The Real Estate Bubble: How To Avoid Losing Money And Even Make Some When It Pops
BATTLECALL GUEST EXPERT: Robert J. Abalos, Esq., InvestingInLand.com
Real estate bubbles do occur and they always go pop. Investors quite often forget that real estate values do not rise consistently over time like a bullet fired skyward but more in spurts and starts, two steps forward and one step back.
Everything I see, hear, and read convinces me that we are approaching a real estate crisis brought on by speculative overbuilding and unreasonable investor expectations, both fueled by ultra cheap and plentiful mortgage money. I know my own local real estate market in Seattle, Washington very well and I travel all around the United States on business and all are experiencing huge sales price surges unsupported by any industry fundamentals. The prices of all categories of real estate, especially single family homes, are rising dramatically but the rents paid by tenants in these properties are barely keeping pace with inflation. In many areas including my own rental incentives are the only vehicle to keep occupancy rates at even baseline levels. ALL expenses related to real estate construction, development, and management are rising, sometimes in double digits per year, from the cost of land, property taxes, utilities, construction materials, permitting fees, workman's compensation, hourly labor, and more, yet investors seem more willing than ever to own investment properties. They want to overpay for properties at a time it costs more and more to own and manage them.
None of this makes any sense. And eventually it will end with catastrophic consequences that will make the NASDAQ stock market crash look like a frat house party that got out of control.
The Greater Fool Theory
This article here today was prompted by a Page One article appearing in yesterday's (March 1, 2005) New York Times.
Entitled "Boom in Prices Brings Investors to Home Sales" the article explains what I have seen and heard for at least three years now. A very large percentage of all new home construction is NOT being sold to homeowners so they can live in these properties but to investors who plan to either flip these properties before or immediately after construction for a quick profit or for rental purposes so they can be leased to tenants under a buy-and-hold model.
The article explains that nearly 10% of ALL mortgages issued in the United States on single family homes were NOT for personal use, up from 5.8% in the year 2000. In Las Vegas the percentage is 16.1%, or nearly one mortgage in five. In Sacramento, Riverside, CA, San Diego, Phoenix, Tampa-St. Petersburg, Fort Lauderdale, Miami, Los Angeles, and other cities the number is above 10%.
What does this mean? Simply this. Investment dollars are flooding local real estate markets having two effects. The prices of existing homes rise due to escalating demand. This means more homes are constructed to capitalize on this demand. But at some point, like the game of musical chairs, the constantly charging demand has to stop dead in its tracks. The cash fueling the demand runs out. Or prices are driven so high that fewer and fewer people can play the game. Government action like higher interest rates or restrictions on bank lending to real estate may suffocate demand, precisely what triggered the last real estate crash of 1989-1994. At least a dozen other scenarios can cripple the very demand so many developers and investors are counting on to make them money. And when demand slackens, the double whammy of oversupply hits the market between the eyes. All those new condos and houses that were designed eighteen months ago to meet all the high demand that no longer exists sit empty. Too few buyers plus too many houses means falling prices, rapidly falling prices. It is inevitable.
This New York Times article introduced us to a couple that is flipping condos in Florida. They have made some money playing this speculative game and want to make some more. So without viewing any floor plans and on just the basis of a phone call they wrote a deposit check for $159,380 to buy two condos in a new construction project. They sold both condos before construction on the project was complete for a total profit of about $456,000. Great return on investment, only what if the condos didn't sell for the higher prices they expected and got? What if they didn't sell at all? What if the prices on those condos fell between the time the contract was signed and the closing date? Did this couple even have the financial resources to close on these two deals simultaneously? Was their earnest money at risk here if they didn't find a buyer at a higher price?
The article mentioned that HALF the condos in this development were flipped before construction was complete. This is speculative construction at its worst.
This is also a classic example of the Greater Fool Theory of Investment. Simply put, it says:
"No matter what foolish price you pay for an equity in a hot market a greater fool will come along and buy you out at a profit."
Not only is this statement untrue, it is a silly and dangerous way to invest. It is the equivalent of playing Russian Roulette with your lifesavings and your life as the wager. I also found it so ironic that this flipping couple in Florida admits in the New York Times article that they "got killed" (their words) in the stock market during the crash of 1999-2002. They apparently have not learned their lesson.
Investing versus Speculating
One of the most important lessons is that smart people INVEST in equities like stocks and real estate while fools SPECULATE on them.
Investing means calculating the intrinsic value of an asset and attempting to buy the asset below its economic worth. In other words, you want to trade a dollar of cash for more than one dollar of equity. Put another way, you want to buy $1.00 of equity for eighty cents in cash.
Speculating means buying assets at any price in the hope that someone will pay more for what you bought. It means buying a dollar bill for $1.25 in the hopes that someone will want it so bad they will pay you $1.30 or $1.40. Or in the cases of some real estate I've seen lately, $2.50.
It is obvious to see the appeal of speculation. It's easy. Investing requires work, due diligence, research, mathematics and calculations, lots of effort. It's boring. Speculation has all the gambler's risks and thrills like going to the racetrack and cheering for your bet. It's quick and fun, when it works that is.
But shrewd investing can virtually eliminate the risk of buying equities like real estate. How can you lose money buying dollar bills for ninety cents? Speculators know they will lose money on many of their deals, lots of it, and just hope in the end they are the Greatest Fool except for the last one.
Avoiding the Bubble's Wrath
If you base your real estate investing strategies on the techniques outlined in my articles, you will be PERFECTLY positioned to not just avoid the deflation that will occur to real estate prices when the bubble pops but actually be ideally situated to capitalize on the misfortunes of others so you can scoop up underpriced assets. There is no more true Wall Street axiom than "The Time to Buy is When There is Blood in the Streets." Being prepared for any market situation is just another advantage of investment over speculation. Investors are not trapped into equities with falling price tags the way speculators are. Nor are they cash-poor due to losses suffered when bubbles burst so they can buy in buyer's markets and sell into hot seller's markets like the one that exists today.
Aside from avoiding all the usual forms of speculation and investing, you can do three things to avoid being a bubble victim:
First, do not buy properties with negative cash flows. Sacrificing real current after-tax income now for possible future capital gain appreciation profits later is pure speculation. It's not only foolish, it's stupid. Why buy any asset that costs you money each month to own??? Isn't the whole point of buying real estate is to make money and not lose it each month? Talk about counting your chickens before they hatch, this is financial suicide. But the vast majority of "investors" (using the term incorrectly on purpose) buying rental properties these days are coping with heavy negative cash flows in the mistaken belief they will reap huge financial windfalls in years to come. Most will be very lucky if they only lose small amounts of money.
Another couple from the New York Times article mentioned above fit the bill. Although they live in the suburbs outside New York City, they bought a one-bedroom condo near Ground Zero in Manhattan which they rent out for $2,225 a month, carrying a $1,000 a month negative cash flow on the property. The purchase price for this property last summer was $499,000. Assuming they actually have a decent tenant who pays their rent on time (a HUGE assumption), they will lose $12,000 this year owning this property, in other words trading after-tax income in the hope that the condo they bought at an inflated price in the middle of a real estate bubble will be worth more in years to come.
But wait. The negative on the property is not fixed at $1,000/month. It's likely to rise. When bubbles burst, rents fall. Tenants buy properties at lower prices and become homeowners leaving vacancies behind. Properties get dumped onto the market and leased any price price. Rent deflation is a classic symptom of a bubble bursting. So the rental income on this condo will likely fall sometime soon. And what about the expense side? Those will always rise over time. Property taxes, utility costs, condo fees, and the rest always trend upwards. Condos as they age require more shared and individual maintenance, further increasing expenses.
This isn't pessimism, it's reality. When you buy a property with a negative cash flow the market is hitting you on the head with a stick begging you to pay attention to an important message and you aren't listening. You are paying too much for a property, or the cash flow from the investment does not support the sales price. How can you earn money buying an equity when your yield is a negative number?
Second, target undervalued classes of real estate. Not all real estate in all markets rises at the same rate. You need to slice the market into segments by property type. At the current time in my market of Seattle, Washington, for example, residential properties and office buildings are selling at unheard of white-hot prices. Land, generally speaking, is red-hot, a bit cooler to the touch but you still will get burned buying some without careful investment. But many older retail properties are still priced at reasonable valuations since the focus is on new construction. People want nice and shiny, not dirty and broken. Plus the local glut in retail space has not been married to higher demand yet. The economy is growing and will catch up soon but for now there is space available for new antique stores, furniture shops, specialty non-Big Box retailers, and the like. You can't walk blindfolded down Main Street and stumble over bargains, they are hidden in the brush. But you can find them if you try.
Don't put all real estate in your local investing area in one basket. Use microeconomic analysis. Residential, office space, industrial, motel/hotel, retail, raw land, zoned land, and more each have their own local economic factors that determine their supply, demand, and prices. Do not use averages to set investment guidelines. Saying real estate sale prices in your community rose 10% this year means very little if residential prices were up 30% while industrial properties were down 10%. The average is plus 10% but so what?
Third, avoid buy-and-hold real estate strategies. Buying and holding real estate is generally NOT a recommended strategy for investors in any real estate market but this is doubly true in bubble markets. Why retain ownership of any real estate when you expect prices to fall dramatically in the near future? After all, they call this a "SELLER'S MARKET" for a reason. Quite often real estate investment appears more complicated than it really is but the terms "Buyer's Market" and "Seller's Market" are about as simple as you can get. People preach the virtues of leverage like it was religious orthodoxy until it cuts against them and they are underwater on their mortgages. The notion of wanting to sell what you own in the midst of a white-hot seller's market is more than common sense, it is something a second grader would understand. If you own a home and you could list it tomorrow and have multiple buyers competing against each other eBay style to buy it from you, why wouldn't you list it? Isn't that every seller's dream? To own an asset so in demand that a parade of buyers would throw money at you each more determined than the next to buy what you own? What greater market conditions could any seller be waiting for? Buy-and-hold under these conditions is putting greed ahead of reason. When bubbles burst it can takes years, even decades, for prices to rise again to bubble valuations. Why not sell your inflated home now to raise cash, buy two or three homes over the next few years when the bubble bursts with your profits, and repeat the process in ten years when the buyer's get crazy and desperate again, as they surely are now?
I'm No Psychic
I know that the real estate bubble is going to burst in Seattle and in many other markets around the U.S. and quite frankly the world. The torrent of cheap money can't last. Each time prices of real estate rise it means by definition fewer and fewer people can afford to buy and number of Greater Fools shrinks. Plus let's not forget the heavy hand of government action which usually brings on an economic crisis when you least expect it. The Federal government attempting to rein in hyperlending on spec real estate projects is like doing necessary brain surgery with a chain saw. Right goal, wrong tool, bad surgeon.
I don't know when the bubble will burst but I know trees do not grow to the sky and real estate prices cannot rise at double digit valuations indefinitely. What I do know is that the bubble will not pop all at once across America. Real estate markets are local and you will hear a thousand pops much like Lawrence Welk and his bubble machine operating at full tilt. The first areas that will get hit are those in vacation and resort areas. People don't need summer homes and they will dump those first. Rental properties and areas with high tenant populations (like New York City) will be next. People don't need to own rentals. But eventually like a plague it will spread to all markets and that will lead to banks and government regulators taking action to save the current absurd valuations by restricting new property supply inventories. In other words, no new money for building new things. This is the historical model and it doesn't work but I'm sure it will be tried. Without access to new capital developers will dump properties at low prices to raise cash and default on existing loans. This increases bank losses and further exacerbates the capital crunch. Foreclosure rates rise as loans go underwater. Bank regulators force lenders to call due real estate loans even when they are current to meet minimum capital requirements, further increasing developer bankruptcies and foreclosures. It's 1989 in New England and California all over again. I saw it with my own eyes and it was ugly. Painful for many, profitable for a few who like Noah built an ark and prepared for the disaster.
Now that you are all depressed and reaching for a Prozac with a Zoloft chaser, here's the good news. You can avoid all the effects of the bubble by not playing by its rules. If you don't play with fire, you can't get burned. Let others speculate on marginal properties with inflated price tags and heavy negative cash flows. You invest according to the tried-and-true methods of my advice and make yourself money now while positioning yourself to sweep up bargains later. Remember that when markets rise driven by hysteria they venture into absurd valuations that are completely disconnected from intrinsic values. The same is true of markets driven by panic and despair on the down side. Dollar bills will be sold for forty cents and sellers will kiss the rings of buyers who offer them that much just because they are so happy to see anyone willing to bail them out of a crisis at any price.
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