When to Avoid Buying Real Estate
The U.S. real estate market continues to see strong growth despite the COVID-19 recession. Overall home prices have risen dramatically in the last decade, even tripling in some markets. Active markets are seeing multiple offers with buyers bidding up prices above the listed price. For example, I was considering a $300,000 partially renovated property that needed $50,000 in repairs. Despite the property's condition, it sold within 24 hours with five offers, three of which were all cash.
Competition Can Lead to Mistakes in Buying
Such a strong seller's market can be frustrating for buyers, especially first-time buyers who are new to the process. Strong competition can also lead to buyers making bad decisions, such as overpaying for a property or waiving an inspection that would have revealed expensive defects. Making these mistakes can put your long-term financial goals in jeopardy. It is important to remember that you make money in real estate when you buy, not when you sell. If the real estate market is becoming irrational it may be better to wait instead of buying. Below are five rules I follow to avoid buying at the wrong time.
Do Not Panic Buy
The first rule is prevent emotions from driving decisions. If home prices seem ridiculously high, do not panic buy, just because you fear being priced out of the market. Fear of missing out is not a good approach to buying real estate. Know how much you can afford to spend and stay within your budget. Overpaying leads to taking on excessive debt, which creates risk. If the maximum mortgage payment you can afford is of $2,500 per month, do not go above it. If you need to go higher you either have to reduce other monthly expenses or increase your income to cover the difference.
Buying more house than you can afford can make it difficult to keep up with monthly payments. If your income falls or you face some other financial emergency you may end up losing the property. This is exactly what happened in the 2007-08 global financial crisis as homeowners got caught up in the real estate hype and paid more for properties than they could afford. When the economy slowed and unemployment rose many households fell behind on their payments and lost their homes to foreclosure. Staying within your budget will help you keep your payments at an affordable level. If you want to learn more about insulating yourself from these risks see Three Big Steps Towards Financial Freedom.
Do Not Waive Home Inspections Unless You are a Real Estate Professional
The second rule is not to buy a property if it requires waiving a home inspection. Unless you are an experienced real estate investor or contractor, waving an inspection goes against basic due diligence. A property inspection costs a few hundred dollars but can uncover major defects with a property. If you are unaware of what is wrong with a property, you do not know how much it will cost to fix it. This applies whether you are buying a property to live in or as an investment. A crack in the foundation, serious asbestos issues, or significant water intrusion could mean tens of thousands of dollars in repairs. You want to know about these issues before you buy so you can discount the price you offer to the seller.
Use Fixed Interest Rates
The third rule is to use fixed rate loans. The Federal Reserve has lowered interest rates dramatically to help the economy recover from the pandemic. Businesses and individuals tend to borrow more when the cost of capital is lower, which in turn stimulates economic growth. Currently, borrowers can secure 30-year mortgages at rates below 3%. These historically low rates allow a buyer to qualify for larger loans to purchase a more expensive property.
For example, qualifying for a monthly loan payment of $1,610 means you can borrow $300,000 at a fixed rate of 5% for a 30-year period. But, if interest rates are 2.8%, the same $1,610 payment qualifies you for a loan of $391,800. This means you can spend $91,800 more on a property for the same $1,610 monthly payment. As a buyer you like low interest rates because you can afford a more expensive homes. But, sellers are clever and know that buyers can now afford more expensive homes. As long as demand for properties remains high, sellers will raise the price of their home. This one of the reasons we are seeing home prices rise quickly despite being in a weaker economy that is still recovering.
Short-Term Financing May Lead to Spiking Monthly Payments
As real estate prices rise, more buyers become priced out of the homes they want to purchase. This can tempt buyers into taking loan with a non-fixed rate. These loans are for a shorter duration. A bank might offer a rate of 2.5% for a three year period which makes the property seem affordable. However, at the end of three years the interest rate resets to the new market rate which might be much higher. If interest rates rise dramatically, so does your loan payment.
For example, a $1,548 loan payment at a short-term interest rate of 2.5% will become a payment of $2,103 if interest rates rise to 5%. This increase of $555 may make your payment unaffordable. The way to avoid this problem is to only use fixed rate mortgages.
Do Not Count on Appreciation
The fourth rule is never count on appreciation. If you are investing in real estate, your decision should be driven by the net income from rents after all expenses are paid. If the rents are too low that they lead to a loss each month these losses will add up over time. You cannot expect appreciation to bail you out from these losses by selling for a higher price in a few years. This is gambling with real estate, not investing. Many investors learned this painful lesson in the 2007-08 global financial crisis. If you earn appreciation, consider it a bonus, but it should never be the rationale for buying the property.
Pay Attention to Economic Indicators
The fifth rule is to pay attention to the broader real estate and economic indicators. Most real estate markets work in cycles, driven by the volume of housing supply along with broader economic indicators such as unemployment rates and consumer spending. The 2007-08 global financial crisis caught some investors by surprise because some of these indicators like unemployment and consumer spending looked relatively strong. But for those who took the time look closer at the real estate market, there were some worrying trends which included an excessive supply of houses. There were also high levels of consumer debt at 1.2 times personal income, which meant households did not have adequate credit available to help them navigate financial trouble.
At the same time there were clear warning signs that lending standards had deteriorated. Lenders failed to perform basic due diligence to verify an applicant's income, assets, and credit score. In addition, some unscrupulous lenders tricked borrowers into loans they could not afford by offering short-term loans with low teaser rates. This led to real estate becoming an asset bubble driven by irrational behavior. The longer an asset bubble inflates, the worse the crash will be when it comes. The global financial crisis led to $7 trillion in U.S. real estate losses by 2012 and over the long-term private lenders lost $535 billion on subprime-mortgages.
As we see real estate prices continue to climb, consider following these five rules before you make your next purchase. Also be sure to have reserves in place to protect against a decline in income or an unexpected job loss. If you are looking for more advice on spotting asset bubbles, see Six Signs of an Asset or Real Estate Bubble and for more information on real estate investing, please see Ten Things to Know About Real Estate Investing.
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