Sunday, June 20, 2010

Real Estate Observations and a Sunday Cook

Plenty going on this weekend in the world of finance. I think I will wait until tomorrow to go over new items, just a guest post and today's cook.

Real Estate as an Investment, Not a Lotto Ticket
Reader Gawains is a Real Estate insider and has years of experience working in the field. Gawains submitted another housing essay and I am including it here as it covers some things which are important:

I remember back in 1987 when the stock market crashed the owner and principal shareholder of Wal-Mart was on tv, and this stupid reporter asked him, "How does it feel to lose a billion dollars in a day?" Mr. Wal-Mart said, "I haven't lost anything, I still own the stock."

Exactly. This really is what the gloom-and-doomers misunderstand in their dire prognostications of evaporated wealth, the difference between perceived loss and actual loss. Mr. Wal-Mart surely would have lost a billion dollars if he had sold his stock in 1987, but he didn't. He simply held onto it and waited for the market to recover. Now, in 2010, that stock is worth considerably more than $1 billion.

The lesson to be learned here is not to panic because of fluctuations in the market. You only lose money if you are forced to sell, especially in a severe downturn. Panic will only lead you down the road to ruin.
It's the same with housing, or any other investment for that matter. A home is the single largest investment most people make in their lifetimes, so it is important to understand the dynamics particular to the real estate market in order not to behave foolishly in response to misinformation or perceived loss and thus realize an actual loss.

First, some definitions of terms.

Fair Market Value (FMV) is an estimate, usually within +/- 10%, of what a house will sell for. Also known as a Broker's Price Opinion (BPO), it is prepared by a licensed broker or realtor and is based on nearest, most recent comparable sales. Factors considered include age, size, location, condition, amenities, etc. The FMV is used to determine the list price.

Market Value (MV) is the actual sales price, what a willing buyer and a willing seller agree to.

Appraisal Value (ApV) is similar to FMV. The difference between a price opinion and an appraisal is, well, not much, other than cost ($300!). An appraisal can only be prepared by a licensed appraiser. It is more detailed than a BPO, with several more pages that have pictures, maps and whatnot. It also includes factors such as quality of construction and price per square foot, and uses different methods to estimate value. However, ultimately an appraisal is based on nearest, most recent comparable sales, just like a BPO. The primary difference though is that an appraisal is ordered by the lender, to justify the loan, and charged to the buyer at closing. Because the appraiser must be given a copy of the sales contract prior to performing the appraisal, he or she often looks for comparable prices rather than comparable homes, because his or her job is to justify the loan, not offer an estimate of fair market value. This is why ApV should not be used to determine list price. The appraiser does not have to sell the house! The broker does. Thus, a BPO is a far more reliable estimation of value. (A realtor only gets paid when the house sells, and incurs numerous expenses in the process, such as marketing, advertising, signage, gas for showings. Therefore, a realtor is not going to list a house at a price it will not sell for--that would be a money losing proposition.)

Assessed Value (AsV) is what the property is taxed on. This is prepared by the county appraiser (who never even enters the house!). It is in no way indicative of value, only of expenses involved with ownership of the property. A good thing to know, by the way.

It is crucial to understand and not confuse these terms in the purchase or sale of a house.

Now, let's cut to the chase. Here is what the prevaricators in the press fail to comprehend, and it's a simple formula.

E = MV - PO

Equity equals market value minus principal owed. That is the fundamental rule governing investment in real estate. A house is only worth what someone is willing to pay for it. Period.

During the mania of the credit bubble, a lot of people took out toxic loans--0% down, interest only, adjustable rate mortgages--and rolled over closing costs (in other words, borrowed more money than they actually paid for the house). Those people are now in a world of hurt.

It matters just as much the type of financing you take out--20% down on a 15-year fixed rate note is the best--as it does the type of house you buy. An older, well-maintained home in an established neighborhood with good schools is gold in real estate, because properties like that tend not to depreciate and can be sold at any time. A new condo in a 20-story building on the Gulf Coast, bought for 0% down on a 30-year ARM, is not. You're now the sole occupant in a disaster zone.

Prudence is the best course in all things. Do not buy into a mania and do not sell into a panic. Rather, make an informed and intelligent investment. Yeah, prices are declining, cratering in some areas, but that's what markets do, they fluctuate and some implode. So what? If you buy on a whim at the high and sell on a whine at the low, naturally you're going to lose money. Duh.

But if you made a prudent decision, not only in housing but in financing, these market swings do not affect you. Simply live in your house and ride out the waves. Pay off your mortgage, then when it comes time for you to sell you will realize a return if not an actual gain. The market will recover eventually, so now is not the time to panic.

Like Mr. Wal-Mart, you still own the house. It's a capital savings account with expenses. When equity (savings) equals market value (sales price) minus principal owed (nothing), then you will have protected if not generated wealth.

Think of taxes, utilities, maintenance, renovations as the cost of preserving or making money. Not as the debt burden most make them out to be.
An excellent essay and one that adds value for myself and the readers overall. If you found this helpful, let Gawains know in the comments.

I responded via email:
Great points. I have always contended that real estate is one of the very best investments IF you buy under the right kinds of terms and withing your means, as you say. While I am a "gloom and doomer" the problem this time around was so many were not buying to hold or generate rental income, but to flip in 6 months to a year. That's the core of it.
I think one of the worst things to come out of the housing boom/bust is that a solid, long term investment like a home was abused like an internet stock by flippers and dreamers. It is going to be a LONG time before old values are even approached.

Sunday Cooks
It was Big Steel Keg time again. I was at the grocery store and saw some beef ribs that looked ok. Usually I get mine at a local butcher shop, but I figured why not. I wanted to make some pulled pork sandwiches so I bought a mini pork picnic (known as a Butt, I am not kidding) for that purpose.

Here are the items before I applied the rub:

Here they are near the end of the cook:

The beef ribs were good, but not as good as the butcher shop sets I usually get. These were a bit too fatty and stringy. The pork was a total disaster and I think that piece was more like a ham than a real picnic shoulder. Oh well, what can you do?

Have a good night.


sedintary state said...

Speaking of Acradabra, I was surprised recently to find out that its connotation as a 'magic word' comes because it forms some unusual patterns when three spellings of it are aligned in a triangle pattern. Who knew?

And further, to my untrained eye GYC it looks like you used this word to get those chops turning out so perfectly.

The song still blows though.

getyourselfconnected said...

Thanks! Who needs magic when you can command the darkside of the force?????

getyourselfconnected said...

I love these kinds of articles should the end be near:

GawainsGhost said...

I appreciate the compliment, GYC. And I hope that what I write calms some nerves in these troubled times.

You're right, it's going to be a long time before housing prices return to what they were just a few years ago. This is because rampant mortgage fraud, appraisal fraud and brokerage fraud drove prices to unsustainable levels, far beyond income affordability. It's going to take years for the correction to occur, and that's not allowing for the surplus of inventory on the market.

The thing is this. Most people don't understand finance. All of these buyers who think that rolling over closing costs is free money they can use for rennovations or a new car or boat, whatever. Are they out of their minds?! They're going to be paying interest on their closing costs for decades.

An interest-only loan makes sense for certain buyers. Say you're the manager of a franchise restaurant. You get paid a salary, $60,000, but you also get a bonus at the end of the year based on how many plates the restaurant sells. That could be as much as $240,000, so your actual income is really $300,000. You just don't realize it until year end.

In that case, an interest-only loan to purchase a house makes perfect sense. You can make minimum payments each month out of your salary, then when you get your bonus you can pay down the principal or refinance.

It is not the type of financing for Joe Schmoe with a no documentation, stated income loan. (I'm not going to name the bank which began this practice in the 1920s, which led directly to the Great Depression, but it's initials are Well's Fargo.)

What we are experiencing is a credit crisis manifested in housing. Prices escalated, in some areas to the extreme, due to fraudulent financing. Now there will be a market correction, and I personally would like to see some prosecutions to go along with it.

We haven't seen the bottom yet, but I expect housing prices to decline 50% from their highs in certain areas where mortgage and appraisal fraud were most rampant.

From my perspective, I can't sell a house, even a repossessed house, to someone who can't afford to pay for it. So employment and wages are a major concern to me.

That said, if you made an intelligent and informed decision in the purchase of your home--that is, didn't buy into all the bubble hype--then you really have nothing to worry about. The market will recover eventually.

It's the speculators and flippers who are in a world of hurt.

A house is a place to line, not a lottery ticket.

getyourselfconnected said...

thanks again for the write up!

GawainsGhost said...

A house is a place to *live in*.

I'm not sure whether it's whiskey to blame for for my typos, or just the sorry state of the industry.

Anonymous said...

Do you really drink Cola and even light?? Wow, as a scientist? Aspartame hello!

mypoint cook said...

Thanks to you give me a great post and content.I appreciate to you for a good content full posts.Thanks...Werribee Real Esta

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