Talking About Yields Again

This week is not shaping up into one of those weeks full of good news. When that happens, Frothing Developer thinks about the medium term. Today we want to talk about yields on investment real estate in Las Vegas.

Prices have fallen on some housing in Las Vegas to levels where, relative to the rent they fetch, they are not just good deals but amazing deals from a cash-on-cash yield basis.  One reason that yield is important is that if you’re making enough yield on an investment, that is, if your taking enough dollars to the bank every month, then you can ignore fluctuation in the price of the asset, and you can ignore disruptions in the market.

Let me dive into some examples.

Consider Park Avenue on Las Vegas Boulevard. One of the first of the wave of condominiums that were built during the boom. Not a project without drama. The Board of Directors has had upheavals. The property management company is being investigated by the FBI, and the whole site has been fighting a construction defect lawsuit for two years now.

Not at first blush what you might consider a perfect real estate investment.

But let’s look at what a purchase at Park Avenue yields.

To start with, we look at the MLS to try to get a sense of what Park Avenue rents for. We’ll filter out the furnished units and the 1 bedroom units. Since the 2 bedroom plans at Park Avenue are pretty similar in size and appeal, we’ll average all of the recent leasing activity in the last 2 months. Throwing out a couple of oddly high outliers (we want to be conservative in our assumptions here), we get average rent of about $1.01psf, or $1176 per month.

Now let’s look at costs:

HOA dues range from $146 to $220. I’m not sure how they’re calculated, so I’m just going to use $200 per month.

Property taxes end up being about .8% per year.

Now let’s look at what you can buy these units for. I took the lowest four prices for units that were not short sales, and that were two bedroom units. The average of the prices for these 4 units is about $140,000. They’re all bank repos.  Two of these units are on the first floor and two are on the second floor. Let’s move the rent down to $1150 to adjust for floor level.  Assuming a 95% occupancy, and budgeting 5% of rents for a property management fee and another $500 per year for maintenance/insurance, you would get a 6% cash-on-cash return if you bought one of these units and leased it out. Add in the tax benefits of depreciation and you get up to 6.7%.

With money markets only deliverying 2-3%, that’s a great return for something as steady as rental real estate. This analysis doesn’t factor in the potential impact of construction defect litigation. It assumes rents won’t fall (probably a safe assumption for Park Avenue, what with the 2000 jobs of M Resort popping up in the southern end of town.)

How about Manhattan, my first project? It doesn’t have the construction defect exposure, and it’s a newer project. We still own some units at Manhattan, which we’ve leased. At Manhattan, we’ve been consistently getting $1500 per month in rent (although the MLS shows that other landlords are not hitting that level). There are units that have shown up in the MLS as low as $200k for standard Midtown plans. Apply the same cost factors and logic, and Manhattan units when purchased at this price deliver 6.2%.

These yields are very impressive. Here’s another way to think about it: suppose you buy one of these units and plan to resell it in 2 years. You want to sell it for $50k more than today’s market. If you mark up the price of a Manhattan unit to $250,000, it still delivers a 5% annual yield.

Yields like this are why there are so many transactions in the market. I started buying undervalued, high-yield units this month, and have bought 4 so far.

What does this mean if you’re sitting on a unit at a much higher price and lower yield? It means that you can look forward to the market moving back up towards your level. How quickly it moves and how far it moves depends on your yield. This is where not all properties are created equal. A lot of the single-family residential units in town have lower yields because they require much more money for maintenance and don’t command rents at the level of Manhattan. But there are probably some real gems out there.

Why Houses Are Getting More Expensive to Build

One thing that’s very important in determining the underlying value of a house is the cost to replace it. Obviously, if it costs $200,000 to build a house, then no one is going to be able to build new ones planning on selling them for $150k. If you buy a house at $150k in this scenario, you know that even if builders are on the sideline now, when they ultimately return to building the houses will cost at least $200k.

It turns out that it’s much much more expensive to build a house than it was even 20 years ago, even after adjusting for inflation. The reason has to do with the continuing addition to the minimum building requirements.

Nothing could more clearly show the impact of this than the following, taken from an email sent out last week by the National Association of Homebuilders:

Fire sprinkler mandates will be part of the 2009 International Residential Code and will be required in all one- and two-family homes and townhouses that build to the code as of Jan. 1, 2011.

The sudden — and controversial — arrival on Saturday of 900 fire officials eligible to vote at the International Code Council‘s final action hearings in Minneapolis swelled the number of sprinkler proponents and the measure was approved by a vote of 1,283 to 470 on Sunday morning.

…

The email that was sent suggests a cost of $1.50 per square foot for sprinkler gear. But it leaves out the significant cost of labor and design (you have to design each sprinkler installation separately with costly consultants and get it signed off by the fire department).

Based on my experience paying for sprinkler systems, this change has just added a minimum of $4,000 to the cost of typical 2-br homes.

Actually, since I’m a condominium developer, this helps even the playing field. I already have to put sprinklers in all my units. Things like this have given a secret cost advantage to my single-family-residential building competitors.

Anyways, getting back to Las Vegas: there’s no evidence that there will be any letup in the slow but steady addition of new requirements to building codes (especially because a lot of the people voting for the changes benefit professionally from the increased code requirements). That means houses will continue to get costlier and costlier to build, albeit safer. Prices may be down in 2008, but logic makes it clear that they can’t stay down.

National Sales Backlog Drops from 10.9 months to 10.4 months

WSJ reports:

The inventory of unsold houses fell to a 10.4-month supply at the current sales pace, compared with July’s 10.9-month supply.

"Paulson Plan Will Make Money For Taxpayers"

Andy Kessler writes in the Wall Street Journal:

In 1992, hedge-fund manager George Soros made $1 billion betting against the British pound. In 2007, John Paulson’s Credit Opportunities fund correctly bet against subprime mortgages, clearing $15 billion for the year and $3.7 billion for him. Warren Buffett is now hoping to make big money on Goldman Sachs.

Chad Crowe

But these are small-time deals. My analysis suggests that Treasury Secretary Henry Paulson (a former investment banker, no less, not a trader) may pull off the mother of all trades, which could net a trillion dollars and maybe as much as $2.2 trillion — yes, with a “t” — for the United States Treasury.

….

Firms will haggle, but eventually cave — they need the cash. I am figuring Mr. Paulson could wind up buying more than $2 trillion in notional value loans and home equity and CDOs for his $700 billion.

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You can slice the numbers a lot of different ways. My calculations, which assume 50% impairment on subprime loans, suggest it is possible, all in, for this portfolio to generate between $1 trillion and $2.2 trillion — the greatest trade ever. Every hedge-fund manager will be jealous. Mr. Buffett is buying a small piece of the trade via his Goldman Sachs investment.

Over 10 years this could change the budget scenario in D.C., which can also strengthen the dollar. The next president gets a heck of a windfall. In the spirit of Secretary of State William Seward’s purchase of Alaska for $7 million in 1867, this week may be remembered as Paulson’s Folly.

Say "Nay" To Frank Nason

In his continuing role as “the guy who can’t do math”, Frank Nason reported to Hubble Smith in yesterday’s article that “the supply of single-family homes is down to 11.8 months”. This is foolish and wrong. To carry out the “How Wrong is Frank Nason’s Math” exercise, do the following:

 

1) go to the MLS database and get the total number of EA and ER single-family residential units (currently 16,861)

2) next, do a search on the number of SFR units that closed in August (2550)

3) Get a calculator

4) Divide 2550 into 16,861.

5) Look at the answer of 6.6 months.

6) Compare it to Frank “I just double everything for good measure” Nason’s number above.

7) Shake your head

8) Wonder how this stuff gets printed.

Another month of this and Frank may actually take the top position of “Who gives Hubble The Most Misleading Information”, supplanting the GLVAR’s routine miscounting of pending units.

“Buyers are Back”

A recent story in the RJ quoted a new research report from Credit Suisse that shows positive signs in the Las Vegas housing market:

“Buyers are back and looking for deals. Traffic levels improved during the summer…Real estate agents noted a growing sense of urgency among buyers to ‘buy while the price is low’ as inventory levels have been steady for several months and sales are starting to improve.”

Robin Camacho, a Las Vegas Realtor was quoted,

“I’m working with so many buyers, it’s unbelievable,” Camacho said. “It’s been tough getting offers accepted lately, even offers for well over list price. Right now, I’m working with at least seven or eight serious, well-qualified buyers — some strictly cash — at the same time, which is incredible, even in a good market.”

Read the full story here

Home Resales Surge

The RJ reports this morning that “Home resales for ’08 already near to matching [the entire total for] ’07.

The Las Vegas housing market is “moving along” and eating through excess inventory of foreclosures, which now account for about 80 percent of resales, a local housing analyst said Monday.

Dennis Smith of Home Builders Research reported 829 new- home sales in August and 3,051 recorded resales.

…

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The inventory of single-family home listings dropped sharply in the first week of September and pending sales on the Multiple Listing Service have been hovering around 200 since June. The resale market continues to absorb inventory of foreclosures and short sales, or homes sold for less than the mortgage owed.

It’s also good to see how low the new-home permit level is:

New-home permits fell to 485 in August, compared with 668 in July and 802 a year ago, Larry Murphy of SalesTraq reported. Overall, permits are down 55 percent for the year at 4,216.

Now that it’s sub-500 per month, that means that the industry is only adding about 6000 homes a year in supply. That may seem like a great deal, but it’s not, especially when you consider that this number doesn’t count homes that are essentially destroyed or torn down. This doesn’t happen in the newer neighborhoods much, but teardowns are more common than one might think. Each time, for example, that an old apartment building is razed near the strip, it removes units from the supply.

Bailout? Or Smart Investment?

A great deal has been written so far about the government’s proposed $700 billion purchase of mortgages. Almost all of it presents it as a huge taxpayer burden and a hard blow for the government’s finances.

I had to look through many articles before I found any discussion of how the government is actually going to purchase the mortgages. When I finally found it, I was very pleased.

The government is going to hold a “reverse auction”. They’re basically going to say “ok, who wants to sell us some 6 month delinquent stated income mortgages, and how good a price are you willing to give us?” Then the government will take offers. If one bank offers to sell at 20 cents on the dollar and the other bank requires 25 cents on the dollar, the government will first buy at 20 cents. It may never get to the 25cents bank, since the amount it will buy is finite. That gives the banks considerable incentive to sell their mortgages to the government (i.e. the taxpayer) on the cheap.

What happens then? The government sooner or later will either foreclose or restructure each loan that is in default. In order for the taxpayer to lose on this deal, the end sales price has to be even less than what the government paid.

Let’s take an example. Suppose there’s a house in Las Vegas that sold for $400k in 2006 with a 100% $400k mortgage, and is now in default. If the government pays 20 cents on the dollar for that mortgage, the government will write a check to the company holding the paper for $80,000. But the government still has a claim for $400k on the property. When the government forecloses and hands the property over to a LV agent to get it sold, the agent will put it back on the market. How many houses that were worth $400k are worth less than $80k now? The answer is hardly any. Most houses in Vegas are able to sell at prices at about 50% of their peak value. So the agent will sell the house for, say, $175k. The government gets the full $175k, and isn’t obligated to give any of it to the original lender. In this case, the taxpayer will double their money.

So whether or not this bailout costs the US taxpayer, or is even profitable, depends on two things:

1) How good the Treasury Department is at running the auction

2) How much other stuff gets thrown into the legislation by Congress

I’m not too concerned about #1. We are very fortunate to have Paulson in charge. You just don’t get to the top of Goldman Sachs without being very very intelligent. He is driving good deals for the taxpayer. The AIG bailout offer was very punishing to AIG shareholders, as was the negotiated Bear Stearns deal. I don’t think much moral hazard is being created here.

Also, the market level was set recently when Merrill Lynch sold a big set of mortgages for $.22 on the dollar. The buyer is going to make a lot of money on those mortgages, in my opinion.

I’m a little more worried about #2, but we’ll see what gets negotiated this week.

This new bailout could be incredibly profitable for the US taxpayer.

New Airline Service to Vegas

WestJet announces new nonstop service to and from the capital of Saskatchewan. They’re also flying nonstop now to Regina and Victoria.

More Drop in Housing Starts = More of A Good Thing

An interesting picture on housing starts. The fact that starts are continuing to drop nationwide is a good thing. There’s a supply imbalance out there, and the best way to deal with it is to stop building new housing for a while. Interestingly, though, housing starts in the West are up considerably. Not sure what to make of that. Could be a sign of renewed enthusiasm in the West, an indicator that companies in the trenches see signs of demand. It’s certainly still hard to get financing to build housing in the West, so the people pulling permits must be pretty optimistic.