Preparing for a real estate downturn

(This is Part 1 of a two-part series. See Part 2: Survival tips for a down real estate market.)

The debate about the real estate bubble wages on – will it burst? Will it be more like a soufflé that collapses when the air is let out? Will the market simply level off and hold steady? Regardless of what happens in your market, being prepared for market shifts will keep your earnings strong while others are struggling.

At Real Estate Connect in July, the consensus seemed to be that we are probably shifting from a red-hot seller’s market in most places to a more normal market. Most experts expect to see a general slide into a slower market. This is also known as a “soft landing.” Others believe the bubble is about to burst.

Real estate, like the stock market, is cyclical. According to Dave Lindorff of Kiplinger’s Personal Finance magazine, the high-flying California markets in Los Angeles, Sacramento and San Francisco have a 40 percent risk of decline over the next two years. Boston leads the list with a 53 percent probability of a decline. Other areas at risk were Providence, R.I.; New York; Minneapolis-St. Paul; Denver; Washington, D.C.; as well as the major cities in Florida. In fact, 2005 second-quarter earnings were down for all major builders.

On a recent show, Clark Howard, consumer advocate and nationally syndicated talk show host, described the Denver market as an example of what may be coming. Like many other markets, Denver has experienced a fast run-up in prices. Prices now have stabilized and inventory is sitting on the market. D. R. Horton, a major national builder, has slashed prices by 10 percent to move its inventory. It is also offering a host of upgrades to attract buyers. This is bad news for sellers who believe the market is still climbing or whose homes are not in top condition or in a prime location. Howard believes that the prices may soon start to drop or at best, stabilize where they are currently. He believes prices may be flat for the next 10 years.

Howard was particularly concerned about people who have taken adjustable-rate mortgages, who have 40-year amortization loans, or interest-only loans. Due to the gradual increase in interest rates, his advice to these individuals was to refinance immediately into the shortest loan period possible. If you have an ARM, his recommendation was to shift to a fixed-rate loan now. Instead of hoping to build equity through appreciation, his recommendation was to start building equity by paying down your loan. In fact, a recent Inman News article warned of more than 9 million adjustable-rate mortgages that will readjust to higher rates in 2007. Unless these owners have the ability to make increased payments, these loans will default. High foreclosure rates put more downward pressure on prices.

If your market is experiencing a slowdown, it’s time to start preparing your clients now to cope with increases in interest rates and no increase in appreciation. A quick way to determine whether this is the case in your location is to check the total number of properties that have been listed, sold, expired, placed under contract, or cancelled over the last six months. Next, for the same time period, determine the number of properties that have been placed under contract or closed and divide that number by six to determine how many properties are selling per month. Divide the number of properties selling per month by the total number of properties on the market. This tells you what percentage of the inventory is turning over each month. If the number is greater than 16 percent, you are in a strong seller’s market. If the number is 12 percent to 16 percent, you are in a flat or transitional market with stable prices. If the number is less that 12 percent, you are in a buyer’s market with downward pressure on prices. An important caveat here is you can have a strong seller’s market in one price range and a buyer’s market in a different price range. For example, in Austin, Texas, the market under $350,000 is quite strong. In contrast, the million-dollar-plus market is soft. As a rule of thumb, the higher price ranges are the first to feel the crunch. When the mid-range move-up buyers cannot sell their properties, the upper end of the market usually comes to a grinding halt. Eventually it trickles down to even the first-time-buyer market if conditions are really bad.

As soon as you spot this trend in your market, it is absolutely essential that you begin preparing your client base for what is coming. You can also help present and past clients prepare for the change by helping them shift their attitude towards equity building. In many areas, flipping properties is common since the appreciation rates have been high. Existing clients should be advised not to expect appreciation in the near future. Encourage them to build their equity by paying down their mortgage. If you’re marketing to past clients who have ARMs, 40-year mortgages or interest-only loans, advise them to consider refinancing now into a fixed-rate 30-year loan. In your normal marketing materials, include market updates that identify where activity is weak and where it may be strong. Point out the price ranges that are seeing the most activity. Also be sure to point out any discrepancies where the market may be a seller’s market in one location and a buyer’s market in a slightly different location. Keeping your referral database informed is one of the best ways to prepare them for a market downturn. Also, don’t be surprised if you are the lone voice in the wilderness initially. Other agents may criticize your negative attitude or sellers may disbelieve what you are saying because other agents tell them the market is still hot. Use your market data to show your clients the truth.

While preparing your clients for a downturn may be important, it’s not nearly as important as being prepared in terms of your own business. To learn more, see next week’s column.

Bernice Ross, co-owner of Realestatecoach.com, has written a new book, “Waging War on Real Estate’s Discounters,” available online. She can be reached at bernice@realestatecoach.com.

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