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2007-02-07 19:43:00

Real Etate Investment is a Three-Legged Stool

Steve Dexter


The economy’s humming along, the stock market is hitting all-time highs, unemployment is down in most areas, and commercial real estate rents are very healthy. So what’s up with this housing market?

U.S. home sales fell to 2004 levels, homebuilders have slashed prices at a pace not seen since 1970 (9.4%), and the national median house price is down 2.4% (U.S. Dept. of Commerce). The California Assn. of REALTORS (CAR) says housing prices will go down 2% and sales will decrease 7%, (ahem). We have 40% more foreclosures being filed in a few short months and California now leads the nation in most new foreclosures filed (RealtyTrac).

Yes, there are some inexpensive real estate markets that still show reasonable growth (Texas, Midwestern areas, the Carolinas etc.) so some areas remain healthy.

I don’t wish to be a nattering nabob of negativity, BUT…. The formerly hot markets of Southern California, Phoenix, Las Vegas and South Florida prove that you need more than lots of people to make real estate sell. Just because healthy job growth can flood an area with  job seekers, job growth does not guarantee that home prices will grow forever to the sky. You need more than demand to make houses go up in value.

You need a three legged stool.

Demand

Demand is just one leg of a three-legged stool that makes for a healthy real estate market in most areas. The other two legs are supply and investment potential buyer confidence.

Supply

Nationwide, builders have been on a rampage and have overshot the mark. Whole housing additions have been erected to meet the insatiable appetite of real estate investors. Jack McCabe, an economist based in Miami, said when he drove through a new housing tract built in the city of Port Saint Lucie located north of Miami he saw mostly dark houses and for sale signs.

Also witness the “dark towers” of condominium projects seen in down town San Diego and some areas of coastal Florida. No lights on at night, nobody there.  One builder told me that these out-of-state investors for whom these housing tracts were erected were buying up everything they could find and paying way more for houses than the locals would. These inexperienced landlords  now find themselves with houses they thought they could quickly re-sell or “flip”, but cannot. 

They try to rent these houses only to find the neighborhood stuffed with other investors trying to do the same thing. For that market to be healthy, there needs to be a very strong buyer/renter demand to compensate for the overabundance of For Sale/For Rent signs in these areas saturated with investors. Sadly, that much buyer demand is hard to find.

How do I know this? As a lender and mentor to hundreds of investors across the country, I get calls everyday from people in trouble.

One call was from Curtis, who owned six new houses with a monthly negative cash flow of $4,000 a month, which was OK until he lost some business contracts and his income dropped. He could not feed the negatives any more, nor pay his now $110,000 credit card bill. He said he thought he could refinance his way to prosperity and continue to feed the beast, but there has been no equity build up for those recent purchases in Florida and Arizona. 

Unfortunately, when he stops making his mortgage payments, he will lose some or all of his houses in foreclosure and may have to declare his business bankrupt. Be very careful when you buy property solely for appreciation -- appreciation is not guaranteed, but those monthly mortgage payments do show up every month in your mailbox, don’t they?

Order my book Real Estate Debt Can Make You Rich and read "The Top 15 Mistakes Most Investors Make."  Go to Mistake #13,  “Not Double Checking the Seller or the Agent’s Financial Numbers Because You Get Caught up in the Excitement." Claims of high returns have always been extremely rampant in real estate beginning with swampland in Florida sold in the 1920s. There is additional information about the best kind of investment property to buy.

Hint: You don’t need to own the brand new, big boxed houses that most builders seem to build these days. It’s easier to make it big on smaller deals.

Investment Buyer Confidence

The third leg of the real estate market stool has to do with economics and buyer psychology.  Why would you want to buy something if you think it’s going to be worth less next year? Today’s buyers are saying, "No," and they are holding on to their wallets.

Commenting on how mortgage lending has slowed as rising inventories in the housing market have led to a "hard landing" for the industry after a decade of strong growth, Countrywide Financial Corp. CEO Angelo Mozilo said at a Merrill Lynch and Co. conference in New York, "We have another year of adjustment, or transition" in the industry until consumers believe home prices won't decline. “Various events will make the change take place and one of them is" a decline in available homes”.

Affordability is another major factor in the housing market. Apartment rents are up across the board in Orange County, CA, where they have been appreciating 4-6% annually for the last few years, making the idea of renting less appealing. Wage gains there are expected to increase 4% to 6% annually while home prices will probably stagnate for a while.

And here is the light at the end of this tunnel. People move to Southern California because they are attracted to the cool breezes, the warm sand and the bright skies. Wage earners here will make more and their rents will spiral out of sight. Years from now, they will see that house payment as that tax subsidized bargain it always has been. As these first-time home buyers enter the market -- BOOM!  We will see the start of the next up cycle in price appreciation.

Wall Street investment bankers are more skillful these days. Credit will not dry up since mortgage bankers can effectively hedge their risk by buying insurance before some of the loans default and even mix in some bad loans with good ones. The risk is more spread out in their portfolios and that is good news for mortgage holders.

A big change is in store for the more than 500,000 California real estate licensees. Some 25% to 40% less homes are sold statewide. Many licensees, mortgage brokers, escrow agents, builders who cannot survive on a third less business will have to go back to other jobs, selling insurance, or letting their spouses make the coins. Many of these newly unemployed who over-refinanced their houses with exotic loans will lose their real estate. Since over 30 % of our job growth for the last five years has been housing related, job losers who cannot afford high-priced California will have to leave the state. That exodus could be a very big number and bears watching.

Will bank foreclosures surge? Yes.  I read a newsletter published by REO Nationwide to divine the mood of these Real Estate Owned (REO) departments. They are gearing up for the carnage wrought by the more 1 trillion dollars in adjustable rate mortgages due to reset in the next 2 years. This is bad news for over-encumbered mortgage holders, but is great news for the astute investor who is credit rich and cash heavy and has a nose for a bargain. Soon it will be buying time again where there will be good deals all around.

Christopher Cagan, director of research and analytics at First American Real Estate Solutions, expects a modestly higher foreclosure rate and deeper discounts next year. Discounts are likely to be larger in areas where inventories of unsold homes have soared, such as in parts of Arizona and Florida, Dr. Cagan says. The big factor in determining the amount of REO homes is local job and population growth. More jobs and higher incomes equal fewer foreclosures.
In these markets of higher distress, banks are already getting a lot of property back so they are holding private auctions.

Dallas-based Hudson and Marshall Inc. expect its auction sales of foreclosed properties to increase substantially this year. David Webb, co-owner of the auction company, believes sales will rise at least 20% in 2007.

The auction firms say their busiest auction markets recently have included Michigan, Ohio, Indiana, Pennsylvania, Texas, and Colorado. "Word on the street is that California, Florida, and Arizona will also be very active in the next 12 months," Mr. Webb says.

So if you are in distress and have properties with negative cash flows, hang in there. Your local market may be going through a down cycle, but consider whether or not your area has solid job growth and strong demographics. If the reasons you invested there still persist, you will win in the end.

Real estate still remains America’s quintessential investment choice. America continues to be the envy of the investment world. Our productivity has doubled in the last 25 years and while we are only 5% of the world’s population, we possess 33% of its wealth. Twenty five years ago, we controlled only 14% of the world’s wealth. Unlike aging Europeans, in the next 25 years our population will grow by 300 to 360 million as young, fertile immigrant families supply much needed labor. Will some of them be living in one of your houses?

(Steve Dexter is the author of Real Estate Debt Can Make You Rich. He is also a loan officer licensed in AZ, CA, CO, CT, DC, FL, HI, ID, MD, MI, MN, NV, OR, UT, VA, WA.)

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