Added by on 2008-11-19

It is interesting to see the headlines feign surprise and ignorance as the housing market continues to fall. This market was doomed to this end as the factors that drove it there piled on top of one another until the foolish consumer could hold the dam back no more. Here’s a quick overview:

1. Leverage- Allowing people to buy a large capital item without any downpayment is foolish. It sets in motion numerous promises that cannot be called upon in the event of financial downturns (Mortgage insurance, credit enhancement on whole loan portfolios, a consumer’s promise to pay, which is difficult, if not impossible to call on when the asset declines in value)

2. Credit Scores-These may predict with some level of accuracy a consumer’s ability to pay, but are not accountable for results, nor can they change as the market changes. My Brother has a giant credit score but no cushion to weather an economic downturn.

3. Builders-When a company can double their money or better by performing a business action on a large scale, that company generally will do anything to get to that result. We allowed builders to make massive money at the expense and grant of the taxpayer. If people pay a premium for a Polo shirt, Ralph Lauren doesn’t use taxpayer money to secure that profit. It sets up a scenario in a downturn where the same builder can sell against previous projects by lowering his or her profits, which sets in motion a downward trend to the “comparable” pricing that allows homes to be sold. It’s just foolish and should, just like the stock market, be managed.

4. Banks-Finance companies make money everytime a consumer signs mortgage papers. It is an origination machine; very profitable and with little recourse except for visible fraud in the short period following origination. It creates a system where banks and finance companies are incentivized to find methods to qualify speculators for many properties, especially where credit scores warrant a loan. In the market of running a public company, such a model promotes growth and market value increase, which are what makes shareholders happy. Banks and finance companies need long term exposure regarding product, which ensures integrity.

5. Realtors-The association that springs from the amalgamation of Realtors in America ran ads at the beginning of the year saying “it was a great time to buy a home,” in spite of the overwhelming information that indicated the market was going to fall precipitously over the next eighteen to twenty four months. Realtors are just salespeople; professional, nice salespeople. They say things like, “house prices always go up in the long run,” and “Remember America isn’t getting any smaller, and once the market “corrects itself” we’ll all laugh about this.” The housing market growth in the past five years was based on loose credit standards, speculative buyers driven into real estate when the tech bubble burst and a lie perpetuated on people who are too busy to learn.

6. It’s brick and mortar, not the American Dream- A home is the biggest leveraged investment you will ever make. You make it to secure a long-term, stable residence for family. It’s great if that investment increases a little faster than inflation and the interest you’re paying, but more important that you don’t lose more money than you can afford. The real estate market is upside down. The rental market should drive sales in math and reasoning but the Realtors and media have driven people to poor choices the past seven or eight years. If you can rent a three bedroom home for $1,000 per month, why would you buy that home for $275,000? You would tie up at least ten percent ($27,500) of capital, and pay about $2,000 monthly, in addition to house expenses, estimated at 3-4% of the home’s value each year (another $10,000). If you put the extra money into a bank account and invested it in a gas station or a laundromat, you’d be much richer over time and you’d always have a lower level of expenses. At the low rental fees compared with property values historically, it’s mathematical insanity to buy a home. Homes will fall further and the government’s current course will do little to reverse the trends in the market. 

The bottom line is when rental rates are at a “ten cap” meaning that ten times the rental income is the value of the home, home prices are safe. Look at a home and make an offer based on ten times the rental income. That’s a ten percent return (gross), but with expenses and depreciation, is about 6-7%. If you can lever a return of 7%, you’ll be safe in the long run. You’ll find that number is about what homes cost to build, which is what they should sell at once the new home shine wears off, just like cars.

It’s easier to invest in things you can see and touch, like a gas station or a sandwich shop, than to invest in markets with immense excess pricing factored in to allow the market participants to make their cuts.  For example, an investment in the stock market has investment banking firm’s ridiculous pay factored in and with the S&P trading still in double digits, what is the justification to that investment. Real returns of less than 10 % should come with incredible security, shouldn’t they? Stay close to home in the next two years, while Obama’s team prepares to launch the rescue boats. Invest in things you understand, at values you believe in (keep 10% in mind as a good buy signal), pay down your debt as quickly as you can and buy assets only if they are below replacement value until the market and capital markets regain composure.

Be careful, watchful and wary. Good luck!

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