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Top Ten Marketing Tips

• By Tom Anderson
• Producer's Web
• 12.14.2007
• PENSCO Trust Company
• CEO & Founder
• San Francisco, CA

Reading the newspaper these days, you would think that what is happening to real estate is similar to what happened to the stock market in 1929. But, a savvy advisor can delve deeper, assess the situation and help guide clients to financial success in an otherwise depressed market. With abrupt changes in any market, there are likely also opportunities. In the current environment, there will be real estate investment opportunities within the next year that probably will not exist again for another 10 years. This article outlines what is happening with real estate today, discusses the causal effects, and suggests strategies that advisors and investors can use to take advantage of the tumultuous market.

Undoubtedly, we are seeing a significant slackening in demand and values for residential property, but not necessarily for the reasons one might assume. The primary reason, of course, is the collapse of the subprime market, but there are other reasons as well. First, let’s understand what has happened in the subprime market – a problem waiting to happen – with families being underwritten for 0 percent- to 5 percent-down mortgages they could barely afford and built-in adjustable rates that they surely couldn’t afford. These adjustable-rate mortgages (ARMs) can be like ticking time bombs. Unfortunately, they have just begun to go off.

The government has figured this out and is teaming up with Congress to get our nation’s banks and other mortgage lenders to retract or freeze (at least temporarily) the rate increases associated with these loans. If you think this won’t help borrowers and reduce the number of foreclosures, you have to consider the fact that the crisis didn’t start until the rate increases started kicking in. It’s not that the loan is subprime and made to a borrower who may not have the best credit or income statement. The problem is that while a borrower may be able to afford the initial monthly mortgage payment of $1,000, for example, he can’t necessarily afford it when it jumps to $1,400 per month as he probably has the same job and financial situation he did when he moved in.

Another factor adding to the foreclosure rate is that the subprime mortgages, doled out with little or no down payment requirement, don’t encourage the borrowers to tough it out because borrowers have no equity or “skin in the game.” On the contrary, we don’t see a surge in foreclosures in homes for which borrowers have put 30 percent to 40 percent down. But for those with little at stake and facing major financial hardship, foreclosure is usually inevitable.

What a smart investor will see in this situation is that borrowers who may potentially be forced out of home ownership are still employed and still have to live somewhere – as is demonstrated by the rise in rentals and rental rates in most areas when there is a significant rise in foreclosures. This means that a real estate investor who is able to take advantage of the current market and hold could potentially buy residential properties at low prices, rent them out for cash flow and eventual appreciation, and recoup costs through these solid rent rates.

While real estate investment opportunities are being created as a result of the free-falling real estate market, some sanity is being realized to staunch the bleeding. But, if the government is successful in persuading lenders to delay the imposition of the higher ARM rates associated with the subprime market, won’t someone pay the price? Of course. And it will be the investors in those mortgages.

Most banks and other mortgage brokers will either underwrite and sell the initial subprime loan or simply broker it. Ultimately, these loans are usually sold by the original lenders to others who are passive investors through investment pools such as those offered through Freddie Mac, Fannie Mae, hedge funds, wirehouses and other institutions. Regardless of who ends up holding the subprime “bag,” they will suffer when the yield of their investment declines with a delay in the ARM pickup. But isn’t that better than writing the loan off altogether when the borrower defaults? Of course it is. And, although through the long and protracted legal process of foreclosure, the institution could reclaim a portion of their principal, it would no doubt be at a net loss in today’s environment. Consequently, I would think that retaining principal and a reasonable interest-bearing loan is a better choice than insisting on the original terms, forcing foreclosure and trying to sell in a down market. In other words, half a loaf is better than none, and I can’t think of a faster way to forestall any more damage to the subprime marketplace than by (temporarily) freezing further ARM hikes.

Many lending institutions holding these loans are getting smart and have even volunteered to refinance their customers into long-term fixed mortgages, with some offering even better rates than with the original loans. Why? Because they know what is coming if they don’t, and they also know that they probably have good borrowers (those who can afford the mortgage and pay it) at a lower fixed rate. Once financial institutions see that the bulk of their loan portfolios are performing again, stability in the mortgage lending industry will be restored.

In the current environment, however, what makes matters worse is that in addition to all of the foreclosures, credit is tightening extremely. Borrowers need higher credit ratings and larger down payments, and even then are not guaranteed a loan. What does it mean when perfectly financially-abled individuals, who could easily make monthly mortgage payments, can’t get a loan? It means no one can – and subsequently no one is – buying until the prices get to the level that the tighter underwriting standards are satisfied. People can’t get into a house; not because they can’t afford it, but because they can’t get credit. So, the current credit crunch is artificially affecting supply and demand. And, when potential buyers are taken out of the marketplace through the pricing of credit, the number of buyers in a market declines in relation to the number of sellers, resulting in a decline in prices (real estate values). For the sales that do occur, these new, lower prices generally reduce the comparables in a neighborhood upon which future near-term sales prices are determined, and eventually an equilibrium between supply and demand returns to the market as prices settle to that level.

Nevertheless, what is happening in the midst of the dramatic shift in market values for real estate is the creation of the largest opportunity for real estate investors in the last 10 years – especially for those who can afford to buy and hold. In general, whenever there is a sudden and significant turn of economic events in one asset class, even in a negative sense, there is an opportunity to run against the herd that’s leaving the market, buy at the abyss and wait for the inevitable return of the market. While many sophisticated and skilled “flippers” made a financial killing in the rising real estate market from 2002 through the early part of 2006, today’s investors can take advantage of discount pricing from residents and developers, allowing them to buy low, hold and rent, and then later sell when appreciation makes it worthwhile.

On the other hand, although we are not seeing the frenetic flipping that we saw in Florida, Phoenix and Las Vegas at its peak in 2005, flipping is still going on. Three months ago, near where I live, for example, some residential property that was recently sold for $930,000 was auctioned off at $450,000. That means that market prices three months ago (based on supply and demand) supported a level of pricing that was 206 percent higher than today’s. While the market could take two to three years to come back, the reality is that the area in question is still growing in population and eventually there is a good chance of seeing appreciation that will bring values back to 2006 levels. That can represent a substantial gain for an investor who can afford to wait.

Today’s domestic real estate market reflects the historical reality that the real estate market is not a national, but rather a local phenomenon. I read last week that less than 20 miles from a town that had 1,700 homes in foreclosure, people were overbidding to buy high-end property. In fact, there was an article recently in a local paper east of San Francisco, that described people sleeping overnight in lines to buy units in a new development (in the vicinity of the previously mentioned properties) for their offering prices, which started at $350,000. These are just examples of how localized the situation in the overall real estate market is, and how related it is to the subprime borrowers and lenders.

One county in northern California – Sonoma – a region heavily hurt by the subprime crisis, still reflects the reality of how the crisis mostly affects those borrowers, properties and locations associated with subprime loans. Changes in values on residential properties sold between October 2006 and October 2007 ranged from down 30.4 percent to up 73.4 percent for high-end homes, and down 51.1 percent to up 25.8 percent for medium-priced homes. One can see that while significant swings in values are occurring across the country, buying opportunities are being created on both sides of the fulcrum based on specific market segments and properties, thus benefiting investors who buy before the up-tick or after the down-tick.

Those who are unfortunately caught up in the subprime crisis, of course, don’t really care who benefits when they are forced out of their home. But, the fact is, they are creating opportunities for those with sufficient funds to purchase their properties from lenders after foreclosure. Take Donald Trump; he currently has full-page ads in certain regional newspapers to promote his educational program aimed at teaching people how to get rich on foreclosures. These are strategies that benefit the investor. But there are also win-win investments that can help the borrower as well as the investor. For example, the borrower is helped back on his feet through either a lease option following a purchase by an investor, or through an equity-share arrangement.

In both cases, an investor steps in before foreclosure to help the borrower until the property can either be sold or refinanced. For his effort, the investor gets a percentage of the profit at the time of sale or refinancing. Such strategies are examples of how investors can help themselves and those victimized by unscrupulous ARM underwriters. By the way, I am surmising that the government will be taking action and introducing more regulation into this industry to prevent a recurrence of today’s debacle in the future.

Another example of how real estate investment opportunities can occur on an individual level is demonstrated by a profitable flip in the works (as of the first week in December). Apparently, as reported in the Wall Street Journal, a developer named Wilbur Ray Todd Jr. of Todd Builders purchased Michael Vick’s home for $450,000. And yes, it’s the same Michael Vick who is the former quarterback for the Atlanta Falcons and is now in jail for his role in illegal dog fighting. Todd plans on cleaning up Vick’s former house and reselling it in a week at its appraised value of $747,000. After all, it is a 4,600 square foot home with five bedrooms on 15 acres with a professional basketball court. Just because its former owner is going to jail doesn’t necessarily reduce its value. Worst case, Todd plans to auction the house at a substantial profit if it doesn’t sell quickly at its appraised value. This is another example of how local and property-specific real estate investing can be profitable, and how extraordinary gains can result from what may appear to be the most adverse circumstances.

Another example of how a savvy investor can take advantage of current market conditions comes from a client who recently took his $300 self-directed IRA, invested $10 of it to consummate a real estate option contract on a residence owned by another investor who wanted liquidity for the right to buy the house for $350,000. Within a week of executing the contract, which had a 30-day expiration, he found another buyer willing to pay $525,000. So his $10 returned a tax-deferred profit of $175,000 in less than one week, all without actually purchasing the property – just by merely assigning the contract. All of the profit is returned to the IRA to be reinvested and grow tax-deferred until such time that the investor takes distributions.

In summary, don’t advise anyone to run scared with the herd out of a market seemingly headed south before you know all the facts. Domestic real estate opportunities may be at their 10-year peak for knowledgeable investors and their advisors. Sometimes all it takes is a change in perspective to spot the gold right there in front of you.