In last month’s issue we reviewed one of the most important aspects of applying economic principles, which is the Latin term ceterus paribus or “all things remaining the same”. We discussed how government intervention distorts market signals which makes it impossible for “all things to remain the same”. In this issue we will discuss two examples of the effects of government intervention on the real estate market.
An investor friend sent me a news article pointing out that BBVA Compass Bank is introducing a new program where buyers can get into homes with as little a 3% down. She wisely pointed out that she would not even consider selling her property using seller financing with less than 10% down. It appears banks will revamp the old policy of easy money.
It seems that lessons were not learned in the last bubble. We know the price of real estate is directly proportional to the financing available. Because of easy financing the demand for purchasing homes will increase, which raises the price of real estate.
What happens when financing is eventually curtailed or the price of real estate reaches unnatural high prices? The bubble will burst and once again the price of real estate will decline and seek its market level. If other banks follow suit, or if home financing becomes even easier, there is no question this bubble will be harder than the first. Why do the powers that be not think this is going to happen again?
Add to this an article I read where the government programs to refinance underwater loans is not having the success that was promised. One third of these loan modifications are turning into defaults. It seems that one third of these “reperforming” loans are turning in to “redefaulting” loans. In other words even with the new government program, home owners are not able to make their payments and are going into default.
The above government programs result in conflicting economic principles. On one end the easy money will tend to make prices go higher. At the same time the emergence of defaults will tend to make real estate prices decline. You tell me what the outcome will be.
“All things remaining the same”, here is my advice taking into consideration the current set of circumstances. First, if you plan on selling your property, or buying a home, now would be a good time since there is money available at cheap prices, and at the same time real estate prices have not risen to the point of being unrealistic. Similarly, this is a perfect time to refinance your properties since interest rates are low and money is somewhat easier to obtain.
We discussed these scenarios in my apartments class a couple of weeks ago. One of the risks of purchasing apartments or rental properties is for easy money policies to be revamped. Easy loans result in good paying tenants purchasing homes instead of renting. Those who owned rental properties in the mid 2000s know very well that vacancies were above average when money was easy, except for C properties.
Apartments and rental properties are categorized as being A, B, C, and D properties. In a nutshell, A properties are your newer, high end rentals, while B properties are more suited for middle class or blue collar workers. C properties are geared to your lower income tenants. For my money, C properties are the safest investments from and economic point of view. The D properties are your war zones. Only the bravest of the brave should be investing in these areas.
Because C property tenants tend to never purchase homes, but continue to rent, I have strongly suggested purchasing good C properties for cash flow. To illustrate this strategy, I received a call from an investor friend who indicated he has been doing quite well purchasing C rentals over the years. Why? Because he is purchasing these properties at discount rates, either from the open market or from banks. He indicated he has never had an unruly vacancy problem, and therefore he is enjoying a very lucrative cash flow. Moral to the story is C tenants do not purchase homes and can make good tenants.
Contrast this to the investor friend that sent me the BBVA article. She fears this easy money program will take away her good paying tenants causing a vacancy problem. Wisely, she is aware of the situation and is prepared to act accordingly.
With this being said, I stand by the advice I have been giving for months. Purchase properties for all cash at rock bottom prices; or purchase with seller financing with favorable terms. Both will give you an excellent exit strategy, as well as increasing your wealth. Along the same lines, if you have notes to sell, now will be a good time because when interest rates rise or when the bubble burst, note prices decline.
Summary: Always have a good exit strategy that does not include banks. Pay attention to the money markets and the Federal Reserve. Above all, act out of knowledge, not fear or ignorance.
If you have questions or comments, CONTACT ME Tom Henderson /a.k.a. THE NOTE PROFESSOR Remember: If you know of someone who has a note to sell, I DO PAY REFERRAL FEES.
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