The Changing Real Estate Market

A housing downturn may be imminent, say economists and real estate investors alike — presenting problems for many people, but opportunities for others.

You’ve probably heard about the coming slowdown in the housing market for a very long time. Real estate is cyclical, and in the United States it has been in an upswing for at least five or six years, which is how long housing prices have exceeded the rate of inflation, says Susan Wachter, professor of real estate finance at The Wharton School at the University of Pennsylvania. That means it’s only a matter of time before we experience a downturn.

It’s hard to believe a downturn is really here. On March 1, the Office of Federal Housing Enterprise Oversight (OFHEO) announced that average U.S. home prices climbed 12.95 percent in 2005, despite rising mortgage rates in the second half of the year. That’s about double the historical average of 6.4 percent, according to Bankrate Inc.

But while the housing market is still appreciating, it’s appreciating more slowly. The Commerce Department announced on March 23 that new home sales tumbled 10.5 percent in February to an annualized rate of 1.08 million units, the biggest one-month drop in nine years.

That means properties are sitting on the market for much longer than they used to. You might expect that in California, where Bruce Norris of the Norris Group, a California-based real estate investment firm, says “we’ve gone from a three-month supply to almost a seven-month supply.” But examples are pouring in from all parts of the country. In Miami, at the Jade Residences at Brickell Bay, 117 of the building’s 352 units are reportedly on the market. And in Manhattan, at Donald Trump’s 120 Riverside Boulevard condos, more than 20 percent of the building’s 250 units are up for resale, according to The New York Times.

And increasing supply almost always leads to falling prices, says Norris. For the first time since the third quarter of 2003, one of the regions in the much-followed OFHEO index showed a four-quarter price decline: Prices in Burlington, North Carolina, fell about 1 percent between the fourth quarter of 2004 and the fourth quarter of 2005.

That may not seem like much, but economists see it as a foreboding sign — and it’s not just due to rising interest rates. “Housing valuations have become somewhat stretched in some areas over the past year,” says Josh Feinman, an economist with Deutsche Asset Management in New York. “Some cooling is likely.”

The slowdown will affect anyone who’s buying and selling property, of course. But real estate speculators — individuals who buy property with the intention of re-selling quickly, or flipping it, for a profit — are likely to suffer the most. That’s because they could be paying mortgages and maintenance costs on properties they can’t sell and can’t rent out for enough money to cover their costs. According to Redbrick Partners, a New-York real estate investing firm specializing in single-family homes, half of the rent an investor can potentially collect does not flow to the bottom line, because it gets eaten up by vacancies, taxes, maintenance, etc. And as supply has increased over the past decade, demand has decreased. Today, Redbrick Partners says rental yields on single-family homes have declined from 7 percent in 1976 to under 5 percent today. And Norris says that in areas of California, a $500,000 house would rent for just $1,400 per month.

There is some good news, however. First, the housing market often fluctuates in different geographical locations. Miami, Florida, is an often-cited example: The number of condos worth $500,000 or more for sale in Miami is reportedly twice what it is in Los Angeles, where the population is four times as large. “If you ask me if the housing marketing is going to experience a downturn, I have to ask you ‘Where?'” says Norris.

In general, the markets that have had the greatest appreciation over the past five years are most vulnerable to a downturn, say real estate experts. “When affordability is at an all-time low, as it is in California, where housing prices have appreciated 300% over past eight years, you lose velocity, or the ability to sell a house at a brisk pace,” says Norris. “And prices start to come down.”

As for specific areas that are likely to experience downturns, on December 16, reported that Las Vegas property values will fall by 7.9 percent in 2006 and another 5 percent in 2007; San Diego property values will fall by 3.4 percent in 2006 and another 5.7 percent in 2007; and Santa Ana/Irvine property values will fall 3.1 percent in 2006 and another 6.1 percent in 2007.

Second, wherever the housing market does cool, it isn’t likely to do so overnight, so sellers needn’t get desperate. Some individuals, of course, will have to sell — those who need to move because of a new job, or a divorce, for example. But others can take some time, as a softening or declining market often takes years.

Finally, it’s also important to remember that one man’s troubles are another man’s opportunity. Some of the best real estate investors buy when everyone else is selling. The theory: As prices decline, it becomes easier for investors to buy properties that create cash flow. They can take their time and negotiate lower prices; they don’t have to waive contingencies, such as appraisals and home inspections; and the income they can realize from renting the property is greater than what they’re paying for it.

In fact, for some investors, like Jonas Lee of Redbrick Partners, buying in a downturn is a way of business. Lee says in a January 22 article that his company has succeeded since 1993 by employing this strategy. The typical single-family home the company buys — usually in the downtown residential areas of rust-belt cities such as Baltimore and Philadelphia — costs just $80,000. He hopes a downturn in the housing market will give him even more opportunities to buy low.

Experienced real estate investors offer two pieces of advice, which vary depending on your plans for the property.

If you’re buying to sell, Norris agrees that buying low is a good idea, but you have to understand the real estate market first. “You have to be able to determine when a down market is about to switch and go up again, and buy then” he says. “A lot of time people will see the market softening and buy too early. For example, someone in California might see a house go from $700,000 to $625,000, think it’s great deal, and buy it. But three year’s later the place will be worth $500,000.”

If you’re buying to rent, Redbrick Partners suggests looking at urban single-family housing. According to the firm’s research, nationwide single-family housing returns have averaged 12 percent since 1976, and volatility has been low, with not a single year returning less than 6 percent. The key to success for small residential landlords trying to calculate the yield for a property costing $250,000 or less, according to Redbrick Partners co-founder Tom Skinner in an October 2, 2005, Chicago Tribune article, is “rent divided by two divided by price.” Typically, that gives landlords their yearly rental profit on a property to within 1 percent. It doesn’t account for any estimate of future appreciation or depreciation, but it is a pretty accurate measure for someone trying to determine if he or she will be make any money by buying a house and renting it out.