What Causes A Perfect Storm?
Well that’s the million dollar question, isn’t it?
What I deem a perfect storm is a set of circumstances that occur once, maybe twice in a lifetime that offers unparalleled opportunity to purchase undervalued real estate at unnaturally depressed prices. There was one similar opportunity in the late 1980s, early 1990s when the RTC (Resolution Trust Corporation – a government-run entity used to liquidate primarily foreclosed commercial assets) had one of the biggest fire-sales of commercial real estate in US history. This was a time that fortunes were made in the acquisition of overly distressed real estate assets. At that time, the market collapse was caused by 3 main factors (1) change in US tax laws affecting real estate investors, (2) Overbuilding, (3) The Savings & Loan banking scandal and fraudulent activity of mortgage lenders and appraisers.
So what’s causing the Perfect Storm Today?
(1) Massive residential property speculation in 2003-2006
(2) Too much credit available to purchase and finance real estate which was overused by lenders and uncreditworthy borrowers
(3) The current overall US market decline/recession that is spreading into a global crisis
(4) Current lack of funds for qualified borrowers
(5) Current oversupply of properties for sale
As you can see, there are 2 stages that follow one after another that lead to the creation of a Perfect Storm and opportunity to purchase real estate at incredible values – The Housing Speculation or Run-Up phase and the Market Collapse. We will examine each of these phases so you are more informed on what has led us to this perfect point in time to invest in real estate.
But first, we need to examine the most important issue a real estate investor must evaluate when choosing where and when to purchase a real estate investment – LOCATION.
Underlying Market Strength
I’m sure you’ve heard the age-old adage, “location, location, location”. I have a different spin on this saying. Mine goes more like, “location, timing, cash-flow”. Nevertheless, location is still number one on the list. If the underlying market is not strong with potential for rental and value increases in the future, then what’s the point of investing in the first place?
First, let’s look at Metropolitan Phoenix as a whole for location. Why the heck would you want to buy property in the middle of the desert?
Even though our market is severely depressed right now, Phoenix has shown remarkable resiliency and long term value appreciation for a number of reasons:
(1) Climate – People want to live here because of the warm, sunny weather. It is why snow-birds come in flocks for the winter and to retire. We all know that the baby boomers are reaching retirement age.
(2) Affordability – Phoenix is one of the most affordable places to live in the US. While this statistic took a temporary hit during the last boom, we have fallen back down to being extremely attractive to business based on real estate values, labor pool and overall cost of living. This will continue to attract business, labor and retirees to the area for the long term.
(3) Standard of Living – very high. Ease of commuting, and a fresh young, vibrant city leads people to want to live here.
These factors have led to the remarkable positive population growth Metro Phoenix has experience for the past 50 years. Even during times of economic hardship, people still continue to move here at a remarkable pace. This puts pressure on the housing market and inevitably leads to appreciation.
After deciding that Phoenix is the right spot to invest in real estate, your next task it to pick a sub-market within the metro region that makes the most investment sense. Some of the most important factors include:
(1) Area of greatest price declines
(2) Proximity to employment
(3) Proximity to amenities
(4) Quality of area
(5) Strength of rental market/values
These will be discussed later in this report and a qualified real estate professional can assist you in selecting sub-markets to invest in that match these criteria.
The Residential Housing Value Run-up
Phoenix real estate has always appreciated at a steady pace with the exception of a few massive run-ups in value followed by sharp declines. The decline of the late 1980s was briefly reviewed above. So what has caused the latest mass-speculation and run-up in values between 2003 and 2006?
Well there were a few culprits that acted together to create this latest debacle.
(1) Underlying Market Strength – As stated above, Metro Phoenix has inherent underlying market strength. That is what got the ball rolling and led to the mass speculation for 3+ years.
(2) Cheap Credit – Interest rates came down to unheard of levels making it easier to buy more assets with less money.
(3) Overabundance of Credit – It started in the late 1990s when Bill Clinton passed legislation freeing up credit to allow more people to buy homes – the sub-prime mortgage market was created. People that really shouldn’t have been buying homes in the first place were not only buying homes, but purchasing larger properties than they could afford. As credit loosened and values started to increase, a run on equity lines of credit and refinancing freed up the equity in people’s homes and allowed them to spend ‘invisible’ equity in the consumer markets on durable goods and services. This created the economic boom that we all experienced in the early to mid-2000s. The result: even homeowners that bought early in the boom and saw their property values increase 50-100% over a 5-6 year period had little to no equity left in their homes by the end of this appreciation cycle as they leached it all out through equity lines of credit and other borrowing methods.
(4) Investor Stupidity – As values went up and loans became easier to attain, investors started buying property with no money down and buying as many properties as they could get loans for (see next point below). It became an exercise in buy high and hope to sell higher.
It got to the point that, in 2005, there were actually busloads of investors that were driving around in town stopping in new housing subdivisions and lining up to buy new homes. Why did they concentrate on new homes? Because they could purchase a home to be built in the future, put little money down to secure it and watch the value of their property increase for 6-12 months without even owning it yet! Then they would either flip it right away when it was completed or hold it in hopes of it appreciating even more.
Builders were turning away buyers, holding lotteries and using other methods to hold back the swarm because they couldn’t build homes fast enough, even as they continued to raise prices on a monthly – sometimes even weekly basis! As a result, new homes were overbuilt in 2004, 2005 and 2006 by a wide margin due to ‘fake’ demand since many of the buyers were investors with no intention of ever living in the home!
This flawed philosophy worked for 2+ years at which time the greatest fool theory became a reality. You know how it works…As you build a pyramid of fools, there are less and less greater fools as you work your way to the top. When you finally reach the summit the greatest fool at the top looks around and sees no-one dumber than himself to buy his property for more money and so, the whole structure comes crashing to the ground. It took a while for owners of property who were trying to sell to realize that prices were in decline, not going up in mid 2006 which resulted in a massive number of listings coming on the market with few takers. This is further explained below under ‘The Market Collapse’.
(5) Lender & Investor Fraud – As the run-up in values was occurring, lenders and investors started to get greedy. Lenders began offering programs that made little or no sense for some homebuyers to get them into a home. Many times, putting a buyer into a home larger than they knew their client could afford with programs that their clients did not fully understand.
Credit was so loose and readily available during this time that many investors and homebuyers were fraudulently misreporting their income too high on ‘stated income’, ‘no-doc’ loans and lenders were turning the other cheek and underwriting the loans with no clear proof of the borrower’s ability to repay.
The Market Collapse
So why did the proverbial %#$ hit the fan? Greed and loose credit were the culprits and it culminated when investors and homebuyers ran out of money to purchase and overall economy began to slow down as people started running out of capital and credit. As the real estate market began to slow down, property sellers remained steadfast in their belief that their home was worth more money than the current market value as it had been in months past. But it wasn’t.
From there, the first phase of the market collapse occurred. Overpriced properties for sale with no buyers. Property owners unrealistically priced their homes for sale too high and buyers began to pull off to the sidelines as they were unwilling to pay the exorbitant prices for homes. Listings began to pile up and very few sales were occurring. Some owners started to realize what was happening and dropped the price of their home to help it sell. As the market leveled off and began to slowly correct, phase two began…..
Investors that were counting on property appreciation soon realized that the end had occurred. They began putting property up for sale en mass further straining the supply side of the market. Because all these investors were buying property based solely on appreciation and NOT cash flow, they soon realized that they would be unable to hang onto their property if they didn’t sell them. Some tried to rent, but because they had paid so much for the homes, the properties were unable to cover the expenses. Some investors and homeowners hung on for longer than others, but almost all of them eventually gave in to the realities of declining property values.
This was further compounded by the variety of ‘flexible’ mortgages that were available to homebuyers and investors including shorter term, loans at lower interest rates. Investors planned on short hold times so naturally obtained lower interest loans with shorter terms as they planned to sell within 1-2 years. As the market declined and those property owners could not sell, these loans became due and because property values were declining, they could not get new loans to cover the value of the old loans. Many more property owners walked away for this reason and it continues today.
As the loans go into default due to non-payment, the owner is left with 2 ways out – short sale or walk away. Many went the route of short sale to minimize the affect on their credit rating and those who could not or would not go that route eventually walked away from their property and let the bank take the property back.
I have another article posted on this site detailing the Pros and Cons to purchasing Short Sales and Bank-owned Properties in Phoenix.
The market was soon flooded with distressed properties of all kinds. This forced home values down further and faster as distressed properties are typically aggressively priced at least 5-10% less than current market value. This cycle has continued to force values down for months to the point where most submarkets in Metro Phoenix have fallen 25-50% in the past 2 years. Some properties have fallen over 60% from their highs 2 years ago.
This has led to further problems in our region. Due to the extent of the downturn and the sheer number of vacant, distressed properties, Many properties are being vandalized by outgoing owners and theft is become much more widespread of vacant properties. This is further compounding the downturn as properties in poor condition are even harder to sell and must be discounted that much more in order to find a willing purchaser.
When Will The Housing Market Hit Bottom?
Good question. Here’s the answer…..
I have no clue. In fact, no-one does. But that’s’ not the most important thing. There is no way to know for certain when the absolute bottom is reached. All you can do is invest wisely NEAR the bottom. Purchase properties that produce positive cash flow (will be explained later), and wait to ride the wave back up.
There are several critical elements in evaluating the state of the residential real estate market and its proximity to turning the corner. Many of these criteria are now pointing to real estate values bottoming out. Here are some of the statistics I have been watching carefully which lead me to believe we are finding resistance that is creating a market bottom.
(1) Housing affordability has shot through the roof
(2) Residential Resales are on the rise
(3) Homebuilding is at a 25 year low
(4) Applications for new mortgages are on the rise
The biggest concerns that still remain are:
(1) The overall economy is weak and likely to get worse before it gets better
(2) Credit is harder to obtain and larger down payments are now the norm when buying real estate making it less available for more people
(3) Still too many foreclosures and short sales coming on the market from the frenzy of a few years ago.
Affordable Housing Is Back!
One of the best indicators on how attractive a specific real estate market is for homeownership is the affordability index. This is a measure of how affordable homes in a particular area are relative to wages and incomes. A number of 65-70 shows considerable value and favorable affordability for a large percentage of the population. As you can see, one of the driving forces of Metro Phoenix growth has always been housing affordability. In the speculation frenzy in the mid-2000s, that affordability plummeted to numbers never seen before. As prices have fallen, you can see the affordability coming back to the point where now, we are above our historical average.
*graph not available on this site*
Residential Resales are Picking up Steam!
As you can see from the following chart (unavailable on this site), sales activity is on the rise, although over 40% of the sales are currently lender-owned properties. This shows that we are starting to hit a resistance at the bottom as people are starting to grab the deals at the bottom of the market. If this trend continues, it could signal the slow-down in price declines and near-term stabilization of our home values.
For these reasons, while I believe we are near the bottom, I think it will be a few years before we see a marked improvement in our area where values begin to rise again. Will it happen? Absolutely! As I have attempted to explain above, the overall Metro Phoenix Market is very strong for numerous reasons and is poised to be a major growth region again – and not too long into the future, either.
So why not wait until things start turning around? Well, you certainly can, but there are 2 reasons why now is the ideal time to get involved.
(1) Abundance of properties (supply) – with so many distressed properties out there of all kinds, you now have your pick of what to purchase and can be more aggressive on price. As the market shifts more towards demand with more buyers chasing good deals, the number of opportunities will certainly diminish, it will be more difficult to find really good deals and there will be more competition to buy them.
(2) Positive Cash flow – prices are so low right now, that it is relatively easy to find residential properties that will produce a positive cash flow. Basically this means that the rental income should cover all the expenses and mortgage costs leaving you with money at the end of the day. This will be explained in greater detail below.
Why Residential Property?
Normally, I don’t recommend purchasing individual single family homes because they are harder to manage effectively and usually don’t cash flow. The major benefits that they have over other forms of real estate you could invest in are:
(1) Liquidity – Simply stated, there are more buyers for this form of real estate than any other. It is therefore easier to sell when needed for the greatest value.
(2) Appreciation Potential – for the smaller investor, it gives you the greatest potential for appreciation if purchased at the right time because there is such a broad market of buyers for housing
(3) Lower mortgage rates than commercial property investments, typically
(4) Values may have fallen 30-60%, but rents have not really fallen much at all.
In our current market, one of the major faults of residential property has been eliminated. It is now easier than it has been in decades to buy residential property in Metro Phoenix at a positive cash flow.
How Do I Buy Property?
I will begin this section by stating that these are my thoughts and suggestions when evaluating property for purchase based on my experience and common sense. These are guidelines that you may choose to follow at your own discretion. I cannot guarantee results or success for any investment. It is up to you to properly evaluate investment opportunities and make decisions in line with your goals and risk tolerance.
Picking the location
Here are important elements in selecting the area to purchase an investment property
(1) Safe area
(2) Close to highway access
(3) Within 30 minutes drive time of major employment centers
(4) Proximity to shopping and other amenities
(5) Proximity to schools
(6) Strong rental market – I mean with a track record of other properties being rented for rates which you can use to evaluate the viability of the property as an investment
Picking the type of property
These criteria are designed to reduce your liability and investment risk and maximize your upside potential. Size criteria is meant to keep the property in the range of properties that are easiest to lease, rent for the highest value per square foot and are also easiest to sell down the road since they conform to the largest market segment of potential buyers.
For Single Family Homes
(1) 3-4 bedrooms, 2+ baths
(2) 1,200 – 2,000 square feet with 2 car garage
(3) Newer homes are better. Try and stay with 1995 and newer
(4) NO pool/spa in backyard (too much liability and maintenance
(5) Low or No maintenance landscaping is preferable
(1) Minimum 2 bedrooms 1.5 baths
(2) Decent amenities in complex (pool, spa, clubhouse)
(3) Stick with larger communities with 100+ units. If you’re looking at a smaller complex, make sure to verify the viability of the HOA and fees
The benefit to condos is less overall maintenance required – particularly on the exterior and to the community grounds. The downside is that they may appreciate at a slower pace than single family residential.
Evaluating the numbers
Even in the best worst market that we have to accumulate wealth through real estate, you need to be careful. There are as many, if not more bad deals out there as good deals. Properly evaluating a property will make all the difference between a success investment and an underperforming one.
Before getting to number analysis, let’s not forget evaluating the CONDITON of the property. We always recommend that you obtain a HOME INSPECTION on every home you plan to purchase to help insure that you are buying what you think you are buying.
Before placing an offer on a property, you want to perform an initial analysis to see if the property will generate a positive cash flow. In order to do this, you should have already been prequalified by a lender so that you know what down payment requirements you will have and what your finance costs will be. Once you know what those cost are, you are ready to evaluate the income and expenses.
Evaluating the INCOME is fairly straightforward. You will want to compare the going rental rates in the area for similar sized homes in fair to good condition and use a figure in the bottom ½ of the going rental rates to be conservative.
Analyzing EXPENSES is a bit trickier. There are a few items that you will need in order to verify costs and come up with a total expense amount. These may be broken down into the following:
Property management – Figure 8-10% of the gross rent will be paid as management fees on single family homes. The more properties you have under management, the better the fee you may be able to negotiate with a management company.
Insurance – You will need to have enough insurance to cover the home and liability to cover accidents, having tenants in the premises. Make sure you have adequate coverage
HOA Fees – Many single Family Homes in Phoenix belong to a homeowner association where fees are collected periodically for community maintenance. Please make sure to
Utilities – usually paid for by the tenant on single family residences, so you don’t have to worry about this. Check with you property manager for what is typical in their area
Legal/Accounting – many investors forget this one. Remember that you own and investment and need to make appropriate plans to minimize your liability and tax exposure. Please talk to legal and tax specialists for more information. The more property you own, the less this items costs per property since you can spread the cost over all your investments.
Maintenance Costs – you may have to pay someone to maintain the exterior of the home One of the main reasons to buy a home with no pool/spa and low-maintenance desert-style landscaping. Once a tenant is in, they are typically responsible for maintaining these areas.
VACANCY FACTOR – You will not always have a tenant in the property. You need to make allowance for time between tenants. If you price your rent aggressively for the market, 1 month per year as vacancy should be more than adequate.
These are costs you will incur in purchasing the property. You may bundle this into the total investment cost along with the down payment you intend to use. They will include:
Escrow fees and other closings costs
Other Inspection Fees (if applicable
Finance Charges (for the loan)
You will be able to prepare an estimate for all these costs prior to putting in an offer on a property. Typically, you will have 10+ days after offer acceptance to run all inspections and tighten up all your figures to make sure your estimates were accurate. If you find something wrong with the home during this time, you will usually have the ability to cancel the contract and get back your earnest money. Speak with your Real Estate Professional for more information about the procedure of placing an offer on a property
It’s important to always have some extra money put on the side to cover emergency expenses, a tenant that skips out or is delinquent on payments, repairs costs, etc. Always be prepared for the unexpected.
Let’s work through an example so you may see how a typical investment might look on a single family home:
Our sample property is a single family home with 3 bedrooms, 2 baths and 1,400 square feet for $100,000. We will assume that you will need to put 30% down to purchase this home. A home like this is fairly typical in today’s market and might have sold for $180,000 – $200,000+ 3 years ago.
Total Purchase Price $100,000
Down payment (@30%) $30,000
Loan Amount $70,000
Down payment $30,000
Escrow Fees $1,000
Finance Charges $1,500
Home Inspection $400
Termite Inspection $100
Total Closing Costs $33,000
Monthly Rent $950
Less Vacancy Factor (1 month) $950
Annual Income $10,450
Annual Expenses (est.)
Property Management (@9%) $940
HOA fees ($50/month) $600
Total Annual Expenses $3,440
NET OPERATING INCOME $7,010
Annual Mortgage Payments (@ 7.5%) $5,874
Positive Cash Flow $1,136
Return On Initial Investment (ROI) 3.4%
return excludes appreciation
Condition Of Property
There are 3 different types of properties you can look at purchasing as an investment as it relates to condition.
Option A – Property In Good Condition & Ready To Rent
Option B – Property in fair condition but requiring cosmetic repair to make rentable. This is a property that might be bank-owned or otherwise vacant for a while. May have been heavily used or poorly maintained by the previous owner. Work required is more cosmetic in nature and easy to estimate. Things like carpet cleaning or replacement, new appliances, repainting, cleaning, landscape repair, drywall touch-up
Option C – Property in poor condition, requiring major repair and/or replacement. I only recommend this option for seasoned, experienced investors that have a background in home construction, repair and cost analysis. While you may be able to purchase property well below current market values and create instant equity by fixing them up, you can also lose your shirt if you don’t know what you are doing.
If you are a beginner real estate investor, I suggest you stick with option A until you get your feet wet and a little more experience with repair and replacement costs.
Remember, it’s an investment. Be a Vulcan. Don’t exhibit emotions when dealing with buying a property or renting it to a tenant. The numbers have to make sense and the upside must be there. NEVER FALL IN LOVE WITH A HOME YOU’RE BUYING AS AN INVESTMENT. You will not be living in it. Think of it strictly as an income producing asset like a stock or bond. Make sure tenants are properly screened and qualified.
It is important to have quality local management to oversee your investment. Yes, it cost more money to pay them, but they help maintain the value of your asset and save you from those calls at 3 am about a plumbing leak. Factor them into the numbers when evaluating an investment and don’t buy anything that doesn’t positive cash flow without management.
Why Not Commercial?
Commercial real estate like apartments, office, retail and industrial make excellent investments – if purchased at the right time. The consensus among leading real estate investment professionals is that this segment of the market has not bottomed out and likely will not for a while. The time to pick up distressed real estate investments in these asset categories may yet be 3-4 quarters away (from 4th quarter 2008).
Why? Because as the economy fails and the recession heads into full swing, many business eventually fail. This drives up vacancy rates and reduces asset performance while at the same time, reducing rental values as more space competes for limited tenants. Investors start demanding higher rates of return and factor in higher vacancy rates into their calculations of asset value driving the prices of property down. It usually takes some time for property owners to catch on to this market trend and reduce their asking prices to falling market values which further puts strain on values. This is the same scenario that has happened in the residential property arena in mid-to-late 2006 and into 2007. I suspect that there will be many commercial properties that enter default and revert back to the lenders creating opportunities for seasoned investors to purchase commercial real estate assets for very attractive values – but the time has not yet arrived. Patience is warranted in this area.
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