Housing Market Hits Bottom
There is ample evidence that the housing market has finally hit bottom – at least in some areas. The hardest hit markets such as Florida and Arizona are showing signs that prices have finally stablized. Granted, these prices are at levels far below just a year ago, not to mention the height of the market in 2006. These markets are dominated by bank owned foreclosures that are selling in many cases for far less than repacement cost. Prices have gotten so low that bidding wars are breaking out and many homes are getting multiple offers within days of being introduced to the market. The New York Times recently printed an article on this phenomenon in the Phoenix area and I have personally witnessed it in the Cape Coral Fort Myers area of Florida. Many are selling for higher than asking price. Sales volume has also increased significantly as homes are being purchased by investors and homebuyers who are looking to take advantage of low prices.
Just how low are prices? In Cape Coral you can purchase a three year old home with 3 BR, 2 BA, and approximately 1,700 square feet for about $85,000. That’s only $50 per square foot. The cost to build the same house today would be approximately $200,000.
The expectation among buyers is that lower prices will continue to attract homebuyers and eventually the glut of inventory on the market will be reduced. Population is still expected to increase in Florida, California, Arizona and Nevada, albeit at a slower pace than previously projected.
These new residents will need homes and at some point – perhaps 2, 3 or even 5 years from now – the excess inventory will be gone and prices will approach or even exceed replacement value once again.
For homebuyers, now may be a great time to get a bargain in these hard hit markets. For investors, the decision is a little trickier. Although prices are bound to recover eventually, there are still some issues of concern. First, most of these foreclosed homes need work. Some need significant work and these houses should be avoided. Other merely need some new paint and carpet and those are the most desirable. They also tend to attract the most bids.
Second, due to the glut of inventory, there is a lot of competition for renters. As a result, rents have come down significantly in these areas.
It may be difficult to generate a positive return on your investment in the short term – especially if you are considering using debt financing. Most likely, you will have to be a cash buyer and you should expect no cash flow in the short term.
Finally, it is impossible to predict with accuracy how long it will take for the the excess inventory to be absorbed, at which point prices should recover. I don’t expect that prices will reach their recent highs for many many years. Nonetheless, they should reapproach replacement cost as inventories are depleted and builders must once again build new product to accommodate the demand from population growth.
Buying Fixing and Flipping Foreclosures
I recently purchased, renovated, and resold a home in East Windsor, NJ. East Windsor is a solid upper/middle class neighborhood in Mercer County. It has access to Exit 8 of NJ Turnpike for an easy commute to NYC or Philadelphia. I bought the property from a bank following foreclosure. The renovations took about 6 weeks in total and I sold the house after less than a week on the market for a decent profit.
There are a number of keys to successfully flipping foreclosed homes. First, you have to pick your properties carefully. Look for homes that are in good neighborhoods, in good structural condition and require only cosmetic improvements. Next, buy the property at the right price. In order to do this, you need to have a solid understanding of the market and the potential value of the house after renovations are complete. Don’t forget to build in extra costs for miscellaneous items and a contingency factor of at least 10% and preferably 15% to account for unexpected costs. There WILL be unexpected costs.
In making renovations, focus on low cost, high impact improvements like new paint and carpet. Kitchens and bathrooms are the most costly renovations, but they will define the character of the house. Don’t skimp on these as they will help ensure a quick sale. But be careful not to overimprove on high cost improvements like stainless steel appliances or granite counters if the market isn’t willing to pay for the extra cost. Finally, when the improvements are finished, price the home to sell. Ask a local broker what price you should list the property in order to sell it within 30-60 days. This will likely be lower than other competing homes in the market. That’s OK. Don’t swing for the fences on your first at bat. Its better to hit a single or double than strike out at the plate.
Projections for 2009
It has been some time since I have posted new blog entries. Since my last post in October 2008, the financial system has collapsed under its own weight. The de-leveraging of our economy has spilled into all sectors resulting in job losses and a loss of consumer confidence. All of this has contributed to still more foreclosures and further decreases in home prices. Given the negative outlook for the broader economy in 2009, most economists expect home prices to continue to decline.
Given the negative outlook, real estate investors must be wary when making new acquisitions. However, along with economic turbulence comes opportunity for those who are well positioned to take advantage of it. Investors with equity should be able to to acquire properties at steep discounts in the coming months.
Bank foreclosures present perhaps the best opportunity to acquire properties at attractive prices. Banks were initially ill-equipped to handle the large case load of foreclosures they suddenly faced. Furthermore, they were initially unwilling to discount their assets enough to attract investor interest. After receiving billions in federal TARP funds, the banks appear to have begun a more aggressive campaign of price reductions in order to clear inventory from their books.
Auction services are a good place to find foreclosed homes at bargain prices. Be sure to check for “buyer premiums” payable by the buyer to the auctioneer, which will add to the cost of your purchase.
Home Prices far from Bottom
A New York Times article in yesterday’s paper seemed to agree with my earlier post that home prices have not stopped their downward descent. As the article notes, the number one factor that drives home values is incomes. As incomes go up, the amount that people can afford to spend on a home goes up too. That is why proposals such as Sen. McCain’s to buy up bad mortgages will NOT stop the fall in home prices. Rather than spend taxpayer money overpaying for bad mortgage, the government should focus on creating new and higher paying jobs. That is the only long term fix for the housing crisis.
News that mortgage rates sharply increased this week further indicates that the home prices will continue to fall. The government’s financial bailout will likely push interests rates up, causing mortgage rates to rise and interest payments to become more expensive, thereby depressing prices. In light of these circumstances, it is not surprise that homebuilders’ confidence fell to new record lows and housing starts have fallen to a 17 year low. The drop in new starts is actually good news for prices as the fall in supply should help reduce or at least stabilize the glut of unsold homes on the market. Prices will stop falling once supply and demand finally reach equilibrium.
What’s Next for Housing Prices?
The stock market dropped 777 points today after Congress failed to pass Treasury Secretary Paulson’s proposed bailout of financial firms. WIthout sound financial institutions, mortgage financing will become more scarce – and more expensive. This will cause further downward pressure on housing prices. The banking crisis is also having a negative impact on consumer confidence. Purchasing a house is one of the biggest investments most people make and they are reluctant to invest in times of turbulence and uncertainty. Speaking on CNBC tonight, Ara Hovnanian, CEO of homebuilder K. Hovnanian Homes, stated that the housing market was suffering from the same panic as the financial markets and that some form of housing stimulus was needed to boost consumer confidence and demand. He further said that in some markets, houses are selling for less than the costs of construction. This, he said, reflected dysfunction in the market which merited government intervention in the form of tax credits or some other housing stimulus. Government intervention of this sort will likely only prolong the inevitable. Hovnanian further stated that until housing prices stabilize, the financial markets will continue to suffer. This is true because most of the financial problems are a function of the losses these firms will suffer on bonds secured by mortgages. As the value of the houses falls, so do the value of their mortgage bonds.
There is no way to tell today whether Congress will actually pass some form of bailout package for the financial markets. If they do, mortgages should remain available to buyers with good credit. Nonetheless, there is evidence that housing prices still have further to fall. According to the Case Shiller Index, real housing prices (those adjusted for inflation) should remain flat over time. As this graph shows however, although home prices have come down signficantly over the past two years to get back to 100, which represents the long term average. Currently, prices remain 25% higher than their long term, inflation adjusted average. Furthermore, if the economy falls into a severe recession as a result of the financial meltdown, real home prices could actually fall below their long term trend line. Eventually, population growth will help to stimulate housing demand and the market will once again stabilize. However, there are few indications that we are anywhere near this stabilizing point. Obviously, market conditions vary widely from place to place and the fundamentals of your local market are more important than nationwide trends. For example, according to the latest Case-Shiller figures, prices in Dallas actually increased slightly month over month (although they were down year over year). Nonetheless, local markets are not immune from the macro trends, as these tend to be reported in the media and can have a significant impact on consumer confidence even where the fundamentals are relatively strong.
There is no way to know for sure how far prices will fall, but there are certain benchmarks homebuyers and investors can rely upon to protect themselves. First, there is replacement cost. Houses depreciate over time and are replaced by new houses. The cost of constructing new homes is a function of the cost of materials, labor costs, land costs, and the builder’s profit. The most elastic of these inputs are land costs and builder’s profits. By comparison, the real cost of materials and labor are relatively stable over time. In markets with a stable or growing population, a homebuyer who purchases a property at or less than the costs of labor and depreciated materials used to produce it can feel relatively secure knowing that the price likely will not fall below that price.
Another metric which can be used to protect real estate investors is the price/rents ratio. Like the price/earnings ratio used by stock investors, the price/rents ratio gives an indication of the property’s value as a function of the revenue it generates. To calculate the ratio, simply divide the price of the home by the potential net rent revenue the property could generate (gross rents less taxes and other expenses). Historically, the price/rent ratio has remained around 16, depending on the market (more desireable markets tend to have a higher price/rent ration than less desireable markets). If the real estate investor is buying property primarily for yield, he or she should expect a yield on a single family house of approximately 6%. If the yield falls below this level, the investor would likely be better off putting his or her money elsewhere. Thus, the price to rent ratio will give a fundamental basis for determining the appropriate price an investor should pay for a home.
Impact of the Financial Crisis on Short Sales and REOs
The U.S. banking system is currently experiencing massive convulsions as a result of the bad real estate loans made over the past few years. A a result, mortgage debt will be much harder to obtain going forward. Credit will be limited to those with the best credit and the vast majority of banks will refuse to lend any more than 80% of the purchase price of a home. This will have a significant dampening effect on demand for housing, pushing prices down. Lost jobs in the financial sector and related industries will further depress demand for housing in the near to medium term.
None of this bodes well for the housing market. Responding to the lack of demand, home builders continue to lower the level of new construction. Nonetheless, there remains significant inventory of unsold houses in most markets and prices will continue to fall until demand and supply for housing reach equilibrium.
The silver lining in the curent market is that real estate investors who have cash available should be able to find some serious bargains in the coming weeks and months – particularly with respect to short sales and REOs. The banking crisis has led to numerous bank failures and those who have survived thus far are in a fight for their lives. These banks need cash – now. Consequently, I expect they will be more willing than ever to entertain short sale offers and REO offers that are far below what they would have considered even a few weeks ago. If you have cash and can close quickly, don’t be afraid to submit embarassingly low offers. If you have been looking for motivated sellers, you have found them in the banks.
REO or Short Sale – Which is the Better Investment Strategy?
Foreclosure investors have several strategies to choose from when buying properties. Due to the fact that the foreclosure process tends to be lengthy, investors can target properties in various stages of the legal proceedings – either in preforeclosure, at the foreclosure auction, or bank owned properties following the foreclosure proceedings (REO). Each strategy has its relative merits and drawbacks, but most investors find that preforeclosures and REOs offer the least amount of risk, and the greatest opportunity to score a bargain.
Logically, short sales should be the best way to purchase a distressed property at the lowest price. Short sales focus on the acquisition of properties early in the foreclosure process and logic dictates that banks should be willing to accept the lowest prices earlier in the process as they could save the costs of (a) lost interest income, (b) accrued property taxes, and (c) legal fees and costs associated with the foreclosure process.
Unfortunately, logic does not always prevail when dealing with the loss mitigation department. One foreclosure service company recently conducted an informal study of 500 short sale offers it had handled last year and found that only 43% of the offers resulted in a sale. In the other 57% of the cases, the bank rejected the short sale offer and chose instead to foreclose on the homes and sell them as REOs. The study determined that 93% of these REO sales ended up selling for less than the last short sale offer price.
The results of this study defy good business sense. After all, a good businessperson would seek to obtain the highest possible price when selling their asset and incur the lowest possible cost. Still, there are some plausible explanations for this apparenly illogical result. One possible explanation is that the study’s methodology may have been flawed. Most scientific studies use a sample size of at least 1,000 random examples. In this case, there were only 500 samples which were all chosen from a single firm’s case load (which may have included a disproportionate number of examples involving certain banks, or geographic regions, for example). Another possible explanation is that the loss mitigation representatives responsible for the study sales were simply incompetent or were too overworked to be able to make good business judgments. Yet another possibility is that the banks failed to recognize that housing prices would continue to fall when they rejected the short sale offers – or that prices would fall as quickly as they did. As a result, the homes were worth much less than expected at the time they were eventually sold compared to when the banks received the last short sale offer.
Whatever the cause, the findings of this study, appear to indicate that REOs are the better investment option compared to short sales. Not only were the REOs purchased at a lower cost than the last short sale offers, but they required less of the investors’ time and effort. The results of this single study should not be considered conclusive evidence for investors going forward, however. The unprecedented surge in foreclosures seems to have taken the banks by surprise. How else can you explain the billions of dollars in losses these banks are taking each quarter?
It would be unwise to assume that these banks are not conducting their own studies and have not learned from their mistakes. One would expect that the banks to take steps to make their loss mitigation departments more effective going forward and anecdotal evidence indicates that this is, in fact, occurring. Consequently, although the study indicates that REOs may have proven the better investment strategy in the study cited, there is reason to believe that short sales may be more competitive going forward for those investors who are willing to work harder for higher returns.
Got a Question About Short Sales? Ask it!
If you have questions about short sales, send me an e-mail at gvinson@nutsandboltsrealestate.com or post it to one of the posts on this site and I’ll be happy to get back to you.
Short Sale Case Studies – Submit Your War Stories!
Have you completed a successful short sale? Have you tried to buy a short sale that didn’t close? I want to hear from you!
I am compiling a database of information on short sales that seeks to quantify some of the issues that are relevant to short sale buyers through a comprehensive study of actual cases. If you are interested in participating, please send me an e-mail to gvinson@nutsandboltsrealestate.com with the following information:
What was your initial offer?
What was the final closing price?
What was the market value of the house?
What was the principal balance on the outstanding mortgage?
What was the BPO price?
How long did the deal take to close?
Who was the bank?
Where was the property located?
Was there a second lender involved and if so, what did they receive?
Share your war stories here and ultimately we will compile better information that will allow short sale investors such as ourselves to be more effective in our negotations in the future. I may request some verifying documents (such as a HUD-1) to ensure accuracy so we all know we are dealing with reliable information.
Thanks, and I look forward to your submissions!
Short Sales: Drafting Your Offer Letter to the Bank
The bank will not explicitly require that you include an offer letter along with the short sale package you have prepared, but if you are interested in buying the property at the lowest possible price, I cannot stress how important it is to include a letter which fully explains how you arrived at your purchase price. Your offer letter is an opportunity for you to lay out all of the facts that justify why it makes sense for the bank to approve your sale at a price which is significantly below the amount of its loan.
Do your homework in advance. Look for recent sales for the lowest price comparable properties (be sure they are, in fact, more or less comparable or your offer will lose credibility) in the area and include these examples as an exhibit to your letter. Then, if applicable, explain how your house is inferior to those examples and therefore deserves a lower price. Here are some reasons which may justify a lower price: it’s on a busy street, it’s older, it has fewer bedrooms or bathrooms, it has less square footage, the windows are old and should be replaced, the kitchen and bathroom décor is old and out of fashion, the siding is old, it needs to be painted, it needs new landscaping, the lot is smaller, etc.
I would also strongly recommend getting the property inspected before you submit your purchase offer. This may cost a few hundred dollars up front, but it could save you thousands of dollars in the end. Most purchase contracts include a provision making the offer contingent upon obtaining a satisfactory inspection of the property. If the offer is accepted, the buyer then conducts a property inspection to determine if there are any significant problems with the condition of the property. If major conditions exist, the buyer frequently seeks a price reduction to account for the cost of repairing the condition. When you are dealing with short sales, these types of subsequent negotiations can drag the already lengthy approval process on for weeks or months longer and may ultimately threaten the deal. Banks are not interested in making repairs to the property and attempting to renegotiate the price to account for repairs you discover after your short sale offer has already been approved will be coldly received.
Accordingly, in order to make the most compelling short sale offer, I would recommend you conduct your inspections before you submit your offer and clarify that your offer is not contingent upon a property inspection. When calculating your offer price, deduct the cost of any required repairs from what you would otherwise be willing to pay when making your offer. Demonstrating that there are property conditions which need to be repaired will also give the bank further rationale to approve your low offer. Not only will this help justify why your offer may be significantly lower than the recent sale price of other comparable properties nearby, it will also put the bank on notice that if they do not sell to you, the next potential buyer will discover the same conditions you did, and that buyer will surely seek a discounted price as well. Include copies of each inspection report you have prepared (home inspection, mold, termite, asbestos, etc.) as well as an estimated cost of repairs with your offer letter and explain that your price already accounts for these repairs.
My step by step guide includes 30 pages of strategy as well as forms for all of the letters and contracts you will need in order to complete your short sale.
