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Homebuyer beware: the real estate game lacks fair play

January 14th, 2010 11:41 AM by Lehel S.

this is a good picture of what is going on right now............

Homebuyer beware: the real estate game lacks fair play

By Nick Love • Jan 5th, 2010

Consider a game of musical chairs, where the chairs represent single-family residences (SFRs). In this game, the music plays and everyone dances around, looking for a chair to snap up at the right moment. But there is a nasty twist. Some players are grabbing chairs before the music stops, taking them into another room where they remain unused, along with other chairs that never even made it to the game. When the music stops, many players are left standing. Only a few were able to make a mad dash and snap up a chair within reach.

This is the current climate for SFR real estate in California. Many future homeowners are left standing around looking for a home, but there is little inventory to be had for those intending to actually put the property to use.

There are five categories of players that purchase SFRs in the California multiple listing service (MLS) market:

  • homebuyers, the primary players, who are committed long-term and have agreed to occupy a property;
  • investors, fundamental long-term players, who purchase one-to-four unit SFRs to hold as income producing investments, and a profit on ultimate resale during retirement;
  • building contractors, who are involved in renovation, adding value to uninhabitable property in order to profit on the resale;
  • local government agencies, that buy up the foreclosed and vacant properties under a federal program designed to renovate a property in order to maintain neighborhoods and avoid vacant nuisances which depress neighborhood values and attract crime; and
  • speculators, (also known as dealers, flippers, hit-and-run artists, sandwichers and momentum traders) who are short-term passive owners, who do not renovate or improve but treat the property as inventory to be sold for a quick profit.

Homebuyers and investors are the first and best users of single family residences, whether free standing structures or multiple unit condo structures.

A homebuyer gets the best direct use out of an SFR property. They own and occupy the property; it fulfills their need for long-term shelter. Their ownership means a direct investment in their home which they will maintain, improve and generally engage in actions to raise property values in the neighborhood in which they live.

But California is a state where only about 55% of all residences (SFRs and condos) are owner-occupied, compared to nearly 80% owner-occupancy in the central part of the nation. The rate is lower in California for a variety of reasons, one being California’s economically mobile environment.

Thus investors who buy-to-let are a necessary part of the California real estate market. Investors purchase the other half of California’s residential properties, which includes large numbers of SFRs, to operate and maintain the properties for annual rental income. They are also interested in long-term gains from the return of their investment on a resale.

The inherent benefits for investors in the one-to-four unit residential real estate market are explained in an article published by the Federal Reserve Bank of Boston “The Myth of the Irresponsible Investor: Analysis of Southern New England’s Small Multifamily Properties.”

Their research comparing New England area investors and owner-occupants of small multifamily (SMF) properties (duplexes, triplexes or fourplex) showed that:

  • investors have better credit than owner-occupants;
  • investors use subprime mortgages to purchase SMF properties less frequently than owner-occupants;
  • investors in SMF properties received fewer notice of defaults (NOD) than owner-occupants; and
  • investors in SMF properties who do receive an NOD, receive them later in ownership than do owner-occupants.

The investor is distinguished from a speculator whose only desire is to flip the property as soon as possible after acquisition, and who pays little or no attention to maintenance in order to maximize quick profits.

Crowding out the homebuyer

Currently three chair thieves play in the real estate market game: speculators, government agencies and building contractors. These players are pulling properties off the market, holding the properties until they can resell them on their profitable re-entry into the market (or in the case of government agencies, a total recoup of their investment).

The purchase of homes by these secondary players limits the available inventory for homebuyers, a condition known as crowding out the homebuyer. Traditionally, this has been viewed as a problem by government agencies and the Federal Housing Administration (FHA).

However, the effort to keep SFRs available primarily to homebuyers has been set aside for two reasons:

  • in light of the foreclosure crisis, strong motives exist to get real estate owned (REO) properties into the hands of any private ownership, no matter the type; and
  • due to the real estate bubble, political stomach is gone for creating incentives for life-long tenants to become homeowners, and thus other players are presently the favored buyers of REOs.

Government agencies have shifted their efforts away from the homebuyer in the name of reducing neighborhood nuisance, crime and depressed property values. Some government agencies (like Riverside County) have taken to development schemes in order to keep REOs well-kept, but are invariably pulling these properties away from property users.

In the same vein, Fannie Mae’s First Look program gives priority to potential owner-occupants as buyers of foreclosed property during the first 15 days an REO is on the market. But this priority is insufficient, and will only serve to frustrate homebuyers involved in a financing process that consistently takes more than 15 days to negotiate a contract with a lender. Speculators on the other hand are ready with cash on hand to swoop in on the 16th day and contract to make the purchase while ignoring due diligence contingencies.

[For more information regarding the First Look program, see the January 2010 first tuesday news blog, Fannie Mae reveals owner-occupant preferential program.]

Building contractors engage in rehabilitation and renovation activities, with the goal of improving the property and then selling it. Unlike speculators, they do not merely wait for the market to increase the price — they add value to the property. Their rehab work can be invaluable in those REO situations where the previous owners damaged the property beyond the scope of an ordinary homebuyer’s repair skills and sweat equity investment.

Contribution of wealth (money) and human capital (labor) to the real estate itself is the participation which provides a long-term benefit to the real estate market. The first and best users of property are the homebuyers and investors. Government agencies and developers can and do act as constructive third-parties when they add value to the real estate through renovations and improvements.  But their participation should be limited, and secondary to homebuyers and investors. On top of current over-interference by government agencies and building contractors, inventory is too controlled by lenders and spread too thin to accommodate the two primary SFR users.

Speculators are the only players whose contribution to the real estate market is in no way constructive, and only serves to siphon funds from those who use or add value to the real estate market.

The zero-sum game

Speculators are passive players in the real estate market, never spending any time or effort on their property acquisitions. A speculator’s only interest is the market place momentum. They sit removed from their property, looking for a profit-window in order to market the property to a buyer at a higher price. The property is regarded as inventory to be taken off the shelf at the right market-moment and sold at the highest price possible.

The property is not a speculator’s concern, but only the profit made on the spread between their low purchase and high sell. Thus, speculation shifts wealth out of the pockets of both the seller who sold low and the buyer who bought high.  Implicitly, speculation pulls money (wealth) out of the market and into the pocket of the speculator, who then moves on, seeking the next market to sponge from. Nothing is contributed to the property, as with the developers or the government agencies. Nor is any sweat equity accrued, as with a diligent homeowner.

Thus, speculators add nothing to the value of real estate: no sweat equity, no enhancement through efficient management. No capital investment of any sort (either human capital or accumulated wealth) is added to California’s inventory of privately-held real estate.

By adding nothing, speculators are involved in a zero-sum game since the profit they skim is exactly equal to the amount of money their conduct takes from the pockets of sellers and buyers.  Sellers and buyers are left that much poorer (or less rich) than they should have been as the speculator slips in with quick cash to pull a juicy profit by sandwiching himself into the market’s short-term momentum.

Thinning out the secondary players

Speculators need to be harnessed and muzzled with adverse tax consequences for short-term ownership, strict code enforcement of ill-maintained or vacant properties, hazard insurance underwriting restrictions, significant downpayment requirements, increased mortgage rates as a speculator premium or a bar from access to the SFR market.

There are those who would like to see speculators thrive. Without speculators, providers of transactional services will lose redundant fees pulled out of multiple transactions on a property as it goes through the hands of the speculator.

The Federal Reserve Bank (The Fed) of Boston outlined various ways the state, local and even the federal government can help the real estate market reduce the appearance of speculators in the real estate market in a paper titled “Challenges of the Small Rental Property Sector.” The paper focuses on relieving the pressure of speculators in the small rental property sector.

The Fed of Boston argues that the government must defend owner-occupied properties. To keep these properties affordable for owner-occupied management means speculators must be kept out. Some possible tools for protecting owner-occupied SMF properties include:

  • avoiding complaint-driven code enforcement;
  • government-enacted programs targeting SMF properties for subsidies and assistance, since larger government-subsidized housing crowds out the market;
  • removing restrictive local zoning; and
  • providing for affordable financing of SMF properties.

Other tools for keeping speculators out of the SMF properties market include the carrot and the stick methods of enforcement.

Financial incentives for long-term investment (the carrot method) are broken up into two categories:

  • multi-tiered building and safety codes for SMF properties; and
  • technical assistance and training for SMF managers.

The state must change building and safety codes, allowing a multi-tiered code for SMF properties which:

  • gives priority to structural problems and safety, but allows time for owners to raise capital to fund corrections;
  • allows older SMF properties to be grandfathered into new codes, as long as this does not allow any major risks to the tenants; and
  • allows property owners themselves to make repairs rather than a licensed contractor.

Additionally, owner-occupants of SMF properties are more likely to make long-term investment in their properties if they are provided with technical assistance and training which:

  • promotes long-term maintenance practices and preservation;
  • educates regarding marketing, fair housing, tax facts and business budgeting; and
  • creates financial incentives for taking courses.

Effective and precise regulation by the government (the stick method) is the second tool in blocking speculators from the market. Severe sanctions should be created for speculators who purchase and fail to comply with code standards in order to flip the property for nominal cost.

Some of these suggestions by The Fed of Boston may have some promise, and some are just pipe dreams. But the government does need to use both “carrots” and “sticks” in order to discourage and thin out the secondary players in the real estate market. The health and stability of the market rests in homebuyers and investors as the primary users of real estate. Brokers, the gatekeepers of the real estate market, must not ignore these fundamentals, as a matter of their own long-term best interests.

Posted in:General
Posted by Lehel S. on January 14th, 2010 11:41 AM

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