Wealth Building Lessons

I’ve previously mentioned how much I love investing in Real Estate, with its leverage and all its tax advantages.

But you must have heard about the hedge funds that invested in collateralized debt obligations on subprime residential mortgage-backed securities and are now worthless, mortgage companies like Novistar and American Home Mortgage going bust, home-builders like Beazer Homes (BZH) and WCI Communities Inc (WCI) rumored to be on the verge of bankrupcy, the widespread drop in home prices and a huge spike in the number of foreclosures.

With all this negative sentiment, I bet you’re wondering if it’s a good idea to invest in real estate?

Well it depends. If you’re thinking of investing in San Francisco, Los Angeles, San Diego, Sacramento, Miami, Orlando or Las Vegas I’d recommend against it. In fact, Forbes magazine rated these places as amongst the riskiest markets in the nation. I wouldn’t even consider buying my primary residence in one of these right now. In fact, I sold my primary residence in San Diego in the summer of 2005. Since then inventory has increased dramatically to where there’s a 13-14 month supply and the sales of homes is only 30% of the new listings. Home prices are dropping and foreclosures are creeping up too.

In fact, despite incessant cheerleading by the National Association of Realtors that the market will re-bound in the beginning of 2008, a few economists believe that we’re in for at least another 18 months of weakness in the housing market. This is based on various factors like the fact that in the past 6 months we’ve had about $192 Billion worth of mortgages adjust to a higher rate and in just February and March of 2008, $196 Billion will adjust probably leading to a further spike in the number of foreclosures.

Along with price drops and inventory increase, I think mortgage rates will increase substantially, especially for investors.

Mortgage rates usually follow the yield on the 10 year Treasury. Since the yield on the 10 year Tbill has been dropping over the past month or so. I thought the mortgage rates would be trending down. Not So! There’s been a divergence between the two. Looking at the 3 month graph of ^TNX (which is the yield on the 10 year Treasury), we see that its been in decline as people flock to it and push the price up and the yield down.

In June I had refinanced one of my properties in Salt Lake City. I did an 80% LTV cash-out refi and got a 10/1 IO NOO ARM at 5.5% with 1.65 points. If you don’t know what the means, you need to read this post on mortgage terminology. Basically, I refinanced the house to a 10 year Adjustable Rate Mortgage, with a 5.5% rate with Interest-Only payments on a Non-Owner Occupied property and pulled out cash so the total loan was equal to 80% of the homes current value. In order to get the low rate I had to buy down the rate with pre-paid interest called “points”, which were 1.65% of the total loan.

Two weeks ago I wanted to get a similar loan for another property. I spent 90 minutes on the phone with Countrywide and ended up locking in a 7/1 IO ARM at 6.75% with 1.5 points. Quite a hike in the rate!

However, I called up on Friday wondering if the the rates had dropped, since the 10 year T-Bill was lower than when I locked in the price.

Unfortunately, the rates on investment property had moved much higher. On a similar loan at 6.75%, I was quoted 3.875 points on a 7/1 ARM, and 4.75 points on a 10/1 ARM. 4 points on a $250,000 loan is $10,000 in pre-paid interest! Plus there are various other closing costs. Thats like paying 11% interest in the first year.

Basically the mortgage companies are saying we’re not interested in doing investment loans anymore so we’re going to make it very unattractive to you. So along with the subprime borrowers, the number of investors buying investment property will also substantially decrease. This will reduce the demand for housing even further.

I definitely wouldn’t recommend someone in California, Florida, Nevada (or those other boom states) to start investing in real estate just yet. If you know what you’re doing, and can set up a system where you buying cheap under-market properties and immediately flipping them to home buyers, that will work, but thats not an easy business for a beginner.

However, there still are real estate plays for your stock portfolio. Avoid Mortgage Companies and REITs because you don’t want to take the risk in this environment. But companies that buy land and properties in South America like IRSA Investments and Representations Inc. (IRS) and Aracruz (ARA), Japanese REITs (which currently don’t trade on the US stock exchanges) and companies in other businesses with tons of land on the books at extremely low valuations are safer ways to increase your exposure this asset class.

I also like real estate in southern Thailand, where coastal property is unbelievably cheap and stunningly beautiful. You can buy a condo on the beach for about $100,000 USD. Even Mexico is becoming more expensive than that. However, thats not without its own challenges so unless you have a lot of spare cash (forget about 20% down, you’re more likely to need 50%+ ) and can work around the laws that make owning land (but not condos) for foreigners next to impossible, you might as well pass. Similarly, land in Vietnam is also cheap.

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