Time to Buy

Foreclosure rates have almost doubled since last summer. Sales are down, rates are up, and price growth, already falling in many major markets, is at best flat. Applications for new mortgages and refinancings are off. And losses in mortgage-related securities just forced Bear, Stearns & Co. to pour as much as $3.2 billion into two investment funds that just last year were producing superior returns.

Don’t panic. It’s the perfect time to buy. The market is reacting to more to psychology, rises in interest rates, and losses in the sub prime market, than to any fundamental weaknesses.

There have been three drops in the real estate market in the last 30 years—the early 1980s, 1990, and today. None of the elements that caused the two previous fluctuations are present today. It’s a great time to build solid returns into your portfolio by snapping up foreclosures and other bargains.

With a few minor glitches, the real estate market rose like a fountain from the depths of the Depression through the late 1970s. The economy was humming, commercial building was stagnant, government policies encouraged home ownership, and the Baby Boom was provided strong demand for homes.

That long boom eventually ended in stagflation in the 1970s (stagflation is stagnant growth accompanied by inflation). That inflation became so dangerous to the economy that the Federal Reserve Board, under chairman Paul Volker, was forced in 1981 to raise interest rates to 22 percent in order to kill it.

Naturally, that produced a recession and unemployment. It was supposed to. Those very high interest rates also brought the housing market to a virtual standstill. Most investors use the past to guide their decisions, and considering the record of previous ten years, even people looking for investment properties had to ask themselves if they wanted to take any risks, when they could get 22 percent in Treasuries.

Volker did the right thing, though. By producing short-term pain, he squeezed inflation out of the economy. That, together with Ronald Reagan’s pro-business policies, put the economy on the track of solid growth.

Banks, and especially the thrift industry, eventually over-lent to the real estate business—especially to office buildings. Thanks to over-expansion in many businesses--fueled by pension fund investment, leveraged buy-outs, and foolish bank lending-the nation entered another recession.

Speculation in homes had meanwhile driven up prices in a phenomenon repeated in this decade, and when the country entered its next cyclical downturn in 1990, prices fell again, not recovering until 1996. That resulting up cycle produced returns that reached over 20 percent by late 2004-early 2005.

It’s not surprising that prices are sliding after a speculative run-up like the one from which we’ve emerged, and you couldn’t trust someone who told you prices won’t slide further before firming.

But the conditions for producing a collapse in the market two just aren’t there. The economy is slowing, but not in recession. The population is not shrinking. Employment continues to rise. Home prices may not be rising anymore, but the most dependable index of the market, the Standard & Poor’s/Case-Shiller Home Price Index (you can find it at http://www.fiservlendingsolutions.com/.), charts the growth in investment returns—not a fall in home prices. Nationally, prices are essentially unchanged, to down only slightly.

Home prices are certainly slow, and mortgage applications are down, but those prices are merely down from a peak and not growing. And much of the drop can be laid at the door of today’s higher interest rates, since, much like bonds, there’s an inverse relationship between interest rates and home prices; buyers look more at their monthly payment than the price of the house, and as that rises with rates, home prices fall.

The big spike in foreclosures, meanwhile, is mainly confined to the sub-prime sector. These mortgages were mostly adjustable—the better to accommodate marginal borrowers--and in today’s higher-interest environment, those marginal borrowers are being squeezed out. That is undeniably bad for them, but it’s not unfair to say these people had little business buying houses in the first place. The market is just behaving normally.

Looked at this way, most of the concern about the future of the housing market is built on psychology, and not market fundamentals. People need a place to live and they keep having children, and if builders stop or slow their building programs—there’s every indication this is already happening--then the worst that can happen to housing, given current trends, is a fall in the very high-end luxury market.

All this only means that investors should be looking for ways to turn matters to their advantage by buying good properties at bargain prices. Even if prices really do fall more sharply, history tells us that they will return, and outpace the previous peak.

You can make money in any market; what’s necessary is to understand the direction it’s taking, and to act accordingly.