Leverage, The Untold Risks With Buying.
This post was more relevant during the bubble of 04-06, but still kind of applies today. I’m not saying not to buy. I’m saying that you need to fully understand the risks involved. Sure people have gotten VERY rich on Real Estate, but you rarely hear about those that go bankrupt. They tend to be less vocal.
People think that “buying bricks” (a house) is far less risky t
han the stock market. Heck look at the Nasdaq that dropped 70% after the .com bubble! That can’t happen with a home, how can it lose 70%?
Well if you put only 10% down, it pretty much happens on day 1!
How? Why? One major difference (stocks vs houses) is being ignored…
LEVERAGE!! LEVERAGE!! LEVERAGE!!
Example:
Lets take a $500,000 home as an example. If a buyer puts 10% down, or $50,000, that leaves them with a $450,000 loan. Because of leverage (using 90% of the banks money to buy your home) all you have to do is close on your house, and on day 1 you have recreated the Nasdaq 70% drop! Since that same day you have lost about 7% (closing costs plus those rascally Realtor fees) in value. That 7% drop in your house value is the same as a 70% drop in your investment (you put 10% down and 7% is gone, that is a 70% drop)!
Just like they say about used cars, the moment you drive it off the lot, the car drops $5k to $25k in value immediately.
Scared yet?
I’m not trying to scare you. If you are asking “then why does anybody buy,” the flaw in the scenerio above is that people usually don’t sell their house after holding it one day. And unlike cars that depreciate, houses tend to go up in value… But not always.
And with appreciation and leverage you can make a killing! One client was saying how she put down 10% and bought a $150k condo. And 4 years later sold it for $300k. She was saying how she had doubled her money! Actually since she only put down $15,000 (10%) she turned that into $150,000 and actually made ten times her investment, a 1,000% return!!!! Party time!
So LEVERAGE significantly increases your profit if things go up, but it can wipe you out if things go down. That is why it is recommended to buy only if your time horizon is long enough. The longer you hold a place, the LOWER your risk (usually). I do however know somebody that had to hold a condo for 10 years just to break even.
There are a ton of statistics out there showing that Real Estate is the #1 fastest way to riches.
So I gave an example of a buyer that made 1,000% (and actually over the last 4 years that was fairly common), but what you never hear about is the down side. Here is one example:
Now an example of a bankruptcy and $150k loss:
“Evelyn” was encouraged by her brother to buy a condo conversion (apartment complex that was upgraded and sold off as new condos). The pitch was “This is DC, DC can never go down! Jobs, government, etc. Everyone is making $100,000 in 1 year and it is a sure thing. The sister said she was very conservative and worried, but still decided to buy a $600k condo in Ballston. She put down “only” $10k-$20k.
She put it under contract a year earlier, closed on it and 9 days later went to flip it! Starting at $665k! She would pocket $30k after fees and double her money! Champagne all around. But it didn’t sell.
This is where I came in. I got a call from a friend that referred her to me. Why? Supposedly the Realtor “stunk.” I didn’t take the listing, it seemed way overpriced.
This is an actual email exchange we had:
- “Frank, it was good speaking to you. Your resourcefulness and dedication is what we need to sell [condo name]. We look forward to hearing from you.”
This is my actual reply after looking into it in 10/2005:
- “While I’d love to bash your old Realtor, I can’t. Nothing has gone under contract in this building so there is no precedence. He didn’t know what it would go for, since nobody knows, so he worked backwards to try and make you some profit (which is fine).”
Thank God I didn’t take the listing!
- It continued to drop. Here is the timeline:
- Paid $600k, tried to flip it 9 days later.
- $665k to $645k over 51 days
- $575k to $540k over 104 days (new Realtor, gotta be the Realtor’s fault right?)
- $520k to $485k over 126 days
- Taken over by the bank at $580,000
- Sold for $465,000
With about $35k in mortgage payments.
That makes for a loss of $165,000!
Conclusion:
Real Estate is NOT a sure thing.
People can make millions quickly in Real Estate.
People can quickly go bankrupt in Real Estate.
- I suggest running the 1/3rd Buyer Scenerio analysis.
- 1/3rd chance of the property going down
- 1/3rd chance of it staying flat
- 1/3rd chance of it going up.
If you have run the numbers and understand what COULD happen, then consider proceeding.
Shameless not so subliminal ad coming… Keep in mind that one way to lower your risk is by getting an agent that will help fight for that extra $5k or $50k when helping you buy a place.
Love to hear your comments.
– Written by Frank Borges LL0SA- Broker/Owner FranklyRealty.com
703-827-4006
Videos at YouTube.FranklyRealty.com
22314, Fairfax Va, DC Realty, Realtor
- 7
- January
- 2007
I agree with the statement that “DC can never go down” and the reasons you listed are valid. The problem is that people do not see the big picture….they think (thought) the DC market only goes upwards. No, it’s cyclical. The market dipped around 1990, again around 1994 or so and then in 2005/6. But it’s risen in between and in the LONG RUN, I believe DC will continue going up. The $600k condo you mentioned will probably sell for $800k or more…..by 2015. You can scoff at that but $200k in 10 years averages $20k/per. Not a good deal if you’re an investor and can’t cover the payments even with renters. But if that’s your primary home and you gain from the utility of living in Ballston, not a bad deal. But “Evelyn” jumped in without looking. Tsk, tsk.
Your story is a prime example of the current investor mentality thanks to HGTV, Property Ladder and Flip that House amongst others. Although I love these shows and they make for great television, they do not accurately portray all the intricacies involved in the real estate market such as community development, job market, and local economy.
It seems to me that too many people over the last two years invested in real estate without having any inclination on how to run a business effectively and efficiently. I still have buyers approaching me trying to “flip that house” and though you can lead a horse to water, you can’t make them drink. My advice goes in one ear and out the other.
I think our government needs to establish legislation that would protect these potential would be investors from themselves. Sadly many have already learned the hard way that real estate isn’t as easy as those late night infommercials would lead you to belive.
My question is – Do buyers that are “buying now” realize that even though they’re getting a “great deal” on a house – maybe getting a price 10% – 20% below initial “peak bubble” listing price – that they’re still paying at least double of what a property sold for just 4 years ago.
Further – Is there any historical data out there that outlines what happens to yoy sales following a bust? And does this tell us (from a historical post-bust perspective) how good of a great buy that really is?
Anyone?
http://tinyurl.com/yhdx5g
Here’s another foreclosure, this one’s in Clarendon 1021 where i believe Frank owns, maybe even occupies. will this further hurt comps?
Hey “anonymous” that referred to the HDTV, why didn’t you put your name? EMail me directly if you can.
I agree. I remember a story on a 21 year old “investor” making a killing on internet stocks. Hum, was he so great or did he happen to be investing WHILE the market was skyrocketing?
Geoff,
Great point. You do hear in the press that it is a “buyer’s market”. They aren’t necessarily saying which direction the market is going, but that it is easier for buyers in this market.
My response to that is, yes it is easier to buy a house if you have no problem paying full price or a tad under. But buyers still have a good amount of risk if this isn’t the bottom. What if the prices drop another $10k in 3 months, or more? That is why it is important to find an agent that will work hard to get you the lowest price possible.
I wish I could post how I did that here, but I can’t since my competition would read my strategies (my clients get to hear it first hand) . I know you might be thinking, “oh just offer $100k under”, it is far more complex than that!
As for the data after a bubble question, I don’t have it. The problem with data is who is writing it. Some like to say “data is data” and you can’t argue with it. I disagree.
But I also don’t believe in timing the market. Just like stocks, a new
high could be time for a pull back or an even new higher high. Only time has been proven to usually be your best shield from a pull back. (I say usually since the Nasdaq is still WAY WAY off the high)
You can look at the Shiller’s graph and look at what past corrections looks like, but then Fannie Mae once tried to show my broker class a graph showing that over the last 40 years there has never been ONE year where housing prices from jan to jan haven’t gone up at least .01%. Trust me, I gave them a lengthy debate.
And with the Shiller’s graph, people will read it and say that those pull backs were because of lack of job growth, something that isn’t a problem today.
Are you saying yet: “Frank, dammit, give me some advice!”
So what does one do?
1) Move away from “your home is your investment” mentality. Drop that from a #1 priority to #3 or #4. You are not a real estate investor.
2) Make sure you have a long enough of a time horizon to ride out any further decline. You should be good with 5-7 years, but I have examples of it taking 10 years, so who knows. I have talked countless friends into renting, when talking purely numbers, renting isn’t all that bad. (but then you don’t have that warm and fuzzy home ownership feeling and a chance at Vegas style riches) I don’t do rentals, use Craiglist.
3) Take some solace that you are buying your $600k place sometimes for $100k UNDER what somebody else paid for it. Maybe it will be $100k OVER the next guy, but I don’t feel that timing the market bottom ever works (look at all the people that sat on the sidelines during the last skyrocket saying every year it must come down)
So if your horizon is long enough, enjoy life and find a great place to live.
ps. Don’t get fooled by % off listing price drops. Even in this market I would rather have a client buy a FULL PRICED new listing (properly priced by a good Realtor) than get $100k off a place that might be $150k overpriced. Value is #1, not the % off list. Rug store clearance 50% off sales don’t fool you, so don’t declare victory just based on getting $50k off on a wildly overpriced home.
(One secret revealed: Smartmoney featured this tip of mine: Have your agent look up the Listing agent’s track record. See if they tend to overprice with their last 5 deals. That might give you some guidance on your offer. If they don’t know how to do this… too bad.)
hey Frank,
use your powers… how’d this one go for 205k?
http://tinyurl.com/yzc8uf
Thanks!
Wow, $200k for a 750 sq foot condo in Arlington… NOT. Yes the tax records show this, but I doubt it was an arms length transaction. Sometimes as part of a person’s employee compensation they might get paid with a non-market price. I’m not talking a discount, I’m talking half price. So I don’t know the story, but this would never be used as a comp by an appraiser and there is more to this that we will never know. Unless you ask her!
Frank, thanks for your great advice. My fiance and I ran into your realtor, Cathy and she suggested we check out your blog. You have given us a lot to think about as we decide whether or not this is the right time to buy for us. Thank you and I hope that you have much success with your businesss. I really appreciate your candidness.
Hey Susan,
Glad you liked the blog. I hope you will read them all AND sign up for email alerts for new ones (on right side of page). Buying a house is a HUGE undertaking and many people approach it as if it is a “no brainer,” until something goes wrong.
Frank