Thursday, May 04, 2006

Real Estate Investing - Boom or Bust

Most realestate agents today do not remember a real estate investment bust.

For instance if you have San Diego real estate you would have to go back about twenty five years to find the most recent real estate bust.

I went through the last real estate investment boom and bust while managing real estate offices. There was a significant decrease in the number of real estate agents as real estate speculation decreased. Right now in California the police ask for your real estate license - because not everyone has a drivers license.

How does a real estate bubble burst?

Last time it happened very slowly.

At first you are not even sure the market has slowed down, then you wait for the market to recover.

Real estate is not like other investments for several reasons. There is no daily price list showing the value of your property, so panics start slower. Most owners of single family dwellings don't have to sell, so they can just let their houses sit on the market. Once prices start to drop a bit - buyers hang back waiting for even better deals.

As prices drop a bit further - owners that borrowed too much against the value of the property may give their house back to the bank - many today already owe more than their house is worth.

The banks don't want to own property - it interferes with their ability to make loans. At first the banks put a fair market price on real estate and hope to make a profit. As the bank's real estate portfolio increases in size, they start cutting prices hoping to break even. Eventually they offer all kinds of special credits and inducements to try and unload their real estate.

In the last real estate crash you could pick up nice houses for a third of what they had once sold for, and sometimes with no payments for a year. There were frequently no takers even at these terms - everyone knew realestate prices were dropping.

Banks will create Real Estate Owned (REO) departments charged with dumping the unwanted housing.

More folks now find with the dropping prices that they are upside down in their loans, they walk away and give the homes back to the banks. The REO departments will get larger, even as the mortgage origination departments shrink.

Banks will quit investing in real estate loans and fund something they perceive as less risky. At this point only perfect applicants will be approved for new real estate loans.

Mark Twain said "
History does not repeat itself - it rhymes."

This real estate investment bubble will be different than the last one - it may even deflate much faster.

This realestate down turn will have to deal with
adjustable rate mortgages, mortgage backed obligations, and a huge host of esoteric derivatives. If those phrases don't mean much now - they will after the financial press starts looking for villains to blame.

Speaking of blame, expect the banks to file lots of law suits against appraisers and property owners for fraud - even though it was the banks that encouraged "liberal" qualifying so they could make more loans.

The real estate market boom may not yet be over, but the hand writing is on the wall.

The bubble pop might have already begun, and it could be dozens of years before real estate may recover.

There is not even any assurance this real estate bubble's burst will be accompanied by deflation or inflation. Absolute real estate prices may increase if the government insists on continuing to print mountains of money - but the prices of everything else will increase even more as cash becomes trash.

As incomes go up slower than expenses - real estate investment properties would still be thrown at the market.


Real estate investments should now be examined - and perhaps sold - before the slowdown accelerates.


If you wait until you are sure the real estate market has turned - it may be too late.


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6 Comments:

Blogger Market Participant said...

It's not clear how much banks will be exposed to the residential mortgage crisis. Most banks acted as "correspondent" originators who made mortgages and then sold them onto the mortgage market.

The people who will be badly hurt are those who purchased the "credit enhancement" tranches of MBS. Since those tranches by desing absorb the defaults and prepayments before the lower traches get touched.

Overall I think we are more likely to see the residential market enter a state of "muddling though" since walking out on a mortgage is a traumatic experience.

8:34 AM  
Anonymous allan said...

Thanks for your comments - they certainly help round out the information.

The big unknown is who will be hurt by the derivatives - and by how much. Counter-party risks may also be large.

So little is disclosed - we just don't know.

Staying with a home that is worth less than you paid, with comparable rental houses available at a quarter the cost, combined with dropping real estate prices also makes it traumatic to stay.

If you will permit an anecdotal story:

I had a friend in the medical field that moved to Houston just before the last oil industry collapse. He bought a beautiful house in a lovely well developed neighborhood of large homes with well kept yards. His income was assured by his position- but the rest of Houston suffered greatly.

At one point he was the only person living in his suburban tract, except for occasional squatters. The upper middle incomes of the city had evaporated.

The exodus started slowly, but loss of jobs and dropping property values emptied the houses. This is an extreme example - but the lessons are real.

We do know real estate investment is a regional rather than a national phenomena. Some areas will be hurt badly, others may not be directly effected.

During the real estate down turn I experienced in Southern California, the greatest trauma was mostly limited to real estate agents, banks, and various associated industries. Of course the home owners that lost or gave up their houses were not winners either.

Thanks again for your comments.

12:53 PM  
Blogger rwre said...

Enjoyed your blog. I live in Denver where the writing has been on the wall for five years. I was a realtor here from 1996 to 2002 and saw the hot market fade away. The funny thing is there were still hot spots that propped up our market artifically. I agree there will be a bursting of the bubble but at the same time I believe there will be a few hot markets that stay hot due to several factors:
1. They have jobs
2. They have higher than average wages
3. They have undervalued housing

When you combine these three conditions you get a good to hot market. Check out my blog at rwre.blogspot.com to see how I find good markets to buy single family investment homes in this new age of real estate investing.

10:30 AM  
Anonymous allan said...

rwe,

Thanks for commenting.

I think there is a good chance that there will still be markets that retain value, perhaps even appreciate.

To your list of three I would add one more. If we enter a greater depression, the safety of an isolated community that still offers social amenities will be attractive to those that can relocate.

Aspen has benefited from this for decades. Other such venues may progress in a similar fashion.

I would also consider international real estate. It has had quite a run also, so many areas may now be over priced - but with the increased mobility of the information age - international real estate will prosper.

Best,

Allan

12:46 PM  
Blogger Lord of the Land said...

What you say is true and a real estate crash is nothing like the dot-com bust.

But while the slowdown of housing prices has begun, rents are only now beginning to climb.

If you bought a house a couple of years ago it may be worth holding on to as the average rents in your area begin to skyrocket due to housing becoming unaffordable.

Your equity gains may slow down (or even stop), but your operating income is likely to climb rapidly. In my area, Washington DC, rents have climbed over 10% in the last year alone.

11:55 AM  
Anonymous allan said...

LO-Land,

Quite true - sometimes.

In fact from a long term perspective it is probably a good idea to watch the trade off between rents and ownership

When rents are extremely low - as now - it may pay to rent. When the equation changes and it becomes cheaper to own comparable realestate - consider buying.

Thanks to all for the comments.

1:48 PM  

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