Do the news and the media have you pulling cash out of your bank account and stuffing it in your mattress? Do you see the world ending and life as you know it coming to a stop? Are you staying awake at night worry and feeling uncertain about you and your family's future? Now is the time for a frank discussion about why current events HAVE to happen, HOW it is going to happen, and what the future REALLY looks like.
What caused the boom?
The boom was generated primarily by three events:
1. Ready availability of cash for banks to lend
2. Low cost for consumers to borrow that money
3. Lower taxes.
All of the three had the effect of consumers spending more money. This was sponsored by the government to keep the economy growing because that is what voters want. This increase in consumer spending was the only thing keeping the economy growing because in reality it should have been declining.
Why the boom shouldn't have happened
Manufacturing and productivity in America has decreased dramatically over the last 12 years. Combined with a Trillion dollar trade deficit, it is incredibly difficult for an economy to grow. The result should have been a declining economy and would have been without government interference. In lay man's terms: if you don't spend your money in this country and you spend it in other countries (oil and trade deficit with China), other countries will grow and you won't. This is not a political statement to buy American, I'm just stating a fact. America hasn't done enough to replace the "lost" money so our economy should shrink and continue to shrink slowly over time as the money continues to be "lost".
So why did house values increase so much?
House values increased dramatically primarily for two reasons: 1. Lower interest rates 2. Speculation (herd mentality).
Most consumers are buying a payment when they are making a major purchase like a house. So the cost of the house isn't as important as the payment on the house. Here is an example: Joe and Jane want to buy a house and they can afford $1200 a month for a mortgage payment. For most of America's history, interest rates were in the 8%-10% range. At 8.5%, they can afford a $156,000 mortgage. At the artificially low interest rate of 5% Joe and Jane can afford a $223,000 mortgage! That is a full $67,000 more than at 8.5%! Lower interest rates encouraged consumers to pay more and buy more house than they could normally afford. This started the house value increase.
After a few years of appreciation, speculators came out of the wood work and started bidding up the sales price of houses, sometimes even above the list price, with the hope that prices would continue to increase. These speculators would sell in 3-6 months after the house had appreciated enough to generate a profit.
Soon the "average Joe" felt like they were being left out and if they didn't buy now, they would never be able afford a house. In many cities, houses were selling hours after it was listed for thousands of dollars more than list price.
During this period some houses were doubling in value in as little as 2 years! With banks eager to lend money at low rates, the vast majority of Americans refinanced their homes to access their "equity" which was spent or invested, allowing the economy to grow. People "got drunk" on the easy money and spent up a storm unlike any other time in our history. As a nation we went crazy, leveraging ourselves with cheap debt, spending it all and for the first time ever, we spent more than we earned.
What goes up must come down
Our economic growth should have been flat or slightly negative based on our trade deficits, declining manufacturing, and declining productivity. In addition with our budget deficits, government overspending, and the continual devaluation of the dollar, interests' rate should be closer to 8%-9% to protect against inflation.
With our current credit crunch and with most of our large banks deleveraging themselves, borrowed cash is going to be very scarce for a few years. This should send us into a recession until real estate and the economy come more in line with the average Joe's income and affordability.
Where is this level at? Since most of the rise was artificial, most cities and states will fall back to or near pre-bubble prices and affordability. My prediction is at least to year 1998 and maybe even as far for some cities as 1991 real estate and affordability prices. Bottom line is we still have a long way to fall in most parts of America.
Creating certainty out of uncertainty
It is safe to say that we will never see that kind of crazy bubble and consumer spending again. A good friend and client of mine, David Butler of Hot Spur Investment Group (www.hotspurinvestmentgroup.com ) has a great analogy for this. If you go out and get crazy drunk, party, and paint the town red, odds are when you wake up it's with a terrible hang over. When you recover and your head ache is gone, do you expect to be drunk again? Of course not! So we are recovering right now but don't expect when the headache goes away to be drunk again.
You can't predict the bottom of the market or when the economy will recover. However, you can establish the bottom by basing your real estate investment on affordability. Affordability is time tested and conservative approach to real estate pricing and values. While much of the due diligence can be somewhat challenging and complex, your main variable is the income of the average "Joe" and what he can afford. This brings us full circle and explains how you can create certainty, plan for the future, and profit by seeing things how they really are.
Profit now conservatively
Wages are stagnant in most cities and states and interests rates will likely go up to 9% to curb inflation. Before you invest in any city in America you need to find out the average income of the people living there. Multiply their annual income by 28% to conservatively determine the annual mortgage payments they can afford. Divide the annual mortgage payments they can afford by 12 to determine the monthly mortgage payment. Now using our conservative interest rate of 9% (where it will likely be in 2-3 years) you have just established the bottom of the market based on affordability.
Below is an example based on Detroit
Average annual income: $39,000
Multiply by 28% for annual payments they can afford and divide by 12 for monthly payment = $910
Likely Interest Rate: 9%
House Value based on interest of 9% = $112,000
Based on affordability the average Joe can afford a house worth $112,000 with interest rates at 9%. As real estate investors we need to buy and fix up a house for 60% of the properties values to guarantee that we will make money. 60% of $112,000 is $67,200. It is not difficult to purchase a house in Detroit and fix it up for much less than $60,000.
My Challenge to you
I want you to apply the same conservative approach to real estate that I do. It is time for you to put the cities you are investing in under the microscope. I'm betting that many of you are buying at too high of a price and probably need to establish the bottom of your market the correct way. If that is not currently possible where you invest, I encourage you to take a good hard look at investing in the city of Detroit where the bottom is already set.
Make your life uncomfortable,
Jeremy Burgess
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