Analysis: why a "Down market" - is really - a "Corrected value market" the time to buy? Now.

Written by : Tim Vasko | Published on May 08, 2008
Category: Real Estate

Assume a $400,000 home in California became an $700,000 home in the period of a few years based on no real tangible value - here's how:

Side note for mathematicians: I'm taking the liberty of the J.M. Keynes approach to this economic analysis and the numbers - ' I'd rather be approximately correct, than precisely incorrect...' (I've also heard this "approximate" quote attributed to W. Carr). Thus, if my math is "off" don't get too hung up on the figures - the concept is to identify economic reality, not the ten grand here or there of value ...

Let's take San Diego as an example - think about the television shows on flipping as a basis to understand the inefficiencies in the real estate market given the costs of the transaction in today's markets.

Envision a home five or six years ago, say 2001, in Southern California (or Florida, Colorado, etc. ... pick your "depressed" market). Let's say that home was sold for $400,000 back in 2001. The net amount was $400,000 (the seller actually received $24,000 less, because the real estate agent and brokerage received around 6%). So the original seller had about $375K in their back pocket at sell to pay off their mortgage balance and get their equity out of their home.

Now let's assume the market heats up, which it has done for the last 5 - 10 years in that area. And that the house appreciates $75,000 by 2002. The new owner figures they can sell the house for around $475,000 and pocket around $50,000 (net of another 6% real estate commission, which goes to the broker and agents of $30,000). And so forth and so on - for 4, 5, 6 times over the upward cycle.

If this continues for 5 sales cycles, the real estate commissions, mortgage fees, closing costs add up to around $150,000 to $200,000. This gets added to the price of that original $400,000 real estate - a false economy really, as the house hasn't changed much, probably with the exception of a few coats of paint and maybe some new tile. The home wasn't gaining any more value in real tangible equity - typically, in a traditional market, houses and their costs of buying and selling were amortized over 10 or 20 years, so the market forces added tangible value. But this model was not was had been happening in these ultra fast paced markets.

The people who had lived in Southern Cal for the last couple of decades, who stayed in their homes, are not the ones in trouble! They just saw their market go up and come back down again. It is the people who bought at the end of the cycle that have lost their equity. The distribution of the home in the from of high real estate commissions were making the prices higher on every sale of the property, driving the price up to well over $600,000 or more, and in the mean time, the "market" was hot, so builders and investors jumped in the game adding fuel to the fire.

At the end of the road, someone, a buyer bought that home for $650,000 or $700,000 or more. A bump of 40% - 50% over the market five years ago. The market then "corrects" - basic economics - the financial systems cant support the "churn" or "flipping". Loan defaults begin - the person that paid "too much" , and who was able to qualify for an overvalued home due to loose credit policies during the same time has no equity - and wouldn't have for some time. This is who is left holding the pumped up pricey real estate? Just like the stock market when it booms, the last buyer in looses if their not out before the bust.

The house price drops, the home mortgage payments are based on a $650,000 price, but the home is worth only $400,000. The unlucky last owner is left in a position, like sitting on a share of IBM stock that was at $150 per share and is now at $95 and still having to pay the higher price, while the market is only willing to pay $95 bucks. Who wants that? Who can afford that?

So that buyer/owner determines that there is no equity to lose, all the losses have happened, and magic occurs. The market adjusts - the price is back at where it started $400,000 in 2001.

This is a simplified view of the "crisis" that we are seeing today. The profits made and spent by the big finance companies and real estate groups - and the resulting effect of an inefficient distribution system.

The stock market makes adjustments based on real time, information. However, stocks are wildly more liquid than real estate, that is the difference, they are traded moment by moment - while with a "typical" real estate market, the trading is supposed to take place years at a time.

And, Just like the stock market, when e-trade and day traders changed the access to information that transformed retail brokerage, the market began to expand globally, boom and move upward - in fact staba change the distribution of information and the transactional elements of real estate.

Would you buy stocks without going on line and looking at a chart? Researching a few articles. Seeing the trends?

Then why would anyone pay hundreds of thousands or millions for a piece of real estate without doing the same type of research?

Tim Vasko

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