Issues Within The Real Estate World and Financial Literacy

This article has been shared by Forest Jinks.

Only two topics of discussion are included in the month’s update but only two topics doesn’t translate into a shorter Update.

Lets get right into it.

More Real Estate Mess to Come?

The relative strength of the real estate market over the past several months has been a beacon of hope for the Bulls expecting a great recovery from our economic woes. This is especially true of California where prices have risen considerably from their lows. National sales indicate a bumpier ride with December sales falling 17% from the year prior (California sales increased 17% over that same period). But even calling for a bumpy ride probably doesn’t do justice to how ugly the picture really could turn out to be. There are three main factors that point to more pain, lots more pain, within the real estate market.

The first pertains to the foreclosure world, of which indicators are commonly reported in the press.

Foreclosureradar.com, a foreclosure tracking website that should know better, trumpeted a decrease in foreclosures towards the end of last year. What they didn’t mention is that foreclosures are down not because loans are strengthening but because lenders aren’t foreclosing. Every day partners and I are tracking foreclosures, hitting the streets to do our research, and standing at the trustee sales hoping a bank will drop an opening bid low enough to create the financial incentive to deal with the property problems for the bank. It is not uncommon for us to come across evidence of properties being in the foreclosure process 10 – 12 months, having had their appearance at the auction postponed again and again and again. This holds true even to vacant properties, many with open access and already completely trashed. Why would the bank not foreclose on that property? The foreclosure picture probably won’t get better for some time yet to come. The majority of loans now entering default were originated in 2006 leaving
2007 loans still to cycle through before seemingly clearing out the high priced loans. But then we have to deal with the crisis of the highly leveraged cheap credit created by pushing FHA loans since 2008. Already over 20% of the FHA loans made in 2008 and 2009 are in default.

This speaks nothing to the impact rising interest rates could have on mortgage resets, and rising interest rates are almost assuredly coming within the next few months. During the credit boom the many buyers for loans were buying the packages of debt, slicing off different layers of it, and then selling it for huge profits. When the real estate market crashed so did the desire to buy loans. At the present, only Fannie Mae is a dependable buyer of loans and she is fast running out of money. Did anyone notice that the home finance world has been nationalized? Fannie Mae is fully a government agency and is basically the only supplier of home finance. The government has already extended the borrowing/lending limits of Fannie Mae but again F.M. is fast approaching its limits.

What happens this time?

Will the government again extend the limits (probably) but will the government be able to find the money to extend the limits? The money to buy the loans is created largely by the sale of government bonds. How long will investors have an appetite for this government debt backed by loans that are racking up increasing rates of default? Because the federal government determines the interest rates at which Fannie Mae will buy loans, it has created an artificially low run of mortgage rates. Should Fannie Mae stop lending no private buyers are going to step in unless the yields are much higher, necessitating an increase in interest rates charged to borrowers to create the higher yields. Increased interest rates directly cause a decrease in affordability, limiting the buyer pool and reducing the price that the remaining buyers are able to pay for a property.

The third factor is commercial real estate. Some are saying that because everyone is expecting commercial real estate to collapse that it won’t, since no one ever expects what happens to happen. But maybe what is unexpected is how big the problem may end up being.

The FDIC greatly loosened bank guidelines in regards to the bank’s ability to rewrite existing loans and to real estate on their books. Not only are these changes artificially propping up the value of the remaining real estate (since the distressed transactions aren’t occurring), but also decreasing the amount of cash banks are willing to loan as they hoard money as defacto reserves for when the FDIC does an about face and changes their policy.

There is nothing pretty about any of the above from a market perspective, but with change comes opportunity and any or all of the above may create great opportunity within the markets.

What can I do about it?

As I promised last month, a majority of this month’s Update will be spent responding to email responses I received regarding the November Update (click here to view). One particular email received from David Campbell (a well respected real estate entrepreneur) got me thinking. His email rhetorically asked, “I agree with you, but what can we do about it?” The question itself can be taken at two different levels, both of which need answering. The first is the personal level, that is to say, how do I individually invest or run my business so I can deal with the current (and future) economic political climate. The second is in the broader sense pertaining to each of our personal impacts on the national or international decisions being made.

Let’s start with the personal level. In November I alluded to the lack of national financial literacy as it pertains to what I opine as poor policy decisions being made. This was shown to be especially true among the populace of Oregon State this past week as they voted to change business tax from being taxed on income to instead be taxed on revenue. With a tax rate of just under 9% this is a massive change in the income statement of businesses operating within the state. There are many businesses that do not have net margins large enough to cover the increase (supermarkets for instance) so to stay in the black they will necessarily have to increase their price to the consumer, the same consumer who voted for the change in taxation. Even at the lowest levels of financial literacy the damage done to the consumer (voter) can easily be understood, and yet over 50% of the voting population didn’t have the financial literacy to vote no on the measure.

The importance of financial literacy cannot be emphasized enough, especially in unsettled times. Those that can understand the effects of decisions being made and react to them will be able to benefit, rather than be hindered by changes in any market. That isn’t to say the most informed will never lose because all of us, even Mr. Buffett, are sometimes taken by surprise. However, having the financial literacy allows us to hedge against those surprises and win the war even if we lose an individual battle. An especially poignant example of this is Germany after World War 1. Having been defeated in the War, Germany (and their allies) was forced to pay retributions to the victors as part of the peace settlement. While this and their war debts reduced fiscal policy choices, it was ultimately choosing a horribly short sighted direction that led to annual inflation rates that reached as high as 182 billion percent (yes billion). According to calculations by historian Niall Ferguson, prices at the end of 1923 were 1.26 trillion times higher than they had been in 1913. This is mentioned not to bring comparison to the potentials of the US economic future but rather to give context to the following quote from Ferguson’s writings on the effect of the inflation, “This (the inflation) amounted to a great leveling, since it affected primarily the upper middle classes: rentiers (those that owned bonds or lent money), senior civil servants, professionals. Only entrepreneurs were in position to insulate themselves by adjusting prices upwards,…investing in real assets such as houses and factories and paying off debts in depreciating banknotes.”

Not everyone is in the position to be an entrepreneur, but by being entrepreneurial in our thinking, by increasing our financial literacy, and being willing to partner/invest with those entrepreneurs that are on the streets, those that aren’t or can’t be entrepreneurs in deed can still benefit from being entrepreneurs in thinking and investing. And I am defining entrepreneurial investing as both real estate investing (assuming it is real estate entrepreneurialism not speculation) and investing active or new businesses. As with any type of investing, not all real estate or real estate entrepreneurs are good places to place money, and not all businesses are a good place to put money.

On a more macro level financial literacy also is important. As has been said by ones much wiser than I, if we wish to find a trait in another we first must have it in ourselves. Although one could hope, it is not surprising our politicians do not have strong financial/economic backgrounds when the population voting them into power is so poorly educated in those same disciplines (as shown by the Oregon vote already mentioned). If, by being educated myself I am able to educate another who in turn could educate another, maybe our society could become financially educated enough to make better societal decisions, or at least put enough pressure on the politicians that bad policy could be averted. In the natural sciences it is commonly understood that all of natural sciences, boiled down to their smallest and most basic increment, are governed by physics. While not as commonly believed, especially by those most heavily involved in the study of each independent social science, economics is truly the base of all things societal. Without a strong economic base progress isn’t made, innovation goes unfunded, art isn’t created, and society eventually reverts back to the governing that democracy is supposed to overcome – that is rule by the few strong, rich, or powerful. While a much more comprehensive study and argument can be made showing this to be true throughout history, one needs only to look at the economic systems and social states of the world’s poorest countries. One needs only to look at societies who are most rapidly increasing their standard of living. Or one needs only to look at those countries, that despite the societal and natural inputs needed, are falling behind. Hopefully by increasing our countries financial literacy we may be able to start repairing the economic base of the country and with the benefits achieved be able to tackle and solve some of societies other issues. As a starving man does not care of the benefits of art, neither can a weak economic base support fixing the problems of a society.

To give a more developed answer the question “what can I do?” we must also contemplate the choices our government has in dealing with the issues before it. Cliff notes of some of the issues: #1. By 2019 the current administration expects interest on the national debt to increase to $700 billion per year from the current $200 billion (this does not take into account the probability of interest rates increasing during that time period). That $500 billion increase is more than the 2009 federal budget for education. That increase is more that the 2009 federal budget for energy, or homeland security, or Iraq, or Afghanistan. In fact, that $500 billion is more than the 2009 for all those things I just mentioned combined. That interest has to be paid some how, but how? #2. Social Security – All of our personal social security accounts are currently unfunded. Long ago the money in the Social Security fund was pulled out for other uses and instead S.S. depends on the deposits of current tax payers to fund current obligations, even though those current taxpayers are supposedly building their own sum of pension distribution. This becomes especially worrisome as life expectancy increases and the massive baby boomer generation inches ever closer to retirement and social security receipt. Stay tuned, by 2015 (or possibly before) this topic could dwarf our current economic issues. #3. The government payroll, paid for with tax payer money, continues to grow in terms of absolute dollars through both increased headcount and increased per head compensation. In Oregon for example (I don’t mean to pick on Oregon), despite mandatory furloughs due to budget shortfalls, average compensation of state employees increased from the previous year. Additionally, the state increased its headcount by 1700 workers. I view this utter lack of financial responsibility as fiscal fraud against the tax payers of state. As another example of bloated government, consider California and its mandatory furlough days. Much to the surprise of no one the state has continued to operate without much of a hiccup. Since the furloughs roughly equate to 1 day every two working weeks this should allow for a minimum of a 10% reduction to the state workforce without a reduction in services offered. Government bureaucracy is the ever strengthening monster that feeds upon the hand that feeds it. When does the momentum of growth and the power of the government become so great that it is impossible to change its path?

How is a government to deal with such massive problems (if it even admits that they exist)? In truth, though not in preference, it may require a social unrest event, with the result of the unrest being true structural change. But we hope this isn’t so and hope instead that our politicians decide to make difficult choices now to avert large future consequences. In the book Talent is Overrated the authors discovered through their studies that to become great at anything, whether it is chess, music, sports or business, a person must put in roughly 20,000 of focused practice, with focused practice being the key. Most of us never learn how to do focused practice because it is a difficult and stretching event done repeatedly. The result, however, is excellence. For the US (although this also applies to Western Europe and Japan) to stay strong (or regain strength depending on your point of view), our politicians must put in the painful “practice”. That is to say right now is the practice time that will result in the country either being great or diminishing.

One particular solution to the Social Security issue is to follow the footsteps of Chile, who is a true success story of the past couple decades. In the early 70s Chilean leaders’ efforts to run the country as a pure socialist society had imploded and the country was a mess. Over the next decade under the leader of a brutal (although ultimately successful) dictator, the country floundered, trying to deal with extremely high inflation and a social care system that was bankrupting the country. Along with other successful policy changes, the true beacon of growth was unleashed in the early ’80s when the labor minister managed to covert a majority of the population from a state run pension fund to a personally managed fund. Since that time Chile has soared to the front of the South American class with the private pension funds averaging 10% annual returns, having a poverty rate at 15% (compared to 40% in the rest of S.A) and having 15 consecutive years of economic growth at over 3% year after the conversion (vs. 0.17% in the preceding 15 years). Just this month, and despite the world recession, the Chilean stock market hit its record highs. Additionally the government is currently a stable democracy and the country safe for its citizens and travelers. In the Chilean example (developed and preached by 1976 Nobel prize winner in economics Milton Friedman) it was the return of a country from a social net styled political and economic system to one where individuals held their own responsibility. Not only did this policy change greatly affect the economic path of the country, but I am sure, as more individuals understood that their decisions were directly affecting their personal future, financial literacy increased. The policy change encouraging individual change and individual change strengthening policy change. I view this as something also needed in the US.

As always, please feel free to email with comments or questions and also check out twitter.com/forrestjinks for short economic thoughts throughout the month.

For those in the North Bay area looking for something to do on the evening of Thursday February 25th, I will be giving a brief presentation on real estate investment opportunities within a distressed market.

Forrest Jinks

Forrest can be reached by calling 707/536-1711 or visit www.altusequity.com for more info. ?