Dan Melson: August 2014 Archives

There are many ways of suckering real estate consumers, and cash as an inducement to get people to swallow a raw deal is one of the most common.

From sellers (usually developers), "free" upgrades are one of the most common. They overprice the property by $50,000, and make you feel like you're getting a deal with "$10,000 worth of free upgrades" that really cost much less. In many cases, they're pre-installed and if you wanted to buy one without the upgrades, they would be unable to accommodate you. But if you're not working with a good buyer's agent who is looking out for your interests, you'll never hear about better properties offered for less.

From agents, they offer commission rebates or reduced price listing packages. But to pretend that these packages offer the same level of service as more expensive packages is ridiculous. If you're looking for a cheap MLS listing service, I've seen them for less than $100. But if you want someone to market your home, look for and attract the buyers you really want, or negotiate on your behalf, you are going to be extremely disappointed. When you are dealing with a strong sellers market like we've had for most of the last decade and don't care if your property sells for ten to twenty percent less than you could have gotten, discount listing services may be the way to go. If you are dealing with a buyer's market, if you have some issues with the property, if you really want someone to market it in such a way as to find your ideal buyer and get the best price, the more expensive agent who does more work is likely to get you enough more money to more than pay their increased compensation.

Agents who offer a portion of the buyers agents commission back are not the most proactive agents out there. They do not typically advise you as to the state of the market and whether there is a better buy out there. They aren't looking for the better bargain, they don't know enough about the state of the market to be strong negotiators, and they're certainly not out scouting properties looking for value and trying to spot issues before you make an offer. They do the minimum necessary to get a commission - they literally cannot afford to do more. It is trivial for a more involved agent to get you a better overall bargain.

Some sellers will offer cash back to the buyers. This needs to be distinguished from paying the closing costs you would normally pay as the buyer, which is legal and acceptable, providing it is disclosed to the lender. When the seller offers to put cash back in your pocket, you have the choice of either disclosing it to your lender or not disclosing it. If you don't disclose it to the lender, congratulations! You have just committed fraud, and lenders do get their dander up over it. If you do disclose it to the lender, they will base their loan off (at most) the net sales price, which is the official price minus the rebate. This shoots yourself in the foot other ways, as well, because it will likely increase your tax assessment, and could increase your cost of insurance.

Cash back from a loan provider is most often an intentional distraction, so that they don't have to compete on the real price of the loan. They tell you you're getting $10,000 cash back instead of how much the loan is costing, they can hit you for an extra $2000 in closing cost markups and three points of origination, not to mention that what they are really doing is adding all of that money AND the $10,000 to boot to your balance, where you'll not only owe the money, but pay interest on it for years. Plus it's likely that they stuck you with a higher than market rate of interest as well, because you were distracted by what you thought was free money, so they make more money there, also. Shop your loan by the terms, rate, and total cost to you. All of this can trivially eclipse the $10,000 they put in your pocket - even if they weren't adding that $10,000 to the balance of the loan.

Offers by a lender to pay your appraisal fees are most often trying to lock up your business from their competition. They're not competitive on price, so they apparently offer you a $400 freebie, while charging you $2000 extra in marked up closing costs, those same three points of origination I talked about, and then they ding you $500 for the appraisal on the final paperwork. This is one of the best ways to get a very high markup on a loan that there is. If you like paying more for a loan than you need to, a "free appraisal" is one of the best ways to go about it.

Finally, this article wouldn't be complete without mentioning several of the ways that quoting low payments for a loan can mess you up. The average consumer may know better in other contexts, but they still shop for real estate loans by which one has the lowest payment. This is basically financial suicide. When I first wrote this, there were so many loan providers out there pushing negative amortization loans, in which your balance owed increases from month to month in order to allow you to make lower payments, that it was difficult to find someone willing to do a thirty year fixed rate loan. The negative amortization loan is now gone - lenders and investors lost too much money on them - but the whole phenomenon is still instructive. People trying to sell you a low payment are crooks. Real cost is interest rate and closing cost of the loan, and negative amortization loans carried real rates more than two percent higher than thirty year fixed rate loans.

Nor is this the only game played by quoting low payments, merely the most prevalent and most egregious right now. Interest Only loans, short term hybrid ARMs, and Temporary Rate Buydowns are all quite common. Even if you manage to dodge that bullet with those who quote you low payments in order to sell you a loan (unlikely), there are still all of the standard games that get played with payment. They fudge the math, they "forget" to include the costs in the computations, they pretend you are going to pay the costs of the loan out of pocket when they know good and well that you intend rolling them into the loan, they just lie about their rates and the costs to get them, or, to be able to quote a low payment, they quote you the rate that costs so much that you will never recover the costs of that loan over its entire lifetime and pretend it doesn't have those costs. The payment is determined by how much you borrow, at what rate, with what length repayment schedule. The math is the same regardless of the lender. You need $X for the obligations - either the current loan or the purchase. Adding the least cost and being charged the lowest interest rate (always a trade-off between the two) makes for a lower real cost to the loan. Remember, when you refinance, or buy another property, you're paying for your loan rate all over again, so all that money you paid to get a lower rate is gone when you let the lender off the hook by refinancing or selling the property. Most folks do this far more often than they realize.

Greed is good, Gordon Gecko not withstanding. But let's make it rational greed, because thinking that you are getting a freebie and not asking what it really costs is likely to cost you many times the amount of what you think you're getting for free.

Caveat Emptor

Original here

There have always been real estate transactions that fall apart. The reasons why they fall apart are as varied as the people who enter into the transaction in the first place. Let's get back to the very basics for a moment. An offer to purchase is a representation that a given prospective buyer would be at least willing to purchase the property on the terms you are offering. Accepting that offer to purchase means that the seller is at least willing to sell it on the same terms that the buyer is offering to buy upon. If one or the other of these parties is not willing to consummate the deal on those terms, why was there both offer and acceptance? There was offer and acceptance, or there isn't anything more than negotiations to fall apart. People fail to reach agreement all the time. That's not what this article is about. It's about what happens to prevent the transaction from being completed after you have a valid contract.

The last credible figure I heard was that 50 percent of all escrows in San Diego County are falling apart. This means that one out of every two contracts don't happen. A few years ago, the proportion was a small fraction of that - I can't find it online, but I seem to remember 11%. This increase is both outrageous and preventable.

The first reason transactions fail is new information. It isn't cost effective or a good negotiations tool for a buyer to spend money on inspection and appraisal before there is an acceptable contract. When this information comes in, you can expect there to be a reassessment of the transaction, because you can expect there to be something about the property that does not conform to reasonable expectations. I certainly can't remember any transactions I've had where the inspections didn't reveal anything new. Most of the ones where I was buyer's agent, what was revealed was trivial enough to ignore, but never a one where there was nothing. Transfer disclosures from the current owner to the prospective buyer are another of the possibilities for new information to crop up.

All of this new information can indicate a need to subsequent negotiations when it comes to light. If the buyer thinks it's small enough that they are willing to accept the transaction "as is", they can choose to let the transaction continue on the track it's on. If it's big enough that they're unwilling to deal with the situation, they can also choose to walk away. The vast majority of the time, the sanest response is some new negotiations based upon the new information. This isn't normally about things like overall sales price, it's about getting the property into the condition and functionality that the buyer thought they were getting in the first place. Either party can be obstreperous and unreasonable at this point, effectively killing the transaction.

There's also the issue of cold feet, and the related issue of "grass is greener" syndrome. Either one can apply to either party in the transaction. In the first, the buyer decides they don't want to buy or the seller doesn't want to sell after all. In either case, they weren't really "sold" on the benefits of the transaction to them. "Grass is greener" is where they still want a deal, just not this deal. Those happen when markets are asymmetric in power. A few years ago, it was sellers who wanted to bail out of contracts they had duly negotiated because someone offered them a higher price. More recently, it's been buyers trying to pull out because they think they've found a better deal somewhere else. Both are vile. It's not a sin to want the best possible deal, but once you enter into a legal contract you should be prepared to honor your representation that you want that deal. Both of these phenomena are the fault of poor agents, and both are a good way to waste a lot of money in legal expenses when their clients are sued for specific performance. I don't want any part of agents that don't take appropriate steps to prevent either one of these in their clients, and I take note when I hear about them. It's also a reason not to take an attitude of "no quarter!" in negotiations. My client signed that offer or contract because those terms will make them happy. If the other side decides they need to bail out because the terms are odious, my client isn't happy.

Closer to the point is ability to perform. This can be a seller who can't or won't or doesn't meet their obligations in a timely fashion. Delivering good title to the buyer is kind of important to the transaction, and it does occasionally happen that the seller can't do this. Or they don't have the money to make needed repairs, or just won't get off their backside to actually do it.

But far more commonly, it's the ability of the buyer to perform their obligations under the contract that kills the transaction. I have heard about occasional buyers who couldn't or wouldn't or didn't perform on other scores, but the most central of these in the current market, and the reason for at least 90% of the rise in failed transactions, is that the buyer cannot qualify for the necessary loan.

The Era of Make-Believe Loans is over, but judging by the evidence, there's an awful lot of people who haven't figured this out yet. That's the first thing I want to find out when I get a new buyer into my office: What's the evidence of their ability to qualify for the necessary loan? How much do they make, what are their other payments, what is their credit score, how much do they have for a down payment, and is there anything about their situation which might be a cause for concern during the loan process? I don't want to give them the third degree, but I want to be confident I'm not wasting their time or mine, and that I'm not setting them up for a failed transaction. Failed transactions don't make clients happy, they waste the client's money, and they aren't any good for my business, either.

A few years ago, if somebody came into my office with a 580 to 600 credit score and two years in the same line of work, chances were excellent that a loan could be done - even 100% financing. That is not the case currently, and the time to plan the loan is before the clients fall in love with the property they can't afford.

Lest I be unclear: except for VA loans,100% financing is completely gone (at least for right now). The same thing applies to Stated Income loans. Purchase contracts not written in concordance with current loan underwriting standards are going to fail and that is as predictable as gravity. Write the purchase contract wrong, and you have killed the deal before it begins because there's something there that's not going to be acceptable to the lender, and sometimes it can prevent other folks from signing off on the deal as well. Furthermore, if the required steps in the contract are going to cause the seller to balk, you're better off finding out before you've got a contract.

The loan environment, especially for loans above 80% loan to value ratio, has changed drastically in the last few years, and all of the changes thus far have been in the nature of making qualification more difficult.

Even the government programs like VA and FHA with their low down payment requirements have their stumbling blocks. Not only do they require a buyer to qualify via full documentation of income (as do ALL government-based loan programs), but there are subsidiary requirements as well. Some properties are not eligible, period. Some people (and some companies) can't be involved, period. Investment property and second homes are iffy to doubtful with the VA and practically non-existent for FHA. It's a real good idea to know if you're going to hit one of these roadblocks before you are sixty days into a transaction that's not going to happen, and now we're all going to pay lawyers to fight over the deposit.

When I list a property, I want real information that tells me a loan is doable for this borrower before I advise my client to accept a given offer. Pre-qualification is a joke and even pre-approvals aren't anything to put stock in. The only examples of either that I trust are ones that I wrote, because I know what went into them. However, Steering is illegal. I can't require the buyer to get their loan through me or even to talk to me (or anyone else of my choosing). What I can do is require their loan officer fill out my form and provide documentation that enables me to determine whether a loan is doable or not. If I can't find a lender that can fund that loan, we've got a problem. When I'm the listing agent, it's kind of important to know this before we counter.

Unfortunately, we've had ten years where loan money was easy to get, no matter how ridiculous the transaction, and it's left a very strong imprint on many agents. Many have literally known no other environment, and they're finding it hard to make the necessary mental changes. I haven't been in the business ten years, either, but I do understand how the loan environment has tightened up and its effects upon my clients. Even the agents who have been in the business much longer may have no real grasp of the loan environment and often they're just checking off the box that says, "pre-qualification" on the checklist because that shows they did their due diligence. That isn't going to fly anymore. It may or may not help them when they're defending against a lawsuit, but it certainly isn't going to make their future ex-client happy about the thousands of dollars they lost, either because they couldn't qualify or because their prospective buyer couldn't.

Caveat Emptor

Original article here

For at least the last thirty years, I've been hearing "affordable housing" advocates yammer about the high cost of housing, and how working families can no longer afford "decent" housing, which they apparently consider to be the three or four bedroom, two bathroom detached home. They go on and on about what is necessary to create more of this type of housing and our "moral obligation" to create more of it. In light of the current situation, I'm going to make a conscious effort to continue my occasional series on factors that influence the overall market for housing. I'm going to examine the broad macroeconomics involved, the assumptions necessary, whether it is or is not long term sustainable, and the choices we face in sustaining or curtailing it.

Today's topic is how the housing market of today came about and what sustains it. A century ago, roughly eighty-five percent of the population did not live in major cities, but rather in small farming communities which more or less blanketed the nation. Suitable land for housing could be anywhere, and so it was much more readily available and much cheaper. When the criteria is "anywhere there's land I can farm," you can choose any arable parcel and build a house on it. Even if you don't live on a farm but in one of the small towns, when you can walk the length of the town in five or ten minutes, it's a lot easier to arrange housing for everyone. If one particular town becomes too crowded, the next one over became attractive. If you need a place for a few more people, one of the farmers whose land immediately surrounded the town could usually be persuaded to sell some land. The cities were dense affairs, much more like european cities than is the case today. Indeed, the few large cities we had built up before World War II still retain that urban core with dense multistory housing that is characteristic of the period. The typical pattern of the day was that young women, in particular, would continue to live with their parents until marriage. Young men of marriageable age would most often live in rooming-houses or boarding houses once they became gainfully employed. Apartment dwelling was only somewhat expected for young couples just getting started and urban dwellers who might have been together for many years, yet could not afford anything better in close proximity to their profession. Urban housing was tight-packed because the land was very expensive by standards of the time, and urban transportation was communal to a far greater extent than today. It is much more common today for even people in Manhattan to own and drive cars than it was before World War II. The use of steel as a building material was a big deal for those urban centers because it meant that it was possible for them to build further up. San Diego is very much a post war city, but even we still have areas that were built in those times - packed in tightly, cheek by jowl, extremely dense living. Once upon a time, before reliance upon military work and bad policy ruined it, San Diego was a major west coast port and the base for the largest fishing fleet in the world - two of my aunts married tuna fishermen. Even further out, in what were before WWII the "newly urban" areas of North Park and National City, the housing very much resembled classic "company town" housing - 600 and 800 square foot one and two bedroom cottages sitting on 3500 square foot lots. These were the era's predecessor to the exurban bedroom community of today, usually owned by members of the skilled trades or young professionals. The core suburbs today such as La Mesa were still economically speaking, farming communities. Even Mission Valley was mostly farms until the early sixties. During this time frame, only the comparatively wealthy lived in larger houses within city limits. If you go to Mission Hills above Old Town, or Grant or Banker's Hill (and here and there in other neighborhoods) you can still see a very few of the large houses for the well-to-do of that era.

Indeed, the three bedroom, two bath detached house in an urban setting for the working class is almost entirely a creation of the post World War II mood in this country. For several years, very little housing had been built, and now these men who had gone off to war and saved the world as seventeen and eighteen year olds who had traditionally remained with their parents or moved on to boarding houses until they got married were now returning as twenty-two and twenty-three year olds who were traditionally married and starting families by that point in their lives. The women to marry them wasn't a problem; the housing to put the new families in was. These folks had several years of savings (war bonds, the wartime sacrifices, etcetera), and the traditional apartments were considered a poor and at best temporary inconvenience until that new modern post-War marvel - tract housing - could be built in sufficient numbers. And if such housing was horribly inefficient in terms of land, utilities, and transportation, nonetheless we were the wealthiest nation in the history of the world, and accommodating their desires for such was the least the nation could do for our valiant warriors. Furthermore, with the aforementioned savings they had accumulated during the war, the young men and their new wives could afford to pay for this new housing. If you're wondering about "It's a Wonderful Life," keep in mind that most of that 1946 movie takes place well before the war, and even by the time of its release, the country hadn't yet shifted very far from the way things were done pre-War.

The land was available and largely vacant then, and certainly could not and can not be covered effieciently by public transportation, but the newly affluent families (through savings during the war and better jobs after) could afford far more automobiles as well. For the first time, women were staying in the work force in significant numbers until motherhood. There was plenty of land available. As a young child in the early sixties, I can still remember when there was space between all of the suburbs, even when we drove to Los Angeles to visit family members or Disneyland. I-5 was brand new thanks to President Eisenhower, and from the point we got out of the Pacific Beach, there weren't any towns visible from the road, just widely separated houses, until we passed Oceanside and Camp Pendleton, at which point there wasn't anything more until San Clemente and San Juan Capistrano, then another good long way past that before there was anything more again. It wasn't until just before Disneyland that we saw more city. The I-5/405 split in the middle of present day Irvine was out in the middle of nowhere back then. My parents almost bought a 320 acre farm just east of the Del Mar fairgrounds the year I was born. One of my best friend's parents had considered a farm in Mission Valley, despite the fact my friend's father was in the navy. If you clicked on the images, you know none of these are empty land any longer.

Why not? Suburban housing and to a lesser extent, support services have eaten it up. The only open area between the Mexican border and the Tejon Pass is the stuff that's been held aside for other reasons, such as Camp Pendleton, which the Marines badly need. Los Angeles with 3.8 million people has an area of almost 470 square miles, while by comparison cities of similar population elsewhere such as Ahmedabad in India, Alexandria in Egypt are a fraction the physical size. If we're going to keep doing the same thing, we're going to run out of places to put everybody. In fact, in Southern California we have essentially done so. New development is taking place in Hesperia and Victorville, or out past Banning, or out in Hemet or eastern Murrieta, all of which are an hour and a half minimum trip time from the center of the urban areas they service, even if you're driving it at an hour when there's no traffic. Nobody wants to drive an hour and a half each way to work - especially not in stop and go traffic when gas is this expensive.

This also creates a lot of logistical problems. Most inhabitants of the cities concerned would have no trouble naming the most salient problem, which is transportation. When you have that many people that spread out, and you need to move them all significant distances at pretty much the same time, it takes a massive amount of transportation infrastructure to do so. US 395, the predecessor to I-15, was one lane each direction from Escondido until just a few miles south of present day I-10. But it isn't just transportation. Utilities are a much larger headache to supply than sixty years ago as well, and the logistics of keeping that many people supplied with groceries and gas and everything else make the transportation and utilities problems seem easy.

Finally, there are legal and political barriers to continuing to build housing in this manner. Environmental concerns are the most obvious of these, but building codes, zoning, and other concerns form significant obstacles to its continuation, as does the consumption of land. Once upon a time Southern California was some of the most productive farm land there was. My wife's uncle was a well-off citrus grower until the developers bought his land for millions of dollars. I can remember (barely) large tracts of citrus in El Cajon and Lemon Grove and Escondido. The only reason the hillsides north of Escondido are still relatively uninhabited avocado farms is because they're steep enough to render development difficult. The same applies to all of the other agricultural land remaining.

All that aside, I would like for housing prices to be affordable, and for everyone who's going to grow up in this country for the next century to be able to afford the type of housing they want, where they want. Absent some major changes in public policy and employment practices, it's not going to happen. The land no longer exists, we can't afford ongoing losses in arable land (look up how few countries in the world are net exporters of food), the transportation networks are saturated, environmental regulations are restricting development as are legal hurdles such as necessary permits (which add roughly $20,000 per unit to the cost of new housing, but over $100,000 to the price due to constricted supply), and lets not forget legal challenges from NIMBYs, BANANAs and environmentalists who already have their 3 bedroom 2 bathroom suburban home, and whose property values just happen to increase in a manner directly dependent upon how far they can constrict the supply of new housing. In short, the current situation does not appear to be sustainable absent major societal changes.

Caveat Emptor

Original article here

Must you sell if you list at a specific price and the broker comes up with a qualified buyer?

in the US in general, no you do not have to sell, but you could still be liable to the broker for their commission. You might also need to justify why your decision was non-discriminatory (assuming that it wasn't), but if (for instance) your broker brings you someone you have had business dealings with in the past, and they have tried every maneuver possible to scam you after reaching agreement in those past dealings, you are (usually) quite justified in refusing to do business with them.

Talk to a lawyer, but generally speaking, if you do not have complete and perfect agreement between the parties on the contract, you do not have a valid purchase contract. If you didn't want to do business with (say) Bill Clinton or George W. Bush, such is your right as long as you refuse to do so on the basis of them being a particular individual, not based upon them being members of a class protected under anti-discrimination law.

In general, nobody can force you to sell unless you've agreed to a fully executed purchase contract. But I'm talking about legal force here, not economic. It can be expensive not to take a particular offer. I am not familiar with any cases where a real estate agent, listing or buyer's, was awarded a commission even though there was no transaction consummated, but that doesn't mean it couldn't happen. And lest the general tone of this article be mis-interpreted, refusing to sell on the basis of race, sex, religion, sexual orientation, lifestyle or any other legally protected reason is setting yourself up for a lawsuit.

List price is a representation that you would be willing to accept that price, but there are other proposed terms of the contract to consider. As I have said before, if you're still arguing about who replaces a given light bulb, you don't have a valid contract any more than you do if you're $100,000 apart on the price. I can't imagine stressing about a light bulb like that, but the point is just because someone offers you full list price does not mean you have to accept their offer. If the other terms proposed are onerous, if it comes attached with conditions you don't care to accept, or if it is merely from an individual who you have done business with in the past and are unwilling to be involved with again, you are usually within your rights to refuse the offer.

Or instead of an outright refusal, you can return a counter-offer back to them, which is usually the smarter thing to do.

Caveat Emptor

Original here

Purchase Money: This is a loan that enables you, in combination with your down payment, to actually purchase the property. If you spend cash to buy the property and get a loan the next day, that is not a purchase money loan. Whether it is or is not a purchase money loan has significant tax consequences everywhere, and significant legal consequences almost everywhere.

Rate/Term Refinance: This is a refinance that does not put money in your pocket for other purposes. As it is more usually defined, this is a refinance that does not put significant numbers of dollars in your pocket. These loans typically have the best rates of the three purposes. For A paper rate/term, you are allowed to pay off an existing first mortgage against the same property, you are allowed to borrow enough money to "seed" a new impound account, you are allowed enough money to pay up to one month of prepaid interest, and you are allowed up to 1% of the new loan amount, or $2000, whichever is less, to be put into your pocket for other purposes. In order to qualify as rate/term, A paper cannot do anything with an existing second (or third) mortgage, unless every last cent of that second (or third) mortgage was spent in acquiring the property, a fact which can force you to either do a cash out refinance or to subordinate your existing second mortgage to a new first trust deed. Sub-prime may have more forgiving definitions regarding other debts, but choosing a sub-prime loan because it allows your new loan to be defined as a rate/term refinance is like voting Cthulhu for President because you're tired of voting for the lesser of two evils. Sub-prime loans have pre-payment penalties by default, and generally carry higher rates.

The difference in tradeoffs between rate and cost can be small to non-existent between rate/term and cash out refinances, particularly at lower loan to value ratios. The difference also varies depending upon credit score, size of loan, and individual lender policy, but it can be quite steep. The point is to get an honest discussion of your options beforehand, not simply to sign up with some lender who pretends that the difference doesn't exist.

Cash Out Refinance is any refinance that does not meet the definition of rate/term. It puts cash in your pocket, it pays off other debts, it includes or combines or refinances a home equity loan or home equity line of credit that you took out for improvements or to pay other debts. Violating any of the requirements to be considered rate/term means that the loan becomes a "cash out" loan. Cash out refinances will usually have the least favorable set of rate and cost trade offs, what the uneducated think of as "highest rates" of these three purposes, at least at higher loan to value ratios. Depending upon the lender, cash out loans with loan to value ratios under seventy to sixty percent may have the same rate structure as rate term refinances. Cash out refinances also usually have slightly tougher underwriting guidelines than either of the other two categories. One specific example that trips a significant number of people is that there cannot have been anyone added to title in the last six months.

Caveat Emptor

Original here

One of the concepts I keep seeing without a decent treatment is the concept of leveraging an investment. Real Estate has this like no other investment. You go talk to a bank about leveraging eighty to ninety or even one hundred percent of your investment in the stock market, or the same percentage of a speculative venture, and see what happens. Be prepared for laughter, and they're not laughing with you. But for real estate the lenders will do it. Why? Because it's land. It's not going anywhere, and they're not making any more.

The fact is that real estate has the potential for leverage like no other. This is due to the interplay of two factors. One is the fact that you can rent the property out to pay for the expenses of owning it, and even if you use it yourself, you're able to save the money you would be paying in rent. Everyone's got to live somewhere, and every business needs a place to put it. The other, more important factor is leverage, the fact that you're able to use the bank's money for such a large portion of your investment. The bank will loan you anywhere from fifty to one hundred per cent of the value of the property. Yes, you've got to pay interest on it, but you're paying that through the rent - either the rent you'd save or the rent you're getting - and there are tax deductions that make such costs less than they might appear.

Now here are some computations based upon the situation local to me. Suppose you have a choice as to whether to buy a three bedroom single family residence for $450,000 (to pick the figure for a starter home) or rent it for $1900 per month. Let's even allow for the fact that the home may be overpriced by $100,000. You have $22500 - a five percent down payment. More than most folks, and you would invest that and the difference in monthly housing cost, and earn ten percent tax deferred if you didn't buy the house. Let's crank the numbers and see what they say.

There is a potential downside, and it could be big. This is a real risk, and anyone who tells you otherwise is not your friend. Look at the beginning of years numbered 2 through 5 in the equity column. You haven't gotten your initial investment back until sometime in the fourth year. Look at years 1 through 7 in the net benefits column. You're immediately down $31,500, due to me assuming it would cost you seven percent to turn around and sell the property. A year later, due to me assuming the bubble has popped, you're down by over one hundred ten thousand dollars, as opposed to where you'd be in you put it in the idealized ten percent per year investment. There is no such thing, but for the purposes of this essay I'm assuming there is. This is the illustration of why you need to look ahead when you're playing with real estate - a long way ahead. A loan payment that makes you feel comfortable for a couple of years isn't going to cut it. You need something viable for a longer term. If you'll look at projected equity at the beginning of years five and six, it goes between fifty odd thousand and eighty some thousand, assuming you've been making a principal and interest payment. You have plenty of equity to refinance there if you need to. If you need to do something in year three, however, you're hosed. If you've been negatively amortizing, you're hosed. You owe more than the property is worth. The payment adjusts, you can't afford it, you can't refinance, and you have to sell at a loss, as well as getting that 1099 love note from the lender that says "You Owe Taxes!"

But now look ten years out. At the beginning of year 11, you have $323,000 in equity, and if you sell at that point, you are $84,000 ahead of where you would have been if you invested that money in the idealized investment I've posited. That's four times your original investment, and I only assumed real estate went up seven percent per year, whereas the alternative investment went up by ten percent per year. How could that possibly be right?

The answer is leverage. That $450,000 was almost entirely the bank's money. The appreciation applied to this entire amount. But you only invested $22,500. The bank isn't on the hook for the value; their upside is only the repayment of the loan. If the property goes to a value of $481,500 and then $515,205 (normal seven percent appreciation in two years), then that extra money is yours. Think Daffy Duck shouting "Mine! Mine! All Mine!". Daffy's got to pay some money to get the property sold, as real estate is not liquid. Then the bank gets all of its money. The bank always gets all of its money first. After that, however, then the extra belongs only to the owner, not the lender.

The lender gets none of the appreciation. This is all fine and well with them, by the way. They've been well paid whether the property increased in value or not. This money from increased value is all yours. This applies even, as in our example, if the property lost value for a while. Yes, if you had had to sell in year two, you'd have been up the creek. But you didn't; you kept your head and waited until the property increased again. Given that you didn't, the only numbers that are important are the numbers when you bought it, and when you sold it. The rest of the time is completely irrelevant to the equation, a fact that is true for any investment, by the way. Doesn't matter if the value is ten times what it was when you bought on paper, it only matters that when you actually sold, it was for a loss. Doesn't matter if the value goes to zero the day after you buy, and stays there for thirty years. If in the thirty-first year it rebounds to fifty or a hundred times the original purchase price and that's when you sell, then you really were a genius. Get it? Got it? Good.

So when the property appreciated back to $688,000 and change at the beginning of year eleven, and you only owe $364,000 and change, that's $323,000 in equity. You're almost fifty percent owner. Even after you pay seven percent to sell the property, you come away with $275,000, as opposed to a little over $191,000 that you'd have in the idealized but unleveraged investment.

Keep in mind this whole scenario is a hypothetical. Every Real Estate transaction is different. Every property is different, every market is different, and the timing makes a critical difference. That's why you can't just call your broker to sell it and get a check within seven days, like you can with stocks and bonds. That's why a decent agent is worth every penny, and a good one is worth more than you will ever pay us. But properly executed, a leveraged investment pays off like nothing else can, and real estate is the easiest way to make a highly leveraged investment that is stable until such time as it is favorable to sell.

Caveat Emptor

Original here

Yesterday, I published the first half of this article, describing the issues currently preventing a return to a more normal real estate market, and the facts that any proposed solution needs to be built upon. At a quick recap, the main facts to take into account are: magic solutions don't exist, people will continue to be people, The Mortgage Loan Market Controls the Real Estate Market. The main issues causing problems are: Overly paranoid underwriting, the overly restrictive requirements regarding income documentation that do not take into account societal changes since they were solidified in the 1930s, and a return of an old (and discriminatory) monster known as the 60% owner occupancy rule that is only going to get worse with time.

So, how would I fix this mess?

First off, I'd get rid of the 60% owner occupancy requirement for condominium loans. Other than scale, I can't see a difference between this requirement and Redlining, which has been illegal for decades. Furthermore, it's just helping the already rich get richer, to the detriment of those without large amounts of cash for a down payment. I described this issue at length in the first half of this article, so I don't want to make those who have already done so wade through it again, but if you haven't read the first part you probably should. This article will still be here when you're done. I've said many times I don't hate rich people and I want to be one of them, but they don't need the rules artificially rigged in their favor. Nor, unlike investments in employment producing enterprises, does this provide economic benefit to the economy. It's a purely parasitic transfer of wealth from those who don't have a large amount of cash to those who do.

Second, repeal or substantially amend the rules essentially prohibiting all but private money lenders from making more money when they make a riskier loan. I don't want to bring back loan sharks, not that they're kept out now. The current rules enacted in 2008 don't keep loan sharks out and they do keep out the enterprises with the ability to bring real competition back to the field. Allowing the regulated lenders with access to the capital markets to make these loans means that for consumers there is both more money available and a less costly alternative to loan sharks. More money legally able to make these loans means more supply for the same demand which means lowered interest rates, as well as meaning that people have the ability to choose whether getting the loan they can qualify for and get puts them into a better situation, instead of being locked out by law. In the early 1990s recession, such loans and the lenders who made them were at least one of the biggest drivers of recovery, perhaps even the biggest - but they're completely absent now because Congress and the Federal Reserve made them illegal in 2008. Allow mortgage securities investors to make more money if they assume a little more risk, and many of them will choose to do so. In fact, net returns on the secondary mortgage market are so low right now it's hard to imagine a scenario where the increased money they make does not more than pay for the increased risk, meaning pension funds and the like which are required to have so many percent of their money in mortgage securities can maybe start showing something more closely resembling a reasonable rate of return to those investing in them.

Third, we need something (or several somethings) that fills at least part of the niche that Stated Income loans used to fill. Yes, Stated Income was badly abused, but when it existed, there were people it was intended for and those who made responsible use of it for many years. The self-employed, those with large deductible expenses, those with gaps in employment or changes in career. When Stated Income loans went away, a large number of people who weren't having any difficulty making their payments suddenly found they were unable to refinance when their loan hit the end of the fixed rate period. People who were making the payments and had made ALL of their payments, had excellent credit, good reserves of money they could access if they had to, suddenly found their 5% interest rate shooting up to 9% or more but through no fault of their own were completely unable to refinance into something more affordable because the rules they originally qualified under were gone, made illegal at the stroke of a pen by the government. Many lost their homes solely for this reason.

I am NOT saying bring back Stated Income. I am saying we need alternative methods for documenting income that are generally acceptable, and acceptable in all loan niches from A paper down to what used to be called sub-prime. Methods of documenting and making acceptable to underwriters interrupted income. Change in Job Title or Career, providing you can show me a stream of income for at least four to six months at what you're doing now, should no longer be a reason to refuse a loan at all. I think the maximum you should be allowed is the stream documented in the current career, but income from all careers you may have had over some relevant period should be allowed up to that maximum. To illustrate what I'm saying, if six months ago you went from making a salary of $3500 per month as a clerk to $6000 per month as a nurse, you should get credit for ($6000x6months + $3500x18 months)/24 months = $4125 per month. If you did the reverse, you get credit for $3500 per month because the maximum is what you're making currently. Document the income, but be real about the economic changes that have happened since the traditional standards were adopted. Currently, if the sort of situation described in these examples applies, regulatory underwriting standards automatically reject the loan, and that's not in anyone's best interest. Current loan standards reject the loan even if someone went from being an employee making $6000 per month to being a contractor with a contract for $9000 per month for doing the same work, and that is nonsense on stilts.

Finally, I'd concentrate on the low end of the market - real first time buyers. I don't mean what the NAR considers to be "starter homes" of up to the conforming loan limit. I mean the people making $10 or $15 dollars per hour and the properties it would be appropriate for them to purchase as first time buyers. These people strongly tend not to have large down payments because they can't save them on such salaries. If a couple is both making $15 per hour, they're making about $4800 per month. If they've got car payments and maybe some debt, they can maybe afford a $200,000 loan at 6%, which may be higher than current rates but is low in terms of both historical rates and where we're most likely headed.

In most of the dense highly populated urban areas where the majority of the actual population lives, this means condominiums, or developments that may look like detached housing but are still legally condominiums. But condominiums or true single family detached housing, this price range is the real foundation of our housing market.

The real first time buyer market is damned weak for reasons that go back nearly 15 years now. In the Era of Make Believe Loans, the people in this market segment got leapfrogged by real estate agents and loan officers who realized they could make a larger commission by selling the people who should have been buying one of these properties a more attractive and therefore more expensive property. And now, with the 60% owner occupation rule for condominiums, the people who should be the market to buy these are locked out of the vast majority of condominium ownership because nobody will fund the loan they need to buy.

Let's take a slightly more in depth look at the situation of this couple who each make $15 per hour. With taxes and health care, if they can save $500 per month, they're doing better than 95%+ of their compatriots, and at $500 per month it takes them about seven years to save a traditional 20% down payment, assuming no financial setbacks at all. How many times you know has a car gone seven years without needing repairs? Why should their cars be any different?

What I'm trying to get at is that these people do not have enough for a traditional 20% down payment, and rules that require them to have that much are not based upon reality. Such rules will crash the market further, if implemented as currently proposed. This will result in further transfer of wealth from these people to the people who already have the cash for a down payment, who then are able to buy for a lowered price, and turn around and make a profit by renting to these people. Even a 10% down payment takes three and half years to save, while a 5% down payment takes just under two years, and none of these figures include the actual costs of buying the property nor any reserves so that a minor setback that occurs in the first couple years after purchase isn't an unrecoverable financial disaster. Think about that: Two years of scrimping and saving just to make a bare minimum 5% down payment, plus at least another year so they can pay the actual costs of buying, plus perhaps another year or more so they've still got something in the credit union in case the car needs fixing after they've bought the property. Minimum four years, more likely 5 or more, of focused disciplined saving just to have the money for a 5% down payment that the wealthy people in Congress and the lenders behind them are trying to outlaw as too small by a factor of 4. I have a great number of words for those who would mandate a 20% down payment rule for all loans, but I can't use any of them in a family friendly environment.

When I look at the loans which are out there and available to the general public right now, there is one loan program which the first time buyer with a 5% down payment can qualify for: The FHA Loan. The downsides, however, are many. The most significant is that the FHA loan is one of those government controlled loan programs out there that never did repeal the 60% owner occupied ratio requirement, and the FHA is now more firmly wedded to it than ever. Practically speaking, this means that once a condominium complex drops below 60% owner occupancy once, those wanting to buy there will never be able to get an FHA loan again. In point of fact, I don't know of any loan current loan programs requiring less than 25% down without a 60% owner occupancy requirement.

The FHA loan charges an insurance premium to borrowers to pay for the chance of default on the loan. Even if there is evidence somewhere showing that the 60% owner occupancy ratio significantly increases risk of default or loss, even if this requirement isn't illegal for precisely the same reason why Redlining is illegal, there is no reason on God's Green Earth why this insurance premium cannot be adjusted to pay for such increased risk, and if ever there has been a reason why we should make an entire insurance pool pay a slight increase in premiums, this is certainly that instance. The practical fact in favor of it is that paying to remove the 60% owner occupancy requirement prevents a crash in value of that development the first time it drops below 60% owner occupancy. Remember, The Mortgage Loan Market Controls the Real Estate Market. If the FHA won't lend on the complex, and every other lender requires 25% down payment in order to buy, people with less than 25% down payments can't buy there, which means the prices fall for that complex. When the value of a property falls, especially for reasons like that, likelihood of default skyrockets. There's a strong likelihood that removing the 60% owner occupancy requirement will lower the default rate over time, thereby lowering the risk and therefore the premiums necessary for that risk.

Even if such a step does not lower the default rate and therefore the risk over time, insurance pools are legally obligated to pay increased premiums in innumerable instances for purposes of social engineering. If you're not going to argue for the abolition of all of them, show me a more deserving candidate. You can't, because there isn't one. I'm a diehard libertarian and deficit hawk, and I'd vote for the US taxpayer financing this increased cost if there was no other way because the benefits to the treasury would far outweigh the cost. The FHA needs to abolish their 60% owner occupancy requirement immediately if they want to move people in urban areas onto at least the bottom rung of ownership. If they don't want to move people onto the bottom rung of ownership, then why do they exist?

Once people are flowing once more into the bottom rung of housing ownership, I think the market will pretty much sort itself out. It won't be immediate and it won't be perfect, but solutions alleged to have either of those properties rarely function anything like intended. Putting into effect small changes intended to push the markets back towards normal don't prevent someone from also finding some other solution I've overlooked, they won't hamper the implementation of additional ideas, and someone does try other solutions this cannot do anything but help push the market back towards normalcy. Those who currently own and live in bottom rung units will have equity increase as well as just flat out being able to sell, enabling them to in turn move to the next higher rung on the ladder if they so desire - and many of them desire, because they've been wanting to sell and move up for years but haven't been able to sell because the loan markets have been so screwed up, first in one direction (leapfrogging them) then the other (cutting them off from potential buyers).

As a general rule, It's really only first time buyers that have issues with saving a down payment. Once you're an owner, equity tends to increase over time. Not universally, and not evenly, but the vast majority of home owners are paying their balances down every month and when normal conditions apply, values do tend to increase for many reasons. The point is, if you buy a $100,000 condominium that increases in value to $130,000 over a period of several years while paying the balance down to $80,000, when you sell you'll walk away with $40,000 after expenses of selling - a perfectly acceptable down payment for much pricier properties. This is the "move up" or "property ladder" idea that, when the loan market isn't as screwed up as it has been, happens every day because of natural demographics. Normally, "move up" owners tend to have more of a down payment than they really need.

It takes some time, but the people in the rungs above that will see the benefits from this as well. It's straightforward macroeconomics. The "move up" or "property ladder" effect works on such a routine level that it's like water is for fish. Fish don't realize water is there, and most folks take the property ladder so much for granted that it is built into all of their assumptions about housing. The fact that it's so screwed up right now is itself one of the biggest things wrong with the housing market. Fix the property ladder, and you go a long way towards fixing the entire market, given time. It doesn't make everything magically better overnight, but as I told you at the beginning, there's no "magic wand that makes it all better right now" solution. There are, however, a few cheap and easy fixes that get things almost inexorably started in the right direction, especially if undertaken together.

Caveat Emptor

Original article here