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Subprime Mortgages and The Real Estate Cycles

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When investing in real estate, one needs to be aware of the "X-Factors" that affect it. If you're unprepared for them, they'll wipe you out.

The subprime mortgage crisis—in which so many people have been hurt—is a tragic but all-too-common example of what happens in the real estate world when the risk-reward balance gets out of whack.

First, let me provide a retrospective definition of subprime mortgages: They are home loans, often to people with weak credit, in amounts they cannot afford, on properties that may now be worth less than the mortgage. In many such cases, the true cost to the borrower is disguised by reducing the interest rate and carrying charges in the early years of the loan, which of course will be made up by higher charges in the loan's later years.

Subprime loans fueled not only an increase in the number of home sales, but also in the pricing of those properties. Ever-higher prices and mortgages were further justified by wildly optimistic assumptions that the recent skyrocketing increases in value would continue in future years.

Unfortunately, real estate is an industry with ten-year cycles but five-year memories. It is a field in which so-called "X factors"—the great unknowns—periodically disrupt the best-laid plans and the best-honed projections of the players within it. Here's the grim truth: As a real estate player, you have almost no control over these externalities, but they have the ability to change the outcome.

Many "X factors", especially those inflicted on us by Mother Nature, are hard to predict. (With a hurricane, you still only get a few days' or few hours' notice.) Even if you somehow anticipate these events, you're not likely to get their timing, location, degree of damage or duration right.

The subprime disaster, though, was a man-made "X factor", and was relatively easy for the pros to foresee. But this begs the question: If the perils of the subprime market were so obvious—and they were!—why didn’t more people speak out and stop this practice? Simple, there were too many incentives working to perpetuate what became a house of cards.

Look sideways at the steroid scandal in major league baseball. The use of so-called performance-enhancing drugs spiked at precisely the time Mark McGwire—and later, Barry Bonds—were chasing their respective home-run records. As former Senator George Mitchell concluded in his damning report, everyone was to blame. League officials, owners, coaches, players, the media, and the fans all benefited from the increased excitement and attention being paid to the game. They decided to overlook what was perfectly visible, right in front of their noses.

It's easy to turn a blind eye, especially if you can see huge short-term rewards for doing so. Let's say you were a homebuilder over the past decade or so, right up to the Time of Troubles. Well, wouldn’t you have tried to take advantage of a market in which the more homes you built, the more you sold? Let's assume, too, that your company was publicly held, and that the analysts and your shareholders were cheering you on, predicting (and therefore hoping!) that your annual earnings would continue to compound. Or let's assume you were selling houses, brokering mortgage loans, or underwriting structured financing vehicles in which the end purchaser was assuming a risk that the rating agencies indicated was minimal. Well, wouldn’t you have wanted to rake in all those unprecedented fees and commissions?

And let's not let the buyers off the hook. As a potential homeowner, dreaming the American Dream, wouldn’t you have jumped at the opportunity? Maybe you did. It was almost irresistible—like buying a car with no money down with zero percent interest.

Unfortunately, properties aren't cars. The future obligations you assume with a property are far greater. Therefore, before you take on a property, you need to make sure that you have a margin of safety, which generally translates into a reasonable amount of cash equity in the home or in the bank. You simply have to take the longer-term perspective. You have to develop the ten-year memory. Why? Simple: Because at some point, one or more of those negative "X factors", man-made or natural, will arise, and if you're unprepared, you'll get wiped out.

The same holds true—even more so!—if you make your living in this industry. Who succeeds, over the long run? It's the value investors: the contrarians who not only can protect their assets, but also can take advantage of opportunities during the downturns. Having cash in the bank (or the equivalent) allows them to capitalize on the upturns early in the "up cycles".

Yes, hedging your bets may seem like a lost opportunity during the good times. You'll feel like a tortoise among hares. But when the cycle turns, and everyone else is getting slammed, you will be making moves for the long term—and thereby tilting the odds in your favor.

Remember: In real estate, it is often the second owner who reaps the rewards.

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