I spend all day every day looking at and working on foreclosures. It can be depressing. And given that the primary causes of foreclosure are price declines brought about by excess inventory, created in part by foreclosures, it’s easy to see how the doom-and-gloomers argue that we are in a self-reinforcing death spiral with no bottom.

In reality, nothing could be further from the truth. There is a bottom, and the gloom will clear.

Let me explain.

Nearly all residential appraisals are based on comparable sales — comps. However, most commercial appraisals rely more on the "income capitalization" approach to valuation. This latter method, applied to residential real estate, casts a lot of light on the market run-up and can help you find the bottom of the bust in your market.

The idea with the income-capitalization approach to home valuation is that rents (income), minus expenses and divided by investment (sales price) equals the return on investment (capital). This return on capital is commonly referred to in the industry as the "cap rate" and should be considered analogous to the percentage return you’d receive on other investments like stocks or treasuries. So, for example, a commercial building with a cap rate of 6 percent on a $1 million investment should be expected to generate a return of $60,000 per year.

If you look at cap rates for residential real estate over the past few years it isn’t hard to see we’ve had a problem during this time. In my neighborhood, houses that were selling for $850,000 at the peak of the market rent for about $2,000 per month. After deducting property taxes and insurance (assuming zero maintenance and zero vacancy), the cap rate is about 1.5 percent, or a "one and a half cap." Now let me ask you: How is this a good investment? You might want to answer "appreciation," but keep in mind that unless rents increase, rising prices only continue to lower the cap rate. Thus appreciation is fundamentally limited by the growth of rents (or how bad of an investment one is willing to make).

Looking forward, you can quickly and easily estimate where the bottom might be in your market by taking local rental rates, multiplying by 12, subtracting taxes and insurance, and dividing by a reasonable cap rate. A reasonable cap rate will vary, going as low as 2 percent for a trophy property in a fabulous location to 12 percent or more in high-crime areas.

Like I said, no self-reinforcing death spiral.

The one reform I’d really like to see come out of the foreclosure mess is the death of the comparable sales appraisal approach in lending. By tying lending limits to local rents, we can ensure that homes remain a great investment for everyone. In places like Stockton, Calif., where prices have fallen as much as 40 percent, cap rates are quickly becoming attractive. While inventories are still downright scary, agents are seeing a noticeable uptick in sales. You can actually buy rentals that cash flow. Renters can afford to buy with traditional 30-year fixed-rate financing. Smart parents that thought negative-amortization ARMs were lunacy are now willing to help their kids, who are now using conventional loans. And enterprising Realtors capitalizing on this new opportunity by letting buyers know they can help find bargains are doing just fine.

If you are in an area where sales are slow and prices have not yet corrected, you may want to secretly hope they do soon. And stop working against yourself by trying to convince everyone that your market is special and can’t possibly go down. Buyers won’t come knocking until you do. It’s going to be a really hard transition for banks, builders, recent buyers and owners that used their homes as ATMs, but despite the best efforts of legislators and regulators, only lower prices will get this market going again.

And don’t buy into the message that prices have no bottom. They absolutely do — largely determined by rents and cap rates.

Just do the math.

Sean O’Toole is founder and CEO of ForeclosureRadar. His blog is located at Foreclosuretruth.com.

O’Toole will speak about foreclosures at Real Estate Connect in San Francisco, July 23-25, 2008.


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