Is It Exceptionally Smart or Insanely Stupid To Invest in Real Estate
by Mark R. Crovelli
by Mark R. Crovelli: Donít
Disarm the Mentally Ill
As a graduate
student and construction worker in San Diego from 2003-2005, I was
afforded an up-close view of the inflation of the last real estate
bubble. It was a truly exciting time to work in the building industry
in Southern California because there was so much money sloshing
around. I literally couldnít even walk into Home Depot without being
accosted by hordes of greedy homeowners and slippery contractors
offering to pay cash to anyone willing to do construction work.
knew was making piles of easy money buying and flipping homes, and
I often heard that I was just plain stupid to not be buying and
flipping some of my own. I was content to just be able to finance
graduate school without debt, however. I decided to move back to
Colorado to finish graduate school at almost precisely the moment
that my friends started making really big money in real estate.
They all thought that I was insanely stupid to leave.
A year later,
an article predicting the collapse of the real estate bubble.
A year after that, my friends in Southern California started losing
their jobs, and a year after that many of my old friends started
losing big money. My decision to avoid real estate investment looked
a lot less stupid at that point.
Only six years
have passed since the largest housing bubble in world history imploded,
and I am once again receiving investment advice from my friends
involving real estate. Instead of buying and flipping homes, they
are now promising me piles of easy money if I purchase "investment
homes" to rent out. My friends are not quite as exuberant as
Californians were in 2006, but the pitch of their excitement is
I am not sold
on the idea at all, however. In fact, I think my friends who are
piling into "investment properties" right now are setting
themselves up for losses on a scale only surpassed by the losses
suffered in the last real estate crash. Real estate is still extremely
dangerous, and only people with a solid financial cushion and who
are willing to take gargantuan risk should be moving into it.
In order to
see why this is the case, first consider the role of property taxes
in real estate investment. Quite obviously, the higher the rate
at which a property is taxed, ceteris paribus, the lower
the value of that piece of property. This much is obvious. But what
most real estate investors do not consider at all is the fact that
property taxes can change. The fact that taxes have been
X amount for the past ten or twenty years is completely irrelevant
if a government decides to raise or lower the rate at which it taxes
the important consideration from an investment standpoint is the
rate at which real estate will be taxed in the future. In
order to make an informed guess about future property taxes, however,
the investor must attempt to forecast the financial condition of
the government that taxes the real estate in any given area. Governments
facing serious financial difficulty in the future should be expected
to try to gouge property owners to make up for budget and pension
is, however, that it is almost impossible to figure out the financial
health of any given municipality. The municipal bond market, which
is a decent proxy measure of municipal financial health, is one
of the most opaque, illiquid and misleading markets out there. Even
the incompetent SEC admits this, by the way. Not only that,
but many municipalities that are seemingly healthy, and which are
still able to borrow massive amounts of money at low rates today,
are completely bankrupt from a long term perspective. Many school
districts in California, for example, have been engaging in myopic
borrowing schemes that basically ensure their future insolvency.
More accurately, these municipalities will assuredly be bankrupt
in the future if they donít raise property taxes dramatically.
To think that
these bankrupt municipal governments and the hoards of government
workers and pensioners they parasitically support are going to just
file for bankruptcy and lay off massive numbers of teachers, police
officers and firemen is just plain silly. Of course they are going
to try to pry as much money out of their tax bases as they can.
If you are a property owner that means you, and your property
taxes are going up Ė potentially substantially Ė at some
point in the future.
If you think
this is merely idle speculation, it is useful to note that the largest
tax revolt in U.S. history occurred during the Great Depression
primarily over property tax rates, as
David Beito has documented. The obvious reason why real estate
stuck out as an easy target for government pilfering during the
Great Depression was, as Beito notes:
could not be effectively hidden from [the governmentís] purview,
the assessor and collector did not have to engage in costly and
unpopular detective work. For all intents and purposes, taxpayers
could not conceal their taxable real estate from the authorities.
When real estate taxpayers, either by choice or necessity, lapsed
into arrears, their delinquency became apparent for all to see.
of visible and immovable wealth are prime targets for bankrupt governments
looking for low hanging fruit. Greek
homeowners found this out the hard way last year. Hence, investing
in real estate at a point when huge numbers of governments are about
to go bankrupt is just an invitation for them to rob you. When the
bond bubble bursts, and municipal governments are en effect
barred from borrowing money to finance their "services"
and pension schemes, where do you think they will turn for money?
The answer, of course, is real estate owners.
unless you are some sort of expert on the financial wellbeing of
the municipality in which you are planning to purchase property,
which is almost impossible for anyone to be, you are making a gigantic
wager on future tax rates over the next 30 years. That, to me, is
the definition of reckless stupidity.
taxes are not the only worrying factor for prospective investors
in real estate. Another fantastically troubling issue is the fact
that interest rates are bound to rise at some point. Even setting
aside the question of whether rates will rise in the next few years,
they are bound to rise at some point before that 30 year mortgage
you are considering taking out is fully paid off. No one with even
a modicum of brain matter could possibly think that we could have
near zero rates for the next thirty years.
means from an investment standpoint is that you will probably be
underwater at some point if you buy an investment property right
now. In plain language, being "underwater" means is that
the value of the home will be less than the amount you owe on the
mortgage. The reason why you are likely to get underwater is that
when interest rates rise, fewer people are either willing or able
to purchase homes at existing prices. While a mortgage payment on
a $200,000 loan at 5% is $1282, the payment on the same mortgage
is $1675 if rates rise to just 8%. A move of just 3%, which is not
large from an historical perspective, results in almost a $400 rise
in a mortgage payment. This means that fewer and fewer people are
willing or can afford to buy houses at existing prices as rates
rise. Hence, home prices will inexorably fall as a result of a rise
that when a person is paying off a mortgage, even a mortgage on
an investment property, he is paying off mostly interest at the
beginning of the loan term. So, even though you might be thinking
that you are building up equity in the home that will offset the
risk of being underwater at some point, you are probably not building
up equity nearly as quickly as you think. If the value of the home
falls 20%, which is perfectly possible in a market manipulated by
government as much as this one is, you are very unlikely to have
built up enough equity to be able to get out of debt if you have
to sell the home before you pay off the mortgage. This means you
are stuck with this "investment home" until home prices
rebound, assuming that the ever do.
not a problem for rich investors who buy homes outright with cash,
but, as was noted above, what kind of a lunatic would want to park
hundreds of thousands of dollars in an investment that canít be
hidden from government and should be expected to be heavily taxed
by bankrupt municipalities looking for easy targets in the future?
imagination takes it for granted that it is smart to move into real
estate when rates are low, but the picture is much more complicated
than that today. Prospective homeowners, especially young ones,
should realize just how much of a hindrance real estate investment
can become. Almost 40%
of younger homeowners are already underwater today, and that
number will grow when rates rise and home prices fall again. When
that happens, these homeowners are stuck with the investment. Moving
away from the home becomes more difficult, selling it almost impossible,
and they are in even bigger trouble if they lose their jobs. Under
such circumstances, renting out the property can be the only option,
but, as we will see below, the future of rental prices in this country
is far from rosy.
consideration that seems to be slipping everyoneís minds today is
that rising interest rates will mean that other investment opportunities
are opening up in other sectors of the economy. There will be opportunities
in CDís, corporate bonds, and money market funds, for example, to
earn a very good return on oneís money without the need to tie up
oneís money in a 30-year investment. These opportunities will be
opening up at precisely the time that home prices will be falling
due to rising rates. Todayís investors in real estate will have
their money tied up in an investment that is falling in price, and
they will not be in a position to capitalize on these opportunities.
of most frequently citied issues influencing real estate investors
today appears to be a fear of inflation. As a devotee of the Austrian
School of economics, I view it as a positive thing that inflation
fears are more widespread than ever before in my lifetime, but I
worry that these people are not viewing the situation with a wide
line of thinking when it comes to real estate and inflation runs
something like this: If you purchase a home today with a fixed loan
at 5%, you will wind up paying off the mortgage with dollars that
are worth much less than they are today. You will thus wind up paying
much less for the home than it is actually worth.
of thinking is correct, as far as it goes, but it does not capture
the entire picture. Specifically, this simple line of reasoning
fails to capture the fact that banks would be massively hit by such
inflation. The banks and other investors holding mortgage-backed
securities would soon discover that they were holding an investment
that was turning out to yield much less than they expected. Instead
of earning, say, 5% from the interest on these mortgages, they would
soon find out that they were holding a security that was earning
negative returns, taking inflation into account. This much
is just obvious, since inflation inexorably benefits debtors and
get interesting, however, is how the banks and other Wall Street
investors are bound to respond in the face of these massive real
losses on their mortgage portfolios. Prospective real estate investors
today must just assume that the banks and other Wall Street investors
are simply going to sit back and say "Hey, we are suffering
huge real losses on those mortgages from before the inflation. I
guess we just have to take it. Too bad for us."
I think, is to assume that the banking cartel is going to do everything
in its vast power to weasel out of the mortgages, and that Congress
and the judicial system are bound to help them to do it. The last
six years were basically a gigantic practice run for the bankers
in how to save their sorry asses through legal obfuscation, threats
of "systemic failure," and using their corrupt buddies
in government to screw ordinary Americans. If you think the banks
are above doing this again when they start taking massive inflation
hits to their portfolios, you are a much more trusting person than
basis for weaseling out of these mortgages is already in place,
and it is called "calling in" the loans. Virtually every
mortgage contract has provisions for calling in loans, which means
that the lender is allowed to demand full repayment of the loan
prior to the loanís completion date. Usually, these clauses involve
situations when the debtor has failed to make a payment or to pay
his property taxes. All the banks need to do is encourage local
governments to raise property taxes, which they are bound to do
anyway since most of them are broke, and this will put more and
more homeowners in arrears in paying them. This is almost exactly
what happened in the Great Depression. At the same time, the banks
will immediately call in all loans that involved any missed payments
in the past (and there are massive numbers of people who have missed
payments over the last six years), and you have a perfect escape
hatch for the banker scumbags to get out of these loans.
surely other ways than this for the bankers to save their own asses,
but the point is that investors in real estate are just plain kidding
themselves if they think that they are going to outsmart the American
banking cartel and the corrupt American congress when it comes
to inflation and real estate. After all, what good is a cartel if
it canít act in times of crisis to save its own membersí asses and
screw everyone else?
nail the real estate coffin, from my perspective, is the fact that
rental prices in the future canít possibly live up to current expectations.
Rental prices and home prices in general are currently inflated
due to the "extraordinary"
number of vacant homes all around the country. The artificial restriction
of supply that has occurred by having these homes sitting vacant
simply cannot last. One way or another, these homes are eventually
going to be occupied by Americans or foreigners. Some of them will
simply be "homesteaded"
by squatters. Others will be bought by starry-eyed investors
hoping to rent them out. Still others will be bought by foreign
gangs hoping to launder money with the assistance of the National
Association of Realtors. No matter how these homes wind up being
occupied, they will put downward pressure on both home prices and
rental prices going forward.
is compounded by the normal problems associated with renting properties,
like finding reliable renters who are not going to trash the place,
regular maintenance costs on cheaply built houses, and finding renters
who will pay their rent on time. Add to this the fact that the insurance
companies that insure these homes are sitting on piles upon piles
of government debt, which will obviously be devastated by the bursting
of the bond bubble, and you have a recipe for the next real estate
not take a rocket scientist to realize that the bursting of the
largest real estate bubble in world history is bound to last for
more than a handful of years. This is especially true when it occurs
at a time when governments all over the world, including
the supposed hegemon, are completely broke. To think that investing
oneís money in an asset that canít be hidden and that canít be moved
at such a time is "smart investing" is sublimely naive.
a time for protecting and, for a lack of a better term, concealing
oneís assets from the prying eyes of bankrupt governments. Money
that looks too easy to make probably is, and money thatís parked
in a manner that looters can see, (and
government is the best looter in history), will probably be
in mind the next time you dental hygienist or your brother in law
tells you that you are going to become a millionaire if you just
start buying houses today.
Crovelli [send him mail]
writes from Denver, Colorado.
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