There’s always something to howl about.

What Happens to the Early Worm?

Quite a while back I asked a question, if the early bird gets the worm, what is the early worms reward for being early? In this tumultuous market we have already seem many early worms. Several months ago a lot of people began jumping back into real estate only to be crushed by the weight of numerous new market developments. But surely the worst is behind us? Think again early worms…

Real Estate is as slow as the stock market is fast. It takes time for sellers to get desperate enough to lower their price and it takes time for buyers’ incomes to rise to the level where they can afford housing prices. The income / price equation did not get out of whack overnight, so buyers and sellers should not expect it to correct itself overnight either.

The Bloodhound Blog is a very deceptive place. You are looking at some of the best real estate agents in the business here. So when they write that their business has not dropped off, it might lead the casual reader to believe that the real estate market is not in a tailspin or even that real estate is close to a bottom. Do not be lulled into a false sense of optimism. This group is adaptable, smart and most of all well above average.

Consider these national facts about the economy and then let’s draw some conclusions about the future of real estate (taken from the latest release of the Biege Book and other financial sources):

-Consumer spending is down
-Manufacturing is down and declining
-Jobless claims are up and rising
-Housing remains weak
-Housing inventory remains well above average
-Dow Jones has dropped nearly 40% over the past six months

The most significant thing on the list above has to be the decline in the stock market. This represents a decline in confidence in the global economy. This level of decline says that investors believe businesses could be in for sustained economic distress. It stands to reason that businesses in distress tighten their belts by laying off workers and reducing compensation. It further stands to reason that consumers without jobs or with reduced salaries do not buy houses (at least not anymore). They rent or remain in their house, using their current savings to cushion the blow of a potential layoff.

To add even more words of caution, it can still be said that prices and income are not aligned. Lots of people point out that housing still has room to decline because the historical ratio of median housing prices to median income is still too high. Couple that with the increased scrutiny that consumers face at the mortgage desk and you have a recipe for further price decline.

And for those readers who would still throw caution to the wind, think about the way real estate equity works. Real estate is a highly leveraged investment. For this reason an investor can generate a 10% return a year on 2% price appreciation. Unfortunately leverage cuts both ways. A 2% decline in price would result in a 10% loss in equity. Here is a very simple example. Let’s say I find a house that was selling for $150,000 and I get it for a steal at $100,000. I put 20% down or $20,000 and take out a mortgage for $80,000 and the house is mine. If in the first year the value goes down 10% to $90,000, I lose 50% of my equity because I still owe about $80,000, leaving me with only $10,000. Even if the market then settles and I get the standard 2-3% appreciation per year, it will take me about 6 years to get back even.

On the other hand, let’s say I wait a year and the market settles. Sure, I may pay $105,000 for the same property, but I am still getting 2-3% appreciation a year, which translates to a 10-15% equity growth. There is really no penalty for waiting in a market like this. The days of 10-15% appreciation in any market are gone, so there is no fear of missing the boat. The only fear now is getting on the Titanic.

This writer suggests that readers should find a safe place to watch the fireworks. Now is a great time to get to know your markets better and survey properties of interest. Cruise the foreclosure / short sale circuit, build relationships and hoard cash. As the markets begin to turn, the best informed investor will be able to react quickly. Having cash available and a strong knowledge of where and what you want to invest in will position investors much better than those that caught the falling knives.