At the risk of being an old “I told you so,” I did predict with some accuracy the current woes assailing the mortgage industry. No, I’m not a Nostradamus. In fact, the mortgage meltdown was easy to foresee, a fact confirmed by the many warnings published over the last several years. Yet, in the frenzy of escalating housing values, most Americans chose to ignore the lessons of history, a costly oversight for many a would-be real estate tycoon. Just paying attention to the word “cycle” could have prevented thousands of foreclosures.
Since World War II, the real estate market in Southern California (my lifelong area of residence) has been an investor’s dream, with housing values increasing an average of about 11% annually. My parents built a 1,200 square foot three bedroom one bath home in 1946. The property cost $1,000 and the construction another $8,600. At the peak of the recent housing boom, almost exactly 50 years later, the home’s value exceeded $500,000. You do the math. However — and here is the key to this discussion — yearly changes in property values have not been uniform. Those hoping to make a relatively quick buck during a less than five year time span should beware.
In the 1970s, a time of wild economic upheavals, home buyers in an upscale Orange County development bought new homes in the $400,000 range. Within one year values had dropped by 50%. Accusations and lawsuits flew like the wind, but hundreds of homeowners found themselves upside down, owing much more on their homes than they were worth. My first home purchase occurred in 1986. My wife and I paid $136,000 for a 1,600 square foot three bedroom two bath home built in 1958. By 1990 its value had more than doubled; similar homes in the neighborhood sold for $285,000 to a high of $310,000. We sold that home in 1991, after the market had peaked, for $240,000 and we were glad to get it. The housing market decline continued, remaining in the doldrums for a good part of the 1990s. Then came the roaring years of 2001 through early 2005.
As an insurance agent beginning my career in 1999, I was uniquely positioned to see the train wreck coming. Beginning in 2002, I purchased hundreds of mortgage leads as home buyers or those refinancing sought life insurance protection for their mortgages. As I met with dozens upon dozens of prospects, a pattern emerged. I would walk up a driveway past a Volvo and a large SUV, discovering during the fact finding portion of my meeting the combined car payments reached or exceeded $1,000 per month. I’d be sitting in a $500,000 home with a $500,000 mortgage at 0% interest for three years or 3% interest for five years, or something close to that. Monthly mortgage payments ranged from $1,500 to almost $3,000. After asking “what happens to the interest rate in three to five years,” I learned it would “adjust.” Can we spell T-I-M-E B-O-M-B? Worse still, when I attempted to close, the spouses would look at each other, wondering whether they could afford $75 per month for life insurance. I knew they were already up against it, having maximized their spending before the interest rate adjustment. Can you hear that whistle blow?
A similar investor blind spot developed as the stock market raced upward during the late 1990s. Folks assumed the yearly 30%, 40%, and sometimes 100% increases would continue forever. One potential client scolded me with, “If you can’t show me mutual funds averaging 30% annual returns, forget it.” During 2001, when the NASDAQ dropped from 5,500 to 1,200, many investors learned the meaning of “cycle.” It’s a real important financial term.
Investing in real estate and stocks will always be excellent ways to build wealth. And, there will be future bull markets; get in early and ride hard. But keep two things in mind. One, bulls are always followed by bears; the cycle never ends. Two, the value of something is neither fixed nor predictable, but is arrived at when, and only when, a buyer and seller agree on a price. Something worth “X” today may be worth half “X” tomorrow. So — and here is the best advice I can offer — invest only what you can afford to lose. Investing your last dime, or worse, borrowing to invest, is a fool’s game.
Learn from the fools, don’t be one.
Posted by Jerry Pomeroy in Economics