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REAL ESTATE BUBBLES, CRASHES, AND CYCLES

WHAT CAUSES A REAL ESTATE BUBBLE?

A housing bubble is caused by the speculation of many homebuyers and homebuilders. Speculation is buying with the hopes of a large profit, and at the same time taking a large risk.

The large risk in real estate speculation is made possible by lenders that allow homebuyers and builders to borrow a high percentage of the purchase price, even when they have no way to repay, except from increasing house and land prices.

During the last housing bubble that peaked in 2007, many buyers surpassed a nothing-down purchase by borrowing more than they paid for the property. A speculator would buy a house for $250,000, obtain a $225,000 first mortgage and a $75,000 second mortgage. Their plan was to use the proceeds from the second mortgage to make the payments on the first until they sold the house at a profit.

Of course, when real estate prices peaked and reversed, most of those who had speculated gave the property back to the lender, causing a huge amount of foreclosures. The foreclosed properties then sold at bargain prices, for far less than it would cost to produce them, and dragged the prices of the nonforeclosed prices down with them. This caused many nonspeculators to lose their homes as prices dropped 50 percent or more as markets crashed.

Millions of homes were then bought at bargain prices by investors and hedge funds set up to take advantage of properties selling for far less than their worth. These properties could be rented for immediate returns that exceeded “normal” rental returns.

The federal government can contribute to bubbles by creating programs that allow homebuyers to buy with little or nothing down and with reduced requirements for income and credit. The foreclosure rate when someone has little or nothing invested and marginal income and credit is often high.

A downturn in housing markets can be caused by many things, including a problem in a local economy, like a major military base or employer closing. It could be caused by the national economy tanking or, like in 1986, a major revision in the federal tax code.

You might foresee some of these events, but probably you won’t. If smart people could foresee major changes in the economy, why would the biggest and smartest investors in the world get caught holding billions in bad mortgages?

CRASHES CAN BE REGIONAL

A crash in another state may not affect your market at all. Often crashes occur regionally when builders overbuild and lenders overlend. This creates too many houses and prices will flatten or fall.

If a crash is a result of rampant speculation, but you live in a conservative part of the country where buyers do not borrow as much, then your market may not be as affected. Many conservative markets just chug along with small increases in prices and rents each year.

Other markets, like Florida, seem to have recurring booms and busts. If your prices are rising at 15 or 20 percent a year, you should suspect that a change is coming.

Study the history of prices and rents in your town. If you live in an area of low but steady growth, your cycles may be mild. If you live in a booming area, know that booms are often followed by busts, and plan for them.

Six Signs Your Market Might Be Near the Top

1. It’s too easy to borrow money. Lenders are soliciting you.

2. Everyone is buying, all of your friends, your tenants, your yardman, your yardman’s kids.

3. Prices are moving up much faster than rents.

4. Buyers are overleveraging property.

•   The seller has bought a new house, and it closes in two weeks.

•   Their payments cannot be made with the rent the property produces.

•   Buyers are able to buy with “nothing down.”

5. Builders are speculating in both land and houses. They are building with borrowed money hoping to find a buyer at a profit. They also borrow to buy land for future building.

6. Without appreciation, there would be no profit. With an investment, you make a reasonable return from the net rents that you collect, without appreciation. Appreciation is a bonus, not your primary source of profit.

HOW A CRASH CAN BE GOOD FOR YOU

A crash in your market may actually be good for you, if you are ready for it. A real estate crash drives the prices of property below their actual value. A house that costs $150,000 to build, and rents for $1,400 a month, might be bought for $100,000 after a crash.

In my market in Florida and in many other towns, houses appreciated from $125,000 to $250,000, then crashed back to less than $150,000—all in a five-year period. Investors were then able to buy a house worth $150,000 for $100,000 because no one else was buying.

GETTING READY FOR THE NEXT CRASH

A successful long-term investor is prepared to prosper in any market. Here are ways you can prepare:

1. Know your market prices and rents.

In a rapidly changing market, it’s challenging to keep up with changes in prices and rents. An active landlord who is constantly buying and renting property has the best information. Lenders and appraisers will be dealing with outdated information. What happened last year or last month is not an accurate indicator of today’s market.

This time lag between actual values and last month’s values gives the active investor an advantage over those who rely on historical statistics. Because appraisers are always relying on yesterday’s sales, their appraisals will be high or low depending on the direction of the market.

2. Have some cash in the bank, or know where and how to get it.

A successful investor has the benefit of large cash flows and the luxury of keeping enough cash on hand to take advantage of downturns in the market. However, a new investor is likely to be fully invested, with little cash on hand. An investor is more at risk in his or her early years because he or she has little in cash reserves.

There are alternatives to having cash in the bank. One is a line of credit that you could draw on if you needed it to survive, or to buy a bargain. A line of credit might be secured by your home. If you do that, know that you are risking your home to buy an investment.

An unsecured line of credit can be available from a bank or credit union. These typically need to be repaid within a short time, and most require monthly payments.

A second source is an investor with cash that would fund your purchase if you found a great deal but were short on cash. More on this in Chapter 9.

A third source of cash would be equity in a property that you could borrow against (or sell) to get some cash to buy bargains.

And the fourth source of cash is the knowledge of how to buy without banks. You will learn more about this in Chapter 8.

3. Rent to tenants with diversified employment.

If all of your tenants are in the building business, they may all leave when the building stops. Tenants with multiple sources of income are more likely to survive a bad recession.

4. Embrace change.

Successful long-term investors embrace change. They anticipate it, look forward to it, and don’t panic when it occurs. As mentioned in my book Building Wealth in a Changing Market (McGraw-Hill, 2007), “Successful investors not only adapt to change, they exploit it. While the majority sit on the sidelines wringing their hands, successful investors are looking for and buying opportunities created by the change.”

While it’s impossible to predict the future or when your market will change, the first person who recognizes the change will be the one who has the best chance of surviving and profiting.

STRATEGIES FOR SURVIVING MARKET CRASHES

1.   Own something free and clear. You may not own a house free and clear when you are starting, but you might own your car, your tools, or maybe a part interest in a property. A great goal is to get your home paid for.

2.   Use options to buy in a hot market. An option to purchase real estate is a contract that gives the buyer the right, but not the obligation, to buy. If prices drop, then the buyer can choose not to close.

3.   Avoid personal liability on dangerous debt. Dangerous debt is described in Chapter 7 as debt that you cannot repay from the cash flow on the property that is security. If you lose this property in foreclosure, then your other assets could be at risk.

4.   Limit your losses. If you own a losing property, the faster you sell it, the less you will lose. A property that costs you a lot to own each month and that is declining in value can consume all of your money and a lot of your time. Dump it fast, and you might have a chance to make your money back by buying a bargain.

5.   Renegotiate debt that you cannot pay. A lender that is not getting paid in a declining market does not want to repossess property. They too want to limit their losses and will renegotiate the terms of debt that you owe them to avoid a foreclosure or possible bankruptcy. Ask them to forgive late fees, reduce your payments, and even reduce your principal balance.

THE CAUSE AND EFFECT OF CYCLES

Rent and Price Cycles

House prices and rents do not typically rise or fall in tandem. When rents are cheap, renters are happy to stay renters. When house prices start rising, more people become interested in buying. More buyers can mean fewer tenants, and result in stable or even dropping rents.

Be aware of the relationship between rents and prices in your town. When rents are cheap relative to prices, then either the rents will increase or the selling prices will fall. Conversely, when rents are high compared to selling prices, more will want to buy and selling prices are likely to rise.

CREDIT CYCLES

When loans for acquiring houses are easily available, prices move up sharply as more buyers compete for a limited supply of houses.

After a recession, bankers are slow to reenter the market. They want to make sure of the trend before lending. Recessions are often followed by legislation designed to prevent the next recession. These new laws also slow a recovery.

CONSTRUCTION CYCLES

When builders can build and sell at a profit, more will enter the market until the market becomes overbuilt. National builders are self-financed through the sale of their companies’ stock, so they are not as limited by the availability of credit.

Smaller homebuilders rely on banks for construction loans. These loans are typically one year in length. When they can’t sell, they are under pressure from the bank to liquidate and pay off the loan. You can buy houses at a bargain price in a down market by just paying off the construction loan.

NEIGHBORHOOD CYCLES

Neighborhood cycles are as important as broad economic cycles. A brand-new neighborhood may look inviting, but it might not look this good again for thirty years.

New houses are often bought by buyers at premium prices and with large loans. The next recession could cause many foreclosures as highly leveraged homeowners walk away from their mortgages. The result is that these homes are often bought by investors who will rent them.

When renters displace owner occupants in a neighborhood, the quality of the neighborhood and the price of the houses declines.

Older neighborhoods where renters are being displaced by owner occupants who buy and fix up a well-located but older home will increase in value. Look for this trend and houses that you can rent for a few years while the neighborhood improves. They often are a better investment than new neighborhoods.

These older neighborhoods often have many free-and-clear houses so there will be fewer foreclosures and short sales during a crash. This gives these neighborhoods more price stability.

HOUSE CYCLES

Houses, too, have cycles: from new, to dated, but still functional, to too old to fix. Most houses I buy are in the middle category and can be kept functional for decades with routine maintenance. Although you can fix any house, it is not economically feasible to bring back most old houses. At some point it makes more sense to tear them down and build new.

Changing Your Strategy as Markets Change

As markets change, you can buy more property when prices are favorable, and sell your weaker properties when prices are higher and it’s easy to sell.

It’s a mistake to try to sell all of your properties at what you think is the top of the market, and then to try to buy back in at the bottom. If you have acquired easy-to-manage houses in neighborhoods with potential, financed so that you have cash flow, don’t sell them just because they go up in price. These are the investments that will produce profit for you every day that you own them. In addition, good tenants are assets. If you sell and then buy back in a few years, you will have to do a lot of work to replace them.

What Part of the Cycle Is Your Market Today?

You can’t know the future, but you can be aware of your market direction today. Are your prices rising or falling? Is it easy or hard to find good tenants? Can you borrow on terms that allow you to make a profit?

When it’s easy to borrow, it’s typically easy to sell and harder to rent. When it’s hard to borrow, you get your best buys and often the rental market is stronger.

There Is Always Opportunity, Whatever Your Market Is Doing

You can find a great buy in any market if you look hard enough and look in the right places. I prove this when I teach my class on acquiring and managing houses once a year in my hometown. In the class students go into neighborhoods and find a great opportunity, often in just a couple of hours. Some years they find a dozen opportunities in a short time. Other years they have to work harder to find an opportunity, but they keep looking until they do. If you’re interested in learning more about my classes, you can see my class schedule at www.johnschaub.com.

There are a lot of houses, most owned by owner occupants and a lot of them sell every year. According to the US Census Bureau, there are more than 82 million detached, owner-occupied, single-family houses in the United States (www.census.gov/hhes/www/housing).

There are approximately 115 million total occupied (owned and rented) housing units in the United States and more than 60 percent of houses are owner occupied. Just under 5 million (4,940,000) existing homes were sold according to data from the National Association of Realtors®. Another 437,000 newly constructed homes were sold in 2014, according to the US Census Bureau. Over the long term, houses have a history of appreciating prices (see Figure 3.1).

FIGURE 3.1    Median Prices of Houses Sold in the United States, 1975–2015

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