By David Langlieb
Consider the following hypothetical – I own a casino with a custom-made roulette wheel that has 50 pockets on it, numbered 1 through 50. I offer you this opportunity: ‘invest’ a million dollars with me on a single spin, and if the ball lands on any number other than 18, I’ll pay out $10,000 instantly. You can do it as many times as you want. The catch is that I keep the entire million if the ball hits 18. That’s a massive downside, to be sure, but it’s improbable. You’ve got a 98% chance of a quick and easy return.
Of course, this is actually an atrocious proposition for the player. As with other casino games, the short-term likelihood of winning easy money obfuscates the long-term rigging. Over the course of many spins and many different players, I’ll claim the million dollars much more frequently than needed for me to finish in the black. Assuming a fair wheel, 18 will, on average, hit halfway through a 50-spin turn. The player will be up $250,000 – again, on average – by that 26th spin, thereby generating a $750,000 net loss. Even if 18 doesn’t come up until the 40th spin, the player will net a $600,000 loss. You’d have to go 101 spins before hitting an 18 to net out a positive return – possible but unlikely. And over the long run, you can’t beat the game. Provided that I start with enough bankroll to pay out the $10,000 winners when I have to, this is a lucrative proposition for me and a significantly more lopsided house edge than actual casino roulette (still a sucker’s game, of course).
Now, consider this addendum: a wealthy (and excessively trustful and uncurious) friend gives you a million dollars to invest on his behalf and doesn’t ask what you plan to do with the money. You immediately bet on my wheel game, and an 18 doesn’t hit. You leave my casino and return $1,010,000 to your friend less than an hour after he gave you the million bucks. He’s very impressed. What a genius you appear to be! If you can duplicate this investment performance daily, you’ll double his money in a month.
I’ve been thinking about this flavor of fallacy a lot these days, as rising interest rates, increasing levels of debt (both public and private), and a bevy of other macroeconomic-adjacent factors have unsettled the domestic housing market. I turned 40 this year, and my fellow millennials and I have lived most of our professional lives without the housing market hitting an 18. Between the last financial crisis (2009-10) and the present day, housing has followed a near-uninterrupted upward price trajectory. To take just one commonly cited data point, the Case-Schiller National Home Price Index, which tracks the purchase price of single-family homes in the United States, rose 122% between the end of 2010 and August 2023. There were only two very slight dips in that period – a few months of 2011-12 and late 2022.
Real estate investing is not casino gambling, of course, but short and intermediate-run price movements mimic the kinds of fibrillations that occur at the roulette wheel. For this reason and others, a return to examining the deeper fundamentals of the market and reasons to buy property is essential right now.
One key fundamental reason for housing’s seemingly unstoppable trendline is that we artificially restrict housing supply via zoning codes. And we do it more aggressively now than we used to, as more of the country gets built out, and incumbent residents routinely exercise political pressure to maintain the density level of the neighborhoods in which they live. The merits and particulars of zoning codes are another topic for another day. Still, the impact of restricting new housing construction to the point where it cannot meet demand has made housing more expensive than it would be in the absence of regulation. All else being equal, this makes housing less vulnerable than other sectors to downward pressure on prices.
At the same time, the democratization of information brought on by Zillow, Redfin, and similar websites has made it easier to research real estate and evaluate opportunities for both homeownership and investing. These tools are a double-edged sword, particularly for small investors. We know from basic economics that as a market approaches perfect equality of information, profit margins shrink. We aren’t at perfect equality yet and probably never will be. Nevertheless, increased access to information presents both challenges and opportunities. As discussed in last month’s blog post, out-of-town cash buyers – institutional investors, hedge funds, etc. – have a greater ability than ever to find small, attractive deals and snap them up before local buyers can get financed. This inequality is a significant factor in the recent uptick in investor purchases of small rental properties.
With all this in mind, here’s one universal principle to keep in mind while approaching real estate acquisition in what appears to be a tightening market:
Find the thing(s) the market cares about that you either don’t care about or can overcome.
The market price of a piece of residential real estate reflects several factors, mostly related to the property’s condition and the surrounding area’s character. But market prices are rooted in collective, conventional wisdom. This wisdom may be at odds with one’s individual preferences (crucial in the case of buying a personal residence) or may be wrong (crucial in the case of purchasing investment property).
What does this mean practically? Here’s an example pulled from my recent experience purchasing a home in South Philadelphia: I rarely drive, so I don’t care about parking. Most of the time, I get around the city using the Indego Bike Share system. This preference puts me dramatically at odds with the average homebuyer in the city, who values convenient parking. I’m one of maybe a handful of prospective homebuyers who told his realtor that “within easy walking distance of a Bike Share station” was non-negotiable.
Similarly, local realtors rarely deal with homebuyers who are ambivalent about parking access. But given these preferences, I could buy a better house than I would otherwise have been able to afford if my priorities were perfectly market-aligned. Parking access is priced into the market value of a home, regardless of whether or not the homebuyer needs it. Of course, if I ever sell my house, the lack of accessible parking nearby may also get priced into the sale. But I can aggressively discount the present value of that future possibility.
Things get more complex when approaching an investment property. As alluded to earlier, the democratization of information access has made it relatively simple for small buyers to put together a realistic rental pro forma incorporating neighborhood rents, operating expenses, and debt service at prevailing interest rates to see if a deal cash flows. Given this reality, local knowledge about a given neighborhood is crucial, which is why PAF prioritizes financing local developers investing in their own communities. Local developers have a more complete understanding of the housing a neighborhood needs and are better prepared to build it. Just as critical, however, is the ability of property buyers to utilize their comparative advantages to bring down the cost of acquisition and development. We talk about this frequently at PAF – contractors who can self-perform work and buy materials at a discount are well-positioned to rehab quality affordable housing. They often make excellent borrowers. The same often goes for attorneys who can review their legal documents or have experience dealing with contractors. In this way, the specialized knowledge and capacity of the buyer can extract value that isn’t incorporated into the market pricing.
The end of the housing boom has been forecast repeatedly over the past several years, and there’s no way of knowing what’s coming next. But the ability to cultivate and utilize individual comparative advantages is time-tested to withstand all housing markets.