We're so accustomed to having our intelligence insulted by politicians that we rarely complain about the dumbed down worldview that we’re spoon-fed by both sides of the political aisle. The partisan mudslinging that we’re subjected to these days makes it hard to imagine a world in which candidates might campaign by voicing nuanced, well articulated views on the complex issues facing our country. That’s too much to ask for, but at least we get to watch the primaries, which offer up the entertaining spectacle of Democrats savaging fellow Democrats and Republicans bashing Republicans as they fight for their respective nominations.

But there are a couple of issues that I think we should all hold our candidates to a higher standard. One of these is immigration reform.

Even the language of immigration reform is fraught with semantic landmines. Do you talk about “illegal aliens” or “undocumented workers”? Do you open the discussion with allusions to Ellis Island or by invoking 9-11. Is this about security or fairness.   Economics or the American way?

But it's safe to say that we're all interested in the state of our economy and national security – these are two tides that lift all boats. And as real estate investors – we’re more interested than most in how the housing market weathers the current storm, not to mention how we operate as landlords and as consumers of labor intensive services like roofing, landscaping and construction.

More specifically – as politicians target employment, benefits, and housing as keys to the illegal immigration question, some municipalities have proposed legislation which would hold landlords accountable for policing the residency status of their tenants. These are bad laws.

The reality of the situation is that it is difficult to take a complex issue like immigration reform and turn it into an effective sound bite, so it’s rare that we see a candidate discuss immigration with any subtlety or insight. But when I hear anyone address immigration I’m listening for a couple of key things…

Does the candidate acknowledge the complexity of the issue, and our society’s complicity in creating it? George W. Bush has lately become fond of invoking our society’s dependence on foreign oil. This is a step in the right direction (although the solutions proposed are all wrong – that’s another post) but as a society we’ve yet to confront the fact that we’re also addicted to imported labor – especially when it comes to difficult, physically intensive, cheap, dangerous work. When I walk into a construction site, a rehab project, a house that’s being cleaned for showing, or a landscaping job I without fail see a group of workers made up almost exclusively of immigrants. Always. Granted, this fact is exacerbated by the fact that I’m in Houston, but many readers will find this to be a familiar observation.

I live in a suburb where the residents, generally speaking, are more inclined to lean towards the Tom Tancredo school of immigration reform than the Hillary Clinton view. But if you walk this neighborhood on any weekday you’ll see the streets dotted with landscaping and housekeeping crews made up of employees who are in the country illegally.  It's interesting that the "Assault on America" philosophy of immigration reform is so successfully sold to those socially conservative families who every week enjoy a beautifully manicured lawn for $35 a pop - courtesy of the invaders. 

Does the candidate appeal primarily to fear? In recent years folks who live in my neighborhood here in Houston have been subjected to some of the foulest, ugliest campaigning I can remember as Hubert Vo (D) and Talmadge Heflin (R) squared off for a seat in the Texas State House of Representatives. They both took the low road on numerous occasions on various issues; one of them was immigration. This ad to the right (actual scan of a flier which landed in my mailbox) won the prize for the crassest.  According to Heflin, his opponent was so uninterested in the general public safety that if he won then Osama himself would eventually stroll into a local Texas Department of Motor Vehicles and get a drivers’ license.

Heflin lost the election in a very tight race, and I like to think that there were at least a few voters, like me, who were pushed into the opponent’s camp because they were angry about having their intelligence insulted.

Does the candidate talk about people?  Immigration is a human issue.  Immigration is about people. I think most of us would agree on how we should treat an illegal alien who slips into the country to sell drugs. But how do we treat an undocumented worker who has spent the past twenty years toiling in a Tyson chicken processing plant, paying social security, contributing to his community, and raising his kids who were born here and are now in high school?

If we were to wave a magic wand and magically deport all 12 million people residing in our country illegally, every restaurant in Houston, San Antonio, Los Angeles, Las Vegas, Miami, and San Diego would immediately close. Our crops would rot on the vine. Poultry and meat would disappear from our supermarkets. Hotels would shut down. Residential level construction work will grind to a halt.

Some of these industries would eventally recover – but at a great increase in cost to the consumer.

So ask youself: is the candidate presenting the issue to me in all its complexity?

Postscript:  The squeaky wheel gets the grease, and there's no area where this principle applies more strongly than in politics.  This blog post got picked up today by topix.net.  Take a look at the comments.  The bottom line is that if the general public is apathic towards important issues then thoughtful voices will be shouted down by the lunatics on the fringes.  Is this the America that you want to live in?

One economic indicator that I consult from time to time is the Global Insight quarterly study on housing prices in America. Here’s an interesting conclusion from the report: of the 330 regional markets surveyed, Houston is the most undervalued.

The Global Insight uses a number of factors in determining the theoretical price equilibrium level for each market, to include tax rates, population density, income levels, plus a somewhat nebulous “desirability factor”. So, as with all economic studies there is some art mixed in with the science, but nonetheless I find this study to be an useful data point when thinking about the relative valuation of markets.

The fact that Houston is ranked as the most undervalued market is interesting in light of the underlying economic factors and the disparity between the market’s current reactions with how it behaved in the past. Nowadays when we think about real estate bubbles we immediately think of California, Las Vegas, Florida, and other regional markets that have grabbed headlines with their flying property values over the past several years. But we forget that the poster child for real estate market collapses was Houston in the mid-to-late eighties.

Texans were knee deep in irrational exuberance long before Alan Greenspan coined the term. When the Gulf States kicked off the Arab oil embargo in response to Western support for Israel in the Yom Kippur War, the resulting spike in oil prices fueled investments in the oil industry. This, in turn, pushed property values to unsustainable heights.  Everyone wanted their own Southfork Ranch. 

Fast forward to the early years of the 21st century. Two rounds of armed conflict in the Gulf, rising demand and tightening supply have again sent oil prices into the stratosphere; and I’d argue that this time around the increases have more fundamental sustainability than in years past. Money is flowing into operational oil centers like Texas and Louisiana. But, the real estate market hasn’t responded. Yet.

The graph below shows the Department of Energy refiner acquisition cost of imported oil. 

Will property values in Houston and other economic centers for energy go up? In the short term, perhaps not. Economic malaise and a jittery credit market will help to continue to keep a lid on the prices, but I love the fact that the downside risk in undervalued markets is relatively low. Currently, investors in some markets need to plop down a 40% down payment in order to get into an property that generates breakeven month-to-month cashflow. Getting into an undervalued one where 5% does the trick feels pretty prudent.

In A Brief History of Time, Stephen Hawking mentions a publisher’s rule of thumb that every equation that a writer uses will cut his readership in half. Real estate investing is based on relatively simple principles - especially compared to the stuff that Hawking tackles - but there are some real estate investing concepts that can be delivered a bit more effectively aided by a few equations and numerical examples. So bear with me...

I wrote in a recent column that when an investment starts “getting good” – when it starts kicking off some cashflow and putting some dollars in your pocket on a month-to-month basis – then that’s the time to sell. This might sound counter-intuitive, but I’ll give a couple of examples that show why it is true.

Judged on the basis of simple price appreciation, the stock market beats the pants off of the real estate market. Over the past twenty years the S&P 500 has appreciated at an average rate of almost 10 percent per annum, and the NASDAQ has averaged over 11 percent. Over the same period the average home price in America has increased at around 5.6 percent. So why do we get excited about the real estate market? Because it allows the investor to prudently use leverage to increase her returns. So why should we consider selling when the investment starts kicking off cashflow? It’s because this is a good sign that your leverage is running out of steam.

Let’s look at a simple example. An investor puts 20% down on a $100,000 property. The investor starts out with $20,000 equity on a $100,000 house, giving him 5-to-1 leverage. Meaning: if the market goes up by 5% then the value of the house goes up by $5,000, a 25% return on the initial $20,000 investment. This is a basic concept you’re probably familiar with.

As time passes by two things are likely to happen: a) the property will appreciate in value (good) and b) your loan balance will go down (also good). But there’s an unintended by-product of these two factors: a decrease in your leverage.

The graph above assumes a fixed rate mortgage at 8% and a property appreciation rate of 4.5% per annum. Now this isn’t a bad investment – in fifteen years that initial $20,000 grows to over $120,000 in equity. That’s an annualized rate of return of around 14%, better than you'd expect out of the stock market. But look what happens to leverage. By year five you can expect to have paid off around $4,000 of the loan. And assuming a 4.5% rate of appreciation, the property will have gone up in value by around $24,000. That adds a total of $28,000 to your equity – so now you have $48,000 tied up in the property. So here’s the results:

• Initial leverage: $100,000 property ÷ $20,000 equity = 5 to 1 leverage
• Five years later: $124,000 property ÷ $48,000 equity = 2.6 to 1 leverage

I don’t day trade stocks and I don’t flip houses – but that doesn’t mean I’m a completely passive investor, either. Smart investors know when it’s time to rebalance – and when your leverage starts falling it’s time to think about re-balancing.

The chart above shows an investor who rolls up his sleeves every five years, sells his properties and reinvests the equity. In the example above, the investor’s $100,000 property had grown to $124,000 – that’s good. But the $48,000 in equity now translates into a 20% down payment on a $240,000 duplex.

Summary:  Sell the property for $124,000, extracting $48,000 in equity.  Use the $48k to put 20% down on a $240,000 property via a 1031 tax deferred exchange.  Five years later: repeat.

Adopting this philosophy can have a dramatic impact on the long term performance of your real estate portfolio. Let’s look at the equity from the two figures above. In the first case, as mentioned above, the initial $20,000 investment grows into just over $120,000 of equity over the fifteen year period. Not too shabby. But the re-leveraged case is far more lucrative, growing to over $250,000 in the same period.

I’m a buy-and-hold investor, but that doesn’t mean holding forever. By executing a 1031 exchange every five years a real estate investor is able to maintain the desired level of leverage and risk and ensures that his real estate portfolio maintains momentum over time.

Related links

• Why is cashflow important?
• 1031 Exchange :: build your portfolio tax free
• If you invested one dollar :: Real Estate vs. Stocks

I had an fun and informative phone conversation the other day with Jeff Brown of Brown & Brown  in San Diego that made me think about cashflow – and the way that different investors think about what it means.

I talk a lot about cashflow in this column, but cashflow isn't really my game when it comes to investing in real estate.  The cashflow question, to me, really isn't about "how much cash is this property going to put into my pocket on a month to month basis."  The cashflow question, to me, is really about "are the fundamentals of this property strong enough that it will support itself?"

In other words: will it reliably generate enough income to cover principal, interest, expenses and taxes, with a little left over to cover vacancies and incidental expenses. When I run the numbers this is the primary thing that I’m looking for.

This is a strategy for long term wealth building; it’s not one that will finance a short term increase in your quality of life.

Compared with other investing opportunities – the stock market in particular – there is a compelling case for real estate. Consider the following two opportunities to invest $20,000:

• Put $20,000 in the stock market (assume a return of 8% - around the historical average)
• Put a $20,000 down payment on a $100,000 single family house (assume a rate of appreciation of 4.5% - also around the historical average)

The stock market’s 8% trumps the real estate market’s 4.5% rate of appreciation, but take into consideration leveraged backed by casfhlow an it paints a new picture entirely.

Instead of making an 8% return on a $20,000 asset, you’re making a 4.5% return on a $100,000 asset. That’s a great trade-off. And if you’ve done your homework on estimating the property’s cashflow potential then you’ve increased your confidence that the rent the property generates covers all of the associated expenses.

So that property isn’t going to finance your new Porsche anytime in the next 12 months, but when you cash out in ten years you can expect to put almost $80,000 in your pocket. And that beats the pants off the $43,000 that the same investment would have generated in the stock market.

Want a bit more risk? Take that $20,000 and put 10% down on two $100,000 properties - in ten years your investment will have grown to almost $140,000.

There is a catch, however. It’s going to be tougher to make your cashflow proposition work on that 10% down case. Assuming an 8% interest rate your annual payments (principal plus interest) will go from around $7,000 per year to over $15,000. Taxes and expenses will also be higher - so you’re going to have to search more diligently and negotiate harder to make the numbers work.

And here’s the ironic part; eventually an investment will turn into a really “good” one – one that starts churning out cash. Your rents should go up over time and your mortgage payments should remain relatively flat (assuming you’re not in some toxic waste exotic, which is harder to get these days). And when the investment starts getting lucrative on a month-to-month basis, that’s exactly the time to sell…your leverage is running out on steam. More on that in a future post….