What Goes Down Must Come Up

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gravity2.jpgWhen Sir Issac was sitting in his orchard back in 1665 (or was it 1666?), I’ll bet he was not thinking about economic theory as the famous apple fell. He would be rolling over in his grave on seeing the title to this post. Blasphemy! In terms of many things, including a macro, free enterprise, capitalistic society, it’s true; what goes down, must come up. It’s just a matter of time. Think of a pyramid scheme that never dies.

Recently, I had the opportunity to check another backpacking trip off of my “life list”: The Grand Canyon. Actually, Kris encouraged the trip…soon after asking me what I was carrying in life insurance. Hmmm. But, that’s not really relevant to my story. I spent a good part of Day 1 descending to the bottom of the canyon and for two more days exploring the side canyons, imagining what John Wesley Powell thought the first time he cruised down this amazing part of the Colorado River. Since I had only enough food for 31/2 days, I had only one way to go to survive – I must go up. I was “demand”. Sure enough, after climbing 5,000 feet and thinking no fewer than three times that I should push the button on my satellite-linked “rescue me” beacon, I made it back up to the rim (and food other than freeze-dried). Demand satisfied.

Pardoning the loose analogy, most markets work the same way when there is sufficient demand, stocks, bonds, and real estate included. To survive, they must go up. This does not mean that they will never go down. That’s another reality of markets. They are cyclical. There are periods of “irrational exuberance” (Greenspan, 1996) to the upside as well overreactions to the downside. Markets are like living things, because they are driven by living things – us. 

So, let’s zero in on our little real estate universe in California, lest we forget that the median sales price for homes had healthy growth for ten straight years. According to the California Association of Realtors, five of those ten years included double digit growth: 2000 = 11%, 2002 = 20.5%, 2003 = 17.5%, 2004 = 21.3% and 2005 = 16%. That’s a lot of growth – compounding growth! Irrational exuberance? I’d say.

As we work through the hangover, we are understandably seeing a lot of frustration by sellers. They have to contend with softening prices and buyer’s revenge. So frustrated are some that when trying to sell and not realizing their price expectations, they are reverting to those dreaded words, “If we don’t get our price, we will just rent the home for a year and then sell it for more.” Having already bought another home with a HELOC or other financial resources, they don’t have to sell. Yikes! But this is becoming a trend. We are hearing this scenario from more than a few agents and have had a couple of these experiences ourselves lately. Of course, our clients did not deem it necessary to advise us at the outset that we had just six weeks to sell their home (in a market with an average market time of 80 days). Only after we spent our money and time did we “earn” the right to know this little tidbit. That’s okay. We believe that the more real estate one owns, the better, at least over the long term. Agents in this market know going in that the possibility of losing the listing exists. Times are tough.

But here’s the problem, actually problems:

Homeowner just became a real estate investor For many of these former sellers, they are an investor for the first time. In nearly every case, the thought process is, “we will take our home off the market, rent it for a year and then sell it for a higher price in one year when the market is better.” But what if the market isn’t better a year from now? While we hope it is, most economists and forecasters don’t think it will be. “Big Ben” Bernanke of the Federal Reserve believes it will be at least the 2nd Quarter of 2008 before things bottom out and his projection is more optimistic than most.  Others project at least another year, or more, of an “adjusting market”, particularly in California where we had such explosive price growth.

When we do hit bottom, how long will we be there? Again, no one knows for certain. So our new investors, hoping to sell for more money a year from now may have sentenced their equity to rental home prison. Now if they wanted to keep the home as a long term asset (5-10 years), that would be great. But most seem to have a different goal. They have now effectively become a speculator, a “flipper” if you will, because they are literally betting the house that they can sell for more money in the relative short-term. I hope they’re right. But if they are wrong, they may have unknowingly just tied up their equity for 3 or 4 or more years. There is a good reason most speculators, other than those who are still betting on Enron or Boston Market, are no longer players in the San Diego market. They recognize that their equity investment could be earning more than zero return on investment elsewhere. Which brings us to the next problem.

Homeowner just became a landlord When the seller cancels the listing and decides to rent, they not only become a real estate investor, but they are also a landlord. If you have ever been a landlord you can appreciate the challenges. For a new landlord, this can be particularly daunting. Of course, if you are not experienced in qualifying your tenant, negotiating the lease, issuing a 3-day notice to pay rent or quit, filing unlawful detainer actions, responding to and fixing broken things, accounting, and other such pleasures, you can always hire a property management company to deal with this stuff – for a small additional fee of around 8-10% of the monthly rent. You may also want to consider to talking to a CPA. 

Homeowner becomes a seller again – You cancelled your listing, rented your home, one year has passed and the lease term is expiring.  Now you get your home back and want to try to sell it again. Forgetting for the moment the market conditions at this future date, your home is now a house or, better yet, a commodity. While most renters may take care of the house, all you need to remember is the last time you rented a car and how you took care of it. After a year, it’s going to need some work to get it ready to sell. Hopefully, the remediation is minimal, but assume the interior will need painting, carpets will need cleaning or replacement, the landscaping will need a tune-up, and more. Better put some money in your real estate investment/management budget.

Now you are ready to sell your house again. We know that the market for home sales will eventually strengthen. But did it do what you expected after just one year?

After the Roaring 80’s, California endured an adjustment period in the real estate market where median prices fell six out of seven years (1990-1996). Remember that this was made worse by a rare and concurrent confluence of events. Our San Diego recession was due to many factors, including the loss of General Dynamics, the S&L crisis, and overbuilding. That was the period in which I bought my first Scripps Ranch home and, thankfully, did not speculate. Even though we suffered through one of the worst economic cycles and real estate downturns in San Diego history, we still enjoyed a nice profit when we sold years later. The key was that we were in for the long-term investment. 

This is why we remain optimistic for buyers today. As long as they are buying for the right reason, their investment will ultimately flourish, and they will benefit from and enjoy the home every day for however long they are there. For those buyers sitting on the sideline waiting and trying to call the bottom, my only suggestion is to do a cost-benefit analysis. Consider if your assumed purchase price savings by waiting six months or a year (no guarantee) or more outweighs the long-term benefits of home ownership.

For sellers considering renting your home as an alternative to sale, be sure to consider the costs associated. Not only will you be faced with the responsibilities of being a landlord, you will likely be in a negative cash-flow position with the bonus prize of having relegated your equity to the “dead money” pile for the next several years. If you do give up on the sale of your home thinking “it must be worth more” and rent with the expectation that you will get more a year from now, I hope you’re right, but I wouldn’t bet on it.

Regardless, history is clear on this. What goes down must come up… eventually.   

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