I wanted a long-term investment with a strong cashflow and limited downside potential. Being a finance guy, I schooled myself in the key metrics surrounding real estate investments (mainly capitalization rates and the relationship between rental rates and purchase price). I built a financial model that helped me to understand the fundamental parameters I was looking for. I looked at all types of properties: commercial, industrial, hospitality and residential…even assisted living facilities. I decided to focus on the residential market because I felt I understood it best, but it seemed I was chasing valuations up and up, and I couldn’t find anything that felt like a good value for the price.
I quickly came to the realization that, from a macro perspective, this was a really bad time to invest in real estate. All the money was moving out of the stock market into real estate, driving the prices up and the capitalization rates (and return on investment) down. California’s central valley was on fire…Sacramento housing prices were shooting up, and one-by-one, prices in the smaller towns in the central valley were rocketing up. I had to look outside California. Similar things were happening in Las Vegas, Phoenix, and other parts of the country. Everything I looked at was outside the parameters of my investment model. Everything seemed overvalued from a fundamental standpoint, and it seemed that everyone was playing a game of musical chairs hoping to get in and get out before the music stopped.
Either I needed to drop the idea or look for an area of the country that still had strong fundamentals. That’s when I started looking at East Texas. I found a great little town where I could find homes for $40K-$70K that would rent for $600-1,000 per month. This was over four times the rental rate per dollar invested than some of the other areas I was looking at. This fit my model, because even if I borrowed 100%, I could cashflow very well! Great fundamentals.
I next looked at the fundamentals of the town and surrounding area. I was very comfortable with the fundamentals of the area after I found the following:
- Great infrastructure: although it was a small town (30-35K population), the big box retailers (Target, Home Depot, Big Lots, JC Penney, Blockbuster, Sam’s Club, etc) had already established themselves. The flagship hospitality infrastructure (Courtyard Marriot, Comfort Suites, Holiday Inn Express, Best Western, Hampton Inn, etc) had also come in and established themselves ahead of the curve. The education infrastructure was strong, with a great community college and a 10K+ student university within 30 minutes. The medical infrastructure was very strong and growing, with two major hospitals and outstanding medical services for seniors/retirees.
- Great location: the town was only a 90 minute drive from Houston International Airport, and close to all the amenities that a large city like Houston offers. It is flanked by two national forests and has two large reservoirs nearby.
- Vibrant, growing community: it is the county seat and retail hub of the area, so even though it has a population of 30-35K, it services a county population of over 80K. It has a low cost of living versus the national average, and it was ranked #1 in Texas as the strongest economy among micropolitan statistical areas.
- Median home valuations in the area had risen steadily and consistently since 1970.
I was 2,000 miles away, but if the numbers bore out the way my model projected, I could build a portfolio of rental homes that could support a management infrastructure, service the interest, principal and expenses, and still have a profit. It wasn’t sexy, and it wasn’t a get rich quick scheme…it was a good fundamental investment.
Besides, any appreciation on the homes would be gravy! Assuming a 5% annual growth in median home price over 20 years (the average growth in the area since 1970), the investment would be an 80% cash-on-cash capital gain. Better yet, if I financed 80% of the purchase, the return on investment would be over 800%!
Many of the residential home investment proposals I have seen over the past years had to make much, much more aggressive assumptions to achieve a strong return. The key assumption in their models, for instance, on an investment proposal for a home in California, Nevada or Arizona, was that median home values were going to increase at an annual rate of 15%+! This was fundamentally unattainable…it is 3X the historical appreciation of homes in the US. Other major assumptions in these models are 20+% down, the use of a negative amortization loan, and rapidly climbing rental rates…all very aggressive, risky assumptions. As the economics of the past few years have borne out, this was a massively faulty model, relying on pie-in-the-sky fundamental assumptions.
I decided to move forward with the East Texas investment model. We bought our first house in March, 2003, and quickly built up a portfolio of 50 properties, mostly single family homes and a couple of duplexes. The total amount of rentals is 60. We established local banking relationships and negotiated portfolio loans that would lend to our limited partnership. We have an internal staff that manages and maintains the properties, and the cashflow from the properties more than covers all our expenses and the paydown on the principal.
It was interesting to go through the housing crisis with this portfolio, because this is where the initial fundamentals of the model were put to their test. As it turns out, because the fundamental values of the homes were not out-of-whack to begin with, the median home prices remained steady throughout the housing crisis. The community continues to grow, and rental rates and occupancy continue to be strong.
As a side note, we weren’t fully scaled up around our property management and maintenance infrastructure because I felt that I wanted our internal costs to be less than if we hired an outside property management company. It was a couple of years ago, and I didn’t want to add to the portfolio because of the massive instability in the housing market and the fact that many of the banks were scared to lend. We looked at our capabilities and decided to start a heating and air conditioning company in the area, leveraging off the infrastructure we built to manage and maintain the property portfolio. The HVAC company is doing very well with minimal management focus, thanks to an interesting business model that is very different than the other related companies in the area. This has been an exciting venture which has increased the profit of our property portfolio because of the shared overhead costs. Now we’re fully scaled over our infrastructure.
I look back on the bullet I dodged by not investing with the crowd, and I feel very fortunate that I stuck with the fundamental principals upon which I started.
My major takeaways from this experience are 1) you can find a good investment even during a bad time to invest, 2) build a good conservative financial model, and; 3) ALWAYS stick to the fundamentals!
I’d love to hear other lessons learned while riding out the real estate crisis…
Cheers,
Brian Royston
Royston Financial Consulting, Inc.
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