Recently by Mark R. Crovelli: Don't Disarm the Mentally Ill
As a graduate student and construction worker in San Diego from 2003-2005, I was afforded an up-close view of the inflation of the last real estate bubble. It was a truly exciting time to work in the building industry in Southern California because there was so much money sloshing around. I literally couldn't even walk into Home Depot without being accosted by hordes of greedy homeowners and slippery contractors offering to pay cash to anyone willing to do construction work.
Everyone I knew was making piles of easy money buying and flipping homes, and I often heard that I was just plain stupid to not be buying and flipping some of my own. I was content to just be able to finance graduate school without debt, however. I decided to move back to Colorado to finish graduate school at almost precisely the moment that my friends started making really big money in real estate. They all thought that I was insanely stupid to leave.
A year later, I wrote an article predicting the collapse of the real estate bubble. A year after that, my friends in Southern California started losing their jobs, and a year after that many of my old friends started losing big money. My decision to avoid real estate investment looked a lot less stupid at that point.
Only six years have passed since the largest housing bubble in world history imploded, and I am once again receiving investment advice from my friends involving real estate. Instead of buying and flipping homes, they are now promising me piles of easy money if I purchase "investment homes" to rent out. My friends are not quite as exuberant as Californians were in 2006, but the pitch of their excitement is definitely rising.
I am not sold on the idea at all, however. In fact, I think my friends who are piling into "investment properties" right now are setting themselves up for losses on a scale only surpassed by the losses suffered in the last real estate crash. Real estate is still extremely dangerous, and only people with a solid financial cushion and who are willing to take gargantuan risk should be moving into it.
In order to see why this is the case, first consider the role of property taxes in real estate investment. Quite obviously, the higher the rate at which a property is taxed, ceteris paribus, the lower the value of that piece of property. This much is obvious. But what most real estate investors do not consider at all is the fact that property taxes can change. The fact that taxes have been X amount for the past ten or twenty years is completely irrelevant if a government decides to raise or lower the rate at which it taxes property.
Given this, the important consideration from an investment standpoint is the rate at which real estate will be taxed in the future. In order to make an informed guess about future property taxes, however, the investor must attempt to forecast the financial condition of the government that taxes the real estate in any given area. Governments facing serious financial difficulty in the future should be expected to try to gouge property owners to make up for budget and pension shortfalls.
The problem is, however, that it is almost impossible to figure out the financial health of any given municipality. The municipal bond market, which is a decent proxy measure of municipal financial health, is one of the most opaque, illiquid and misleading markets out there. Even the incompetent SEC admits this, by the way. Not only that, but many municipalities that are seemingly healthy, and which are still able to borrow massive amounts of money at low rates today, are completely bankrupt from a long term perspective. Many school districts in California, for example, have been engaging in myopic borrowing schemes that basically ensure their future insolvency. More accurately, these municipalities will assuredly be bankrupt in the future if they don't raise property taxes dramatically.
To think that these bankrupt municipal governments and the hoards of government workers and pensioners they parasitically support are going to just file for bankruptcy and lay off massive numbers of teachers, police officers and firemen is just plain silly. Of course they are going to try to pry as much money out of their tax bases as they can. If you are a property owner that means you, and your property taxes are going up — potentially substantially — at some point in the future.
If you think this is merely idle speculation, it is useful to note that the largest tax revolt in U.S. history occurred during the Great Depression primarily over property tax rates, as David Beito has documented. The obvious reason why real estate stuck out as an easy target for government pilfering during the Great Depression was, as Beito notes:
[R]eal property could not be effectively hidden from [the government's] purview, the assessor and collector did not have to engage in costly and unpopular detective work. For all intents and purposes, taxpayers could not conceal their taxable real estate from the authorities. When real estate taxpayers, either by choice or necessity, lapsed into arrears, their delinquency became apparent for all to see.
Owners of visible and immovable wealth are prime targets for bankrupt governments looking for low hanging fruit. Greek homeowners found this out the hard way last year. Hence, investing in real estate at a point when huge numbers of governments are about to go bankrupt is just an invitation for them to rob you. When the municipal bond bubble bursts, and municipal governments are en effect barred from borrowing money to finance their "services" and pension schemes, where do you think they will turn for money? The answer, of course, is real estate owners.
In short, unless you are some sort of expert on the financial wellbeing of the municipality in which you are planning to purchase property, which is almost impossible for anyone to be, you are making a gigantic wager on future tax rates over the next 30 years. That, to me, is the definition of reckless stupidity.
Property taxes are not the only worrying factor for prospective investors in real estate. Another fantastically troubling issue is the fact that interest rates are bound to rise at some point. Even setting aside the question of whether rates will rise in the next few years, they are bound to rise at some point before that 30 year mortgage you are considering taking out is fully paid off. No one with even a modicum of brain matter could possibly think that we could have near zero rates for the next thirty years.
What this means from an investment standpoint is that you will probably be underwater at some point if you buy an investment property right now. In plain language, being "underwater" means is that the value of the home will be less than the amount you owe on the mortgage. The reason why you are likely to get underwater is that when interest rates rise, fewer people are either willing or able to purchase homes at existing prices. While a mortgage payment on a $200,000 loan at 5% is $1282, the payment on the same mortgage is $1675 if rates rise to just 8%. A move of just 3%, which is not large from an historical perspective, results in almost a $400 rise in a mortgage payment. This means that fewer and fewer people are willing or can afford to buy houses at existing prices as rates rise. Hence, home prices will inexorably fall as a result of a rise in rates.
Also note that when a person is paying off a mortgage, even a mortgage on an investment property, he is paying off mostly interest at the beginning of the loan term. So, even though you might be thinking that you are building up equity in the home that will offset the risk of being underwater at some point, you are probably not building up equity nearly as quickly as you think. If the value of the home falls 20%, which is perfectly possible in a market manipulated by government as much as this one is, you are very unlikely to have built up enough equity to be able to get out of debt if you have to sell the home before you pay off the mortgage. This means you are stuck with this "investment home" until home prices rebound, assuming that the ever do.
This is not a problem for rich investors who buy homes outright with cash, but, as was noted above, what kind of a lunatic would want to park hundreds of thousands of dollars in an investment that can't be hidden from government and should be expected to be heavily taxed by bankrupt municipalities looking for easy targets in the future?
The popular imagination takes it for granted that it is smart to move into real estate when rates are low, but the picture is much more complicated than that today. Prospective homeowners, especially young ones, should realize just how much of a hindrance real estate investment can become. Almost 40% of younger homeowners are already underwater today, and that number will grow when rates rise and home prices fall again. When that happens, these homeowners are stuck with the investment. Moving away from the home becomes more difficult, selling it almost impossible, and they are in even bigger trouble if they lose their jobs. Under such circumstances, renting out the property can be the only option, but, as we will see below, the future of rental prices in this country is far from rosy.
A final consideration that seems to be slipping everyone's minds today is that rising interest rates will mean that other investment opportunities are opening up in other sectors of the economy. There will be opportunities in CD's, corporate bonds, and money market funds, for example, to earn a very good return on one's money without the need to tie up one's money in a 30-year investment. These opportunities will be opening up at precisely the time that home prices will be falling due to rising rates. Today's investors in real estate will have their money tied up in an investment that is falling in price, and they will not be in a position to capitalize on these opportunities.
One of most frequently citied issues influencing real estate investors today appears to be a fear of inflation. As a devotee of the Austrian School of economics, I view it as a positive thing that inflation fears are more widespread than ever before in my lifetime, but I worry that these people are not viewing the situation with a wide enough lens.
The popular line of thinking when it comes to real estate and inflation runs something like this: If you purchase a home today with a fixed loan at 5%, you will wind up paying off the mortgage with dollars that are worth much less than they are today. You will thus wind up paying much less for the home than it is actually worth.
This line of thinking is correct, as far as it goes, but it does not capture the entire picture. Specifically, this simple line of reasoning fails to capture the fact that banks would be massively hit by such inflation. The banks and other investors holding mortgage-backed securities would soon discover that they were holding an investment that was turning out to yield much less than they expected. Instead of earning, say, 5% from the interest on these mortgages, they would soon find out that they were holding a security that was earning negative returns, taking inflation into account. This much is just obvious, since inflation inexorably benefits debtors and harms creditors.
Where things get interesting, however, is how the banks and other Wall Street investors are bound to respond in the face of these massive real losses on their mortgage portfolios. Prospective real estate investors today must just assume that the banks and other Wall Street investors are simply going to sit back and say "Hey, we are suffering huge real losses on those mortgages from before the inflation. I guess we just have to take it. Too bad for us."
More realistic, I think, is to assume that the banking cartel is going to do everything in its vast power to weasel out of the mortgages, and that Congress and the judicial system are bound to help them to do it. The last six years were basically a gigantic practice run for the bankers in how to save their sorry asses through legal obfuscation, threats of "systemic failure," and using their corrupt buddies in government to screw ordinary Americans. If you think the banks are above doing this again when they start taking massive inflation hits to their portfolios, you are a much more trusting person than I.
The legal basis for weaseling out of these mortgages is already in place, and it is called "calling in" the loans. Virtually every mortgage contract has provisions for calling in loans, which means that the lender is allowed to demand full repayment of the loan prior to the loan's completion date. Usually, these clauses involve situations when the debtor has failed to make a payment or to pay his property taxes. All the banks need to do is encourage local governments to raise property taxes, which they are bound to do anyway since most of them are broke, and this will put more and more homeowners in arrears in paying them. This is almost exactly what happened in the Great Depression. At the same time, the banks will immediately call in all loans that involved any missed payments in the past (and there are massive numbers of people who have missed payments over the last six years), and you have a perfect escape hatch for the banker scumbags to get out of these loans.
There are surely other ways than this for the bankers to save their own asses, but the point is that investors in real estate are just plain kidding themselves if they think that they are going to outsmart the American banking cartel and the corrupt American congress when it comes to inflation and real estate. After all, what good is a cartel if it can't act in times of crisis to save its own members' asses and screw everyone else?
The final nail the real estate coffin, from my perspective, is the fact that rental prices in the future can't possibly live up to current expectations. Rental prices and home prices in general are currently inflated due to the "extraordinary" number of vacant homes all around the country. The artificial restriction of supply that has occurred by having these homes sitting vacant simply cannot last. One way or another, these homes are eventually going to be occupied by Americans or foreigners. Some of them will simply be "homesteaded" by squatters. Others will be bought by starry-eyed investors hoping to rent them out. Still others will be bought by foreign gangs hoping to launder money with the assistance of the National Association of Realtors. No matter how these homes wind up being occupied, they will put downward pressure on both home prices and rental prices going forward.
This issue is compounded by the normal problems associated with renting properties, like finding reliable renters who are not going to trash the place, regular maintenance costs on cheaply built houses, and finding renters who will pay their rent on time. Add to this the fact that the insurance companies that insure these homes are sitting on piles upon piles of government debt, which will obviously be devastated by the bursting of the bond bubble, and you have a recipe for the next real estate catastrophe.
It does not take a rocket scientist to realize that the bursting of the largest real estate bubble in world history is bound to last for more than a handful of years. This is especially true when it occurs at a time when governments all over the world, including the supposed hegemon, are completely broke. To think that investing one's money in an asset that can't be hidden and that can't be moved at such a time is "smart investing" is sublimely naive.
Now is a time for protecting and, for a lack of a better term, concealing one's assets from the prying eyes of bankrupt governments. Money that looks too easy to make probably is, and money that's parked in a manner that looters can see, (and government is the best looter in history), will probably be stolen.
Keep this in mind the next time you dental hygienist or your brother in law tells you that you are going to become a millionaire if you just start buying houses today.
Mark R. Crovelli [send him mail] writes from Denver, Colorado.