Real Accidental Estate

 At Investing by Accident, if you comment, I will publish. In that spirit, here is the most recent Accidently Asked Question:

Where in Israel do you think home and land prices are rising the fastest to “flip” houses or purchase for rental income? Are homes more profitable across the line east of Modiin?

Before answering these questions, I must confess that I may not be qualified to write about this topic because I am somewhat of an expert. Here are my actual qualifications:

1. I bought a co-op apartment in Riverdale in 2002 and sold it at the height of the market in 2007. You may be interested in the sale prices, but unfortunately for you, I am Israeli and will absolutely not tell you. However, we can discuss personal details about family planning as much as you like.

Actually, I am also American. I bought it for $270,000 and sold it for $450,000. Wow!

2. I own an apartment in Modiin which makes me a real estate investor by accident.

3. This is not actually a qualification, just an important life note: never buy an apartment. I learned this the hard way by owning the co-op. Your neighbors will make too much noise, you will have to pay for fixing the building as it falls apart, and the people who run the building are insane.

I never learn a lesson, which is I bought another apartment. Thankfully, this time around it’s working out much better. My neighbors are wonderful and the building is brand new and fairly well built. Still, you can’t have everything. The person running the building is insane. I suppose we deserve that much. After all, we elected him by accident.

Real Estate by Accident

Investing in real estate is fairly straightforward. Basically, you buy a property (“real estate”), often by borrowing a large amount of money to do so (“leverage”). You rent out the property (“operating income”) and use the money to pay your expenses like borrowing costs and maintenance (“carrying costs”). Whatever is left, you put in your pocket (“$”). Finally, when the time is right, you sell the property for a lot more than you bought it for (“$$”).

As you can see, real estate is an attractive investment because you not only make money from the rental income (“yield”), you also make money from the capital appreciation of the property (“$$$”).

Rental Yields

I am a big fan of looking at rental yields when considering if real estate is a good value. I decided to sell our apartment in Riverdale when I noticed that rental yields were declining. At the time, I understood this as a sign that more and more investors were starting to speculate in the market.

From the time we bought until the time we sold, here is what the calculations looked like:

	2007 (Sold)	2002 (Bought)
Home Price	$450,000	$270,000
Rental Gross	$3,500	$2,500
Rental Net	$2,400	$1,600
Rental Net / Year	$28,800	$19,200
Yield	6.4%	7.1%

In the case of co-ops, the owner pays the monthly maintenance charges. After excluding this from the calculation, I observed a declining yield, 7.1% to 6.4%, which I took as an indication of increased speculation in ‏the market.

The lower the yield from rental income, the less money there is to pay for the carrying costs of the property. Investors should only be willing to give up this income if they think that the property will appreciate significantly. Their thinking is that they will be able to make enough money when they sell that it doesn’t matter if they don’t receive significant income while they hold the property.

Admittedly, even in 2002, the rental yields were already borderline from this perspective. Rental yields should really be 8% or higher for the investment to be considered sound. Otherwise, there tends to be little excess from the rental income after paying off mortgages, maintenance and other expenses from owning the apartment.

Yields in Modiin

I ran the same calculation on my apartment today, and here is what I am seeing:

	2014
Home Price	2,500,000
Rental	8,000
Rental / Year	96,000
Yield	3.8%

Basically, this is insane.

To illustrate how insane this is, just consider: if you borrowed 70% of the value of the apartment, a 30-year fixed mortgage at 5% would cost you 8,700 shekel per month. This is more than the rent!

Why would any investor buy at these prices? I am not entirely sure, but I can think of three ways it possibly could make sense.

Way #1: Property Values Continue to Rise

The most obvious way to understand this situation is that investors think that the rate of appreciation that we have seen in recent years will continue for years to come. To illustrate, here is how the property will increase in value if the rate of increase continues to be about 10% year-over-year:

	Home Price
2014	2,500,000
2015	2,750,000
2016	3,025,000
2017	3,327,500
2018	3,660,250
2019	4,026,275

In this forecast, after you sell the property in 2019, you would have made 1.5 million shekel. Considering that you only invested 750,000 shekel (30% of the 2.5 million), you actually have a total return of 200% on your investment!

Even after taking into consideration closing costs on both sides of the sale, and even assuming that you lost 1,000 shekel per month on the difference between the rental income and your carrying costs, you still made a tremendous amount of money.

You really have to be quite insane to think that prices will appreciate this much, but this level of insanity has happened before (“America”) and could be happening again.

Alternatively, it could be that something else is going on.

Way #2: Rents are Going Up

Investors may be thinking that rental prices will be increasing sharply in the years to come.

This may have some actual basis from what seems to be happening in my neighborhood right now. The demand for rentals is way out of pace with the available supply. I hear story after story of people who just give up and look in a different neighborhood because they simply cannot find any apartments available for rent.

If so, we may just see a sharp rise in rental prices in the next couple of years. Here is what the yield will look like on the 2.5 million shekel apartment with 10% increases in rent year-over-year.

	Rent	Yield
2014	8,000	3.8%
2015	8,800	4.2%
2016	9,680	4.6%
2017	10,648	5.1%
2018	11,712	5.6%
2019	12,884	6.2%
2020	14,172	6.8%

Also here, you have to be somewhat insane to think that people will be willing to pay over 14,000 shekel per month to live in a 5 room apartment. Although Modiin is the best place in the world to live, unless incomes rise sharply, it is hard to see how anyone could afford this.

It could be that investors are anticipating some amount of increase in both real estate prices and rents in a combination that somehow makes sense. 

Or, it could be something else is going on.

Way #3: Something Else is Going On

Perhaps this has nothing to do with investors at all. Actually, the fact that there are so few rentals available may indicate that most of the homes in the area are occupied by owners. If that is the case, people may be buying homes less for an investment and more to simply live in them.

This could explain the prices we are seeing, as people will tend to spend as much as they can afford to get the home that they want. In the past 5 years, we have been in a period of extremely low interest rates which has enabled people to borrow much more than if rates were at more normal levels.

If this is the primary driver of prices, we should expect them to remain high (and climb higher) as long as borrowing costs remain low, demand remains strong and supply is constrained. In practical terms in my neighborhood, it would mean that these prices are not moving as long as people want to live here, no one wants to move and the Bank of Israel keeps interest rates low.

If you are investor, your risk is that any of these things could change. The rental yield is very low, which means your investment succeeding depends on rents rising, real estate prices increasing, or both. You would basically be betting that none of these factors will change.

An Accidental Answer

If you are planning to invest in real estate in Israel purely as an investment, I think you should look carefully at the rental yields and find an area where the numbers make sense. I don’t know where this is, but it is not in Modiin.

However, if are planning to invest in real estate because you need a place to live, that is entirely a different matter. In fact, it deserves its own treatment in next week’s blog.