Buying and Selling: August 2006 Archives

I am an adamant believer in the Non-exclusive Buyer's Agency Agreement. In practical terms, as opposed to the Exclusive Buyer's Agency Agreement, it is so much to the advantage of the consumer that it isn't funny, and it doesn't usually hurt good agents. On the other hand, the proponents have one argument going for them that I do respect, having experienced it more than once. I start a client on the searching process. I explain it's going to take looking at a minimum of 12 to 15 properties before they know what the market is really like in their area in their price range. I find a whole bunch of properties, and start taking them to a few. I offer rational, real world comparisons of their comparative virtues. Ask about what they liked versus what they didn't, what they could live with and what they couldn't. And then, in between, one or both partners gets a wild hair about going to view another property. I've explained what their price range is, but they either don't realize it's out of their range or don't care. They just want to see what it's like. And because the property is out of their price range, it's going to be a more desirable property - that's why it costs more money!



So they go out, and after my careful work of making sure to stay within their budget, on a sustainable loan they can afford, this othe agent shows them what, by comparison, is the property of their dreams and says they can buy it!, and he knows where they can get the loan! If this sounds familiar, it happens a lot. "Dan was showing us such ratty properties by comparison! This guy is showing us beautiful stuff we love! Let's buy one!" and the first I find out about it is they tell me they're in escrow on someone else's property.



Most people buy based upon emotion. If you want to make one change in the value of your financial future, learn how to take emotion out of your decision-making process, especially on anything big enough to require payments. Once people have emotionally convinced themselves that they deserve this property, my rational analysis of the situation doesn't have a snowball's chance in July of talking them out of it. I know this very well. I could stamp out buyer's transactions at the rate of three or four per week by showing clients two or three ratty fixers within their budget and then moving in for the kill by showing one immaculate property in ready to move in condition for thirty percent more. But I'd have problems shaving without looking in the mirror, and I need to shave every day that I work. The reason that wasn't within their budget is that they cannot afford the payments, or they cannot afford the real payments.



And that's why there is money in fixers. It's all very well for people to say they are interested in the $400,000 fixer that fits within their budget and that they can fix it up and sell. Particularly first time homeowners, particularly young married couples, and especially if they have children, show them the $600,000 move in ready and they will bite almost every time, budget buster or not. Put all three factors together and not all of the wisest people in history together could talk them out of it.



So the smart operator offers $350,000 for the fixer that's been on the market for four months, spends $40,000 on upgrades like carpet and modernizing the kitchen or adding one more bedroom and bathroom, and turns around and sells for $620,000, of which she keeps approximately $186,000 in profit. If the buyer needs them to pay some closing cost in order to make the transaction happen, she still makes $175,000 for a few months work. Not bad, eh?



Now the average couple don't have $40,000 to upgrade the property immediately. I don't know the last time I saw or heard of a first time buyer who wanted to put a downpayment. Most potential buyers right now don't have anything significant they could put down if they wanted to. But if they buy that fixer, they have a lot more room on their monthly budget and as much time as they want. At 6% interest rate and California standard property tax rates, the $620,000 loan has a payment of $3717, plus $646 in property taxes. The lesser property, even if they buy for $400,000, the payment is $2398 and the taxes are $417. I know that it's smarter to split the loan into two, but work with me for the sake of simplification. So the already fixed property costs $4363 per month, while the fix it themselves costs $2815. That's over $1500 per month difference they have to put towards fixing it up. In two years, they've got the $40,000 from that $1500 per month alone. This is leaving aside the issue that the rate on the bigger loan isn't going to be as low. They can concentrate on the most important updates. Sure, it's a pain. That's why buyers are willing to pay $620,000 for the ready to move in property. Actually, they'll line up to pay $620,000 for the more attractive property. It's just the way things are. And they get done with their two year project, and now it's worth every bit as much as the property that was worth $620,000 to start with. At 5% for two years, that's $683,000. If they sell, that's approximately $235,000 in their pockets (tax exempt in most cases) instead of in the professional fixer's. If they bought the move in ready property and then sold, they'd net about $15,000 by the same calculations.



Now most properties, even fixers, won't generate quite this kind of quick windfall. But that is a real example I encountered not long ago. Moral of the story: fix it yourself if you can. By isolating off the emotional appeal, you've made yourself - or saved yourself - a lot of money. And the reason there is money in fixers is because most people won't do this, instead convincing themselves that they're good people and they deserve this beautiful property. But if you deserve the beautiful property, you also deserve the huge cost, and the huge payments to maintain it, and you definitely don't deserve all the profit that the folks who buy the first kind of property make from the sale.



Caveat Emptor.

UPDATED here

If a home for sale has a refrigerator included on the listing report, and the buyer's agent does not write that it goes to the seller in a contract, is the buyer actually entitled to the refrigerator. I am actually going through this right now.

The listing does not matter. What does the purchase contract say? That is the complete controlling fact of the whole entire transaction.

If the contract is silent, what matters most is whether the refrigerator in question is appurtenant to the land or not. Appurtenances are things which are physically and structurally attached to the land which is always the primary thing being sold in a real estate transaction. For a standard house, nobody would seriously argue that they have the right to remove it, because it is attached securely to the property. There are service pipes coming out of the ground attached to the ground and a foundation it is attached to. There are electrical service wires, telephone wires, and cable TV wires. All of which would come up if you pulled the house away. So the house is appurtenant to the land. This is how all real estate transactions are really structured, by the way. You are buying the land, and the house, if there is one, comes along because it's attached to that land.

So if the refrigerator is somehow built in, such that removal would be a nontrivial project, then it's appurtenant to the land. If all you have to do us unplug it and push it away on a dolly, that's not appurtenant, and there is no more reason why they should have to leave that than why they should have to leave their dog, cat, or child.

Now this is not to say that you can't build an excellent court case based upon the fact that there was an implicit promise made in the listing, and everything else in the contract was built off of what that listing said. Talk to an attorney for more information than I can ever give you on that score.

Even if they're not obligated, the seller might leave the refrigerator anyway. Maybe they've got another, maybe they are just living up to what they promised even though they might not be legally required to do so. Most people are mostly honorable.

In any of these cases, of course, the seller also can force you to go to court by being an obstinate donkey. It's not like you have the magic power of enforcing agreements. That power belongs solely to the executive branch, which will take no action in cases like this without a court order. Whatever the court says is final. Unless it's some $25,000 wonder fridge, however, it is not likely to be worth going to court over. Much cheaper to buy a new refrigerator, and your expected return on investment is much higher.

Caveat Emptor

Updated here

I just moved into a rental house with an option to buy. I figure I can probably save up around $40-45k for a down payment in three years. how should i save? The Roth IRA tax loophole for first time home buyers maxes out at $10k and takes 5 years anyway. It sounds dumb, but the best safe short term investment I can think of is savings bonds. There has to be something better!

Your major constraints here are a relatively short time frame and you want a certain amount of safety. The idea of investing the money is that you want to get more money, not lose your investment savings.

So if you're going to move outside the realm of guaranteed investments for this purpose, you are going to worship at the altar of diversification. Stocks generally go up, but can go down (roughly 28 percent of all years since records have been kept), and indeed, are not anything like a panacea. Therefore, if you're going to risk the stock market or the bond market in order to obtain their higher returns, you're going to want to diversify, diversify, diversify in order to prevent anything short of a general market decline from ruining your investment.

With that firmly in mind, individual stocks are probably not a good idea. If successful, the idea is that the income will be mostly capital gains, which are taxed at a lower rate. Unfortunately for this idea, it's hard to get efficient and diversified individual stock investment for less than $100k. At $100,000, you've got a down payment to be extremely proud of.

The same with individual bonds to an even greater extent. When most bonds run in $10,000 to $50,000 denominations, diversifying is not really an option when you're just trying to save up for a down payment. If one of your bonds suffered a significant downgrade, bond price would take a hit, and therefore a very large part of your investment would suffer a setback.

Next on the list is government savings bonds and bank CDs. These offer a guaranteed return. The problems are that it's a mediocre return at best, and it's all ordinary income. Still, 5.5% or so for bank CDs is safe and secure, even if it reduces to about 4% after taxes. US Treasury securities have a four year minimum holding period to get their guarantee. Me? I stopped loaning the government money twenty years ago.

All of the various insurance products are a bad idea. You're saving for something you want within five years, not something forty years away or trying to insure a possible loss. Nor does the tax treatment help. Secure commodities investment is one of those oxymorons.

Finally, there are mutual funds. These are diversified by their very nature. In fact, my usual complaint is that they are too diversified, but in this case, that's actually good. Pick a good fund family that covers all of the major asset classes, including bonds. Yes, you pay management fees (and advisement fees or a sales loan if you are smart to help keep you from over-reacting to short term market events), but you can average nine to 13 percent per year, pretax, seven to ten afterward. A large portion of gains will be capital gains, taxed at lower rates than ordinary income. This isn't a certain or guaranteed investment, and can lose some of your principal, even all of it in theory. Nonetheless if you're comfortable taking what is in my estimation a small amount of risk, it can really pay off.

Caveat Emptor

UPDATED here

Okay, I did an article called Why Renting Really Is For Suckers (And What To Do About It). Fairness demands that I do a companion article on situations where buying is not a good idea.



There actually are some. First off, the math just plain works against it for less than about three years. If you know you're going to have to relocate in less than three years, chances are you shouldn't buy. This is not to say that professional speculators are stupid, just that they are playing with different assumptions than most of is. If one victim isn't desperate enough to sell for thirty percent under the general market, they'll go find someone who is. But they don't buy for a place to live. They're buying with a professional eye towards making a profit, and quite often, they don't. If your situation is that you're looking for a home to live in, and you're going to have to sell it instead of renting it out after less than three years, chances are you shouldn't buy. In this instance, it's not the idea of being a property owner in general that is the major factor in the decision, it's how long you're going to own that property.



This is not to say that nobody has ever made money buying for less than three years. The just concluded seller's market right here in California is the counterexample to that contention. But real estate appreciation happens when it happens, and you never know until afterward what it was. If people could predict the market with that much certainty, then it would make sense to try and time the market. They can't, and it doesn't, at least not for the ordinary person.



You shouldn't buy if you can't get a sustainable loan that you can afford. If you don't have at least three years of a fixed rate on an amortizing loan you can afford, you should probably not buy. The market returns 5 to 7 percent per year on average. That is a very different thing than five to seven percent every year. Some years are plus twenty. Other years, like this one is likely to end up, are minus twenty. If you have a sustainable, affordable loan, you'll pay some principal down and you should be able to refinance when the adjustment hits. This doesn't apply with negative amortization, interest only, or shorter term loans. Particularly if there's a prepayment penalty, you'll likely eat up all the principal payments you made with that prepayment penalty. Now suppose you got caught in a twenty percent down year? Over longer periods of time, things even out, trending towards the average return of 5 to 7 percent per year. But that's no comfort whatsoever to those people who bought into unsustainable loans on overinflated properties in the last two years and are now facing huge problems because they can't sell for what they owe, and they can't refinance into a payment they can make. I didn't do it to anyone; I could have made a lot more money if I was so willing. But that doesn't mean there aren't a lot of them out there.



The market is unpredictable. All I can tell you for sure is that it's still declining right now and the next upturn might not come for several years. The only time the value of your property is important is when you sell or when you refinance, but if you haven't got a stable loan, you're looking at a mandatory time when your value is important. If you can't last until then, the eventual market upswing will be of no comfort. Eventually, I'm confident you'll make a better profit than you could anywhere else. But eventually can be quite a while, and if your time constraints don't stretch far enough, that's a problem. A big problem.



Third group of people who shouldn't buy is those without a sufficiently stable income, particularly if their available cash isn't enough to smooth out the bumps. If you need $6000 per month, and you make $24,000 in one whack about every four months, that might appear to be enough, but consider what happens if for some reason it is six months between paychecks? Once you're a couple of months behind and your credit score is toast, it doesn't make that go away if your next check after that is only two more months.



I think I've been clear enough on the evils of buying too much house for your income. People should not overstretch financially to buy a home, but the majority do. You get a month behind on rent, and it is a problem, but if you get a month behind on your mortgage, that's part of your credit score for ten years, and puts you in a whole different class of borrower for two. Plus you're likely to be behind on your next month, and the one after that. This is a lot less of a black mark for renters than it is for owners with a mortgage. Then when you're ready and can otherwise really afford a mortgage, you can't get one or you can only get one on prohibitive terms. So save up enough to smooth out the bumps, and it certainly doesn't hurt to have a down payment also, as that will make the hurdles you have to get over with irregular paychecks that much lower.



That's basically it. If you think you have another one, I'm interested in it, but those are the only three I can think of. The mathematics and economics do generally favor home ownership, even without that generous tax allowance given for the interest deduction and state property taxes, but there are cases where the general rules get overridden. Contrary to what many people were saying not too long ago, you can lose money in real estate, as the fact that property values locally are down about 20 percent from peak should attest. You can also become financially crippled for years. Nonetheless, if you take care to keep it within the realm of what you can afford, and what you can afford to make payments on indefinitely, then the worst that is likely to happen is that you'll owe more than the property is theoretically worth for a while. If you don't need to refinance or sell during that period, that's just unimportant. In cycles stretching back hundreds of years, real estate has always come back to higher prices than before, even accounting for inflation. The critical thing is to make certain you can wait it out.



Caveat Emptor

UPDATED here

Yesterday I dealt with a very disturbing phone call from a would be client. He was very happy with the way I found bargain properties, and wanted me to find him such a property. All very well and good. But he said that a condition of the transaction had to be that he would receive cash back from the seller in order to rehabilitate the property while financing the entire amount. This is not so good.



I am well aware there are all kinds of self-proclaimed real estate gurus out there, many of whom push precisely this sort of strategy. That does not change the fact that it is *FRAUD*.



The lender evaluates a property based upon accounting principles, which is to say Lesser of Cost or Market. Whichever is less, the cost of the property or the market value. Market value is measured by the appraisal. It's not perfect, and it's not foolproof, but it's the best thing there is. Cost is measured by purchase price - the price at which a willing buyer and a willing seller exchanged the property. It has to be worth that much or the buyer would not have been willing to pay it, would they? It can't be worth more or the seller wouldn't have sold, would they?



Manipulating either purchase price or appraised value for financial purposes such as justifying a higher loan amount is fraud. Since there is no other rational reason to do that, it's pretty universal that manipulating appraisal value or purchase price is fraud.



Many people have all kinds of rationalizations why doing this sort of thing is permissible. "Real Estate goes up in value," "It'll be worth that much eventually," and "It'll be worth that after the renovations!" being very common. None of these addresses that fact that that's not the situation now, and the lender is lending based upon the value now, not later.



The purchase price, in particular, is the purchase price because that it how much money the buyer is paying and how much money the seller is receiving. But if the purchase price is $400,000 but the seller is returning $20,000 to the buyer, then the real purchase price is not $400,000, is it? The seller is only getting $380,000, and the buyer is only paying $380,000. If it was a cash transaction with no loan involved, there would be no doubt. If I hand you $400,000 and you hand me back $20,000, I've only given you $380,000, not $400,000, and there's no doubt about it. You've only got $380,000. Only the fact that there is a lender in the middle of most transactions gives any leeway to confuse the issue, and if you're hiding something about a transaction in order to induce some other party to perform a financial action they would not otherwise, that is a textbook definition of fraud.



Lest there be any mistake, you do have to hide it. If the terms of the purchase contract state that there will be this rebate, the lender will treat the purchase price as $380,000, and underwrite the loan based upon a $380,000 purchase price. Telling the entire truth defeats the possibility of it working, and once you have neglected to inform the lender of this significant fact, you are committing fraud.



Some people will cite the example of Seller Paid Closing Costs as justification for this, but that is an entirely different matter. Indeed, traditionally lenders treated seller paid closing costs, over and above the seller's usual share, as reducing the purchase price. It is only the last few years, when it has been pointed out that everything about real estate transactions is negotiable, and that the seller must have been willing to pay those costs in order to consummate that transaction, that the lenders began to allow it. But it is to be noted that all of that money is going to third parties, people who are being paid for their services in making the transaction happen, none back from the seller to the buyer.



Consider instead this scenario: Jim and Joe trade the stock of corporation A. The public sale price of that stock is $100 per share, but as soon as Jim has Joe's money, he quietly hands Joe back $20. The price Joe is paying Jim for the stock is $80, but to the observer unaware of the side transaction, it's $100. It's going to appear to the general public that both Jim and Joe consider that to be a fair trading price, and people will often be willing to pay both Joe and Jim that $100 per share price because it looks like that's the price, or think they're really "getting a deal" if Joe or Jim will sell to them for $98.



Now lest we be unclear, as soon as the side transaction comes to light, the SEC and FBI are going to sweep in and both Joe and Jim are going to find themselves charged with share price manipulation, which is to say, fraud.



The situation I've described as defrauding the lender in this instance is no different at the root. You are hiding a part of the transaction in order to induce the lender to give you a larger loan than they otherwise would have.



Now, before I leave this subject, I want to ask you what kind of an agent or loan officer you'd trust to commit fraud upon someone? When such activities are discovered, such agents and loan officers lose their license and usually go to jail. Do you want to do business with a loan officer or real estate agent who commits fraud? Who deserves to lose their license and go to jail? If they're willing to lie and commit fraud upon one part of the transaction at the lender's expense, why would they be unwilling to lie and commit fraud at someone else's expense? For instance, yours? If I were to point out some agent or loan officer who is under indictment for fraud, and is going to lose their license and go to jail as soon as the verdict comes back, I'm sure you'd all go right out and book a transaction in a hurry with them right now, right?



Now this would-be client quickly lost interest when I explained all of the above. He said, "I'll get back to you on the property!" and hung up. He'll find someone to help him out, no doubt about it. But that's one transaction a good professional wants no part of. I'm better off without him. And I'm confident that if he actually pulls a few of these transactions, one day he'll go to jail and be a convicted felon, and that is as it should be.



Caveat Emptor

UPDATED here

About half the listings around here do not have a single number asking price, but rather a range in which offers will be considered. Even many agents have trouble understanding range pricing. I've seen and heard more than one agent rail against it, saying that it is essentially "repricing the home".



Range pricing began in Australia and was brought to the United States by a certain major real estate chain. That chain is not one I particularly like doing business with, but that doesn't mean range pricing is a bad idea.



Range pricing is a way of starting people talking, and to begin the negotiating process; nothing more. If there's no offer made in the first place, I can guarantee there will be no transaction. The idea of range pricing is to jump start the negotiations.



Range pricing is not appropriate for all properties, nor in all markets. In the buyer's market we have now, I'm certainly more hesitant to use it, as it offers more information as to the owner's state of mind. In a seller's market where prices are rising rapidly and sellers have all the power, it gives an indication as to what a serious offer is and what it is not. In a buyer's market like now it tells some buyers exactly how much leverage they may have. I'm also more leery of using it on commercial properties.



One thing many agents (and others) misinterpret range pricing to mean is that any old offer inside the range should be accepted. This is the mark of an inexperienced negotiator. If they say offers will be considered between $400,000 and $425,000, that is not the same thing as saying "I want $425,000, but I'll take $400,000." There are many other terms and conditions on a purchase contract besides just the price, and there is no mandate to agree with even a full asking price offer if those other terms are prohibitive. Indeed, an agent who knows how to figure out other terms to offer in place of higher price is likely to save you far more than any commission they earn. Even price is rarely just price. For instance, if I write an offer for $410,000 cash, no contingencies, with a $10,000 deposit, most sellers should rightly treat that as superior to an offer of $425,000 with the seller paying $10,000 of closing costs and only a $2000 deposit, contingent upon financing for sixty days. Note that the seller nets over $4000 more if the latter offer actually closes, but the former is a much stronger offer and if two such offers were to come in and other things were equal, I'd strongly counsel taking the cash offer, especially as the latter offer is indicative of a not very well qualified buyer without much commitment to the idea of purchasing the property, and there would be a high probability that the transaction will not actually close. There are all kinds of terms on purchase contracts, and having a discussion as to what's important to the other side can be a way of making your offer much more attractive without necessarily raising your price. For instance, owner occupants are often understandably nervous about whether the transaction is going to close, and committing large sums to alternative housing before it actually does close. If you can think of a way to address that concern, you're miles ahead of the negotiator who can't. Every situation is different, and what works one time may not be appropriate to even offer the next.



So if I see a property with range pricing of $400,000 to $425,000, I want to educate my buyer clients that an offer of $400,000 even with the seller paying up to $20,000 of closing costs is not within the range indicated. Indeed, as I've said elsewhere for such offers, a $380,000 sales price with the buyer paying their own way is a superior offer from the seller's point of view. If they insist, I must and will submit it, but even in the current buyer's market I wouldn't be surprised to see it rejected outright with no counteroffer.



In the current buyer's market, those few buyers willing to purchase properties have an enormous amount of power, and this will continue until the seller to buyer ratio gets a little less lopsided. So in the current market, I might actually offer significantly less than the asking price range, secure in the knowledge that if this seller rejects it, I'll find something just as good tomorrow where the seller will accept. Some will. So if some won't, so what? You learn to spot the sellers that have the power to refuse, and the ones who have to take anything vaguely reasonable.



Now admittedly, I don't do a lot of listings, as most sellers don't like to listen when I tell them to price their property to the current market if they want to sell. (And if they don't, why are they talking to me?) I've only got one listing right now, and quite often, none. But when I'm showing them what the market is like, and what reasonable prices for properties like theirs are right now, I'll ask a couple of questions once I'm convinced they understand. Everyone knows what they want to get for the property, and by the time I'm done, they better understand what a reasonable asking price is and why it's stupid to list for more. But after that, once I've explained that there are offers and then there are offers, and the price isn't the only thing worth paying attention to, I'll then ask them, "Now that you know what a realistic asking price is, what would be the lowest price you would consider selling for, if someone offered everything else you wanted? Great deposit, all cash, no contingencies for financing, etcetera?" Next I'll ask, "How far over the realistic asking price we've agreed on would you require going if the buyer came up with some odious terms: takes possession early, no deposit or not much of one, wants a long escrow, etcetera?" Rebates always raise the necessary price at least dollar for dollar, by the way. A $380,000 offer with no rebate is superior to $400,000 with $20,000 rebate from both buyer's and seller's perspectives. Then, depending upon how much the seller needs to sell, I'll use that information to help me figure the endpoints of the asking range (assuming I'm not just going to use a single asking price). I won't just use either number, of course. But that, together with the state of the market and how much power buyers think they have in the market at the time, will give me a good feel for what the lower number of the range should be.



There is another, entirely different benefit to range pricing is that when the search is done on MLS or its substitutes, the lower number in the range is going to trigger your property coming up on more searches. Now, if you're a listing agent, MLS and MLS substitute buyers are more likely to be aggressive, and often unrealistic, bargain hunters, as opposed to people who really want to live in the neighborhood around this property. MLS inhabitants are not my favorite buyers when I'm listing a property, for that and other reasons. But if this property comes up on their search, they might look, and if they look, they might make an offer my client is happy to accept. If they don't even see it as they're searching, I guarantee no offer will come in from them. So range pricing helps me capture these people's attention. Whether interest, desire, and action follow is anybody's guess. But they might, where without range pricing they definitely wouldn't.



In short, range pricing, properly done, is not repricing the home, and it is a good way to get the buyer and seller to the table. It is not appropriate for every property in every market, but for those it is appropriate for, it's a useful tool. Properly used in the right market, it can even help your seller get a higher price for the property than any single number asking price you'd dare use.



Caveat Emptor.

UPDATED here

Okay, you might expect a Real Estate Agent to have a post with that title, but I'm going to surprise the doubters by hauling out a spreadsheet and proving it with numbers.



The fact is that if you have moderately decent credit you can qualify for 100 percent financing. The more you have for a down payment, the better your interest rates and the lower your payments, but even so, you can make it.



The first thing to remember is that you have to live somewhere. When you buy, you place your cost of housing forevermore under your own control. Inflation means nothing to the housing costs of someone who's already bought. Rising rents means nothing - unless you've bought an investment property to rent out, also. We are currently facing a period wherein rents are likely to rise precipitously. Why? Low vacancy rates (3.4% in San Diego), and many landlords facing adjustable rate mortgages that are going to adjust upwards. It doesn't matter that your landlord has been nice up to now. They were banking on selling for a profit and right now, they can't. When the monthly outlay goes up, they're going to raise the rent. They will get it, too. If you won't pay it, someone else will.



Once you have bought, you step off of that one way escalator of rising rents. Rents increase at a yearly rate about comparable to inflation in most cases, and rents never drop. I have never heard of a rent decrease except in areas that were so far gone they might as well have been war zones. You only borrowed $X when you bought, and unless you take cash out (which is under your control) you should never owe more money next year than the previous one.



So buying stops your situation from getting worse. What about making your situation better? First off, I need to observe that with rising rents, your situation will always get worse until you do buy. But buying really does make your situation better. Not immediately; there's always a hit for buying, and it always costs money to sell. But within a couple of years the average person will be above any reasonable return they can earn any other way, and the reason is leverage.



Fact one: you always need a place to live, and the options are to rent or to buy. Renting typically requires less cash flow, but returns nothing. Once you have bought, all that lovely appreciation belongs to you and nobody else but. Let's look at an actual scenario for San Diego, one of the highest priced places to buy.



I looked at one particular property earlier today with an asking price of $450,000. We're going to leave aside the issue that with the market as it is, $410,000 would be a really terrific offer, and use that $450,000 asking price. The most comparable rental in the area is $1700 per month. For people with dead average national median credit scores, I have 6.125% on a thirty year fixed rate loan for the first 80% of the loan, and 8.75% on the second mortgage. Yes, I'm assuming a 100% loan. Total loan costs, one point and approximately $3400 in closing costs. With sellers outnumbering buyers 36 to 1 right now, it's an idiotic seller who isn't willing to pay your closing costs. Your payments on the two mortgages are $2187 and $708, respectively. Call it $2896 with rounding. I'm going to assume you're married, which means you get a $10200 standard deduction on your federal taxes for 2006. Furthermore, property taxes are about $470 per month, and homeowner's insurance costs about $110 per month for an HO-3 policy, the best there is. Total cost of housing: $3476 per month. Over twice your cost of renting, yes. But $400 of that goes straight into your own pocket, in the form of principal you're paying off from month one. Furthermore, $2960 per month is a tax deduction, from which you'll get a benefit of $(2960*12)-10,200 (standard deduction), or slightly more than $25,500 per year, from which someone in the 28% tax bracket will see a tax reduction of about $7145, returning another $595 per month to your pocket. $3476-$400-$595=$2481 net costs per month to own that property. Less the $1700 rent, works out to $781 extra you're spending. Furthermore, if you turn right around and sell it, you're going to be out about 7% of that sale price. Assuming it's the same $450,000, that's $31,500 you're down.



However, property values don't stop rising just because the renters of the world would like them to. Let's assume you're going to make a slightly below average for this area 5% per year in absolute terms - not inflation adjusted. Most of California has been averaging seven percent per year for the long term, over cycles and cycles of pricing. The CMA for the first property I bought, at the peak of the last cycle fifteen years ago says $320,000, an 8.8 percent per year average increase. So 5% is definitely on the low side. Let's assume you have a twin who continues to rent, and invests that $781 per month, tax free, while you take it and buy a property. Actually, let's go ahead and give your twin the full net cash differential of $1143 per month.



One year later, he's got about $14,400, while your property is worth $472,500. You've got about $27,000 in equity. On paper, you're ahead of him, but remember that real estate isn't liquid and there are always selling expenses. You're really still down by about $20,000 as opposed to your twin. Darn! Just when you had a really good brag going. But wait! Now your twin's rent is raised to $1768 - right in line with 4% inflation. But your mortgage costs are fixed.



Run it out another year. Your twin has about $29,700 in that account. Looking pretty good, right? Well, you've now got a value of a little over $496,000 and you have about $56,000 in equity. You're not really ahead yet, but deducting the 7% costs of selling net you about $461,400. You've made over $11,000, net, not counting the equity you paid down! But your twin has almost $30,000. Why is renting for suckers, you ask?



Go out one more year. Your twin's rent has gone to $1838 per month, but even so his investment account still has a tad over $46,000 in it. Looks like he's pulling away! Or is he? Your property value has gone to almost $521,000, and you only owe $434,000. You're up almost $87,000, and even allowing the standard 7% for costs of selling, you're would now have over $50,000 in your pocket, several thousand dollars more than your twin.



Every year from then on, you pull further ahead. After ten years, when his monthly rent is over $2500 per month, you've got $350,000 in equity, and even after the costs of selling, are over $100,000 ahead of your dimwitted twin.



Lest you think that if your twin started with $45,000 due to a ten percent down payment it would make a difference, the answer is not really. It cuts the lead, but not the essential facts. I could cut the rate on the second mortgage a bit, but let's leave it at 8.75% for the purposes of this exercise. True, after three years you're still lagging your twin in this scenario, as that investment account is $95,000, but only by a few hundred bucks. Your equity is $130,000, of which $94,300 would be left after the expenses of selling. After ten years, he's $80,000 behind you, net of the cost of selling.



Suppose you start with a full 20% down payment? You're still $55,000 net ahead of the game after ten years. Your twin started with $90,000 earning ten percent, but not only do you not have that expensive second mortgage, you've got $450,000 earning 5%, and it's all yours and then some. This is the concept of leverage. That loan turns out to have been a good thing, as it enabled you to leverage your down payment into a much larger appreciating asset. So you only earned half the return - it was on five times the principal! It translated into a much bigger number. By the way, your twin only has the edge on you in cash flow by about $120 per month at this point, and he's going to be negative next month.



Now the real estate market doesn't earn nice smooth returns like this. Neither does the stock market, or anything except maybe bank CDs or the money market, at a fraction of the return illustrated here. Furthermore, it reliably and unavoidably takes about three years to come out ahead on a real estate investment. There are always the twenty percent per year markets, but those don't happen very often and never predictably. What I'm talking about are is making money in the slightly below average market years also. Note that you'll still make twenty percent in the years the market does. Sometimes you get lucky. But "time in" is so much more important than timing that they don't even play in the same league.



You don't have to be a genius, you don't have to have perfect credit, and you don't have to make a mint. You do have to pick properties that you can afford to make the payments on, and you do have to make the decision to accept a couple of tough years for cash flow. There just is no avoiding this hard fact. There are loans that promise otherwise, but they have bitten everyone I've ever met who tried them. Once you have made the decision to accept those lean times, however, the good times seem to flow from them for the rest of your life. The sooner you make the choice to accept them, the better off you will be.



Caveat Emptor.



UPDATED here

In the interests of fairness, I've also written a companion article, When You Should Not Buy Real Estate

One of the phenomena that I am encountering is fear of the market in buyers. They are concerned that prices are falling, and that they will lose some or all of their investment.



Well, the first thing to understand is that buyer's markets are not the time for "flippers". You are not going to buy the property and make a profit after the expenses of selling in six months. That's a seller's market, and we don't have that now. Two years ago, most prospective buyers were using the f-word. Now, those people who were buying to flip are caught flat-footed by a market that has turned, like deaf kids in a game of musical chairs. The signs were there, but they were just a little too greedy.



Nonetheless, a buyer's market is the best time to buy for everyone else, and here's why: Inventory. Turnover Rate. Market Saturation. Supply and Demand. Instead of being the kings of the world, sellers have now turned into the beggars. The ratio of sellers to buyers locally is approximately 36 to one and climbing, as 960 properties were listed but only 397 purchase agreements were reached last week. Imagine you're in an environment where there are 36 people of the opposite sex for every one of yours. I'm assuming you're interested in the opposite sex, but even if you're not, you should be able to understand the implications. That one woman with 36 men to choose from is going to be able to get just about anything and everything she wants. Even the woman who would be completely ignored in other circumstances is going to have multiple, attractive suitors. Alternatively, the one man with 36 women to choose from is going to end up pretty darned happy, even if he is short, fat, ugly, middle aged and balding.



Now the sellers in this market don't really have the option of choosing other sellers, as it doesn't help them. They have real estate, they want cash. Just like how that short fat ugly balding middle aged guy does pretty well for himself when there are 36 women for every guy, so does the buyer who has cash, or can get it via their power to get a loan.



Prices are likely to drop for a while, but you will never again have this ratio of sellers to buyers, and the market could turn at any time. If you wait for the market to turn around before you put in a bid, you will be much less sought after. Right now, the power of the market puts buyers in control of the transaction. If this seller isn't quite desperate enough to do what you want them to, the one down the street or around the corner is. Like the 36 men to every woman scenario, if this man isn't able or willing to meet the woman's full wish list, she can move on to someone who is.



Buyer's markets don't last long. The last one was less than a year, and only about two months that buyers had the power that they do now. If you buy for a little more than market bottom, so what? The only time value of the property is important is when you sell and when you refinance, and I've already told you this is not a flipper's market. But once other potential buyers get the idea that there are bargains to be had, they will come out of the woodwork, and the vast majority of your purchasing power will be gone when the ratio of sellers to buyers drops to four to one. And soon after that, they turn back into seller's markets. When that happens, watch the prices - and the profits - shoot back up.



Miss the window now, and you'll pay for it later. Any market is always most lucrative when everybody else wants to do the exact opposite of what you're doing. Pick and choose your properties with care, and you will do very well when the market turns, whether that is next month or next year. Right now, you have your pick of sellers, and your pick of their properties, and the leisure to consider. When the ratio of sellers to buyers drops, it gets much harder to find these kinds of bargains, and much harder to get in before someone else has locked it in by getting an accepted offer.



Caveat Emptor.

UPDATED here