Sunday, August 28, 2005

REAL ESTATE INVESTING

When you notice the whole world zig, then it’s a good time to zag if you want to make money. This article is a good reminder that people live in the short-term and there are certain advantages of not following them off the hill.



As they happily watch their houses swell in value, Americans are changing their attitudes toward mortgage debt. Increasingly, a home is no longer a nest egg whose equity should never be touched, but a seemingly magical ATM enabling the owner to live it up or just live.

This spend-now-rather-than-save-for-later phenomenon has produced undeniable benefits. Experts attribute much of the nation's economic growth to cash-out refinancings, home equity loans and other methods of tapping rising home values. And additional real estate investments financed by home equity have contributed to the rising home prices that bring owners such pleasure.

"If you paid your mortgage off, it means you probably did not manage your funds efficiently over the years," said David Lereah, chief economist of the National Association of Realtors and author of "Are You Missing the Real Estate Boom?" "It's as if you had 500,000 dollar bills stuffed in your mattress."

He called it "very unsophisticated."

Fredrich Hayek discusses in his masterwork, THE ROAD TO SERFDOM, the trappings of inflation. The storekeeper that purchased products at the pre-inflation price has the good fortune to sell them at the current inflated price and he loves the idea so much that inflation becomes a drug. The problem as Hayek points out is the system can only continue for as long as the rate of inflation continues at a rate higher than the projected rate. As soon as the projected rate catches up to reality, the storekeeper loses his advantage, because the projected inflation rate is already figured into his wholesale costs. If the projected inflation doesn't materialize, the storekeeper can be ruined because he now has to sell his products as less than cost.

Although Real Estate prices are being driven by supply and demand instead of inflation, the same negatives will start to infect people who have bought into the recent paradigm shift. Those homeowners that begin to factor their home equity into their lifestyle will soon find themselves either short of the equity they need to continue their new lifestyle or too far into debt to service the interest. The result for some will be chaos.

The equity in your home is not necessarily wasted capital, because it actually represents a savings in interest payments which reduces your overall cost of living. The IRS interest deduction is a nice incentive to owning a home, but paying less in interest is actually a better deal, because you save the actual amount versus the small percentage of savings offered by the govt.

The only real jusification for cash-out re-financing is to pay for needed home repairs, or to invest in something that will earn you a greater rate of return than your mortgage interest rate. For instance, if you are borrowing against your equity at 6% then you need to get a return on that money of more than 6%.

Even if the money you spend increases the overall value of your home, it still might not be a good idea. First, most home improvements do not result in a dollar for dollar increase in the value of your home. You’re probably lucky to get 50 cents on the dollar unless your improvement is an actual addition to your square footage.

The other negative is that whatever value you to add to your home will be added to your overall property tax bill, meaning that the improvements will continue to cost you down the road. If your family is expanding and you need the space, then a homeowner might have no choice. But those with the choice should decide if the trade-off is worth it.

Re-financing to pay off credit card debt is also tempting, but it can only be a positive if you’re willing to tear those cards up. Empty credit cards are more of a temptation to continue the same behavior than a road to recovery.

Retirement begins the day your passive income is greater than your expenses so although cashing out your equity is a temptation in the short term, it can only work for you if it reduces and not expands your debt (expenses) in the future.

One of the pitfalls of working for the man is that people are usually most dependent on their employer as they reach their 50s. That’s also the time that they’re getting most expensive to keep around. A person who has sacrificed lifestyle leading up to that magic number is most likely to take any surprises more easily. Those who invest well and have controlled their debt will even be able to retire by then. Those who have been living off their assets will have to work later in life to find independence.

I planned on keeping my current house even after the new one is built, but I’m beginning to re-think that decision. The cash flow is positive, but I think the appreciation is going to slow or halt in the next few years due to several factors.

1. Many homeowners with interest-only loans are going to realize that their wages haven’t increased enough to re-finance to the currently higher interest rates. Those with ARMS may face similar problems. As soon as the equity stops compiling, the result will be more inventory on the housing market either in sales or in foreclosure.

2. People who made living decisions based on a rate of increase of their equity could find themselves spread too thin. More people will be forced to sell or lose everything.

3. Whereas places like San Francisco have real land scarcity because of environmental laws, most of the places in Florida seeing an increase in value will be tempered by the surge in development. There are 12 high-rise condo units in pre-sale mode to be built in downtown Orlando in the next 5 years. The starting prices are $300,000 and up. In addition to that, many apartment buildings in Orange County and the surrounding areas are being sold as condos. Plus there is still a lot of vacant land in Central Florida. Any daytime flight in or out of the city confirms that. Supply is doing everything it can to meet demand here.

I don’t know when the plateau will happen, but forces controlled and uncontrolled will increase the housing supply at some point in the next few years and the consumer behavior we're seeing makes me think it will be painful for a great many. Those with money in liquid assets may have an opportunity to take advantage of the next paradigm shift.

1 comment:

E said...

Very good Tom. There is no escape from basic supply and demand, and real estate is still a cyclical market even when the up cycle is long. Saving regularly, getting out of debt, and managing one's lifestyle are foolproof strategies that never go out of style. Sure, one should take advantage of favorable markets, but at some point the local real estate markets are going to crash down on many people's heads. It's like the baseball card collection - it's not having it that's valuable, but selling it.

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