Few people buy real estate for cash, a reality which means that to play the investment game you need access to capital — especially capital which is cheap today and cheap tomorrow.
One of the reasons so many people are now facing foreclosure is that they only got half the cheap-money formula right. They found loans with low costs up front but not low costs year-after-year. The result was that when up-front teaser rates ground to a halt, monthly costs immediately began to soar, sometimes rising 40 percent, 50 percent and more.
However we’re now at a very unusual point in financial history, one which home buyers and foreclosure investors may want to examine with care. During the months of March and April interest rates were at or near long-time historic lows. No less important, interest rates and risk were actually upside down.
Rates & Risk
The usual equation for interest rates is plain: Less risk equals lower rates. If you have good credit and a hefty down payment you’ll get a lower rate then someone on the brink of financial failure. Another way to look at risk is this: Some loan formats are less risky then others. Fixed-rate loans with set monthly payments, for example, are regarded as less risky than adjustable-rate mortgages and their changing costs.
But if risk is an issue, why do ARMs usually have a lower start rate than fixed-rate mortgages? The answer is that lenders subsidize up-front ARM costs because they worry about rising rates in the future.
In other words, if you finance with a fixed-rate mortgage you have a hedge against inflation. If you finance with an ARM, then the lender has the hedge and you’ll be faced with higher costs if rates go up over time. To induce you to take that more-risky mortgage the lender will offer a lower price up front for an ARM and more liberal qualification standards so you can borrow more.
During the past decade many borrowers took the lender offers because they believed ARMs, option-ARMs and interest-only loans represented little or no real risk. Home prices, they figured, were always going to rise. If you bought a home with little or nothing down and financed with an adjustable-rate mortgage, what did it matter if rates rose in three years, five years or seven years? Since prices were rising you could always dump the property and make a profit. It was a sure thing.
At least that was the theory.
Once home prices stalled in 2006 and 2007, millions of people had mortgages where they were forced to pay higher monthly payments when “teaser” periods ended. Payments could rise 40 percent, 50 percent or more. Because property values had dropped and homes had been purchased with little down it was not possible to refinance to a lower rate or to a fixed rate. Now, suddenly, owners had homes they could neither keep nor afford. Financial calamity was assured.
Rates Go Upside Down
Given this background, how can we explain the week of April 16th? According to Freddie Mac the rates were upside down, 30-year fixed-rate loans were priced at 4.82 percent with 0.6 points while ARMs were priced at 4.91 percent with 0.7 points.
This is an amazing set of numbers. Is there an opportunity lurking here for homebuyers and investors?
That’s the question which is intriguing a growing number of people. Here’s why:
Imagine that two years ago you could have bought a metro area townhouse for $650,000. In May 2007 the interest rate was roughly 6.3 percent. If you bought with 10 percent down the deal would have looked like this:
Purchase price $650,000
Down payment $65,000 plus closing costs.
Monthly payment $3,620.99, with fixed-rate mortgage on $585,000 (taxes and insurance are extra)
Today the deal is different. The price of the property has fallen to $500,000, a 30 percent decline. Combined with far lower interest levels — about 5.07 percent — the economics of the property are radically different.
Purchase price $500,000 (saving $150,000)
Down payment $50,000 plus closing costs (saving another $15,000)
Monthly payment $2,434.99, with fixed-rate mortgage on $450,000 (taxes and insurance are extra)
“The new math of real estate pricing and financing is beginning to rebuild investor interest,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s largest online source of foreclosure listings and data. “Deals that made no sense a year or two ago are now starting to seem logical with new pricing and rates. Meantime, the population isn’t getting any smaller and people still need places to live.”
Not Risk Free
While the numbers in many areas are certainly better than they were a few years ago, real estate investing now, as then, is not a sure thing. There is risk.
“Except for low home prices and very low mortgage rates,” says Time magazine. “All of the elements for a recovery in housing are missing. Those two things should be enough, but balanced against them are shrinking access to credit, an inability of Americans to get higher wages, and crippling unemployment.”
For instance, in a community with many job losses there may not be enough paying tenants to support even lower monthly rentals. The price declines seen to date may not represent the bottom of the marketplace, so values could decline further. And while interest rates may be at or near historic lows, they could go lower. During the Great Depression some government securities actually offered negative interest rates, a level not seen in our time.
Today’s prices are not “bargain” prices. They instead reflect market values and market values are simply down from the past few years. In some markets there are opportunities to capture additional value, in others not. Investors need to look at each property with care before making a purchase decision.
The National Association of Realtors reported that its March Pending Home Sales Index was up 3.2 percent over February and 1.1 percent higher than when compared with a year ago. While these numbers do show a slight rise in real estate activity, the changes are not big and may reflect nothing other than the new $8,000 credit for first-time homebuyers that’s only available in 2009. Moreover, these are national numbers so local markets could be very different.
It’s too early to say if the housing slide has reached bottom or anywhere near bottom nationally. On a local level it’s plain that many areas are now in trouble and will remain in trouble for months if not years.
But for the first time in perhaps three years interest rates, home prices, government policies and tax preferences seem aligned. Unlike 2007 and 2008 there are real programs with real money being spent to restart the housing market. Such momentum, in and of itself, is worth watching along with mortgage reform, bankruptcy changes, employment levels and corporate profits.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.