Sunday, September 28, 2008

The Beginning of a New Real Estate Cycle--

The American Public is up in arms about the financial bailout of Wall Street. The investment banks, large and mid tier Banks, and to a much lesser extent community banks all played a part in this debacle. But do not blame the banks alone, we the borrowers deserve as much blame as the banks. Everyone needs to relax and stop worrying. Its the job of Congress and the financial gurus at Treasury, The Federal Reserve, SEC and FHFA to restore faith in the in American Economy and free up liquidity. This act of socialism may end up causing more pain than pleasure. I just hope that it is less socialism and more capitalism.

Don't blame this on lax lending standards. Don't blame it on Wall Street. Don't blame it on subprime. Blame it on all of these. It was a combination and convergence of market and financial events. The national (and local) real estate market from 2000-mid 2007 had gone wild. Prices were going through the roof and there was unprecedented growth. Those who were smart enough to sell were becoming multi-millionaires. Those who wanted to live like millionaires refinanced the market equity in their homes (more like used their homes as ATM machines) to live lavish lifestyles and buy worthless assets. And finally, those who should have remained renters wanted to join the party. It was crazy.

When the quantity of any commodity which is brought to market falls short of the effectual demand, all those who are willing to pay... cannot be supplied with the quantity which they want... Some of them will be willing to give more. A competition will begin among them, and the market price will rise... When the quantity brought to market exceeds the effectual demand, it cannot be all sold to those who are willing to pay the whole value of the rent, wages and profit, which must be paid in order to bring it thither... The market price will sink...

An Inquiry into the Nature and Causes of the Wealth of Nations, by Adam Smith. Methuen and Co., Ltd., ed. Edwin Cannan, 1904.

The national real estate market is going through a correction. Why? It has to. Our capitalistic system of supply and demand requires it do so! Is it for the good of our economy? Absolutely! It's healthy for the market to go through this cycle. It is necessary so that the market can collect itself, rest, and grow again. What concerns me is that the government intervention will artificially prop up the market.

Why did the real estate market undergo such price appreciation? There are many reasons. The most basic are: speculation and population growth.
When particular real estate markets have properties being traded between buyer and seller at a frenetic pace, particularly for investment, market values will rise quickly. The result is real estate valuations that become suspect because the price increases are occurring faster than the local affordability levels.

For example, a real estate investor buys a home for $150,000, adds $50,000 in improvements, and sell its 90 days later for $300,000. That house gained a 150% price appreciation in the three months. What happens if 25% of the homes that are being sold in any particular area during a period time(say, one year) are growing exponentially while incomes stay flat. It will result in problems. Overtime, this price to affordability effect will impact the market as potential buyers can no longer afford to buy a home.

Also, existing homeowners who saw the market heating up, wanted a piece of the pie. So as prices kept going up, those homeowners started putting their properties on the market. Some where the same people that cashed out their equity (and had blown all the cash on frivolities) now realizing that they had more debt than they could afford to carry, thus forcing them to sell along with those that just wanted a piece of the action. Eventually, the market became flooded with property.

Invariably, as demand slowed, sellers were still trying to sell at the highest prices possible, but it was too late for them. They are usually the ones who fail to see the end of the growth period and eventually, have to adjust their prices and so, the market corrects itself (just like the stock market).

What happens next? Once the market has fully corrected, prices stay flat and growth slows for a period of time,the upward cycle will begin again as demand starts to rise.

Please take a moment to view this video from a conference in California. The speaker, a CEO of a top California Real Estate firm, has an exceptional insight into real estate cycle. While the speech later gets into the California real estate in particular, I think the early part is very informative. Click here to see video

So what does this mean? It's an opportunity for the savvy investor. Now is the time to be buying when everybody is selling.