Do You Buy Real Estate Now or Wait? Part 1/3

To become wealthy in America, the old adage has been you either buy real estate, invest in stocks or inherit. Unless you have rich relatives who are going to leave you a nice nest egg, like most of us, you probably have to decide how to invest in stocks, bonds, real estate, precious metals or your own business to acquire wealth.  The last few years this hasn’t been easy to do, except of course for the current bull run in precious metals like gold and silver.  In fact, buying gold has been about the only sure thing the last decade.

Stocks haven’t returned much over the last 10 years and real estate, while historically a long term great place to invest, has of late been a guessing game as to whether to buy and jump on that road to riches securing your piece of the American Dream or wait till things settle down some more.

For years when I was selling investments, I would run across real estate investors who had all the answers.  I finally came to admit during those days that there really wasn’t anything, from a long term perspective, that could beat real estate as an investment.  But when the euphoria of owning real estate got to madness levels in the mid 2000’s, something had to pop.

The Real Estate Investor Knows Everything

I remember in 2006 speaking to a real estate investor about diversifying into gold and his comment was; “You mean to tell me you think gold is going to do better than real estate?” I spoke with another person who owned about $10 million in real estate tell me in 2006 that if the real estate market fell, he’d be buying more. This is the mindset of the real estate investor.  They have known no time in the past almost 20 years where real estate wasn’t a good buy.

Unfortunately, these folks didn’t sell in 2006 and have since seen the “sure thing” turn into a pump and dump from its peak.  Many real estate investors were left with either foreclosure or the hope of government intervention as their only way out of the mess.

Those who were fortunate to get out though, might be thinking of getting back in today.  And those who are new to the game need some understanding as to “what’s happening now” before taking the leap into ownership.

Since the peak of 2006, with the subsequent stock market fluctuations and ever increasing unemployment that followed, real estate investors have learned there are some risks one needs to consider before going “all in” with purchasing property. They’ve also learned the need to diversify.

This article will explain those risks at present from an interest rate and economic analysis and try and shed some light on whether real estate is still the best place to put your money or if there are some risks related to pursuing the American Dream of owning your own home.

Who Knew So Much Criteria Would Go Into Buying A Home

Along with an interest rate analysis, this article will include economic  observations of  GDP, the U.S. Dollar, Unemployment, Wages, the Federal Reserve, Consumer/Baby Boomer Sentiment, Household Debt, Government Spending, Inflation and more.

Real Estate agents and investors can benefit from this analysis as well since they are the one’s who seem to always be “gung ho” in buying property themselves or attempting to get others to buy.

Real Estate Agents Don’t Make Money Until You Say Yes

The tactics real estate agents use in getting you to sign on the dotted line will vary. Lately they’ll tell you “real estate prices are at historic lows and so are interest rates” or “the market has been coming back and you better get in before it takes off without you.”

While interest rates are at historic lows, real estate is not going to take off without you. Let’s look at interest rates first and then see what the future holds for real estate and whether you should buy now or wait.

Interest Rates Are At Historic Lows

One of the main reasons to buy real estate today is interest rates are at historic lows. In the 80’s when I was doing financial planning for folks, they would brag about having purchased their home in the 60’s and only having a 5% rate for their 30 year fixed loan. Interest rates never fell below 9% in the 80’s compared to the 60’s, so they had good reason to brag.

Source – Measuring Worth

Does today represent the 60’s?

Unfortunately today doesn’t represent the 60’s except for one side of the equation; interest rates.  Mortgage Interest Rates today have a national average of 5.14% according to bankrate.com which is equivalent to the same rate of 1966.

Why Are Interest Rates at 44 Year Lows?

When answering this question, one need only look at the Federal Reserve who technically manipulates the markets based on their own understanding of the economy.

But the economy goes through business cycles in which output and employment are above or below their long-run levels. Even though monetary policy can’t affect either output or employment in the long run, it can affect them in the short run. For example, when demand weakens and there’s a recession, the Fed can stimulate the economy—temporarily—and help push it back toward its long-run level of output by lowering interest rates. That’s why stabilizing the economy—that is, smoothing out the peaks and valleys in output and employment around their long-run growth paths—is a key short-run objective for the Fed and many other central banks.

How Do Interest Rates Affect the Economy?

Lower interest rates make it easier for people to borrow in order to buy cars and homes. Purchases of homes, in turn, increase the demand for other items, such as furniture and appliances, thus providing an additional boost to the economy.

Lower interest rates mean that consumers spend less on interest costs, leaving them with more of their income to spend on goods and services.

Lower interest rates make it easier for farmers, manufacturers, and other businesses to borrow to invest in equipment, inventories, and buildings. Also, the returns that investments will produce in future years are worth more today when rates are low than when rates are high. That gives business more of an incentive to invest when rates are low. Increased business investment, in turn, makes the economy grow faster, as productivity, or output per worker, increases faster.

At least that’s the Federal Reserve’s plan in theory.  In practice, many blame them for the meltdown.

The reason those people I met in the 80’s were so happy in securing low interest mortgages is what the Fed is afraid of.

Another problem is that a surprise inflation tends to redistribute wealth. For example, when loans have fixed rates, a surprise inflation redistributes wealth from lenders to borrowers, because inflation lowers the real burden of making a stream of payments whose nominal value is fixed.

The Fed of course views this “surprise inflation” as a bad thing….for the banks.  In fact, it’s a good thing for those who have a low interest fixed rate mortgage.

The inflation of the 70’s and 80’s caused interest rates to shoot up.  Those who got in with low priced loans were taking advantage of inflation in that banks couldn’t adjust their loans higher to take into account current higher interest rate trends.  That’s why today, it makes sense to have a fixed rate mortgage as any adjustable rate mortgage is for sure going to cost you more in the long run once this inflation kicks in (and it will).

Is this why banks are so stingy to loan to people today?  Does this mean now is indeed the time to buy real estate?

To answer these questions, we first we need to understand the economic analysis.

Certified Financial Analyst Vitaliy Katsenelson offers his take on what’s happening noting the move by the Federal Reserve to stop buying mortgages via Fannie and Freddie has not caused a rise in interest rates when normally it would.  This further shows why the Fed doesn’t want to rain on the housing parade at present.

Uncle Ben went off quantitative easing in the mortgage market in late March, or, in plain language, the Federal Reserve stopped buying mortgages of Fannie and Freddie in the open market, which had been keeping mortgage rates artificially low.  Of course, the Fed stopped doing this after going through a trillion dollars (billion doesn’t impress anyone, not anymore).  I am watching mortgage rates closely, because the Fed’s sudden absence from the mortgage market should, in theory, drive interest rates up.  Practice so far disagrees with theory: mortgages rates ticked up a little in early April and then declined again.  Mortgage rates are extremely important to the housing market, as they determine housing affordability – higher interest rates, in the 6-7% range, may reignite a double dip in the housing market.

Today, you’ll have a hard time finding a bank that wants to originate and keep fixed-rate mortgages on their books when interest rates are at 5% (this is why almost all mortgage originations are backed by Fannie or Freddie).  First of all, they don’t want to expose their balance sheets to significant interest-rate risk if/when rates rise, which is a common expectation, but they can hedge that. Second, and most importantly, at 5% you are not charging enough for risk; and finally, why bother with extra paperwork if you can borrow at close to zero percent and buy risk-free (or so we truly hope) government bonds instead?  Higher, free-market-set long-term rates may change this behavior.

Parts 2 and 3 will be forthcoming… I have to keep these posts as short as possible so people will actually read them rather than see how long it is and decide not to read.  Unfortunately, that’s human nature these days.