The old adage “the early bird gets the worm” points to the advantage of being first to market. But, has anyone ever thought about the early worm, clearly he was not so lucky. Many of the people who are jumping into the foreclosure market now may be the early worms.
Typically, I am the first one to support jumping into a market that has sustained a significant decline in fundamentals and an increase in the foreclosure rate. The problem with today’s market is the lack of an exit strategy for this type of investment. Take Michigan for example, I luckily got out of this market in 2005 during a downturn. While I made a healthy profit, the investors who bought properties during that time are now the same investors in foreclosure.
The difference between the 2005 market and today is simply access to capital. Many foreclosure markets have two types of buyers. The most common buyers in these markets are low-income families looking to move into their first or second home. In the past these buyers were able to secure subprime or other credit neutral financing. With these vehicles gone or very hard to find, these buyers have been taken out of the market.
The other buyers in these markets are investors. Typically, savvier than families, investors like to get in for a bargain. Unfortunately commercial interest rates have been steadily rising and the prospect of moving these properties has been declining. The commercial interest rate directly affects the value potential of the property. Consider an increase in the commercial multifamily interest rate from 6% to 7.5%. On a $100,000 loan, that is about $100 a month payment increase. With rents holding steady in many markets, the investor will probably have to eat this increase.
Two to five years ago investors could simply rent a property out while waiting for a sale. That option has almost been taken away with the increase in interest rates. Additionally, having a renter in the property opened the buyer pool up further to cash flow investors. Now, the only investors left to turn to are the speculators, looking to buy low, hold, and sell when the market rebounds.
Speculators too have been burned by this market, however. On the positive side, the very nature of speculative buying will keep them in the game. Conversely, they will be smarter and looking for even deeper discounts. This means that investors looking to cash out of a foreclosure will be looking at prices equal to or less than what they paid.
One final watch out for flippers and other foreclosure buyers out there is the appraisal values of the property. Appraisals always lag the market since they use trailing market data. If you think that your foreclosure will ultimately sale for the current market value, you are dead wrong. Key signs to look for in these types of market are time on the market and the number of reduced listings. Foreclosures themselves hurt market value, so the simple act of purchasing one or more in a neighborhood signals a market decline.
Acting before the market in real estate can net investors big gains. Make sure you have a sound exit strategy in today’s market, however. Unlike past down markets, the capital constraints and rising cost of capital could make many investors the early worm for later birds.
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