A Warning for Condo Speculators

Chicago Sun Times ^ | 2/16/2005 | Terry Savage

[ex-Texan]

Q: My husband and I were on a great path to being financially stable. We both started saving for retirement early on, we both have great credit and we have always tried to live within our means and save for a rainy day.

Before we were married, we purchased a condo in the loop. After we were married for a year, we decided to buy a second condo for investment purposes -- and this is where the trouble starts. We used $20,000 that we had saved -- for a rainy day -- and took a second mortgage on our unit for $20,000 to make up our down payment for condo number two. The real estate developer was offering one full year of mortgage, assessments and taxes as an incentive to buy -- not to mention the unit was rented.

We thought this was a win/win situation. We would have two years minimum of no out of pocket costs, and at the end of that period or even before we can put the unit on the market and sell. We figured even if the value only increased by $5,000 it was still a good thing.

When we applied for a mortgage, the lender informed us that our credit score was good enough that they were going to approve us for a no doc loan. I now think this was a red flag for us to realize "this means you really can't afford this loan, but we're going to give it to you anyway."

Well, here we are two years later, and I fear of what is to come. We put the unit on the market in April 2005 with no luck thus far. We first started the price out high, but by the summer we had came down to our exact purchase price.

In November 2005, the tenants' lease was over, so they left. Now we are in the last stage of the two-year period with no out of pocket costs. We are hopeful that we will get a tenant in the spring, but the rent does not cover all of the costs of owning the unit. We pay our current bills no problem, but once we have to start covering the costs of our second condo on our own, there is going to be no way.

I know the bank will want us to blow off our current debt and pay them first. We've worked so hard to keep our credit scores looking A+, and now I'm afraid of what is going to happen.

I know you can't tell us what to do, but can you advise me on how to handle this? Should I start talking to attorneys or debt consolidators? I just want to be pro-active in taking care of this costly mistake.

A: I hope you don't mind that I'm going to print your letter -- with no names, of course -- because for sure you're not the only ones in this situation. About two years ago the speculative condo boom was at its peak. And now many speculators are about to find out that it doesn't take a "crash" or "breaking the bubble" to create your own personal speculative crisis. All it takes is being unable to cover the carrying costs.

Now, I'm going to tell you exactly what I told a woman I know who mentioned she was in the same situation way back last summer. I don't know if she followed my advice, but I told her then and there to reduce the offering price at least 10 percent below what other condos were going for in the same building -- and to tell the realtors that she would offer them an extra incentive if they'd sell it by Labor Day. I told her that at least she'd be the first one out the door -- before the rest of the crowd figured out the situation, and cut their prices too. And when she said she didn't want to cut the price, I reminded her that the carrying costs for an extra six months would be equal to the price cut.

I told her then that I knew I would be writing about this phenomenon in six months -- and now it's starting to happen. So my advice stands. If you can't carry this property, then you have to bite the bullet and list it at such an attractive price that it is the first one that gets sold.

Now, by printing this response I know I'm going to get letters from other people accusing me of starting a "run" on the condo market. So let me forestall that. I don't think I have that power, to suddenly frighten people into selling. I think that the selling wave will happen inevitably because so many people are over-extended in the speculative condo market. If you can get a renter, and carry the difference, fine.

I believe in real estate as a long term investment. But if, as in the case of the people who wrote me in this letter, the carrying costs are too burdensome, it is better to act sooner than later.

And one more thing. They didn't say, but I'm betting that many condo speculators had adjustable rate mortgages, expecting to sell within a couple of years. If interest rates do continue to rise, then the carrying costs could adjust upward even more. It's something to keep in mind.

That's The Savage Truth.

[MineralMan]

Wow! That sounds like a real scam, and I'll bet the guy clears his own risk, while leaving his "clients" holding the bag. It's too bad so many people are so easily convinced of things.

The Scientology link is also scary. It's good that you're outa there.

[BagelFace]

"What is a No Doc loan"

I believe that is when the transaction is finalized solely by a verbal agreement followed by a firm handshake.

[MineralMan]

Basically, that's it. A No Doc loan is based on your statement of your income and your credit score. Watch yourself on this, and don't get hooked into any fancy loans. If you stick with a fixed rate, long-term loan with a substantial downpayment, you'll be OK, as long as the payments are doable without strain.

However, the interest rate on such a loan will be a bit higher than a traditional 30-year mortgage. You might want to think about just a straight loan where you have to provide the documentation.

[NYFriend]

Thanks. What's considered a "substantial down payment"? I took a home buying class from a broker last year (adult ed. classes are a great deal, it cost me $10). The broker said you need to have about 12% of the purchase price on hand as cash to cover taxes, fees, inspections and down payment. It worked out to be about 5% down, which sounds pretty low.

[TXBSAFH]

FYI, I heard on the news this morning driving in that Washington Mutual was alying off 2500 people from its morgage division.

[walford]

I recall G. Gordon Liddy saying on numerous occassions to never buy real estate w/o a lawyer.

You'll notice that the buyers in this story felt queasy about the 'no-doc' loan scenario, but their 'eagerness' overcame any thoughts of prudence. So they went ahead anyway.

Sometimes our initial instincts are correct.

[Centurion2000]

I heard on the news this morning driving in that Washington Mutual was alying off 2500 people from its morgage division

That's a huge red flag.

[TXBSAFH]

That and the number of repos I have seen in the market is up.

[MineralMan]

Seems like FR had a glitch. I answered this earlier, but the reply didn't post.

These days, who knows what a down payment should be? It has changed so much. The more, the better, though. But, you'll have what you have, I imagine.

I'd put some bucks aside, though, preferably in an account you won't access, due to some sort of penalties. A 5-year CD is good, these days, and the interest will come fairly close to your mortgage rate. The idea is to have a reserve to pay your mortgage in case of a crisis like a lost job or illness. I'd call 6 months of mortgage payments the minimum.

This is going to be your home, long-term, if I understand you correctly. I'd put as much into it up-front as you can and try like crazy to pay it off before you retire. Having no mortgage payment after retirement is really good.

[The King of Elflands Daughter]

Depending on your age and family situation, you might consider not basing the mortgage on both salaries. That way, if you are young and don't have kids yet, you don't have to keep both parents in the work force when there is a baby. It's one of the things that I don't regret doing, but everyone's situation is different.

[MineralMan]

"You'll notice that the buyers in this story felt queasy about the 'no-doc' loan scenario, but their 'eagerness' overcame any thoughts of prudence. So they went ahead anyway.
"

And now they'll pay. Mortgage brokers are evil people. Two years ago, they were all selling cars. Now they're selling paper. They take their commission, and that's all they care about. How the terms of the mortgage affect you is irrelevant to them.

I have not met a single mortgage broker I would have near me. Not one.

[TXBSAFH]

I know a guy who owns 5 rental properties, he has had them for years. He is selling them all.

[Koblenz]

Be responsible for your investments and your loans. We have an interest-only 7 year ARM, 2 years into it. I only make the minimum interest payment each month.

However, I also put another amount, equal to about half my interest payment, into an S&P 500 index fund. It is automatically deducted from my account. I am doing that in lieu of my mortgage principal, as I believe that over time, the S&P will beat the mortgage interest.

Furthermore, the mortgage is less than 50% of the house's current value. It was about 55% of the value when we moved in two years ago, but I figure the house has appreciated somewhat, if nothing else than the fact that it has a new roof and boiler and basement floor and a bunch of other stuff we financed out of pocket to repair / upgrade.

[Dont_Tread_On_Me_888]

I wish I could help you, but for others:

1] Failure to use the advice of professionals often costs "do-it-yourselfers" fortunes. I have been advising against direct real estate investments for about one year now. I was advising FOR real estate related investments in 1999-2004/05 period. There were four mega-waves all happening together that pushed real estate demand higher, and nearly all these factors have run their course and are reversing, slowing or flattening.

2] This couple purchased the second condo for an "investment". Not trying to play Monday-morning quarterback here but the typical Latin America fund (iShares "ILF", for example) was up about 50% last year and over 100% over the last two years. $40,000 invested here would have grown to $80,000 in the last two years, a far different scenario than what the condo deal turned out to be.

The point I am making here re the Latin America fund is not that it would have been wise to mortgage $20,000 to invest in a stock index, but that TRENDS were different--real estate was at a peak and due to come down (or demand come down) for about four major reasons, and by contrast, stocks in general and international (and small cap and mid cap) indexes were doing VERY well and in EARLY stages of an upturn. Real estate is late stage right now.

3] Major investment decisions should be made in concert with a highly qualified investment advisor--with real estate, that is NOT a real estate person, but a true adviser qualified to advise across ALL investment classes.

The "Money Magazine", discount broker, do-it-yourself push, etc. is quite harmful to the typical person. Most investment variables are much more complex than what most people believe.

In my practice, you would not believe the percentage of investors I have advised who have, over the last five years, had most their 401k, IRAs etc. money invested in large cap stocks, even though large cap stocks have trailed badly mid and small and international for better than six years. People think they know what they are doing, but most do not have a clue about all the factors involved in what makes things tick now versus earlier versus projected later.

I can't help this person now, but hope that some future "do-it-yourselfers" that lack sufficient knowledge take warning. Always better to seek sound advice before taking such great risk.

NOTE: All points here are general and used for example purposes and are not to be taken as specific advice for any one individual.

[TXBSAFH]

You are probalbey in good shape, just because you are so upside on the mortgage. But there are people out there who owe 100% or more with intrest only loans because that is what they could afford. If this market goes south as I think it will there will be a lot of people losing their shirts.

[agrarianlady]

Anecdote.

We sold our large house last March. We realized it was not a good long-term investment as the carrying costs would be not worth it over the long term. (the size of the home being the issue, as well as the way it was built).

I went to the lawyer's office to close and he said how good real estate was as an investment. I said I was looking to diversify. He grinned to my real estate agent next to me.

She said later in the car that they had liquidated everything they own, including their 401Ks, to buy a beach house with a no-doc loan.

Oh well.

We are currently renting and hanging onto the cash. There has been a 400% increase in inventory here in the exurbs of Northern VA so we have much more to choose from if we want to buy again. But maybe we'll wait. Somehow I don't feel the urge just yet.

[TXBSAFH]

The only real estate I would invest in now is a home for my family. I think the market is going down soon.

[walford]

"And now they'll pay. Mortgage brokers are evil people. Two years ago, they were all selling cars. Now they're selling paper. They take their commission, and that's all they care about. How the terms of the mortgage affect you is irrelevant to them."

But one is not vulnerable to that sort unless laziness, ignorance and greed are factors on the 'victims' side. This is why charlatans prey upon certain old ladies who are themselves looking to make a quick buck without bothering to do the research or ask too many questions.

My sympathy goes only so far.

[Onelifetogive]

Not trying to play Monday-morning quarterback here but the typical Latin America fund (iShares "ILF", for example) was up about 50% last year and over 100% over the last two years.

This is a great trick, but as an investment advisor, telling me what will be up 100% over the NEXT TWO YEARS would be significantly more valuable.....

[DCPatriot]

But there are people out there who owe 100% or more with intrest only loans because that is what they could afford. If this market goes south as I think it will there will be a lot of people losing their shirts.

If it's your primary residence you only "lose" if you sell it.

Yes, you lose paper equity, but...it was only paper to begin with.

Condos are still very strong in certain locations.