Asset Deflation: The New Rules of Real Estate

By: Steve Moyer | Thu, Apr 5, 2007
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"Three Rules of Work: Out of clutter, find simplicity; from discord, find harmony; in the middle of difficulty lies opportunity." ~ Albert Einstein

I mentioned a couple of weeks ago that our next piece would cover the "new rules of real estate," as post-bubble asset deflation indicators dominate the landscape. Meanwhile, our latest Safehaven article generated more than 300 emails in a week's time -- our greatest response ever -- and was picked up by websites in the United Kingdom, Germany, Italy, China, Canada, Mexico, and even Cuba . Obviously we have come to an inflection point on the investment curve and are edging ever-closer to the "point of recognition" as it pertains to real estate. And real estate is key, because in my opinion its collapse will take down all asset classes for some time. Ergo, we humbly offer real estate's new rules:

When it comes to selling your real estate, better a year too soon than a day too late.
As real estate values deflate in the U.S., it is clear that different markets will take their lumps at different times, much the same way dot.com stocks bit the dust one at a time when the NASDAQ collapsed in 2000. Some areas will buck the trend and hold up better than others. But scattered markets throughout the U.S. have already experienced the onset of real estate deflation, more communities are faced with that reality each day, and the psychology is getting damaged beyond repair. Peoria's problem is your problem as lenders pull back (or go bankrupt), homebuilders decline to offer earnings guidance, and the mainstream media convey the news of the spreading disease. Investment manias have always ended in deflationary depressions and we have just concluded the two grandest investment manias of all time, piled one on top of the other.

Ideally, you will have sold your investment real estate in 2005-06, but you still have time to come out just fine. You will be a winner if you sell now and set the cash safely aside, even if it's a week, a month or a year too soon in your area.

If you are buying real estate to hold right now, you could lose your equity and ultimately your property.
At the very least, you should be taking a wait-and-see approach to buying at this point. The risk/reward ratio is completely out of whack and the snowball is just beginning to form, just a few hundred feet from the top of this enormous and steep mountain. If you can't see the danger and are buying property, face it -- you could pay dearly.

Perhaps the best metaphor is that of a runaway freight train: Why take the chance of trying to grab hold and jump on now when the train has started to pick up steam on its way to careening wildly out of control? It makes entirely more sense to wait until the train crashes through everything, then comes to a wheezing, sputtering, exhausted stop. At that point not only can you board the train safely, you can buy it for next to nothing, restore it to its former glory, and guide it prudently back to the top of the mountain.

If you are counting on the Federal Reserve to "inflate" in order to save real estate's bacon, I believe you are making a mistake.
The market will be taking it from here and the Fed will be powerless to "fix the problem." Socionomist Robert R. Prechter, Jr. (author of the recommended Conquer the Crash, 2002) in my opinion says it best. Take note:

Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts...

The expansion of credit ends when the desire or ability to sustain the trend can no longer be maintained. As confidence and productivity decrease, the supply of credit contracts.

The psychological aspect of deflation and depression cannot be overstated. When the social mood trend changes from optimism to pessimism, creditors, debtors, producers and consumers change their primary orientation from expansion to conservation. As creditors become more conservative, they slow their lending. As debtors and potential debtors become more conservative, they borrow less or not at all. As producers become more conservative, they reduce expansion plans. As consumers become more conservative, they save more and spend less. These behaviors reduce the "velocity of money," i.e., the speed with which (money) circulates to make purchases, thus putting downside pressure on prices. These forces reverse the former trend...

If people and corporations are unwilling to borrow and unable to finance debt, and if banks and investors are disinclined to lend, central banks cannot force them to do so. During deflation, they cannot even induce them to do so with a zero interest rate.

Thus, regardless of assertions to the contrary, the Fed's purported "control" of borrowing, lending and interest rates ultimately depends upon an accommodating market psychology and cannot be set by decree. So ultimately, the Fed does not control either interest rates or the total supply of credit; the market does...

Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward "spiral" begins, feeding on pessimism just as the previous boom fed on optimism. The resulting cascade of debt liquidation is a deflationary crash. Debts are retired by paying them off, "restructuring" or default...In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities and real estate, causing their prices to plummet. The process ends only after the supply of credit falls to a level at which it is collateralized acceptably to the surviving creditors.

I ask you to use common sense; once people start depending on "the government" to preserve their investments, that little voice should be telling them that they're on shaky ground. This is a multi-trillion dollar problem and much too big for any central bank or policymaker to contain, particularly if lenders pull back and ordinary folks lose their appetite to borrow more money, which is what we see taking place right now.

Forget the statistics about home values holding up; they're not.
Speaking of the government, don't rely on government statistics which indicate that real estate values are hardly falling at all. Of course, that varies from market to market but for the most part, it's nonsense. That hissing sound is housing bubble deflation. Ask any honest realtor if their market is changing. Read news accounts (www.prudentbear.com offers daily-updated links to dozens of articles, good news and bad, from mainstream American newspapers and financial media). People in communities across America are walking away from their upside down, nothing-down mortgages as the housing mania unwinds. Homebuilders are giving buyers $30,000 to $50,000, even $70,000 worth of free upgrades, credits and "incentives" while still reporting the sale at full (or gross) price. Back-to-market foreclosure properties are adding to the slump, while bankruptcies in the U.S. are up 70% year over year. There are significantly fewer buyers, and those buyers are offering less. I would not be surprised if many (not all) U.S. real estate markets have already experienced 20% market declines in the most recent 18 month period.

Additionally, the number of sales is down considerably -- in many markets 30% to 40% -- so the number of people willing to buy for just-beyond-peak prices has already dropped substantially. While the "average" may hold up statistically for a time, dunderheads willing to pay that average will be fewer and further between. As hokey real estate loans move closer to extinction and more equity is required to buy, the numbers will only get worse.

The market is in the process of going splat, buyers are noticing and getting skittish, the mainstream media coverage is reinforcing the psychology and the foreclosure/lending/ banking crisis has just begun. The challenges we face from the real estate shakeout become more daunting each day.

If you do buy a hardship property or get an amazing deal on something right now, by all means get in and get out.
I recommend waiting to purchase an even better deal later on and avoiding the exposure of being a market timer right now, but if you do find something that is a particularly good buy or needs a lot of work and can be sold for a profit, get it done quickly. Buy it, fix it, sell it. Know going in that if the news continues to get worse, or if the lending picture changes or the stock market falls hard or market confidence erodes further, you could end up taking a loss, doing a lot of work just to break even or find yourself stuck with the property for a decade or longer without much, if anything, to show for your efforts.

Foreclosures are everywhere, but remain patient; the deals will get even better as the crisis unfolds.
Finding foreclosures will not be difficult (heck, Yahoo! just announced an online "Foreclosure Center" to take full advantage of the developing trend). But in two or three years, as the market goes ka-phlooey, there will be so many foreclosures to choose from you'll have bargaining power beyond your wildest dreams. And the more cash you set aside now, the more you'll be able to buy distressed property for nickels and dimes on the dollar as desperate lenders compete with each other to get real estate off their books.

Don't leverage into anything.
During the credit contraction/liquidity crisis portion of the post-bubble meltdown, anyone who is leveraged will get punished. So do not borrow against one property to buy another, do not buy with little or nothing down, do not use your line of credit to buy real estate, and do not take on a teaser or negative-amortization loan betting on market appreciation going forward. Look at everything with the most critical eye you can muster right now. In fact, resist your urge to use leverage to buy any investment, including stocks and precious metals. All asset categories will fall together in the coming deflationary environment -- at least for a time. The term "leverage" should become passé for quite a while.

If you buy now, there may be few or no willing buyers when you decide to sell (or are forced to sell).
I know this is difficult to imagine after 70 years of real estate appreciation, but the last time the United States experienced a post-bubble, deflationary depression (1929-1933), real estate fell almost completely out of favor and property values fell precipitously. Unfortunately, because of the bigger bubble, I expect things to be even worse this time. When a liquid asset (like a stock) loses value, you can still sell it, albeit for a loss; real estate is not liquid, so if that market "crashes," you are not able to simply call a broker and sell it immediately. You may find a damaged buying psychology and no buying interest, and find yourself faced with the difficult choice of taking a loss each month or walking away from your investment.

If you do buy now, the next buyer may have a lot more trouble finding a loan even IF he wants to buy it from you.
The subprime and Alt-A. mortgage meltdowns offer hints as to what's to come. As foreclosures mount, lenders find it more difficult to pawn their irresponsible loans off on the secondary market and stop offering those loans. Dozens of lenders caught in the crosscurrent have already gone bankrupt. As the crisis unfolds, Fannie Mae will surely change the rules of their game, too. Undoubtedly, as values continue to fall, lending practices will become increasingly more stringent. At some point buyers will likely need significantly more real (i.e., unborrowed) cash to buy property. The problem is Americans are not savers, they are borrowers, and if they can't get their hands on easy money or can't borrow against other assets as easily, they probably will not buy. And those with the necessary cash will certainly demand a much lower price.

Therefore, even if financing is readily available to you for the time being, you must allow for a risk premium in case the next buyer faces a different climate. Of course, once again this suggests that you shouldn't buy now. You'll come out better if you wait until money is hard to get for most everyone, and you're the only one who can come to the party with cash.

If you plan to keep any property, get a long-term, fixed rate loan. Better yet, pay down the loan balance or pay it off completely.
I recommend you sell all real estate right away (except for possibly your home), but if you do keep a particularly special property, make sure you don't have a balloon payment coming due in five years and risk the chance that replacement financing is no longer available. Better to lock in your financing now -- long-term at fixed interest rates -- in case the worst happens and it takes 15-20 years for values to rebound to today's levels (which is a distinct possibility), or consider using proceeds from other property sales to pay off your loan entirely. When real estate values tanked during the Great Depression in the early 1930's, financing became difficult to get, rents fell for eighteen years and it wasn't until 1954 that property values got back to par.

Stop borrowing against the equity of your home.
I know this has been too easy and all-too-very tempting, especially when mortgage interest rates have been historically low and the interest is tax deductible in most cases, but this borrowing mentality got out of hand to the point that accessing your home equity became easier than getting financing on a new refrigerator.

It really did feel like we were getting richer by the minute via Fed-created, artificial and short-lived value increases in our property. "Why not borrow more when my property is obviously going to be worth more every year?" many homeowners assumed. Americans were able to buy things (cars, time shares, dream vacations, home electronics, appliances and all sorts of things we didn't really need) and continue to finance them into their mortgages while keeping monthly payments pretty much the same (especially if borrowers felt confident enough to roll the dice on a teaser loan).

Alas, the rules of the game are changing. I know it will require an adjustment in thinking and old-school budgeting, but if you plan to keep your home and are fortunate enough to still have substantial equity, you must make the decision to live within your means. Pay down debt wherever you can. Work to pay down your equityline, do not use your home mortgage any longer to "consolidate your bills," close that preposterous checking account which automatically adds to the balance of your home loan. Implement a tight and disciplined budget. Become lean and mean. Take at least 10% of your paycheck and tuck it away safely for savings. Safe cash will be king in the coming environment and you'll be able to use that money to make money.

Do not listen to the National Association of Realtors, the CEO's of Coldwell Banker Real Estate, Countrywide Financial Corporation, or anyone else in the industry whose livelihood depends on your willingness to place at-risk your hard-earned money.
Friends, listening to what these folks have to say is akin to walking into a car dealership and asking the salesman if today would be a good day to buy a car. I have been in the investment real estate business for 25 years and the N.A.R. has never taken any position other than, "Now is the best time to buy real estate!" They proclaim it in up markets, down markets, sideways markets, active markets, dead markets, high interest-rate markets, low interest-rate markets and this-little-piggy-went-to-the-market markets.

Be ready for the propaganda. Industry people will look you in the eye and maintain that "there is no real estate bubble." They'll goad you by saying that "it's a buyer's market." They'll say that "real estate values in the United States always go up in the long run," (unfortunately, to them, "always" means since 1932. Real estate values collapsed in the U.S. after the Stock Market Crash of 1929 and also dropped an average of 70% over 16 years' time in Japan's very recent post-Nikkei bubble real estate deflation).

The pimps will tell you authoritatively that the last time we had a downturn in the real estate market, it only lasted a few years at which point values took off again. (And they're right; 1990-1993 saw real estate values drop in the U.S. before the glorious run-up began. The problem is, this time it is a post-NASDAQ bubble, post-real estate and mortgage bubble-bubble long-term deflation situation, not a normal real estate down cycle).

Eventually, they'll tell you with great conviction that "we've reached the bottom" and they'll continue to do so year after year after year forever and ever, Amen.

I may be early, or wrong.
Of course I believe my analysis is correct and that it's my responsibility to convey this to our readership. For heaven's sakes, I'm in the real estate industry and obviously wouldn't be writing this series otherwise. I am ever hopeful that "things will be different this time" but investment manias have never ended any other way and too many obvious signs point to the stated outcome. If the Fed can somehow further-delay the bubble-on-bubble's asset deflation and depression, terrific; I encourage you to use that stay of execution as a means of coming out whole. Can central bankers beat back deflation if the majority of people decide to stop buying and recklessly borrowing against their real estate? I give it about the same chance Sanjaya will become the next American Idol.

Gold and silver bugs write in to say that the Fed will opt for hyperinflation over deflation, and that the precious metals will soar (and I've learned to never argue with metals bugs). I offer another opinion: That the United States Federal Reserve will elect to protect the dollar first (its primary legal responsibility), and take the same path it chose in the 1930's when it raised interest rates to prop up the dollar in the face of a deflationary depression. I also say that the real estate collapse and change in psychology will be too unwieldy to prevent a massive credit contraction, and that that contraction will render the Fed impotent.

And if I am wrong, which we can all hope for, I appreciate the fact the dialogue is taking place. I have been heartened to hear from hundreds of readers who are open to the discussion and no longer blindly walking the assumed path that real estate values are guaranteed to go up and up forever. The vast majority of our readers have already taken (or are in the process of taking) a defensive posture; that was certainly not the case a year or two ago.

Some folks sold their NASDAQ stocks at the top of the curve in January of 2000; they were the ones who protected their assets and won the first game of the Asset Preservation World Series.

You now have the chance to do the same thing with your real estate.

 


 

Steve Moyer

Author: Steve Moyer

Steve Moyer,
PonderThis.net

Steve Moyer is a columnist and assistant editor of the monthly newsletter, Ponder This.... (www.ponderthis.net). He has been an investment real estate broker since 1982. Contact Steve at StephenLMoyer@aol.com.

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