Allow me to rant for just a moment. This week President Obama hatched what he calls the “Making Home Affordable Refinance and Modification” program. Apparently the historic plunge in real estate values hasn’t made homes affordable, so he has a program that will in theory stabilize home values. We here at The Two Wise Acres’ School of Real Estate Investing (impressive, I know) are baffled at how slowing the fall of home prices will make them more affordable. I mean, exactly how does using our tax dollars to artificially prop up the price of an asset make the asset more affordable? But then again, we thought Joe the Plumber asked a very good question. Then Senator Obama promised to spread the wealth, and here we are.

With that rant out of the way, let’s look at the Home Affordable Refinance and Modification program and the potential impact on real estate investing. There are two components to the Making Homes Affordable plan, a refinance program and and a loan modification program. The refinance program simply involves Freddie Mac and Fannie Mae buying loans even if they represent up to 105% of the appraised value of the home. The idea is to allow homeowners to refinance into low rate fixed mortgages who, because of the drop in the value of real estate, wouldn’t otherwise be able to refinance.

Granted, a really good argument could be made that Fannie and Freddie are mistakes in the first place. But if the government is going to be in the business of buying mortgages, this change to allow refinancing doesn’t bother me much. It’s the loan modification program that is the real problem.

Why the Mortgage Modification Program is a Bust

The modification program is a complicated beast. It involves lowering the interest rate on mortgages to as little as 2% and extended the terms up to 40 years so that the homeowner’s monthly mortgage payment is no greater than 31% of their monthly income. But wait, that’s not all! You also get a free set of steak knives, a $49.95 value! Ok, you don’t get steak knives. But what homeowners will get is up to $5,000 over five years paid directly to their mortgage company to pay down their mortgage. Where does the $5,000 come from? Uncle Sam, also known as the government, also known as you and me.

That’s right, the government is now going to pay people to stay in their “American Dream.” And we also are going to pay the mortgage companies that agree to modify the loans in the first place. Happy times are here again! All of these handouts add up to $75 billion, which a long time ago was a lot of money.

Real Estate Investors are Evil

So what does this have to do with real estate investors? Plenty. To begin with, neither the refinance nor the modification program apply to investment properties. That’s fine, but it’s the stated reason why that really toasts my 1031. Here is how HUD Secretary Donovan described the situation on Face the Nation:

We have designed this plan to make sure that the folks who did take advantage of people — whether it was lenders or speculators or flippers — that they’re not eligible for this plan,” Donovan told host Bob Schieffer on CBS News’ Face The Nation. “We’re going to have a very strict program to make sure that people who participate are what they say they are. We’re not going to benefit those who took advantage before.”

So now real estate investors are all evil speculators and flippers who take advantage of people and are not what they say they are. Thank God we have the government to figure all this out for us and protect us from these evil people.

FYI, Mike and I are NOT flippers. We tried to flip the last HUD foreclosure we rehabbed, but nobody would buy the damn thing.

Why can’t the Obama administration simply say the program is for owner-occupied homes? Why are real estate investors now speculators and people who take advantages of others? Do Mike and I take advantage of others when we risk our capital to buy a crappy looking home, fix it up, and rent it at a reasonable price? I can tell you that the neighbors who have had to look at the dump sit there for months or longer are thrilled when we buy it and fix it up.

And furthermore, it’s been real estate investors that have been buying many of the foreclosures over the last 12 months. If it weren’t for investors, the current housing market would be a lot worse than it is. Did speculators contribute to the housing bubble? Of course they did. And some of these speculators are called homeowners!

Last week, PMI Group, of private mortgage insurance fame, released its “risk index” rankings for U.S. major metropolitan areas for the 4th quarter of 2007. PMI’s risk index measures the likelihood that housing prices will be lower in two years than they are now. As the map above shows, Phoenix, Las Vegas, and well, pretty much all of Florida and California were the big winners with the highest probability of declining prices over the two year period (i.e. the highest risk index). PMI’s Risk Index derives the probability by considering the amount and rate of recent historical appreciation and price volatility, housing affordability, and other local economic conditions including unemployment rates.

Does a high likelihood of price declines translate into putting the breaks on investment purchases there? I don’t think so. While price declines impact returns and the possibility or even probability needs to be considered, the risk of any real estate investment and the resulting returns will be determined by the price at which you buy your investment, not price movements in the market as a whole. For our part, we continue to keep a close eye on market rents to determine price, and we hope to find even more opportunity during the difficult markets.

If you would like to read more detailed information about PMI’s Risk Index and the areas depicted above, you can find the full report here.

Here’s in interesting chart from the NYT showing the impact subprime mortgages have had on foreclosure rates. In the mid-west where Mike and I buy properties, there have been lots of foreclosures, but their connection to subprime mortgages is less than clear. In fact, some of our best foreclosure deals were made before the subprime mess erupted. The NYT’s article is worth a quick read. And you can click here for a bigger view of the graph.

Foreclosure news has become an all too common headline. This week’s news cycle about foreclosure activity increasing 75% in 2007 was just the latest in a continuous stream of bad news for some homeowners. While we write principally for the real estate investor here on TWA, we are joining a group of our personal finance cohorts writing en masse this week about homeownership, financing, and other challenges facing homeowners (see below). For our part, we want to offer some suggestions to homeowners facing difficulties paying their mortgage or selling their home in this down market.

Selling without a Real Estate Agent

Many homeowners purchased their homes over the past few years with little or no money down. When circumstances change, such as loss of a job or relocation, there may not be enough equity to cover selling expenses, such as realtor fees and closing costs.

Seller’s closing costs outside of realtor’s fees can be as little as 2% (or less) of the sale price. But using a real estate agent adds another 6%. The savings from selling your home on your own may be enough to make the sale and still cover the mortgage balance. Keep in mind that selling without a realtor is not easy. Hiring a real estate agent offers the advantage of providing your home with greater exposure to this buyers’ market, which means going it alone will likely increase the time on the market until you receive an offer. But there are many resources to help the DIY home seller, such as For Sale By Owner, Owners.com, FSBO.com that can help.

Do a Short Sale

A “short sale” involves selling your home for less than the mortgage balance where your lender agrees to forgive the shortfall. By definition, a short sale will require the agreement of the lender. In many cases, lenders are open to this alternative to avoid incurring the costs of foreclosure and reselling the home at the inevitable discount afterwards.

For this alternative, hiring a real estate agent with experience dealing with short sales is the best choice. Unfortunately, attempting to break through the maze of lender bureaucracy to get the necessary approvals is probably beyond most homeowners. In any event, the real estate agent will be paid from the sale proceeds. In a short sale, this means the bank’s money. When you contact a real estate agent, ask questions. Make sure she has experience in dealing with buyers in your situation, as well as with lenders and investors.

Also, for those who previously considered this option but rejected it due to the tax liability resulting from debt forgiveness, everything’s changed. Congress passed legislation in December to eliminate this tax liability for most homeowners facing this situation.

Lease your home

Become a landlord; rent your home. While becoming a landlord may not be at the top of your wish list, renting your home for a price that covers your expenses can provide a couple of years to allow market conditions to improve while your mortgage balance declines from your regular payments. Renting your home is also likely to be a quicker solution than selling your home, with or without a real estate agent. If you consider this option, start with determining current rents in your area and see if rents for your home will be sufficient to cover your mortgage payment (together with real estate taxes and insurance) and an appropriate allowance for maintenance costs. If not, consider whether you’ll be able to cover the shortfall. While having to make up for a shortfall isn’t the best solution, it can still be a better alternative than foreclosure or bankruptcy.

For those considering this option, we offer further resources on TWA under the property management tab that can help you get started and provide information about leasing, such as advertising your rental and approving prospective tenants.

Sell to an Investor with a Lease Back and Purchase Option

For those who owe more than their house is worth, want to avoid foreclosure, but still want to stay in their homes, this may be the right choice. At its essence, a sale and lease back involves a sale to an investor—likely a short sale with the lender’s approval—and an agreement by the investor to lease the property back to you following the sale along with the option to repurchase. At the right price, investors like this option because they have an automatic renter for the property. For the homeowner, it provides a way to stay in the home with a chance to repurchase.

There are several points to keep in mind here. First, this type of transaction is too complicated to go it alone. Again, hiring a good real estate agent is a good place to start. You may also want to hire an attorney to review any purchase option agreement.

Second, make sure that the rent and repurchase option are affordable. If you’re considering these options, you’ve already decided that your payment is too high and your home can’t sell for what you owe. That means the rent and the price to repurchase have to be lower. If this isn’t part of the deal, don’t consider it.

Third, if you already have credit problems, make sure that the option to repurchase will allow you sufficient time to improve your credit to obtain financing. Contact a reputable mortgage broker to review your credit and determine whether and when you might qualify for a new mortgage loan.

Fourth, beware of scams. Unfortunately, the unethical few will always rush in to exploit opportunities wherever they are to be found. I do not believe the unethical few are, by any means, representative of real estate investors as a whole. An investor can be a part, even a necessary part, of a solution that’s best for you. A good investor should be looking for those solutions as well as looking for a reasonable profit. A good real estate agent can help you sort them out.

Other Articles for Homeowners

My Thoughts On This Whole Mortgage Crisis And Why I Don’t Feel That Bad @ My Two Dollars

Why renting is right for us right now @ Mrs. Micah

Why We Have an Adjustable Rate Mortgage @ My Dollar Plan

Debt-To-Income Ratio and Why It Matters @ Moolanomy

Catch a Falling Knife – Buying the Housing Slump @ Millionaire Money Habits

Can we afford the Payments @ PaidTwice

Pay off Credits Cards with a HELOC @ Debt Free Revolution

So You Want to Buy a Fixer Upper @ Remodeling This Life

Frugal Hacks For Your Home @ Being Frugal

American Subprime Crisis—Should We Care @ Plonkee Money

Mortgage escrow accounts Explained @ Cash Money Life

Don’t Use Your House to Pay for Your Life @ Rocket Finance

Why the Sub-Prime Crises has not Affected Canada Yet @ Four Pillars

That Damned Rent vs. Buy Question @ Blueprint for Financial Prosperity

Predatory Mortgage Lending and the Subprime Market @ Chance Favors

After Foreclosure Guide to Housing: It Ain’t Easy @ DebtKid

How to Avoid Foreclosure – The Definitive Guide @ Credit Withdrawal

The Real Cost of Homeownership @ Single Guy Money

Realty Trac has released data showing that 2,203,295 foreclosure filings — default notices, auction sale notices and bank repossessions — were reported on 1,285,873 properties nationwide during 2007, up 75 percent from 2006. The report also shows that more than one percent of all U.S. households were in some stage of foreclosure during the year, up from 0.58 percent in 2006. December alone showed an increase in foreclosure activity of seven percent.

The hardest hit area was Nevada, with 3.4 percent of all households in some stage of foreclosure proceedings. On a monthly basis, Nevada also had the highest foreclosure activity for all 12 months in 2007. Florida won the silver medal with more than two percent of households in foreclosure, while Michigan took home the bronze with 1.9 percent. Other states in the top ten included California, Colorado, Ohio, Georgia, Arizona, Illinois and Indiana, all with more than one percent of households entering some stage of foreclosure proceedings.

You can find more details, including a detailed listing of foreclosures by state here.

For the individual real estate investor, media reporting of the national real estate market is simply not very useful. But it’s all we hear. Phrases like “the housing crisis,” “the subprime meltdown,” and the now ubiquitous “housing bubble” pepper economic news reports. For many, it’s tempting to take this news and conclude that now is not a good time to buy, or conversely, that now is the best time to buy. Others point to current national trends and reach even broader conclusions that real estate is a bad investment or, for would-be homeowners, that renting is better than buying.

In this climate, repeating the old adage that “real estate is local” takes on particular meaning. For the individual real estate investor in Utica, New York, it matters little whether real estate in Santa Barbara, California is overvalued. Recently, I ran across an interactive map, reflecting results of an analysis of real estate values in various areas of the country by National City Bank’s economics department.

The map summarizes conclusions from a study of home values in 330 metropolitan areas comparing home prices for the second quarter of 2007. The map categorizes areas that are overvalued, moderately overvalued, fairly valued and under valued and reflects the percentage of over or under fair value. The valuation conclusions are based on the ratio of household income to home prices, adjusted for household population density (i.e. number of homes per square mile), mortgage rates, relative income level between areas, and a constant. The constant reflects historical higher or lower income to price ratios for a given area, which attempts to capture other preference factors.

What Bubble?

Not surprisingly, many of the red zones–the overvalued areas–appear in the West Coast, Arizona, Florida, and the District of Columbia–the same areas that had those daunting price growth rates in the years leading up to the current market. And indeed drilling down to one of the overvalued metro areas illustrates when the speculators stepped in. Take Flagstaff, Arizona, for example. The graph below shows the growth rate of incomes in line with home prices right up until the 2004-2005 and then pop–people paying prices for homes like they’re going out of style.

But then there are all of those green areas–fairly valued–such as areas throughout the Midwest and much of the South, for example. Even a few gray (undervalued). For those areas, there was no period of out-of-line price increases. That’s right–no bubble.

There’s certainly no shortgage of negative news in residential real estate. But this resource provides a little perspective. While few markets will be completely immune from negative impacts from problems in the mortgage market, not every area will be experiencing a price correction. Quite simply, in many areas, none is needed.

For every noteworthy market downturn, it seems that there’s always someone saying, or perhaps more accurately, Congress hearing, “there oughta be a law. . . .” And so it is with the subprime mortgage decline and spike in home foreclosures. The House of Representatives answered the call, real or imagined, earlier this month by passing the Mortgage Reform and Anti-Predatory Lending Act of 2007 (H.R.3915).

The House bill tackles a series of perceived problems in lending and mortgage brokering practices. And then, according to the bill’s summary, it does this:

Sets forth minimum repayment standards for residential mortgage loans. Requires creditors to determine, based on verified and documented information, that a consumer has a reasonable ability to repay the loan, according to its terms, and all applicable taxes, insurance, and assessments.

Did you catch that? It appears that the House of Representatives’ solution to the troubled mortgage market is for Congress to jump into the underwriting process. So even while the consequences of bad lending and borrowing decisions are being meted out among financial institutions, investors, and homeowners, the House proposes to step in and make things just a little bit worse, providing its own brand of restriction on home loans.

You can read more about the Mortgage Reform and Anti-Predatory Lending Act of 2007 at MarketWatch.

As the housing market soared skyward a few years ago, renters were the ugly step-child of the community. I can remember renters literally gazing at the floor as homeowners discussed their new found wealth at parties and around the water cooler. Today, homeowners are the ones gazing at the floor and renters are thumping their collective chests in victory as housing prices head downward. It seems that the emotions generated by sudden changes in asset prices trump the old adage, “buy low and sell high.” And out of the ashes of the housing wild fire have come a slew of “renting is better than buying” articles. Well it ain’t so. I assert that for most people most of the time in most places, the financial benefits of home ownership trounce renting. It seems odd to me that I might have to go to great lengths to defend that proposition, but allow me to put forth my case for home ownership.

Taxes, Leverage and Inflation

Three things help make home ownership a better, long-term financial move than renting:

1. Taxes: First, interest on mortgages and property tax are tax deductible, which reduces the cost of owning a home. True, not everybody can benefit from these deductions, but most who own homes can and do. Second, the first $250,000 (if single) or $500,000 (if married) of gain from the sale of a primary residence is excluded from capital gains tax. This is a significant benefit, particularly when comparing real estate to other forms of investment. These benefits are not available to renters.
2. Leverage: Most real estate is bought with borrowed money. For example, a $300,000 home typically may be purchased with anywhere from a 0 to 20% down payment. Assuming a 10% down payment, $30,000 plus closing costs buys the home. If the home goes up in value by say 4% the first year, the increase is $12,000 ($300,000 x .04). The point is, appreciation applies to the value of the home, not the amount the homeowner has invested in the property. Now of course the value of real estate may go down one year, as it has in 2007, but over the long term, real estate has gone up in value, which brings us to point #3.
3. Inflation: Inflation benefits homeownership in two ways. First, as noted above, inflation increases the value of real estate regardless of the amount invested in the property. Second, inflation increases the cost of renting. In contrast, assuming the homeowner obtains a fixed rate mortgage, the monthly payments are fixed for the life of the loan. Taxes and insurance will increase, but the monthly payments for the borrowed money will not. This last point cannot be overstated. I lived in my first home for 11 years. When I moved, my monthly mortgage payment was $1,200, which included taxes and insurance. The cost to rent my home would have been about $2,200.

It is worth pointing out that each of the above factors could turn against home ownership. Congress could change the tax laws. They did in 1986 and real estate took a dive. Inflation, something we’ve come to expect since leaving the gold standard, could turn to deflation. I doubt it will, at least over the long term, but it could. And the cost of leverage could become prohibitively too expensive. But right now, all of these factors favor owning over renting.

You’re not relying on a rent versus buy calculator, are you?

For many of you, my three factors above are worthless if I can’t defend my view with hard, cold numbers. Enter the rent versus buy calculator. These calculators are lots of fun, but they must be used with care. They can only spit out numbers based on numerous assumptions that you enter. These assumptions include the future rate of inflation on real estate and renting, maintenance costs, your tax bracket, and future increases in insurance and property tax. Second, you must compare buying and renting the same house. If you’ve sold your home and moved into a small rental unit to save money, that’s terrific, but it says nothing about the relative benefits of buying and renting. Third, even if you get all of the assumptions right, they will change over time. You may live in an area where home prices have far outpaced rental values. This may make renting more appealing today, but eventually rental values will catch up or home values will come back down (everything reverts to the mean, everything).

All of that said, my favorite rent versus buy calculator can be found here.

JD at Get Rich Slowly mentioned this calculator the other day, and it’s one of the best I’ve seen. I used the calculator to determine if renting or buying one of our rental properties would be best. I picked one of our properties–”No Basement” to be exact–because I know the rental values and value of the property. My assumptions include 3% inflation rate, 10% return on stock market investments, and a 20% tax bracket. The calculator includes costs for taxes, insurance and maintenance. Here were the results:

So under these assumptions, buying beats renting after just 2 years. And note that I assumed home values would go up by just 2%. The better assumption is 3-4%. My guess is right now you’re screaming, “yea, but look at the assumptions you’ve entered! A home worth $130,000 rents for $1,045, are you nuts?” Good point. Actually, that’s what No Tenant does rent for when it has tenants, but that’s for another article. Fine, let’s set home value increases and rental increases to 4%, jack the price up to $200,000 and keep the rents at $1,045. The results are that buying beats renting after six years. Of course, we could keep increasing the cost of the real estate and eventually buying would never beat renting, which brings me to the third and final section of this Apologia.

Are Mike and Rob hypocrites?

TWA is a real estate investing site. Mike and I make money because some choose renting over homeownership. The fact is that home ownership is not the best choice for everybody all the time. We rent to families in the military who move every couple of years. We rent to younger couples just starting out. We rent to families who don’t plan to stay in the area permanently. And we rent to families with credit issues. Sometimes renting does beat buying, and here are some situations where renting may be the best alternative:

1. You move frequently. The transactions costs associated with buying and selling a home will eat away at any financial gains home ownership offers.
2. Monthly rent is less than 0.5% of the home’s value: This is a very general rule of thumb, but if you can rent a $200,000 home for $1,000 or less, renting may be the way to go. Keep in mind, however, that this rent versus value disparity may not last forever.
3. Bad mortgage terms: If you can’t get a competitive, fixed rate loan, buying may be too risky. The news is filled with stories of homeowners (and former homeowners) who bought more home than they could afford using exotic loans. If it takes more than 10 words or so to describe the terms of a loan (as in, “Your mortgage is a 6.5% fixed rate 30 year loan.”) be afraid, be very afraid.
4. You lack savings: Most loans today require a down payment, and 20% is required to avoid private mortgage insurance. Buying a home with no money in the bank is very risky. Renting while you save for a down payment and an emergency fund is a safe, conservative approach to home buying.

Notice that one of the reasons to rent that is NOT included is falling home prices. If you want to time the market, go ahead. It seems that everybody cautions against it, but everybody thinks they can do it. Falling prices should encourage buying, and eventually they will. But don’t let the current housing market conditions convince you that real estate is a bad choice. And if you don’t believe me, would you consider listening to Warren Buffett: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

In evaluating an investment property to buy and hold, the key is determining rental income. The first question most buy and hold investors will ask is “What are comparable rents for the home?” Comparable rents, like comparable prices, are based on today’s information–a relatively known quantity and critical to determining value. But in the current market, with foreclosure news permeating the media, many are wondering about the impact that foreclosures will have on future rents.

My statistical model of determining future events usually dictates that I consider Rob’s astute predictions and then take an opposite position. I call my approach Rob Contrarianism™. Rob has told me that he expects rents will increase, at least in part, as a result of foreclosures. My typical model notwithstanding, on this point I tend to agree with Rob.

Why Rob Might Be Right This One Time

Rents like all prices are, of course, dictated by supply and demand. As foreclosures continue, many homeowners will become renters. So, demand for rental property will increase causing rents to rise. While some foreclosed homes will undoubtedly be purchased by investors and will add to the supply of rental property, they will be only a portion of the foreclosed properties. Stricter lending criteria will further add to demand for rental housing. Higher down payment requirements and credit standards will mean that some would-be new home buyers will be unable to obtain financing under the previously looser lending practices, requiring them to remain renters, at least for now.

Some Evidence It’s Started

There are some indications that rents are already on the rise. For example, Denver, CO, impacted by substantial foreclosures, is seeing the lowest vacancy rate in 10 years. Similarly, the northern Midwest is seeing declining rental vacancy rates and commensurate rent increases, according to the Federal Reserve’s Ninth District, due in large part to foreclosures and slowing housing sales. Perhaps, most surprisingly though, is that some metro areas, such as Cleveland and Detroit, that have been among the hardest hit by foreclosures are seeing rents rise at some of the fastest rates while they suffer from broader economic problems.

But Let’s Not Get Carried Away

Higher rents mean higher investment returns. While it appears that rents may well be on the rise for awhile, “awhile” might be the operative word. In areas like Cleveland and Detroit, for example, that are experiencing fundamental economic problems, such as job loss, the decline in population may very well overtake the increased demand for rental housing due to foreclosures. Further, except in areas where there are geographic limits to new builds, above market returns will drive new building to meet the demand.

For Rob and I, we look at this rental trend as perhaps somewhat of a reinforcement of our buy and hold investment purchase decisions. But we don’t pick those investments based on my (and especially not Rob’s) speculation as to what will happen in the future. So ultimately, we’re still looking first and foremost at sale and rental comps because today’s information carries the day.