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Real Estate Investing
My Take, Part One. Bubbles

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By jiml8
August 23, 2002

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I had a phone conversation this afternoon with TMFTom9, who called me asking why I commented in an earlier post on this board that I was selling a lot of properties.

So, I told him. That conversation has also prompted me to get off the pot and start writing. [And Tom got to writing on this subject too -- see Thursday's Fool on the Hill column.]

Now, I also commented in that post that I was mulling over a post discussing my view of the current real estate market. I had been holding off writing it because, really, I wanted to write an article rather than a post and making it a post would probably set a record for length on TMF. I didn't really have the time to write the whole thing, and I was just putting it off.

So, what I am going to do is write a series of posts over the next several days, discussing what I think is going on and where it might lead. I have no doubt this will trigger some substantial threads, but I won't participate in the discussion until I have finished the series.

Now, some people may remember that in December 2000, I put up this post:

http://boards.fool.com/Message.asp?mid=13901874

(pause while you review it).

For about nine months after I posted that, it looked to me like I had kicked it squarely between the goalposts. Everything I predicted seemed to be coming true.

Then, it was 9/11.

The attacks seem to have led to a bit of a phase shift in the real estate marketplace and in conditions generally WRT investment and rental housing. I am now, I think, looking at the most treacherous and dangerous market I have ever seen. I think there is a distinct possibility that the entire investment housing market will collapse nationwide within the next year. Understand, I am not predicting that at this point, but all the indicators appear to be in place and I am actively selling now.

So, let's talk about real estate bubbles.

What, exactly, is a real estate bubble? Well, it is when real estate prices are too high. But what, exactly, is "too high", and how do we tell? Well, we tell when prices have been run up for awhile and suddenly prices are coming back down, right? Right?

Wrong. A housing bubble exists anytime that housing prices should be falling, but have not yet started to fall or are perhaps still rising. By that definition, it seems likely that major portions of the US (perhaps most of the country) are in a bubble right now, even if prices have not been substantially appreciating in their area.

It is easy enough to identify a bubble. All you have to do is to look at the real estate investors marketplace, and look at rent and occupancy trends.

In general, landlords are not really free to set their rent to whatever they choose. On the low end, they are constrained by the need to make money; buildings have fixed costs that must be met, and variable costs that must be met when they arise. The aggregate of these costs sets a floor on the rent that can be charged, if the landlord is to have money left in his pocket at the end of the month. On the high end, rents are set by what the market will support. Market support is controlled by several factor, not the least of which is the average mortgage cost for a homeowner.

Buying a home is a tradeoff for the person who would live there. On the one hand, the home represents something of an investment in that eventually the mortgage is paid off and the homeowner owns his shelter free and clear. On the other hand, the homeowner is exposed to market shocks, lacks easy mobility, and bears the risks associated with owning, and has to handle maintenance issues himself.

Renting, on the other hand, is low risk for the tenant. The tenant can pack and move at the drop of a hat, doesn't have to worry about maintenance, and bears little risk.

So, from the landlord perspective, rents may be set to a premium (usually not much of a premium) over the total cost of ownership of a home; renting may then prove to be attractive to people who would otherwise buy. The landlord cuts his maintenance costs by taking advantage of the economies of scale, and the difference between his total cost and the rent he charges is his profit.

Now, this works well so long as circumstances are such that the minimum rent the landlord can charge and make money is less than the maximum rent he can get. But what happens when the maximum rent is less than the minimum the landlord needs? When this happens, obviously, the landlord loses money. This means that rents are out of line with mortgages, and rents must eventually come down to return to alignment. But the landlord can't drop rents; he has a mortgage too. So, we see a condition where the property investor gets squeezed out of the market, usually at a loss.

This process leads to a turnover in the investment properties in an area, at declining prices, and results in lower rents. The lower rents then work to soften the housing sales market in the region as properties become less attractive for investment and as renting becomes a more attractive option again, vs buying, resulting in further softening of an area's home sales.

It might also happen that a landlord, needing money, will reduce his occupancy standards. This will quickly destroy a neighborhood; low quality tenants in a substantial property will cause home values to drop for some distance around. Thus, when the landlords are in trouble, all real estate owners are in trouble.

Now, in the current environment, we have historically low interest rates on mortgage money. This, inevitably, has led to a certain amount of price inflation as sellers take advantage of the opportunity to pocket more money while not impacting the purchaser's monthly cost to own. But this inflation has not offset the drop in rates; the average monthly mortgage cost is declining.

Furthermore, the Federal Gov't has been instituting program after program to encourage home ownership. The goal may be laudable (it's debatable) but in fact they are distorting the marketplace, at a time when the marketplace is proving to be extremely vulnerable to shocks. Due to government programs, it is possible to move into a new home for essentially nothing down. This removes the traditional requirement to establish a goal and save for it and de facto pressures the rental marketplace. It also removes most of the risk to the purchaser; having invested nothing, there would seem to be nothing to lose if the purchase loses the home. To this extent, purchasing a home begins to look like renting. Furthermore, from a risk/reward standpoint, buying becomes much more favorable than renting, because there is the possibility of building equity if things don't go wrong.

As a consequence of these two factors, low rates and government programs, rents have stalled in many places around the country, vacancies are rising in most places in the country, and property investors are being badly squeezed.

All this is happening at a time when bankruptcies are near an all time high, foreclosures are at an all time high, the stock market is melting down, and at the same time home sales are near an all time high.

The total combination suggests that rents must come down, which will only happen through turnover of property investors. This will result in a reduction of housing prices throughout all marketplaces affected, which could well be most marketplaces in the United States. The process could be gradual, or it could be very abrupt. The gradual scenario is survivable by everyone, but we could very well get the abrupt scenario. If we do get the abrupt scenario, it will begin with a large wave of bankruptcies of property management companies. This may well happen, since the triggering event for this is looming.

In my next post, I will discuss why.


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