I lost millions in real estate three years ago. So the fact that housing prices are falling again doesn't shock me as much as it should, even though this time it's happening in the real world instead of a virtual one.
In early 2008, Zillow dropped the value of my house from $6.6 million to $5.5 million. Did I worry? Sink into depression? Cry? Nope. I just ignored it.
The reduced Zestimate was still millions of dollars more than I ever imagined my house would be worth. And, unfortunately, millions -- and millions -- more than the house actually was worth, even at the peak of the market. For some unfathomable reason, Zillow decided the antique Victorian in suburban New York City was worth as much as a beachfront estate in Southern California.
It wasn't. And the fantasy that it was didn't last long. Zillow cut the value more than 80% after I emailed site editors and asked them to help me find a buyer willing to pay close to what they claimed the house was worth.
Obviously, the super-inflated price was an error. But it was a mistake with benefits. Because once you see the value of your property climb unrealistically and then fall just as quickly -- even if it's only online -- you gain perspective.
You stop thinking about the equity you gained or the principle you lost, and you start thinking of your primary residence for what it is: A place to live.
If you're lucky, you can stay long enough to recoup what you paid. If you're not, as many of us have found out long before this housing bubble broke, you're lucky to get someone to pay enough to cover the remaining mortgage. Home ownership may still be an American dream... as long as you don't confuse the concept of shelter with investments.
And that makes reports like the latest Case-Shiller National Home Price Index a little easier to swallow. Home prices in the nation's largest American cities fell 4.2% in the first quarter, pushing past a low set during the worst of the Great Recession and eliminating all hope for a quick recovery in the housing market.
Prices fell below the previous bottom set in April 2009, confirming a much-feared double-dip in home prices across much of the nation. "Home prices continue on their downward spiral with no relief in sight," David Blitzer, chairman of the S&P index committee, said today.
Twelve of the 20 cities tracked by the index posted fresh lows in March: Atlanta; Charlotte, N.C.; Chicago; Cleveland; Detroit; Las Vegas; Miami; Minneapolis; New York; Phoenix; Portland, Ore.; and Tampa, Fla. Other than Washington, D.C., all of the major cities tracked by the index posted a year-over-year decline.
Nationally, house prices are back to their mid-2002 levels. If you adjust for inflation, prices are back to late 1999 levels. And it's still getting worse. "We expect house prices to drop at least another 5% before turning around in 2012," says Patrick Newport, an economist at IHS Global Insight.
Falling house prices damage the economy in several ways. As Newport explains:
They reduce wealth, which reduces consumer spending. They squeeze builder profits, which reduces housing starts. They force lenders to tighten lending standards, since the collateral is depreciating in value off the bat, reducing existing home sales. They reduce state and local property tax collections, resulting in spending cutbacks. They raise the level of uncertainty, which has made an increasing number of Americans think twice about participating in the housing market. Finally, they lead to more foreclosures, which in turn lead to further declines in house prices, which lead to more foreclosures, and so on.
And on and on. At some point, the market will recover. Prices will stabilize. Those of us who managed to hold on to our properties may even make a profit. In the meantime, losing so much money has never been so easy.
Re: leverage only as a hegding position, what's wrong with the following use of leverage? Notice the risk to cash flow vs. the risk to lost equity. The dicussions seems to have focused mostly on risk to equity which matters when you sell and less so when you hold.
Say you have an investment that returns a rate of 10% . Let's even say the standard deviation on the return is 2% - so very stable. Let's also say that your cost of money is 6% - so you've got a spread of 4%. If you leverage with a 50% loan, your spread has been leveraged so that your cash-on-cash return requires half the investment at twice the return resulting in a cash-on-cash return of 14%. Of course, what's been talked about is the additional risk. The risk in cash flow comes from the distance between your income (the 10%) and your requirement to service your debt (at 6%). In the case where you have no debt, it's the risk that your cash flow becomes negative. Completely unleveraged, this distance between your 10% return and negative cash flow is 5 standard deviations - essentially risk free. If you leverage (50%) with debt payments at 6%, your debt service is now 3% (6% on half the purchase price) or 3.5 standard deviations from your income. That's a 0.02% chance of your income falling below your debt service requirement - higher than zero leverage, but still safer than many other investments. Now if you leveraged at 100% (say buying a house), while you have zero room for any downward movement in value (and therefore equity), your debt service is right at 6% so your spread has been reduced to the 4% (the investment return rate minus the cost of money). This is still 2 standard deviations before you have cash flow problems. That's less than a 2.3% risk.I'm not recommendting this 100% financing scenario, but even that is less risky to cash flow than many other choices.
So given that I can invest the proverbial no-money-down, get cash flow that represent the 4% spread, and have 2.3% risk to ever having a cash flow problem, tell me again why leverage should be used only for hedging rather than magnifying. Remember, I'm talking about an individual investor - not a govt or large fund.
I totally agree with you that "Real estate is not risky, Leverage is". Leveraging is more appropriate for hedging your existing position rather than using it as an investment tool itself.
I agree with your comment that most of the risk comes from leverage. When I buy apartment buildings, there's a balancing act between the amount leveraged and the risk reduction strategies. When you buy stable and performing apartment buildings, banks look at the historical numbers to make sure you have a significant buffer between your NOI (net operrating income) and your monthy debt service. A typical ratio today would be 1.25 (i.e. you have a 25% buffer). If you plotted your NOI line on a chart, you'd see ups and downs resulting from fluctuating income (e.g. rent), and expenses (e.g. utilities, repairs, etc.). The trick is to look at the volatility of that line and make sure it doesn't get too close to the debt service line that's below it on the chart. You can even use Six Sigma principals to make sure that the NOI is a sufficient number of standard deviations away from the debt service line. Using strategies to reduce the volatility is often overlooked at a great way to further reduce risk. Having said all this, the NOI line for a single-family home is way too volatile for me. You're either 100% occupied or 100% vacanct! It's way to easy to be under water in any particular month.
Real estate is not risky, Leverage is. No matter what kind of investment you make, bond, equity, real estate, commodity, once you leverage yourself too much, there is a chance you end up like these investing bankers in 2008.
If I understand correctly, the scheme is your partner put down 20%, the original owner loaned you 20%, and then the banker loaned the rest 60%, I guess you must be reponsible for the interest & principle payment of the 80% house value loan. (If not, tell me your partner's name, I want to do business with him :-))
Leverage is magnifier, if you bet right, your return is magnified. if you bet wrong, your loss is also magnified. Practically, your leverage dwarfs these Wall Street Firms.
With this high leverage, it is possible that your return is infinite, only if you bet right, (i.e. you paid the bargain price, had a consistent, positive cash flow), you will win big time.
However, if you paid a price higher than the house's real value, or for some reason, the cash flow is disrupted. what can you do? Either you sell the house below the price you paid, or you hangs on with a negative cash flow. Either case, your return from the positive cash flow so far can be wiped out easily, and you may also need to cough up some money to cover the loss. (If your partner's 20% down is the first line of defense, congratulation! You found a generous partner, but I doubt he will cover more than 20% loss, or share the negative cash flow with you)
That is the risk of high leverage, I don't think you minimize this risk, it just does not show up during good time.
People at AIG FD collected CDO premium for quite long time, made easy money hand over fist, and assumed they took no risk at all. Then in 2008, they lost every penny they made before, plus dragging down the whole AIG with them.
I know you're talking about the macro issue of whether a single-family-home is an investment or not, but at the micro level it all depends on who holds the risk and who hold how much return. Let's say I buy a cash-flowing income property with a 60% LTV bank loan, and 20% owner-carry loan, and for the last 20% (the piece that's the most at risk), I find an equity partner who puts up the 20% cash down and we share the cash flow and equity above my partner's 20% 50/50. I've done several deals like this. Minimizes risk for me and my returns are infinite since the rest is someone else's money. I'm not saying this scales to a macro level, but don't presume that staments like "real estate is risky" are a blanket truth.
Do you think all those real estate agents who never stop yapping about what a great investment a home is will ever get the message? I mean, owning a house offers great benefits, and you might make money on it in the end. But it shouldn't be viewed as a retirement fund. For that,. you buy investment properties.
One thing we need to keep in mind is the leverage that is allowed on Real Estate. When you buy a house, mortgage company allows you to down 20%, a leverage of 5 times. During the boom time, they let you down 5%, or even less. If you bet right, you make tons of money in a short time. Of course, there is the risk of leverage, you can be easily wiped out if you bet wrong.
Before the Great Depression, Brokage firms allowed investors to bet on stock (margin trading) with 10% down. You put down $1 dollar, and bet $10, we all knew what happened after that -- As the dark joke goes, when people required a windowed room at any hotel near Wall Street in 1930s, hotel stuff usually asked "You need the room to sleep or the window to jump?". After the Great Depression, we have the SEC rule, 50% minumum on any margin trading.
If the government setup the new law that all real estate transactions required at least 50% down payment, will there be any subprime crisis in the future, I bet not, at least not as serious as the one happened in 2008
Most people blamed the greedy Wall Street firms for the sub prime mortgage meltdown, actually the government is the primary guilty party in this case. The removal of Glass-Steagull Act, the lax tax loophole on real estate, all have a share to the crisis.
So many people got used to being real estate wealthy that they thought it would never end and used their homes like an ATM only to be faced with the cruel realty that they spent phantom money and now have debt they can’t afford. Understanding that real estate wealth is not realized until someone actually sells a property is a good realty for owners to keep close to their heart. If you stay for the long term you should be okay but speculation and phantom money are a deadly financial combo.
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