This article comes from First Tuesday Journal Online
This article analyzes how Baby Boomer dissavings will spur investment in real estate through 2025, and what industry professionals need to know to counsel potential investor-clients.
Risk-averse retirees change the investment playing field
Although the financial crisis and Great Recession delayed the retirement of many of the Baby Boomer generation, it remains a demographic certainty that the Baby Boomers will indeed retire throughout the next twenty years. The real estate repercussions of this massive exodus of Baby Boomers from active employment have been discussed for good reason by first tuesday on multiple occasions. [For an in-depth analysis of the effect retiring Baby Boomers will have on the real estate market, see the first tuesday Market Chart, Boomers retire and California trembles; for more information about the Baby Boomer flight from suburbia, see the July 2011 first tuesday article, From city to suburbia then back.]
In addition to the direct impact of the wave of Baby Boomers looking to sell their single family residences (SFRs) in California’s suburbs, also called the periphery, and continue the movement to our cities for a healthy dose of urban amenities, Baby Boomer retirement will have a secondary, but no less important impact on real estate investments. [For more information about the shift from suburban to urban living coming in the next few decades, see the July 2011 first tuesday article, The fate of suburbia.]
The stock market’s loss is real estate’s gain
The prime age for building wealth in the risky stock market coincides with the prime earning years of an individual’s life. This makes sense: any financial shocks experienced by a downward turn in the stock market can be borne with relative ease when one has a steady income and time to wait out its recovery. As Baby Boomers grew into the peak savings and investment ages of 35-59 in 1981-2000, the stock market prices and earnings consequently jumped — a simple function of supply (limited availability of stocks) and demand (increasing amounts of disposable income).
However, as individuals approach retirement, their risk tolerance instinctively decreases since they have fewer working years to recover money lost due to a risky investment gone bad. Consequently, their interest in braving the volatility of the stock market to build wealth wanes. This timeline of risk tolerance throughout an individual’s life is a time-tested and predictable measure of how robust stock market growth will be.
And therein lies the proverbial rub. As they retire, Baby Boomers will dissave by taking much of their wealth out of the stock market and spending it. By the same supply and demand rules which boosted stock prices when Baby Boomers poured their savings into the stock market to save for retirement, the growth of and return (resale profits) on stock market investments will weaken as Baby Boomers dissave in the 2010-2025 period.
Furthermore, since this impact is a foregone conclusion, Wall Street has somewhat built the Baby Boomer exodus into current stock prices. Thus, even before the actual impact of Baby Boomer dissavings sucks money out of the stock market, the projected impact is already putting downward pressure on stock prices, which with company earnings are collectively aggregated in the P/E ratio for comparative analysis. [For the full report on Baby Boomer dissavings and its impact in the stock market, see the August 2011 Federal Reserve Bank of San Francisco (FRBSF) Economic Letter, Boomer Retirement: Headwinds for U.S. Equity Markets?; for more information on the direction of the stock market and the P/E ratio, see the first tuesday Market Chart, S&P 500: Stock pricing vs. % earnings (P/E ratio).]
Even in spite of the personally bitter postponement of retirement forced on Baby Boomers by the financial crisis, the next 15-20 years – peaking around 2020 – will still see gradual Baby Boomer retirement sapping the stock market of its vitality and long-term wealth-building potential. When Generation Y (Gen Y), the children of the Baby Boomers, reach their already-stunted professional strides and look around for ways of growing their retirement nest eggs, they will likely find conditions in the stock market and its management ill-suited to meet their investment needs. [For more about Gen Y’s rough start in employment, see the October 2010 first tuesday article, The demographics forging California’s real estate market: a study of forthcoming trends and opportunities — Part I; for more information about how Gen Y will influence California’s real estate market, see the May 2011 first tuesday article, Where the buyers are.]
Gen Y’s alternatives to the stock and bond markets are few: either deposit savings (which will bear near non-investment returns with banks currently in a general state of insolvency) or real estate.
Shifting to long-term real estate investment
Fortunes, it is generally noted, are made by steps taken during times of economic distress. California’s real estate market is no exception to this rule: as the stock market becomes increasingly less profitable, Gen Y investors will branch out and seek the inflation hedge provided by income properties situated close to strengthening population centers. The years remaining in this decade will be a prime period to invest in real estate positions.
Brokers and agents who plan to handle transactions for income property investors must explain away two particularly prevalent misconceptions held by fledgling investors:
- the distinction between homeownership and real estate investment; and
- the diametric differences between short-term and long-term investing.
Many beginning real estate investors will approach acquiring real estate income properties from the same standpoint as they do when buying a home. Their first instinct is to purchase property when the herd purchases (as happened during the Millennium Boom buying frenzy), which is precisely the wrong time to purchase any property – be it shelter or investment.
Further, first-time investors often erroneously transfer their bundle of emotions devoid of number crunching that go with homeownership to real estate investment. For example, when the typical homeowner purchases his home, he makes an implicit sacrifice – the opportunity cost of putting his money elsewhere – to financially anchor himself to his home. Further, he exchanges the mobility allowed by rented shelter for the perceived stability of owning shelter – homeownership.
As constantly happens, the shock of a lost job or the need to relocate to further a career (and income) puts financial pressure on the homeowner to sell his home, all the while crossing his fingers in hopes he will find a buyer at a price high enough to recoup the hard-earned, after-tax money buried in his home. [For more information about the difference between homeownership and real estate investment, see the August 2011 first tuesday article, Homeownership: a piggy bank investment.]
These emotional risks pushing decisions by a potential homeowner when faced with the idea of having to sell at the mercy of a “bad” market are misguidedly imputed to income property investments. This inapposite comparison is especially pronounced for first-time income property investors who typically try their hand at SFR income property investment, or who use the quixotic example of the ill-informed (and sometimes lucky) speculator as their model of real estate investing behavior. [For more information on flippers in the real estate market, see the August 2010 first tuesday article, Speculations on speculator suppression.]
In reality, long-term income property investors, also known as buy-to-let investors, have no emotional attachment to a property, no need to concern themselves with what will happen should they need to relocate their personal residence for any reason. At the time of acquisition, they merely do the math on whether an investment (in a property’s income and expenses) will return annual earnings sufficient in amount and nature to justify its purchase for the long-term – “long-term” being the operative phrase. Income property, it must be understood, is a collectible; the family home, not.
In for the long haul
Stock market investments are by nature a product of herd mentality, subject to short-term jolts and shocks representative of (often) ill-informed human reactions to momentum (even gossip) but not data. Wealth is quickly built, and quickly lost in a frenetic need to keep above water — a risky game, at best.
The durability of buy-to-let real estate investment, on the other hand, is dependent on time-tested real estate fundamentals. Based on these fundamentals, the price paid for an investment property is:
- the present value of its future flow of net income, coupled with predicted growth in price by inflation and appreciation for profit over the long-term; and
- anchored by a “recession proof” location for weathering both the booms and busts of the inevitably recurring real estate cycle.
Unlike in a family shelter, which is subject to the employment conditions of the homeowner, income property need not be sold until the owner is ready to cash out at retirement. Should the timing not be favorable for selling when an investor is ready to dissave, he can collect rents on the property until the real estate cycle comes around to favor sellers.
A centrally-located income property reaps the benefits of stable, more recession-proof rental income. Unlike volatile stock prices and spikes in SFR prices following real estate bubbles, residential rents in the desirable urban core adjust according to the rate of consumer inflation (as do the payroll receipts of employees) and remain on a relatively constant trajectory. [For more information about the draw of the urban core in California’s real estate recovery, see the July 2011 first tuesday article, From city to suburbia then back.]
Residential rent from properties properly situated in other than periphery locations runs very close to the equilibrium trend lines for consumer inflation over long periods of time — something a homeowner cannot take advantage of since they simply buy and sell subject to the cyclical violence of booms and busts existing when they must sell. These “wipesaw” financial conditions are not of concern to investors of rentals as investor expectations are tied to rents, not the price of a property once they have made the decision to buy. [For more information on consumer inflation, see the first tuesday Market Chart, Consumer Price Index — Urban Consumer (CPI-U).]
As a result of our current depressed economic conditions due to the financial crisis, housing bust and Great Recession, the base of investors — both new and experienced — in the coming real estate investment era will be wary of putting down large sums of money in individual investments, or simply without the means to do so.
Expect to see a marked rise in group investments in the name of limited liability companies (LLCs), limited partnerships (LPs) or tenancies-in-common (TICs), known as real estate syndicates. In addition to the financial protection brought about by group investments (sharing losses, as well as profits), investors also reap the benefit of having a built-in property manager for-hire in the broker arranging the investment. [For more information about real estate syndication, see the first tuesday book, Forming Real Estate Syndicates, Third Edition.]
Not only does syndication make sense as a brokerage business — earning fees for arranging the deal as well as for the ongoing property management of the syndicated property — but brokers and agents who know how to form and manage group investments can accumulate great wealth since they share in the future of the investment. Learning how to find, control and market suitable investment properties gives brokers and agents a way of getting their foot in the door while the real estate market is still poised to make its recovery.
Brokers and agents must get the message out that real estate investment is a viable — even necessary — alternative to the stock market. The stigma of real estate as the lesser form of investment (an attitude inculcated by the abuses of every service provider in the real estate market during the Millennium Boom) needs to be dispelled while the stock market is in disarray.
The name of the game is diversification: no investment is one-size-fits all. So as Gen Y comes of age and begins to look around for sound ways of working their money, real estate professionals need to consider investment options which benefit their clients while at the same time nurturing their own practice and personal net worth. So learn how to work with income properties, and the return on your time, effort and talent will be solid for this and the coming decade.