".  When the market is in the "fear zone" that is an incredible time to buy.  Opportunities to buy at high yields give an astute investor cash flow.  If one's investments are cash flowing they can wait for a long time (forever) for the market to eventually run its cycle, go into the greed zone and capitalize on the insanity that always eventually prevails.

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