A recent quarterly survey by N.A.R. found (National Association of Realtors) that U.S. home prices rose at an annual rate of 13.6 percent. When you adjust the rise with inflation, according CNN Money, this is the strongest increase ever recorded! The biggest gainer being Phoenix, AZ.
When you compare this with the last article I published, it looks like the market is ripe for a bad downturn. Based on this last article which showed that the majority of Californian’s were over $70k short of income to support the median home, it’s hard to find where these gains are coming from. Earlier in the boom, interest rates really helped to explain the growth. Of course there are other factors like population growth, increased economic health, etc., however interest rates were probably the biggest driver to increased housing prices. Almost every 1% drop in interest rate increased the housing affordability by approximately 10% (based on the same monthly mortgage payments).
Today however the real estate market is completely different. Interest rates are now climbing thereby decreasing the mortgage amounts people can afford. The problem is that the lowering of interest rates created a bubble, where the prices were no longer determined by logic. If you ask the vast majority of people on the street just how much interest rates can affect real estate prices, they can’t tell you. Actually, if you ask these same people why housing prices have increased, they can’t give you a logical answer other than houses are a great investment and they’ll always increase (which isn’t true by the way). What’s happened is that emotions are now ruling the market, setting us up for a large real estate crash! The good news is that there are many things you can do to protect yourself.
10 things to do to protect yourself from the upcoming housing crash:
1. Generally avoid the real estate markets with the strongest gains. Although not perfectly accurate, it’s a good metric to start with. It’s the same principle as the dot com boom. The tech companies that has the largest and unexplainable gains where the most likely the ones that fell the hardest. Not always, but generally. The same is probably true for real estate markets.
2. If you’re going to buy a property, get a fixed rate mortgage of at least 10 years, preferably more. Based on the last 40 years of data, no real estate bust has lasted more than 7 years, so with a 10 year fixed rate, you should be protected from any interest rate increases that cause the market to crash. As well, this gives you a much more accurate idea of what your fixed costs will be. Therefore if you can’t get positive cash flow today, you should be able to keep that positive cash flow for at least 10 years.
3. Avoid interest only mortgages. Plain and simple, avoid them! These are very risky for most people because very few people are adept at handling the associated risk. If you can only afford your home this way then you’re buying too much home. You’re putting yourself at a high financial risk. Fortunately for real estate investors, and unfortunately for uneducated home owners, 31% of all new single family mortgages in 2004 were interest-only mortgages which will create great deals in the next few years.
4. Start hoarding your cash now for when the market does drop. This will be a great time to get properties much lower than today. Based on the housing affordability index of California, we could see drops as high as 56.7%. Who wouldn’t appreciate the possibility of purchasing properties as much as 50% lower than today!
5. If you’re going to pull out equity from your house, verify that you’re not over-financing yourself, that you have the same protections mentioned above as someone buying today.
6. Assumable and transferable mortgages provide you with more protection than not because if interest rates increase as expected, you can sell your mortgage with your property at today’s low rates. So for example, if interest rates climb to a historical average of 8-10% lowering the prices of homes, you can still sell your properties higher than the neighbors because you can also sell the mortgage with the property. That is you don’t have to decrease the price of your property by 30-50% to keep the same monthly mortgage payments, your transferable mortgage does it for you!
7. Whatever equity you pull out today, don’t use it to acquire consumer goods or pay off consumer debt. Use it wisely because you will need it tomorrow.
8. Assuming you went with a low down and a short term mortgage (either variable or 5 year fixed), start preparing yourself by saving as much cash as you can because if you have to refinance (say in 5 years), and you owe $200k on your property, but the price has dropped to bring it below that, say to $180k, then you will have to come up with some additional cash to cover your refinancing. In a bust real estate market, banks will probably not lend out 100+% mortgages. You’ll have to come up with at least that additional $20k, probably more.
9. Verify that all your properties are cash flow positive. Not that they shouldn’t be, but if they aren’t, it’s going to get a whole lot more difficult for you if you have a short term mortgage (5 years) or a variable mortgage as interest rates increase.
10. CASH IS KING! Start saving your cash now. This is where fortunes are made and lost, and fortunately for those with cash, this is where they are made! If you look at history, the common person buys at the peak of market booms and sells at a loss in market busts. Whereas strong investors, those that have lasted through many busts and booms, generally do the opposite. The near future will be one of those times, be prepared for it!