What Would Warren Buffett Do? The Hottest Trend for Savvy Investors

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If Warren Buffett was going to invest in anything right now, where would he put his money?

At first, that question may be difficult to answer. But if you think about Buffett's classic investment approach – focusing on real assets with a reliable return and prizing valuation – it gets a little easier.

Stumped?

Try the housing market – single-family rental homes to be precise.

"If I had a way of buying a couple of hundred thousand single family homes and I had a way of managing them… I would load up on them and take mortgages out at very very low rates," Buffett said in an interview with CNBC. "It's a very attractive asset class right now."

It's a classic buy low, sell high opportunity – and one that more and more investors are taking advantage of.

In fact, sales of investment and vacation homes surged 65.4% last year to 1.2 million units, the highest level since 2005, according to the National Association of Realtors (NAR).

Naturally, low home prices were a major catalyst for that surge.

Last year, U.S. home prices were down 33.8% from their 2006 peak. But another factor was increased interest from investors – many of which boast six-figure salaries and desire a more consistent return than the stock market offers right now.

"I have doctors, lawyers, an engineer from Apple who told some of his buddies," Brian Hardie, who manages rental properties, told Forbes about his clients.

And with foreclosures on the rise this year, there will be an even greater opportunity for entrepreneurial investors, which means Hardie's client list at Regency Property Management will likely continue to grow.

Indeed, foreclosures that had previously been held up by litigation relating to robo-signing and other malfeasance on the part of banks are once again moving back through the system following a $26 billion settlement five major banks reached in January.

A February report from RealtyTrac showed new default notices – the first step in the foreclosure process – were up 1% from January. Furthermore, default notices increased dramatically in some states, such as Pennsylvania (35%), Florida (33%) and Indiana (37%).

As the NAR recently pointed out, 20% of February home sales were foreclosures. And if RealtyTrac's forecast for a 25% increase in foreclosures this year comes to fruition, the number of distressed sales will rise even further.

Meanwhile, the heightened rental property interest, dually helped by inflation, has given landlords more power – which means rents across the country are increasing.

This has created an optimal situation for investors that have the wherewithal to make it work for them.
"Overall home ownership cost is exceptionally favorable – even if home prices have a little further to fall – since long-term interest rates are currently near all-time lows," said Money Morning Global Investment Strategist Martin Hutchinson. "Prices in many markets have already dropped far enough that rental yields are quite juicy, especially compared with interest rates."

So how can investors find the best deals?

Location, Location, Location

If you're interested in getting into home rental properties, it's best first to look locally. Chances are, you already have an idea of what houses in nearby neighborhoods should cost and maintenance will be less of a burden.

However, that's not always possible, like for those unlucky enough to live in big-city California or Detroit, two areas where rental real estate is unattractive. If that's the case, you can use three main criteria to determine whether or not an area is worth investing in.

They are:

  • Employment.
  • Price trends.
  • And rental yields.

For the first, the U.S. Bureau of Labor Statistics publishes monthly data on state unemployment trends, the Regional and State Employment and Unemployment Summary.

Right now you'd do well to avoid much of the Midwest, Florida, California and Nevada, which all have relatively high unemployment rates. Even though housing prices in these states may be down 50% from their peaks, the chance of being stuck with an unemployed tenant is just too high.

Conversely, the Plains states, such as North Dakota, South Dakota and Nebraska have almost no unemployment, while Virginia and Maryland have relatively low unemployment.

However, investors should beware suburban Virginia and the Washington, DC suburbs of Maryland: They're expensive, have low rental yields and are largely dependent on the government.

Second, take a look at the Standard & Poor's Case-Shiller Home Price Indices, which track prices for 20 metropolitan regions.

Through January 2012, the leading measure of U.S. home prices showed annual declines of 3.9% and 3.8% for the 10- and 20-City Composites, respectively.

To choose an investment area, you can look for two types of bargains.

One is regions where prices are no higher than ten years ago, like Detroit, Cleveland, Las Vegas and (almost) Phoenix and Atlanta. The other type is areas where prices have dropped more than 50% from their peak, like Phoenix (again), Miami, and Las Vegas.

Eliminating Cleveland, Detroit, Miami and Las Vegas because they have high unemployment, you are left with Phoenix and Atlanta. Both have an unemployment rate between 9% and 10%, around the national average. To these you might also add Texas, which had much less of a boom, and where reasonable prices combine with relatively low unemployment.

Finally you'll want a high rental yield. You can use the inverse calculation, the price-to-rent (P/R) ratio, which divides the average cost of home ownership by the yearly estimated received rent income.

Moody's Analytics (NYSE: MCO) calculates P/R ratios for about 70 metropolitan areas, as well as the United States as a whole. This data is subscription-only, but fairly recent versions can easily be found on the Web.

With rents rising, P/R ratios will be declining so conditions right now are favorable. Given that borrowing costs are in the 4% to 5% range, and that maintenance costs and taxes are high, investors should look for a rental yield of at least 8% — in other words, a P/R ratio of more than 12.5.

Taking all these measures into account, Atlanta, Phoenix and a few choice markets across the Midwest are strong candidates, if you have the luxury of living nearby.

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  1. Joseph Tricarico | April 9, 2012

    I am looking into the possibility of Rehab + Sell or Lease. Which ever route chosen has the least amount of risk or some other investment vehicle.
    Thank You

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