The signs are we’re in or nearing a good time to look at a vacation home or a property in a vacation area. I don’t think we’re entering a new real estate boom, so don’t expect buying now will set you up for big capital gains in a few years. I’ve been saying that residential real estate has been bouncing along a bottom that will last for years, and the data seem to support that. I suspect if we roll into another recession, there will be another fairly modest leg down in many markets.
You can’t time the bottom of a real estate market, and it’s a long-term proposition. For the patient buyer, this is at least time to search for what interests you and be prepared to buy when you think the time is right, but only when your goal is to own a property in an area for a long time. Conditions vary considerably around the country. Prices in luxury areas are firming up faster than those in other areas, as are areas that are attractive to international buyers. In almost all areas you’ll be able to buy at a price substantially lower than five years ago.
Every real estate market is different. Don’t rely on news reports to decide if the area you’re interested in is near a good buying point. There are important factors to consider.
You can get a handle on a market’s valuation by computing the cap rate, or capitalization rate, on a property. Estimate the sale price of a property. Then estimate the annual rent minus maintenance, insurance, taxes, and management costs to arrive at the operating income. Divide the operating income by the sale price to arrive at the cap rate. A 10% or higher cap rate is high and indicates a property is a good value relative to its rental income. As the cap rate nears 5% or less, you aren’t projecting much of a rental income to compensate for the lack of liquidity and risks of owning a property. That’s a highly valued market. While this analysis using estimated rental income, you should do this analysis even when you don’t plan to rent the property to others.
That’s only the first step.
Try to determine how overbuilt the general area is. The more overbuilt it is, the longer the recovery period will be. More importantly, overbuilding usually contributes to other general economic and cultural problems in an area.
When you like a particular development or subdivision, discover how overbuilt it is. A development can be overbuilt even when the general area isn’t. A lot of vacant homes or unsold lots means each current homeowner has to pay more in fees and taxes to maintain the facilities and infrastructure and to handle any unforeseen costs. Overbuilding also keeps a lid on rental income and price appreciation, because supply exceeds demand. The general appearance of overbuilding and vacant properties also makes it harder to attract residents.
Check the history of homeowners’ fees and local taxes. Perhaps they seem reasonable relative to what you’re paying elsewhere, but have they increased substantially the last few years? Is it likely that they’ll need to increase the next few years to cover expenses and make up for foreclosed and vacant homes?
Examine recent foreclosure and default rates. Even an area that hasn’t had much building could suffer an oversupply of homes when there are a lot of homes in the foreclosure pipeline or already on the market.
Be sensitive to the potential for travel costs to rise and change people’s habits. When gas prices rise as they have periodically the last few years, people seek vacations that are within four hours or less of driving distance. They are less willing to fly or drive long distances. Rising gas prices could affect rental income, price appreciation, and the ability to sell a property if you need or want to. To maintain a floor under a property’s value and make it easier to sell when you want to, the property should be near a large population that would want to vacation there.
When you narrow the search down to an area, it’s a good idea to buy the best location you can afford. A home on a ski slope or water will hold its sale and rental value better than something that’s cheaper because it’s not in the prime location. A prime location also sells and rents faster than others.
There are a couple of other points to consider.
You’ll likely have a tough time getting a mortgage on a second home or vacation property these days. Lenders demand more documentation, a higher down payment, and better financial security. They also take longer to make a decision. About 40% of vacation home purchases in recent years were for cash.
Finally, don’t count on current tax breaks for second homes. If you need to deduct the mortgage interest and real estate taxes to make the home affordable, you’re taking a risk. There’s likely to be either comprehensive tax reform or a reduction of tax breaks for things such as second homes in the next few years. Details will depend on the election results, but you should anticipate change.
RW September 2012.
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