Jul

25

Keep It Or Dump It: An Apartment Building With Exploding Rents–But A Languishing Market Value

July 25, 2012 | By Tekoa Da Silva

    Imagine that seven years ago you purchased an apartment building for $500k in a blue collar neighborhood, containing 20 apartments, each of which rent for a rate of $500 per month—for a total monthly rent roll of $10k.

    Your vision of the neighborhood’s future inspired you to buy the building. You’ve been closely watching development of education and technology in the state and city, and have watched as one development plan after another is initiated by both public and private enterprise. Two new colleges are slated for construction in the next ten years, and due to space constraints, there is no room to build additional housing units—creating the perfect long term environment in which your building will thrive.

    The local government is passing tax incentives to promote and attract new technology start-ups, all of which require office space, parking spaces, more restaurants for new employees to eat lunch in every day, and of course, more housing.

    Tax revenues are doubling and tripling, and in response, the municipality is adding new employees of their own to maintain the level of service and maintenance the area is accustomed too.

    For all these reasons you decided to purchase the building.

    In the short term, there will be petty annoyances of dust and noise due to construction, but in the long term the area will be transformed, rents will increase along with the property value, and this one investment alone may provide a life of abundance not just for you, but for your children and grandchildren as well.

    After closing the sale, you hug your attorney and real estate agent, drive home to kiss your significant other, and together get dressed for a romantic evening of live music, your favorite restaurant, favorite entree, wine, and of course, your favorite dessert. Life is great.

    The next day you wake up and decide to list your building with a management company. You find the best company in town, and get started in a fantastic business relationship.

    Over the course of the next two years, this management company presents you with renovation & expansion plans for your building. You follow their advice and increase the number of units in the building by adding new stairways, converting library rooms into bedrooms, and repositioning walls. The original 20 units now become 25 units, with higher rental rates of $600 per month. Your monthly rent roll went from $10,000 to $15,000 per month—a 50% increase in revenue! As a result, the market value of your building nearly doubles—to $1mm.

    To reward yourself for your ingenuity, you once again take your significant other out for a romantic evening on the town, with all your favorite sights, sounds, and tastes. Life couldn’t be any better.

    One morning a few months later, you purchase the newspaper and notice a group of tradesman congregating with coffee in hand at 9:00 a.m.–which is odd, because by this time of morning they’ve usually been at work for three hours already. Opening up the paper, you read they’ve all been laid off. As a result of new regulatory requirements, college construction has been postponed, and hundreds of local people have been fired.  A few of your tenants move back home with their parents and your total monthly rent roll drops from $15,000 to $13,000.

    In response to the new economic hardship, local policy makers ease back on regulations, and within a year everything’s back to normal. Your rent roll returns with a vengeance, now exceeding $15,000. Each of your 25 units now rents for $650—a 30% increase from the time of your purchase. Total income is now $16,250—a staggering 62.5% total increase since the time of purchase!

    Life is good yet again, and you sit back and relax. Out of curiosity, you pick up the local real estate paper to check on the growing market value of your building, only to discover that while you’re monthly rent roll has increased by over 60%–the value of your building has collapsed and is languishing at your original purchase price of $500k! In a fury, you call your real estate agent looking for answers.

    Your agent tells you the majority of real estate buyers do not believe the new economy “hype” of the area. They’ve “been around a long time”, and know that change won’t happen and growth cannot occur, because “big dreams always fail in this town”. Since this group owns and controls a majority of the local wealth their convictions create a valuation “damming” effect–capping local real estate prices despite steadily growing rental yields.

    Shaken but not deterred, you move forward with responsible ownership of your building. You call the management company and brainstorm ways to further increase the monthly rents. A plan is created to install cell phone receptors to the roof of the building, increasing total rents by $1,000 per month, for a total of $17,250 monthly. This is now an astonishing 72.5% increase in monthly income since your time of purchase.

    Celebrating the victory and now 15th marriage anniversary, you and your significant other go on vacation, and enjoy all your favorite things, as well as an of exchange gifts, jewelry, and words of renewal for the next 15 years. Life just gets more and more rewarding!

    Following you’re return home, you’re invited to an investment seminar with the most successful businesspeople in your area. You attend the conference, and are wowed by the fancy cars in the parking lot, the fancy suits, and all the stories of success. At one point during the evening over wine, a small group begins to ask you about your success, and you share with them the story of your 25+1 unit rental apartment building.

    The questions asked by your new friends become sharper, with particular emphasis on net worth and capital gains. One person asks how much you purchased your building for, and how much the market value is now. Stammering, you respond with “$500k purchase price seven years ago…and my agent says it goes for about the same now…”—to which you hear a chuckle, and a few excuse themselves to the bathroom.

    “My dear friend”, one of the group comments, “Isn’t the whole point of investing to make money by buying and selling? You’ve owned the building now for seven years, and it hasn’t rewarded you with any capital gains? Why wouldn’t you buy something with better prospects!”

    Driving home that night with haunting memories of people snickering at your expense, you lay in bed and have trouble sleeping. Early the next morning you call your real estate agent with specific instructions to dump the building despite the rapidly increasing rental yields. Both the management company and the agent beg you to reconsider, indicating that over time as large infrastructure projects reach completion, the city will achieve higher valuations. You ignore their advice, intent on never looking a fool around fellow “successful” investors ever again.

    You sell the apartment building for the same price at which you purchased it, and with a sigh of relief trade the proceeds in for a waterfront condo which will surely appreciate in value during the years ahead–despite the fact that it carries a negative rental yield (ie., the rent is not enough to cover the mortgage).

    A few years later you open up the real estate section of the newspaper, and see a picture of your old building for sale by the sucker who purchased it from you. Chuckling, you scan the page to see how much money the current owner will be losing. To your astonishment—the building is now listed for $5 million—ten times your original purchase and sale price!

    The new “sucker” had strong, patient hands, and knew how to “sit tight” when an asset is appreciating in value. In fact, the buyer made no improvements to the building at all—she simply waited for the perception of the overall market to change, while enjoying the sweet rental income.

    —–

    The narrative we just walked through is typical of every major new investment trend.

    At first, strengthening market fundamentals attract early-adopting investors, who are greeted with burning pessimism and mainstream ridicule. Following the early-adopters is a grueling wall of worry, a washout of weak hands, more ridicule, and another wash-out—all before the final “belief” stage—where the public believes the story only after it materializes in front of their eyes.

    After market materialization, the real opportunity is gone, and early adopters trade their positions to eager and unimaginative buyers.

    You might be thinking this story is an unrealistic “fantasy” which doesn’t occur in real life—I beg the contrary.

    I’d like to show you a numerical snapshot of one of the world’s largest and safest gold mining companies. In fact, I modeled the entire apartment building story as a parallel to this company’s strengthening internal value!

    Over the last seven years, the share price has absolutely languished—while during that period earning power of the company (and many others like it) has grown by leaps and bounds!

    XYZ Large Gold Mining Company:

    2005

    2011
    Net Earnings

    $401 million

    $4.4 Billion
    Dividends

    0.22

    0.51
    Cash & Equivalents

    $1.03 Billion

    $2.7 Billion
    Total Proven & Probable Gold Reserves

    88 Million Oz.

    140 Million Oz.
    Share Price

    $29

    $33

     

    Net Earnings are up over 1000%!
    Dividends are up over 130%!
    Cash & Equivalents are up over 100%!
    Total Proven & Probable Gold Reserves are up nearly 60%
    …But the share price is up only 13%

    A quick glance at these numbers shows the internal strength of this company has far outperformed the hypothetical “apartment building” example discussed here today.

    But why has the share price of this mining company performed so poorly over the last seven years?

    In my opinion, it’s for the same reason the apartment building couldn’t get any appreciation from the market. Nobody believed the story, especially those who controlled the largest amounts of money. They believed the town was a joke like it’s always been, and that any progress made so far is irrelevant.

    Mining share investors today who attend mainstream investment conferences are more likely than not snickered at over wine—and are bailing out due to stubbornly low share prices—despite exploding increases in net earnings, dividends, and cash & cash equivalent balances.

    Bailing out of a market while it’s mired in disbelief is fine for a while—but to open the newspaper one day and read the story of a man or woman who purchased your shares only to sell them for ten times a higher price after all your hard work of holding and waiting—that would be painful to say the least.

    So good luck in the days and months ahead, and let your own imagination be your guide!

    Best,

    Tekoa Da Silva
    Bull Market Thinking

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