Investing in a Volatile Market:

There IS a Better Way

 

 

Summary.  The recent crash of the stock market has been leaving investors grasping for answers.  After years of hearing the merits of investing in the stock market for the long term, investors are confounded by the realization that the S&P 500 stock index has actually declined over the last 10 years, and total returns were negative (as of Oct. 10, 2008).  The extreme volatility of the stock market makes it a very high risk investment.  Older investors have seen their retirement dreams get crushed, and younger investors are searching for a reliable investment mechanism for the long term.  Fortunately there is a strong alternative class of investments:  real estate --- if it’s the right real estate.   

Despite the "mortgage market meltdown", some markets, such as Jackson, MS and Memphis, TN, actually have appreciated since 2005, unlike the East and West coasts that have made all of the news.  Nationally, in the last 10 years, median single family home prices appreciated an annual average of over 5%, and over 6% during the last 40 years.  Even if an investor paid all cash for a median priced property 10 years ago, he could have gotten at least a solid 7% return on just the cash flow alone.  But combining the cash flow with the appreciation, an investor would have received a total return of well over 10%, with volatility a tiny fraction of the stock market.  But the key is knowing where to invest; even better returns are possible.

 

 

Market shock. The recent stock market crash between September and October 2008 was traumatic for investors who had significant investments in U.S. and international equities.  In a single year, between October 10, 2007 and October 10, 2008, the S&P 500 stock index, the main barometer of the U.S. stock market, lost a staggering 42.5% of its value.  The mortgage market meltdown, the tightening of the credit markets, failures of esteemed major investment banks such as Lehman Brothers and Merrill Lynch, the oil price bubble, the fall of the dollar, and similar financial strains conspired to cause investors to flee the market. 

 

 

In particular, middle-aged and older Americans have been deeply affected.  Many retirees with exposure to equities have seen their portfolios, and therefore their incomes, shrink dramatically.   Many individuals contemplating retirement are now having work several additional years to make up for their losses, while others are resigned to a much more modest retirement.  The golden years look more like brass. It has been very disconcerting to see large moves in the stock market on a daily, and sometimes an hourly basis.  Not many people are comfortable seeing their life’s savings in the stock market dropping 5% or more some days, not knowing if and when it will come back.

 

 

What to do?  Investors of all ages are struggling with how they should be managing their investments.  Conventional financial wisdom is that investing in equities is the best long-term strategy for growing one’s “nest-egg”, as equities over the long run have outperformed bonds, money market funds, CD’s and similar conventional investments.  But is that really the case?  Many investors have believed that if they merely “buy and hold” stocks, that over the long term they will get very strong returns.  But is that really true?  The answer to both questions is that it depends on the timeframe.

 

Figure 1 below shows the S&P 500 stock index and its returns over the last 40 years, as of Oct 10th of each year:

 

 

Time-frame	10/10/08	1 Year Ago	10 Years Ago	20 Years Ago	30 Years Ago	40 Years Ago
S&P 500 Index	899.22	1564.98	984.39	278.24	104.46	103.29
Annual returns*	N/A	-42.5%	-0.9%	6.0%	7.4%	5.6%

 

*Compound annual growth rate (CAGR)                                      Source: Standard & Poors

 

 

Figure 1.  Compound Annual Average Returns for S&P 500 Stocks

 

 

Investors who “bought and held” stocks in the S&P 500 index 40 years ago got a 5.6% return compounded annually.  Not bad, but not great, either.  The 30 year return was better at 7.4%, and the 20 year return was only 6.0%.  Investors who bought 10 years ago actually lost nearly 1% per year; if they bought 1 year ago, they lost 42.5%! 

 

 

If we as investors were skilled enough to know precisely when to buy and sell, of course, the returns would be spectacular, but outside of perhaps Warren Buffet, there are not a great deal of investors who can time the market.  Its volatility creates great risk.

 

 

From the chart in Figure 2, we can see the wide variation of returns of the S&P 500 over the last ten years.  While the compound annual return across these dates was bad enough at -0.9%, the volatility --- the standard deviation--- was over 20%!  For investors who bought a the wrong time, or sold at the wrong time, it was a disaster.  Who among us wishes to predict what 2009 will bring?  Another down year?  A big bounce back up?  Even Warren Buffet, in an October 17, 2008 article in the New York Times said, “I haven’t the faintest idea as to whether stocks will be higher or lower a month --- or a year --- from now.”

 

 

 

  

 Figure 2.  S&P 500 Annual Returns 1999 – 2008

 

 

 

As to traditional alternative investments, bonds historically have under-performed stocks, albeit with lower volatility.  CD’s are quite secure, but returns have been ranging from 3% - 5% per annum, just enough to keep up with inflation.  So what is an investor to do?  Fortunately there is an alternative investment class that shows great promise --- real estate!

 

 

Why single family real estate?  While there are several classes of real estate, investing in single family homes has great appeal for four key reasons:

 

• Total returns can start above 10% per year, consistently, and are frequently much higher
• The returns on real estate are far more stable, less volatile and more predictable than the stock market
• The performance of real estate has little to do with what happens in the stock market
• Investors understand the nature of the asset that they are investing in (buying a house)---they are already homeowners
• Single family homes are easier to sell than nearly all other classes of real estate

 

The nature of real estate is that it is a basic commodity.  All people need food and shelter before all else, and real estate is the source of that shelter.  When the supply of land is fixed and the population of a nation continues to grow steadily, demand for housing continues to grow steadily as well.  This is one of the reasons why housing prices in general have grown so consistently and predictably over the long course of time, notwithstanding the “housing bubbles” of the Far West, the Northeast and Florida.  The rest of the nation --- mostly the central and southern US ---  did not experience those speculative housing bubbles and have had much more stability in the prices of homes. 

 

 

The housing bubble.  Using the examples of the contrasting markets in San Diego, CA and Jackson, MS, note the difference in home price stability in the charts below in Figures 3 and 4.  The “housing bubble” in San Diego that formed between 1998 and 2005 is quite pronounced, as is the “pop” in the bubble as housing prices declined. 

 

 

 

 

 

 Figure 3.  San Diego Median Home Prices and “Housing Bubble”

 

 

Jackson, on the other hand, had no housing bubble to begin with, so there was nothing to pop.  The data for Memphis, TN shows a similar result.  The stability of these prices and the relatively constant performance of the housing market in Jackson and in Memphis make them both low risk areas to invest.  There is little danger of a collapse in housing prices based on what history tells us.

 

 

                

Figure 4.  Jackson MS Median Home Prices

 

 

 

Generating high returns in real estate.  Real estate properties that are rented to others generate returns to investors in three ways:  through the appreciation of the property, through the cash flow that it generates each month, and through the pay down of the mortgage by the renter each month (if there is a mortgage on the property at all).  Over the long course of time, home values in the U.S. have done extremely well.  Over the last 40 years, the average annual appreciation of a median-priced single family home has been 6.2% per year.  During the last 10 years, even when factoring in the recent turbulence in the mortgage market, the appreciation of a single family home has averaged 5.3% per year.  Contrast that return with the stock market, which returned a loss of -0.9% during that same period (Figure 5.)

 

 

 

 

Figure 5.  Comparison of S&P 500 Returns vs. Single Family Homes, 1999-2008

 

 

Now, consider that in addition to appreciation, on a cash purchase investors can reasonably expect to get net cash flow in the vicinity of 7 - 8% (also known as the capitalization rate, or “cap rate”) on a well-chosen property.  The cash flow is simply the annual rents less all annual expenses, such as taxes, insurance, maintenance, and property management.   This cash flow divided by the purchase price of the property yields the cap rate.  When factoring in the tax advantages of depreciation, the equivalent return to an investor of a 7% cap rate is typically 8 – 8.5%, depending on the investor’s tax bracket.  Cap rates vary widely across different regions of the country and for houses in different price ranges.

 

 

Combining the two sources of return, cash flow (as measured by cap rate) and appreciation, it is evident why real estate is able to produce returns of at 10% to 13% per year on a steady basis.  Using the power of leverage to finance properties instead of paying cash, returns can sometimes exceed 20% per year, but the number of investment properties investors can finance outside of their own home is presently limited to three under current Fannie Mae guidelines.

 

 

Low risk.  Rate of return, while very important, is not the only consideration.  The level of volatility (the standard deviation) of an investment is a measure of its risk.  We know form the recent wild swings up and down of the stock market that it is volatile, and the industry measures that volatility as standard deviation of the return.   Note the large swings in the returns of the stock market in Figure 4.  The 5% standard deviation of median-priced real estate in the U.S is about five times less volatile than the stock market (standard deviation of nearly 25%) in the last 10 years, meaning that real estate is a relatively stable and less risky investment.  In addition, prices move very slowly in real estate and are fairly predictable, so the anxiety factor about where real estate is headed is much lower.

 

 

Low correlation with the stock market.  Another important benefit of real estate is that its performance is fairly independent of the stock market.  As the stock market returns move up and down year over year, the movements in real estate prices may or may not move with them.  For investors seeking to diversify their investment portfolios, this low level of correlation makes real estate a very attractive component to add to their investment pool.

 

 

Where to invest.  Given that real estate offers higher returns, lower risk, and moves fairly independently of the stock market, the key question is where to invest.  Not all real estate is created equal.  While there are many factors that influence choosing where to invest, investing is mostly about good location: investing in metro areas and specific neighborhoods with pricing stability and good appreciation potential.

 

Location can be characterized by many factors, but there are three main factors that stand out:

 

• Relative valuation
• Pricing momentum
• Cash flow

 

Relative valuation simply means assessing whether a location is considered over valued, fairly valued, or under valued relative to where prices “should” be.  One institution which analyzes such relative valuation data is a major bank, National City Corporation.  They use some sophisticated algorithms to calculate what median home prices should be in a given metro area, analyzing such factors as household population density, mortgage interest rates, relative income levels and characteristics unique to the history of each metro area.  When their calculated housing price is compared to actual median housing prices in a metro area, they can estimate by what percentage median prices are over or under valued.  For investment purposes, of course, it is wisest to invest in undervalued metro areas.

 

But relative valuation is not the only consideration.  For example, San Diego and Jackson are both considered undervalued markets as of Q2 2008 at about 18% undervalued.  But note the pricing momentum in the graphs in Figure 6: 

 

 

  

Source: National City Corporation, Sep 2008

Figure 6.  Relative Valuation of Real Estate in San Diego, CA & Jackson, MS

 

 

From the graphs, we can see that both San Diego and Jackson are undervalued after 2007: the median prices (blue line) are below the theoretical fairly valued prices (red line).  But prices are still declining in San Diego, while they are rising in Jackson, so Jackson is considered a better location for investing at this time.  Over the long term, actual prices (the blue line) will correct toward the red line (the theoretical value).

 

 

From a cash flow point of view, there is wide variation on the cash flow in different metro areas.  Again comparing San Diego to Jackson, we find that rents relative to the price of the homes are about are about twice as high in Jackson and in Memphis.  With high rents and low taxes and insurance, cash flow (and cap rates) in Jackson are outstanding.

 

 

Since Jackson is a substantially undervalued market, has upward pricing momentum, and has high cash flow, it would be considered an excellent location to invest both now and in the foreseeable future.   While all of the comparisons have been made between Jackson and San Diego, Memphis TN exhibits most of the same characteristics as Jackson, and is also well suited for investment.

 

 

Work with professional investment companies.  From the foregoing it is clear that real estate in the right location can offer higher returns at lower risk than the stock market by a wide margin.  It is extremely important for investors to work with real estate investment companies who are reputable, experienced, and very knowledgeable of their business.  Investing in real estate should not ever be a white-knuckle ride.  In evaluating which investment companies to work with, consider the following capabilities:

 

• Experience: a proven track record
• Excellent industry reputation
• Knowledgeable of their profession
• Financial information fully and fairly disclosed
• Certified quality properties offered for sale
• Excellent customer service
• Provide assistance with all aspects of the transaction
• Easy to do business with

 

A good investment company should obviate the need for an investor to become a real estate expert, any more than they need to become a stock market expert to invest in stocks.

 

 

Meridian Pacific Properties is a solid choice.  At Meridian Pacific Properties, we pride ourselves in setting and meeting the highest professional standards for ourselves.  We seek to earn our clients’ trust and respect as we guide them carefully to help them meet their investment goals.  We have completed over 100 buy/sell transactions in the last several years.  The metro areas in which we invest have been selected out of the 330 metro areas that we have analyzed.  Over the years we have formed a strong business network with a number of key associates, including contractors, mortgage brokers, appraisers, inspectors, and other service professionals so our investors do not have to.  We would be pleased to have the opportunity to serve you.