Real estate prices have gone berzerk in many parts of the US, and in many parts of the world.

The unwind has already begun in the US, and may be coming to a neighborhood near you soon.

An extremely interesting and informative book which deals with the whole boom and bust phenomena is, "Sell Now!" by John R. Talbott.

Unlike many "real estate experts" the author has done extensive research and a great deal of analysis on various aspects of the bubble. The bottom line is, in so many words, that crazy lending led to crazy prices. When the crazy lending goes away (as it has done and is doing) the crazy prices will go away. Many banks and mortgage companies will be severely weakened by the bust, and the ones that survive will be extremely conservative in their lending going forward. Real estate prices will tend to return to fundamentals--for investment real estate, prices will equate to actual rental returns (before the boom, residential real estate tended to sell for between 10.5 and 12.5 annual rents, depending on the location in the US. In some places, real estate now sells for over 30 times annual rent).

The author also details how the boom was really international, spreading to many cities all over the world. So it's possible that the bust may be international as well.

The Economist magazine did an article last year calling the current real estate bubble, "the greatest bubble in financial history".

So what does this mean for you?

If you live in a house that has appreciated a great deal, and you have a lot of equity, I suggest you read "Sell Now". You may not wish to follow the author's advice, but it would be wise to know what your options are.

Real Estate Bust Dynamics

I was around during the oil patch and later S&L related busts in Oklahoma some years ago. Depending on the location, prices dropped anywhere from 25-30% (suburbs) to 90% (inner city fixer-upper rental property). During the real estate bust in California during the early 1990s prices around LA on average dropped around 25% from their peak in the late 80s. Real estate may not have dropped nationwide since the 1930s, but it has had extreme falls in various places at different times.

For those of you who are interested in investing in foreclosures, I would like to offer some advice.

First, just because a house is a foreclosure doesn't make it a bargain. House prices may fall for many years, and may recover very slowly, since banks and mortgage companies will be too weak to do any wild lending for a long time. In a stagnant market, rental values will be very important, since it may be difficult to sell for a quick profit.

I've seen a single house go through multiple foreclosures over a period of several years. An investor would buy, thinking he had gotten a bargain, only to have the market fall another 20-40%. The property would be foreclosed again, a different investor would buy at a still lower price, and sometimes face difficulty or foreclosure as prices dropped even further.

If a property has a good, positive cash flow, this isn't as much of an issue. You can hold the property, collect the rents, and wait for the market to recover.

If the property produces a negative cash flow, you might face considerable difficulty in holding the property. It's no fun to lose money every month, and in a falling market it's hard to say when you might be able to make money on the sale of the property.

In realistic terms, I would hesitate to pay over ten times annual rents for a property. If it's a great property in a great area, maybe twelve. Over that you won't have much of a cash flow. At present, interest is close to 7%,  annual property taxes in most areas are 1% or more of the purchase price, repairs should cost a minimum of 1-2% per year (less than that and your property is probably not being maintained properly), insurance and utilities another 1/2% to 1%, and vacancy and collection losses should be allowed, amounting to 1-3% of the purchase price. Add it all up and it easily exceeds 10% of the purchase price per year to own the property. Paying ten times annual rent for a property should allow for a moderate cash flow, if everything goes well and you know what you're doing.

Also being realistic, I think property has several years yet to fall before there will be many real bargains in most areas.

I realize that my back-of-envelope analysis here is simplistic, but lots of people get into real estate with no plan for cash flow. Tenants can be unpredictable and destructive, and can pay late or not at all. The time you make money in real estate is when you buy--you set yourself up for success by paying the right price for the right house in the right area. You set yourself up for failure by paying too much in the wrong area for the wrong house. You set yourself up for success by screening for the very best tenants you can get, without discriminating against anybody. You set yourself up for failure by not checking references, by not checking rental history and credit, and by renting to people just because they talk a good line and wave money in your face. Learning how to screen tenants properly is probably the second most valuable skill that a serious real estate investor can acquire (the first is learning how to buy right).

Over the last few years many people bought houses which were poorly constructed, in mediocre areas, for ridiculous prices. When people come to their senses, many of these houses will be worth perhaps twenty or thirty cents on the dollar, depending on the area and how much they went up during the boom.

There are zillions of books on real estate investing out there, but keep in mind that most of them were written during the boom--investing during the bust is a different game altogether. Flipping houses, buying a house and painting it and making $50,000, is rapidly becoming a thing of the past.

When the financing really dries up, it might take many years before a house goes up $50,000. But, it can still be a good business if you buy right, if you are set up for a positive cash flow from the beginning, and would like to have a predictable income from rents.

How Do You Know When To Buy?

It's difficult to gauge when to buy in a falling real estate market, but there are some things to watch for.

One, when the mass media becomes universally negative about real estate, it's probably a buying sign. Just as when they were universally positive about real estate a couple years ago it was a selling sign.

The kind of media negativity we've seen lately has been fairly tepid compared to what you need to see as a buying sign. When you see Time or Newsweek with covers like, "Will Real Estate Ever Stop Falling?", and "Real Estate Horror Stories" it may be time to start looking.

A positive cash flow from rents would be another promising buying sign. When you can buy a house, rent it out at the market rate, and generate a positive cash flow after paying the mortgage, repairs, utilities, etc, that ordinarily would be a good time to buy. Even if prices drop a little more you have the cash flow to even things out.

Another buying sign would be the failure of a large bank due to mortgage foreclosures. Many mortgage companies have already failed, but no large banks. Failure of a number of large banks would be a definite buying sign.

When basically nobody wants to buy real estate for an investment it's also a buying sign. You're looking for extreme negativity, when very few people are interested in real estate. In general terms, when nobody wants something it's a good time to buy it--given that it's still a viable asset. It may take a few years for things to get to this point, so a lot of patience and observation is warranted.

Another promising sign would be very large-scale auctions of foreclosed property. There are a few isolated auctions already, but when things really get into gear there should be auctions with hundreds or even thousands of properties. Banks and mortgage companies will have so many foreclosed properties and the market will be so slow that they will have few other options for dealing with them. A foreclosed house costs a bank or mortgage company money every month, and generates no income. An owner-occupant can wait things out if they can still make their payment, but a bank or mortgage company doesn't have that option.

Most likely you should look for several signs taken together as confirmation of a good time to buy. One sign in isolation may not in itself be enough. Every one of the above signs were present in the bust in Oklahoma and Texas in the late 1980s and early 1990s.

Auction Basics

You won't necessarily have to buy a house at an auction to get a good deal, since large auctions of properties can depress prices locally. Large scale auctions can be a cause as well as a result of depressed markets, depending on how contained or how out of hand things become.

Auctions may or may not be the way to go for you, since you normally can't inspect a property as much as you would be able to with a non-auction sale. It can be easy to pay too much for a property at an auction, since you can get caught up in bidding against others. You have to make decisions quickly involving tens or hundreds of thousands of dollars.

On the other hand, you can get some great deals at auctions. Most people who come to auctions are not serious bidders, many people basically come to see if they can get something for nothing. If you come prepared to buy after thoroughly evaluating the properties available and knowing how high you will go for the properties you want, you can get some bargains.

If you can, attend one or more auctions to see how things work before you actually bid on anything. Actual knowledge of the auction process will be extremely valuable should you decide to purchase one or more properties at auction. Auctioneers are trained to build excitement and get people to bid--their intent is to get you to bid as much as possible, since they are usually paid a percentage of the sales price. Your interest is in paying the lowest amount possible. Keep in mind that in some auctions you may encounter what is known as a "shill"--a person hired by the seller or auctioneer to bid on properties and raise the prices, who has no intention of ever winning a bid and buying a property. The more reputable auctioneers will not permit this, but there are still "shills" out there.

If you decide to bid at an auction, be sure to arrange financing beforehand, if you need it. Some sellers will provide financing for properties purchased at auction, but it isn't common. It's customary to put five or ten percent down on the day of the auction, should you have a winning bid, and to close within thirty days or so.

Sheriff's Sales, where you purchase a property at auction at the county courthouse, are another matter. The main drawback with this sort of sale is that you often don't know exactly what you are getting. You often don't have the opportunity to inspect a property closely before purchasing it, and you don't always know if the title is completely clear. If you are able to do your homework on the property, if you can determine whether the condition and title are both good, it can make sense.

In a market that falls rapidly and deeply, it often makes sense to buy from the bank after the Sheriff's Sale. You have more time to inspect the property, you can often purchase for far less than the balance owed at the Sheriff's Sale, the title is generally guaranteed to be marketable, and most sellers will at least haul off the junk and take care of some repairs to the property. Some people specialize in buying at Sheriff's Sales and know the ins and outs--if you decide to go this route, do a few dry runs by going to Sheriff's Sales before you actually plan to bid.

Valuation

Valuation in a rapidly falling market is a tricky matter. Assessed value from the courthouse can be wildly optimistic, since the County Assessor will sometimes keep increasing assessments even after the market has begun falling. It's not uncommon for a property to be assessed 20-35% or more than  it actually sells for in a falling market. I've seen properties assessed for ten times more than they sold for.

In a rapidly falling market appraisals also tend to be less useful. In a falling market, houses can't readily be compared to other houses which sold nearby under different sales conditions--how can you compare the value of a house which sold when financing was extremely easy to the value when financing is extremely tight?  Location and features are of course important, but if nobody can get financing, how much is a house worth?  Best to forget what houses sold for during the boom, since those prices are gone and aren't coming back anytime soon.

If you are able to hold a house for income, valuing a house based on a multiple of annual rents is a very good gauge. Rents tend to be far less volatile than prices under most circumstances, and rental amounts can be easily estimated by checking what comparable places rent for locally. As I discussed above, I would be reluctant to pay much over ten times the annual rent for a house. Over this and you may have a negative cash flow. Essentially you would be subsidizing your tenants every month, paying them to live in your property. Better that you should just send me a check every month (ha-ha). 

I would also be reluctant to accept the valuation advice of real estate salespeople. They know what houses sold for in the past, rather than the present and future value, which is what you are concerned with. Some of the on-line valuation sites like Zillow.com (http://www.zillow.com) can be useful since they can give information on comparable sales--but in a falling market it's best to understand that current and future values are often much lower than comparable sales would indicate.

In this new market, your estimation of value is probably as good as the next person's, provided you do your homework.

In the pre-boom days it didn't make sense to spend $40,000 on a kitchen (unless it was a very high-end house) or $20,000 on a bathroom, since you could rarely recoup the investment upon sale. We're probably going back to that environment--make the house nice, but few luxury features or over-improvements will pay off for most houses. If you can buy houses with some of these features without paying extra for them, fine, but in general it probably wouldn't make sense to drop that kind of money on most houses. Don't be persuaded to over pay for a house just because it has granite countertops or a jacuzzi tub or whatever. These kinds of things really won't increase the value of a house much going forward.

Don't forget that it costs around 8-10% of the sales price to sell a house--6% for the real estate salesperson, figure 1-2% for lender required repairs, 1%-2% for closing costs like title insurance and the paperwork blizzard where everybody even remotely connected with the transaction piles on to get their cut. If it's a slow market, plan on paying some of the buyer's costs as well. If the property is vacant for a long period of time before it sells, it may cost considerably more than 10% to sell.

Since it costs so much to sell real estate, it doesn't make sense to buy a property unless it's at least 10% under market value. If you buy at market value and have to sell before the market comes up, you're at least 10% underwater due to the selling costs. In a bad market you really can't afford to pay the market price.

The Garbage Property

During the boom, a lot of "garbage" properties sold for a lot of money. People would seem to pay almost any price to get into real estate, and they could get into a garbage property since they were cheaper than places that were actually built properly.

It's amazing to me that banks and mortgage companies would lend on some of these places.

A garbage property is a property that has very little economic value apart from being used as perhaps a low-end rental. Garbage properties are places that were basically not built properly in the first place, or which have been remodeled very badly over the years, or which have been very badly maintained over a long period of time. It might be possible to fix a garbage property, but why not buy a place that was built and maintained properly for a little more money?

During the real estate bust, you should be able to buy properties that were built extremely well for not much more than a garbage property.

Even as a rental, garbage properties can be a lot of work--lots of repairs (since they weren't built properly in the first place) hard to get and keep good tenants (tenants know quality and junk when they see it), and the rents are usually lower.

You can make money on garbage properties, but it's a lot easier to make money on houses that were built and maintained properly. 

Investing In Farm Land

Farm land has come up in price quite a bit in the last few years. Most people probably wouldn't think of farm land as an investment, but it does have certain advantages.

A growing world needs more food, and that means rising prices for some crops, and thus for land. Many farmers rent land so they don't have to tie up capital, and that leaves an opportunity for those with money but no desire to farm.      

Decent farm land can be bought for under $1,000 an acre in some parts of the country (wheat land in Oklahoma, for example). Good land for growing corn tends to be quite a bit more expensive (corn doesn't do so well in Oklahoma).  

Crop prices (and crop land prices) tend to not be correlated with stock prices, so it can be one way to diversify out of stock and bond investments.

See Part 1 of this article in the Finance Section: Investing in Bear Markets

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