Real Estate Investing: Why Cash Flow Is Now King

August was a busy month for  Standard and Poors. The huge ratings agency downgraded the debt of the United States, the first such decline in modern history.

Less noticed was another  pronouncement from the S&P: The shadow inventory of distressed homes is  getting smaller.

“It’s good news that things are  starting to slow down and we’re getting closer to the end of the problem,” said  Diane Westerback, S&P’s Managing Director of Global Surveillance Analytics.   Speaking to CNN,  Westerback added that “it could mean a gradual recovery for the market.”
   
Can this be true? Has the housing  market finally reached bottom?
   
Just-issued S&P  numbers do show that the shadow inventory has shrunk from $433 billion in  the first quarter of 2011 to $405 billion in the second quarter.

That’s still a lot of real  estate. The National  Association of Realtors reported that in July the typical home sold for  $174,000. Distressed homes sold with “deep discounts,” roughly 20 percent,  according to NAR spokesman Walt Molony, or about $139,200 apiece.

If we divide $405 billion by  $174,000 it means the shadow inventory today includes nearly 2.4 million homes.

   

How  Long?
At current sale rates S&P  says it will take 47 months to clear out today’s inventory of distressed homes.  Some areas will take longer. For instance, the New York City metro area has so  much unsold inventory and so few buyers that it will take 144 months to clear  out, according to S&P.
   
The ratings firm also says  something else: the “shadow inventory will continue to jeopardize the housing  market’s recovery until servicers are able to improve liquidation times.  However, if and when that happens, an influx of homes will likely enter the  market, increasing supply and driving prices down further.”
   
How is it possible that faster  sales will push down home values and increase the shadow inventory? That  doesn’t seem to make a lot of sense — shouldn’t the faster sale of low-priced  distressed properties help clear out the supply and improve the housing market?

It should, but at this moment it  won’t. Here’s why:
   
The  Speed Paradox
If the sales pace for distressed  homes picks up the number of troubled homes should decline, all things being  equal. But all things are not equal because today’s shadow inventory — as big  as it is — should actually be larger.

Late in 2010 foreclosure filings  began to decline. The fall-off in foreclosure actions was not the by-product of  better economic times or more employment, instead it was caused by a  combination of actions and events:

     
  • In  many states it was found that clerks had signed foreclosure affidavits —  sometimes hundreds  per hour — without checking to see if the information was correct, meaning  that some homes may have been improperly foreclosed. As a result courts in many  states established stricter paperwork standards, thus slowing the process.
     
  • The  foreclosure process has become longer in many jurisdictions because state  legislatures have imposed new requirements before a property can be taken. For  instance, borrowers must be given the opportunity to modify their loans or  engage in mediation with the lender.
     
  • In  a number of cases lenders have been unable to prove they actually own the note  after a series of electronic transfers and assignments. Without proof of  ownership lenders have no standing to foreclose.

Now imagine what would happen if  the problems of the past year were overcome and the foreclosure process  returned to the norms of mid-2010. Foreclosure processing would be much faster,  REO inventories would swell and a bigger shadow inventory would push down home  values.
   
Cash  Flow
Regardless of whether we are at  or near the bottom of the real estate meltdown, a view which is hard to  justify, it’s plain that depressed values will be with us in most markets for  several years even in the best case. Is there any part of this picture which  seems alluring?

Actually yes. Selected real estate investments. For cash.

Unlike real estate’s go-go days  where the goal was to buy with as little down as possible, buyer thinking today  has been reversed. NAR says that nearly 30 percent of all homes sold in July were bought outright for cash.

Why cash? Several reasons:

First, large numbers of  properties are available at discount. With an all-cash offer, the cost of  acquisition can be further reduced because there are no mortgage points or fees  to pay.
   
Second, the all-cash buyer has  leverage in the marketplace because the transaction is not dependent on lender  approval. That can mean more bargaining power and a lower purchase price,  better terms or both.

Third, rent can readily produce a  positive cash flow because there’s no monthly cost for mortgage interest or  principal.

Fourth, investors can defer taxes  on much of their return with write-offs for depreciation. When they sell they  can get the benefit of long-term capital gains rates.

Fifth, in the event of vacancies  there’s no mortgage to pay from other sources and accounts.

“The marketplace is plainly  telling us that large numbers of investors and homebuyers are purchasing real  estate for cash,” said James J. Saccacio, chief executive officer of  RealtyTrac. “In an economy which features minimal and even negative returns for  traditional investments, buying selected real estate for cash and generating  spendable income is a strategy with a lot of attractions.”

   

At this writing a 5-year CD pays  about 2 percent. Given that the most-recent monthly inflation  rate is better than 3.6 percent, it means a CD investor is losing buying  power.

Or, consider this example:  Imagine that you have $50 million sitting around. That’s a lot of cash. It  makes you very important in the financial world. Deposit that money with a bank  and you should get preferred treatment, lots of toasters and maybe a free  safety deposit box.

At least that’s the way it used  to be. Now, according to the The Wall Street Journal, the Bank of  New York Mellon has a new policy which says customers who place $50 million in  their accounts “will face an annual fee of at least 0.13% of the excess  deposits. The fee would rise if the one-month Treasury yield dips below zero.”
   
In other words, there’s a $65,000  annual charge for the bank to hold your money. Why? Because the world is awash  in cash, the reason interest rates reached a 50-year low in August.

Meanwhile, even though times are  tough and likely to remain tough rents are rising and vacancies are down. People need someplace to live and ownership is increasingly not an  option: ownership  rates have now declined to levels not seen since 1965 so there are more  renters competing for good properties.

Positive cash flow. It’s a  wonderful thing.
  ____________________
  Peter G. Miller is syndicated in more than 100 newspapers and operates the  consumer real estate site, OurBroker.com.

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