Homebuilder shares have been rallying strongly and there may be a short squeeze happening in KBH. 53.70% of the float is sold short according to Yahoo Finance. It may be possible to make a small profit by shorting into the squeeze.
KBH is GAAP unprofitable and has negative cash flow from operations. Either way you look at it, it is unprofitable. It seems clearly overpriced as it has a price/book ratio of 2.85.
A lot of people and a lot of books claim that you can make a killing in real estate. In my jaded, cynical opinion, a lot of this information is more hype than substance.
People who simply talk about making a killing in real estate
…yet they haven’t actually made a killing in real estate.
People who seem to make a killing in real estate
Real estate can be highly leveraged because investors can take out large mortgages on their properties. This magnifies their gains and it also magnifies their losses. In a real estate boom, their gains are spectacular. And in real estate busts, their losses are also spectacular. Donald Trump almost went bankrupt. And he is one of the survivors.
If you do something where you have a small chance of going to 0, you will eventually lose all your money. This is also known as Gambler’s Ruin.
If somebody is doing real well in real estate, they might simply be crazy.
People who actually make a killing at real estate
Middlemen. There are various real estate agents and brokers in the industry. These people typically take on very little risk (they are not leveraged) and collect fees. The distribution of talent and money is very uneven. A small minority of people make almost all the money. (To be fair, these people do add value to society because no real estate would be sold without them. I don’t mean to disparage them when I say middlemen. Also, you could be in the small minority of people who are really good at it.)
Really smart developers. Real estate development is the riskiest part of real estate and also potentially the most profitable. Often the development company owns land, which can drop 90% in price (this happened when the US real estate bubble burst). The wiser, not-so-crazy developers like NVR will instead own land options. They have a right but not an obligation to buy a piece of developed land. When the US real estate bubble burst, the landowner was stuck with the suddenly not-so-valuable land. I would also point out that NVR emerged from the ashes of bankruptcy protection as its predecessor company took on too much risk and had to enter bankruptcy protection. They learned their lesson.
Other than the two examples above, I don’t know of people who make a killing in real estate without taking on crazy risks. With low leverage and risk, real estate is otherwise a place where investors can make reasonable but not insane returns.
Buying condos pre-construction
There is risk from land price fluctuations and from construction risks (e.g. it make take a few years for the developer to sell all the units in the condo). I don’t know of people who have been able to consistently make money in this fashion. Usually some retail “investors” make money, think that they are genius, imitators flood the market, the bubble bursts, and a lot of people lose their deposits (and maybe more…). This has happened many times in places around the world.
1. Buyers are overpaying for real estate.
Buyers are overpaying for real estate. One measure of real estate values is the cap rate (capitalization rate).
The cap rate is the profit of a property divided by how much it cost to buy. The profit is basically the rental income minus all the various expenses (plus a contingency for tenants from hell, vacancy, etc.). The cost to buy includes all the various transaction costs like the realtor’s fee (if you used one), taxes, etc. etc.
Currently, the cap rates for Toronto real estate range from 2% to 6%. Properties in undesirable areas like Jane and Finch make up the higher end of that range. Newly built condos and upscale housing in desirable areas make up the lower end of that range.
Renters are getting an amazing deal on middle and higher-end housing. Paying 2% of what it would cost to buy these properties is a great deal. Instead of getting a mortgage and putting down a downpayment, you can put that money into the bank and collect 3% interest. Yes, interest rates are pathetic right now. But the cost of rentals are even more pathetic.
2. Mortgages can be really risky
If you get a mortgage with a 20+ year amortization period, you may be really uncomfortable if you really understand the risk.
After 5 years, you will need to renew your mortgage. If interest rates rise, your mortgage payments can jump dramatically (e.g. double). In the 70s and early 80s, interest rates rose to historic highs and many people lost their homes. It’s financially devastating and also emotionally devastating for it to happen. History will sometimes repeat itself. And no, this time is not different. I am not saying that interest rates will definitely skyrocket, but that there is a possibility that it will happen. If you can’t stomach a good possibility of a devastating financial loss, then perhaps a mortgage is not a good idea.
Do your own thinking
1- Real estate does not always go up. Historically, there have been many drops in the Toronto real estate market.
2- Please crunch the numbers for yourself. For some cases, landlords are throwing money away to renters.
And if you don’t mind living in unattractive areas like Jane and Finch (I actually wouldn’t mind), then it can make sense to buy housing there.
3- Other people have credit card debt. And payday loan companies have a lot of customers. That still doesn’t make it a good idea. You need to do your own thinking. Crunch the numbers for yourself. Figure out your tolerance for risk.
