Speculation is a battle. The forces of greed and fear drive the financial markets, and the speculator attempts to profit from these moves. Speculation is not investment, although most do not understand the distinction. Speculation is the battle of the individual against the herd. For those who understand it and have learned to move against the emotional forces of fear and greed, there is opportunity to profit. For those who follow the herd, there are brief moments when profits are available, but few have the discipline to take them. Most speculators are slain by the market.
Like many others, I have a disdain for pure speculative flips.
People who buy properties, make no improvements, and attempt to resell
it for a profit simply inflate market prices. There is no value added.
People who rehab old or run down properties do a community service, and
they earn the money they make. However, flippers are merely financial
parasites profiting by constricting supply at reasonable price points.
Of course, flipping is a dying art, and those who are attempting it now
are losing money which makes for great schadenfreude.
Flipping is much more difficult now, not just because prices are
dropping, but because the constriction of credit and the tightening of
financing terms makes it much more costly and difficult to do. The
Option ARM with 100% financing was the ideal tool for the flipper. It
allowed him to enter the market with none of his own money, it
greatly reduced the carrying cost of the property, and it gave him downside protection in the event prices fell. With these conditions in
place, it is no wonder speculative flipping became the pastime of every
would-be Donald Trump in California.
Another behavior enabled by loose credit during the bubble was
cash-out serial refinancing. With the ability to get access to cash
from the property without selling it, there was no need to sell the
property, and many speculators held their properties and withdrew their
cash as needed. Houses were treated like savings accounts earning a
very high return. Of course, they were not withdrawing free money, they
were adding huge amounts of debt, but since the debt service costs were
low, and since nobody thought they would ever have to pay this money
back out of their income, cash-out refinancing became the rule rather
than the exception.
Today's featured property is an example of a speculative cash-out
serial refinancing flip-flop. The speculator bought the property with
100% financing using a 1-year ARM, took out some cash, refinanced with
an Option ARM, took out some more cash, and now they are walking away.
One of the myths about Christopher Columbus and his voyage to discover a quicker trade route to the East was that he had difficulty getting crewmen to serve because they believed the world was flat, and if they sailed far enough, they would fall off. Similarly, one of the myths about residential real estate is that prices always go up, and if they rise too high, they will not fall off. The people who bought in Columbus Grove did so right at the peak, and the continuing activities of the builders finishing off the community pushed their resale prices off the edge of the flat earth. The drop there has been remarkable.
The Columbus Grove experience shows what happens when large amounts of must-sell inventory is concentrated in one place. When prices become extremely inflated, and the market finally starts to fall, it creates a downward spiral that does not abate until prices are at fundamental valuations. However, the rate of decline is largely dependant upon the amount of must-sell inventory in specific areas. So far, the areas that have fallen the quickest have been those with large percentages of subprime loans (Santa Ana,) large numbers of new homes (Columbus Grove,) or both (Riverside County). This does not mean that the neighborhoods like those in Irvine are immune from the crash, it will just take longer here, and since it will take longer, they may not fall quite as far on a percentage basis because rents and incomes will be increasing as prices fall (we hope). Irvine and other neighborhoods will fall in time, most likely when all the Alt-A and Prime ARMS reset.
Remember during the bubble rally when everyone was in love with real estate? Turns out it was an infatuation. The fickle homeowners who sought to possess real estate at any price are now dumping their lovelorn properties en masse. Of course, it is easy to become infatuated when something or someone is making your dreams come true. All people had to do was buy a property and begin extracting and spending all the free money it provided. Now that the market has reversed, and people are saddled with crushing debts, and the property is no longer providing free money, it is easy to see why the object of their infatuation has lost its luster.
Today's featured property is another casualty of the low end of the market. There is much less denial at the low end, and much more carnage -- for now. The married woman who bought this as her sole and separate property has some of her own money in the game, so she showed more resilience than those who bought with 100% financing. You see, with any market price collapse, it starts with the weakest hands -- those that paid way too much and have little incentive to hold on. When these people sell, it drives prices lower and distresses a whole new group of market participants -- people like today's owner that have some money in the game, but not very much. The people who put 5%-10% down who are currently underwater will be the next group to give up. Of course, this will distress those who put more money down or purchased even earlier. Eventually, all of those who are overextended or deeply underwater will give up and capitulate to market forces.
The movements of financial markets are very mysterious and notoriously difficult to predict. Where will the stock market be today? Up or down? Your guess is as good as mine. Of the various types of financial markets, residential real estate markets are probably the easiest to predict because they trend for long periods of time. Of course, the difficult part is predicting when they will reverse. I thought our local real estate market would reverse in 2004, but the widespread sale of the Option ARM delayed the crash for two full years.
The top of the market is relatively easy to identify after the fact. When sales fall off a cliff, prices will soon follow. The bottom is a bit trickier. Sales volumes will pick up at the bottom, but it will also pick up in the false rallies leading to the bottom. Upticks in prices are not telling either because bear rallies have that feature as well. The relationship between price and rent is a good indicator. It predicted the last two bottoms, but if the price-to-rent (GRM) is at historic lows, we may not necessarily be at the bottom because inventories and foreclosures may be very high. In fact, I am of the opinion (and I am not alone) that we will have an overshoot of fundamentals based purely on supply and demand problems due to the REO inventory. Too many people borrowed too much money, and these owners will need to be flushed from the system before it is over.
Personally, I will not try to time the bottom tick of the market. I will buy when I can save money versus renting. In fact, I would prefer to buy before the bottom when inventories are high because I will have the widest selection of properties to chose from. If you wait until the bottom is clearly in the rear view mirror, inventories will be low, and you may not find the property you want (don't worry, you will not be priced out forever.) The previous bottoms gave about a 3-5 year window of opportunity before prices rose to valuations that were too high relative to rents. This time, the window of opportunity may be longer. The ARM reset problem will persist into 2012, and it will take another 2 or 3 years for all the foreclosures to work their way through the system. I may buy in 2010, but I will not expect to see any appreciation before 2015. That will not matter to me because I will be saving money each month versus renting, and I don't plan to sell any time soon.
Today's featured property is as mysterious as the markets. It was only listed yesterday, and there are no pictures. Perhaps they will be up by the time this post airs.
Do you remember the days when a relatively low-priced property would bring out the knife catchers and get bids over the ask? Those days appear to be behind us. The price on today's featured property was dropped $100,000 at the beginning of the month, and it is still there. It is discounted 30% off its 2005 purchase price which likely represents almost 35% off the peak valuation. With another $70,000 to $90,000 off, this property would be at rental parity. Prices are still free fallling, but at least a potential bottoming figure is in sight. To be honest, I did not think we would be seeing prices like this in 2008.
