Quite a while back I asked a question, if the early bird gets the worm, what is the early worms reward for being early? In this tumultuous market we have already seem many early worms. Several months ago a lot of people began jumping back into real estate only to be crushed by the weight of numerous new market developments. But surely the worst is behind us? Think again early worms…
Real Estate is as slow as the stock market is fast. It takes time for sellers to get desperate enough to lower their price and it takes time for buyers’ incomes to rise to the level where they can afford housing prices. The income / price equation did not get out of whack overnight, so buyers and sellers should not expect it to correct itself overnight either.
The Bloodhound Blog is a very deceptive place. You are looking at some of the best real estate agents in the business here. So when they write that their business has not dropped off, it might lead the casual reader to believe that the real estate market is not in a tailspin or even that real estate is close to a bottom. Do not be lulled into a false sense of optimism. This group is adaptable, smart and most of all well above average.
Consider these national facts about the economy and then let’s draw some conclusions about the future of real estate (taken from the latest release of the Biege Book and other financial sources):
-Consumer spending is down
-Manufacturing is down and declining
-Jobless claims are up and rising
-Housing remains weak
-Housing inventory remains well above average
-Dow Jones has dropped nearly 40% over the past six months
The most significant thing on the list above has to be the decline in the stock market. This represents a decline in confidence in the global economy. This level of decline says that investors believe businesses could be in for sustained economic distress. It stands to reason that businesses in distress tighten their belts by laying off workers and reducing compensation. It further stands to reason that consumers without jobs or with reduced salaries do not buy houses (at least not anymore). They rent or remain in their house, using their current savings to cushion the blow of a potential layoff.
To add even more words of caution, it can still be said that prices and income are not aligned. Lots of people point out that housing still has room to decline because the historical ratio of median housing prices to median income is still too high. Couple that with the increased scrutiny that consumers face at the mortgage desk and you have a recipe for further price decline.
And for those readers who would still throw caution to the wind, think about the way real estate equity works. Real estate is a highly leveraged investment. For this reason an investor can generate a 10% return a year on 2% price appreciation. Unfortunately leverage cuts both ways. A 2% decline in price would result in a 10% loss in equity. Here is a very simple example. Let’s say I find a house that was selling for $150,000 and I get it for a steal at $100,000. I put 20% down or $20,000 and take out a mortgage for $80,000 and the house is mine. If in the first year the value goes down 10% to $90,000, I lose 50% of my equity because I still owe about $80,000, leaving me with only $10,000. Even if the market then settles and I get the standard 2-3% appreciation per year, it will take me about 6 years to get back even.
On the other hand, let’s say I wait a year and the market settles. Sure, I may pay $105,000 for the same property, but I am still getting 2-3% appreciation a year, which translates to a 10-15% equity growth. There is really no penalty for waiting in a market like this. The days of 10-15% appreciation in any market are gone, so there is no fear of missing the boat. The only fear now is getting on the Titanic.
This writer suggests that readers should find a safe place to watch the fireworks. Now is a great time to get to know your markets better and survey properties of interest. Cruise the foreclosure / short sale circuit, build relationships and hoard cash. As the markets begin to turn, the best informed investor will be able to react quickly. Having cash available and a strong knowledge of where and what you want to invest in will position investors much better than those that caught the falling knives.
SM says:
Michael, Great post. I completely agree with you but I wish more people would read this and understand that it is not a good time right now to be buying. I am in San Francisco and the residential market is still strong here in the city, but any suburb outside of the city is getting crushed. I am with you, save the cash and pounce when the time is right.
Sean Murphy, Rofo – San Francisco Office Space
October 16, 2008 — 10:39 am
Jean Louis R says:
Totally agree with your post Michael. I was visiting my daughter in Los Angeles last month and I noticed the same thing than Sean described for San Francisco. Basically, the advantage is for the one who knows how to wait and act fast when the time comes. Thanks!
October 16, 2008 — 2:36 pm
Dylan Darling says:
I think cash flow needs to be accounted for. Lets say the home you buy for $100,000 is getting you $900 a month. Your monthly mortgage would be around $505 a month at 6.5%. Add another $150-$200 for taxes and insurance and that leaves you somewhere in the neighborhood of $200 a month in your pocket. Not big bucks, but it’s cash flowing.
October 16, 2008 — 3:12 pm
Edge - The Credit Crunch says:
Good post Michael and something that provided reassurance that I was on the right track when I had a conversation with my gf about our children’s college funds (or lack thereof).
She had been told of the great benefits 529 plans offered and while I agreed to a point, doing the math I realized that for my oldest child, she only had a little more than 10 years before she would be starting.
Assuming an optimistic theoretical return of 10% on the underlying mutual funds (as we wouldn’t have the income to buy credits), we’d still be relegated to only earning interest on the money we’d put up.
Now, this was before the bailout and subsequent Dow drop. Housing was the only bubble at the moment.
And still, I couldn’t help but think that the money we’d be putting in there for relatively short term gains (as it’s not like she could just NOT go to school for 10 more years while the economy rebounds), would be better put into a smart and carefully chosen investment property.
Especially as our current situation didn’t allow us to invest copious amounts and we’d only be earning interest on hundreds of dollars at a time.
Leverage cuts both ways and as you and others have said, if you work hard to make a profit at the purchase, you’re on much better footing.
This came to me the other day as I was watching the market crash. The thought of saving for years with all we could afford to send our kids to college only to see that money all but disappear was quite unsettling.
At least in an investment property, even if we didn’t have enough savings early enough to pay for tuition… We could at least provide her with reliable housing at no charge 😉
Not quite sure why this is relevant, I just promised I’d share that tangent on the next Michael Cook blog post I came across 😉
October 16, 2008 — 4:00 pm
Peter Maclennan says:
Michael,
Are you making this suggestion to investors in real estate or for the citizen that wants to buy a home?
For the average home owner, I would think that this is as good a time as any if their long term plan is to live in the house for a period of at least 5 years. Or am I wrong? Would you say that they should wait?
October 17, 2008 — 10:09 am
laurie mindnich says:
NY is so late to the “party” that outsiders aren’t able to convey wisdom without provoking a defensive posture by those in the glare.
November 19, 2008 — 7:39 pm