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5 risky real estate moves to avoid now
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There's no crystal ball when it comes to the real estate market. Don't
make yourself more vulnerable by getting into risky loans, dicey rental
properties or other perilous positions.
By
Liz
Pulliam Weston
Overconfidence can be an investor's most
deadly flaw. Yet many people are displaying plenty of overconfidence
when it comes to real estate.
They're sure home prices can only go up -- or that values will crash
tomorrow. They're committing to risky loans and not thinking about how
they're going to make the much-higher payments to come. They're gambling
their current wealth on future, speculative returns without truly
understanding the risks.
"I'm nervous," said financial planner Delia Fernandez of Los Alamitos,
Calif., who says she sees plenty of clients act as if they have a
crystal ball. "We know we can't sustain this growth rate
but nobody
knows what the future holds."
If you're considering any of the following risky real estate moves, you
might want to think again.
Risk: Timing the market -- with your home
Some pretty smart people are seeing real estate bubbles, and a few are
backing up their intuition by selling their homes now in hopes of buying
again later at bargain prices. Doug Duncan, chief economist for the
Mortgage Bankers Association, and Dean Baker, the director of the Center
for Economic and Policy Research, are among those taking their profits
to the sidelines in anticipation of the bubble popping.
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Should you follow suit? Probably not. There are plenty of problems with
the concept of "shorting the market" by selling your home. For instance:
- Prices may not crash. While double-digit home-price
increases aren't sustainable for the long term, your particular
housing market could well experience slower growth rather than an
actual decline. That means you could be priced out of your desired
neighborhood or wind up paying a lot more for a similar house.
- Bubbles tend to persist. Even if there is a crash, it may
not happen for years. Remember, there was a three-year gap between
Alan Greenspan's infamous "irrational exuberance" comment and the
actual bear market in stocks.
- The cost of pursuing your hunch is high. Selling your
home will cost you about 6% in real estate commissions, plus the
expense of moving. When you eventually buy your replacement house,
you'll face closing costs and possibly higher interest rates on your
new mortgage. In the meantime, you'll be paying rent to some
landlord -- perhaps for years. That could eat up a lot of the
profits you're trying to protect.
- You may freeze. Some people who've sold their homes
assume they will boldly swoop in to buy other people's foreclosures
when the crash comes. (That's what Duncan did during Washington,
D.C.'s, last slump in the early 1990s.) But a declining real estate
market is a frightening thing, and many find themselves paralyzed on
the sidelines, unwilling to buy with prices still sliding.
If you're intent on timing the market, at least consider waiting until
your area shows some signs of weakness, such as prices actually falling
in the higher-end ZIP codes.
"Prices in real estate don't come down overnight like the stock market,"
said economist Delores Conway, director of the Casden Real Estate
Economics Forecast for USC Lusk Center for Real Estate and a veteran of
the Los Angeles market crash of the early 1990s. "If (real estate
values) come down, they come down gradually."
Risk: Stretching to buy a home with risky
loans
It's one thing to take on a big mortgage if your payment is fixed for 30
years, since inflation will eventually ease the strain of making your
monthly nut. It's quite another to stretch using a loan that can explode
in your face if you hang onto it long enough.
Interest-only and "flexible payment" or "option" mortgages typically
give you the choice of making relatively small initial payments.
Interest-only loans don't require principal payments in the early years,
while flexible payment loans typically give you four options each month:
an interest-only payment, a regular payment, a regular payment plus an
additional principal payment or making no payment at all.
If
you stay in the home long enough, though, you'll
be required to start paying down principal, and
your payment can soar. Higher interest rates
will affect most of these loans, as well,
because few have a fixed rate. With flexible
payment loans, interest rates can change as
often as monthly, and your mortgage amount can
actually grow over time if your payments aren't
sufficient. (For more details, read "Could
you handle an interest-only loan?")
Interest-only loans made up more than 45% of
total lending last year in San Diego, Atlanta
and San Francisco, according to BusinessWeek
Online and LoanPerformance, a San
Francisco-based real estate information service,
and they made up a third of the loans in 10
other hot markets. (Similar figures aren't
available for flexible-payment mortgages.)
That's scaring many mortgage-rating companies,
such as Fitch, which fear higher interest rates
will lead to a spike in foreclosures on these
loans. Falling real estate values could hurt
these borrowers more than others, because many
of them won't have built much, if any, equity
and could become "upside down" on their
mortgages, owing more than their homes are
worth.
Risk: Buying
money-losing rentals
In most markets, it's smart to choose property
that commands rents that are at least high
enough to cover your out-of-pocket expenses.
(For details, read "How
to find good investment property.") This is
especially important in bubbly markets that
could burst.
Some people think rentals will be in higher
demand if foreclosures rise, but history has
proven otherwise. Many of those who lost their
homes in previous real estate busts lost their
jobs first, Conway said, since economic
downturns are what triggered the drops in home
prices. People without jobs tend to leave the
area in search of better prospects.
Los Angeles County, for example, lost more than
200,000 jobs a year for three years in the early
1990s, which set off the state's first-ever
"out-migration" where more people left the
Golden State than arrived. Rents tumbled as
vacancies soared; foreclosures on rental
properties climbed as landlords tired of losing
both money and equity.
You can give yourself some protection by making
sure your investment property has positive cash
flow in good times. If you have to cut your
rents, you may still get enough of a tax break
to stay afloat (thanks to depreciation and
deductible expenses).
Risk: Draining your
home equity for other investments
Financial planner Fernandez isn't dead set
against using home-equity loans to buy other
investments. Some of her clients have
successfully built profitable real estate
portfolios this way. But using home equity to
supplement a stock or mutual fund portfolio is a
possibility only for the most risk-tolerant
investors.
What concerns her are people who are diving in
without considering the potential costs, or
those who are "doubling down" by buying more
property in the same, highly appreciated area
where they own their primary homes.
Some want to use variable-rate loans like
home-equity lines of credit to fund their
ventures, not realizing spiking interest rates
could make the deals unprofitable. (For more,
read "5
tips for wisely tapping your home equity.")
Investors need to be reasonably confident their
future returns will exceed the costs of
borrowing the money, Fernandez said, and that
they can handle any volatility that comes.
Most people, though, are probably better off
funding their investments out of current income
rather than borrowing to buy more, Fernandez
said. If you do decide to borrow against your
home, keep a cushion of 20% equity and consider
a fixed-rate loan to lower the risks.
Risk: Owner-financed
second or third mortgages
Some sellers prefer not to realize their profits
all at once because that can trigger a major
capital-gains tax bill. (Profits exceeding
$250,000 per person on a primary residence are
potentially taxable, as are all profits on
rental property.) Instead, these sellers become
lenders, allowing the buyer to make payments to
them over time. This helps sellers stretch out
their tax bill over a period of years, rather
than having to realize the gains all at once.
This strategy isn't incredibly risky when the
seller is in "first position" on the home -- in
other words, when the seller is providing the
primary mortgage. At worst, the seller will get
payments for a few years until the buyer
defaults. The seller might have made more money
selling outright, but at least he gets his home
back.
Those who finance second or third mortgages,
though, might not be so lucky. If the borrower
defaults, the primary mortgage lender gets first
crack at recouping the loan. Only if there's
equity left do the lenders in second or third
position get paid off. In a declining market,
those lenders can be left out in the cold.
Liz Pulliam Weston's column appears every
Monday and Thursday, exclusively on MSN Money.
She also answers reader questions in the
Your Money message board.
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