Four and one-half percent interest rates create some unique opportunites, defer some big problems, and create other problems. The policy will probably save the Federal Reserve’s member banks billions of dollars, and that is all they care about anyway.

Asking Price: $425,000

Address: 97 Weepingwood, Irvine, CA 92614

{book6}

The Third Wave — Pain

No compromising, a nation going blind
The leaders are on their knees
The third wave has just begun

When I first wrote about the impact of 4.5% Mortgage Interest Rates, I decried the idea because the subsidy is obviously going to be temporary, and the removal of the artificial props will cause prices to resume their decline. The impact of rising interest rates on future home prices is dramatic.

With more time to contemplate the impact of 4.5% interest rates, I now see they open up unique opportunities for cashflow investors. People buying for cashflow are not concerned with resale value because they do not intend to resell. Profit and loss for a cashflow investor is determined by its income not its resale costs decades into the future. The Federal Reserve with the blessing of the Treasury Department of the US Government is orchestrating 4.5% interest rates to entice cashflow investors back into residential real estate. Without cashflow investors this mess will never get cleaned up.

If prices fall low enough, and if interest rates drop low enough, returns to cashflow investors become very large. In fact, they come to be greater than all competing investments in the marketplace. Under those circumstances, money will flow back into residential real estate, and the plethora of foreclosures both on the market and in the pipeline can be absorbed by cashflow investors seeking superior returns. The next several years represent a once-in-a-generation opportunity for cashflow investors to pick up long-term holds generating superior cash returns. If lenders are stupid enough to inflate another real estate bubble later, profiting by appreciation would be a nice bonus to the cashflow investor.

The very low interest rates also create opportunities for people to purchase 20+ year homes at or below rental parity and avoid the pain of further price declines; however, this is the harder play. Few properties in Irvine are trading at or below rental parity, but they are common in desirable areas of Riverside County (Yes, there are desirable areas there). This NOT a play where you overpay today and wait for appreciation to catch up to you. It only works if you are saving money over renting.

If there are properties in which you would be willing to live for the long term, and if they can be had for at or below rental parity, then you are only hurt by rising interest rates and declining prices if you must sell while resale values are depressed (an event that happens more often than most believe). Eventually–cue the 20 year holding time–fundamentals will rise to support prices at higher interest rates. On an inflation adjusted basis, you can never recover from overpaying up front, but in nominal terms, there will come a point when you can get out at breakeven. Keep in mind, you are trapped in an underwater situation once interest rates start going up and values start going down; however, you are trapped in a property that still costs you less than renting, so you are far better off than the typical homedebtor trapped in their homes today.

Do I recommend this play? No. But it is a legitimate way to acquire a property with 4.5% interest rates and not get burned. I still recommend waiting until (1) prices are even more depressed, (2) the foreclosure crisis begins to wane and (3) interest rates are higher. You will get a better price, and you have the possibility of refinancing into a lower payment if interest rates drop again. You can refinance into a lower payment, but not into a lower debt.

If you look at the cost of ownership for today’s featured property, you see that it costs about $2,200 per month to own. With 4.5% interest rates, this is at least at rental parity and probably below it. If someone can find a rental listing where an updated 1500 SF 3/2 can be rented for $2,200 in Irvine, please post the link in the astute observations. I believe this property is at rental parity–not that people would want to live here for 20 years.

To illustrate why this play does not work for any property other than a very long term hold, consider the impact of an increase in interest rates to 7.25% illustrated below. The long term historic average for mortgage interest rates is 8%. It is realistic to think we will see 7.25% interest rates in the future. When and if that happens, the value of this property would drop another $100,000. Is this property nice enough to be trapped in for 20 years?

Everyone who understands credit cycles knows interest rates are going to rise, it is only a matter of when and how far. As I outlined in Real Estate’s Lost Decade if the FED can somehow control the rate at which interest rates rise, they may be able to hold prices relatively stable. If they lose control (likely) and interest rates rise too fast, then prices will resume their descent. Buying at 4.5% interest rates is fraught with risk; however, many people will buy once prices are at or below rental parity. Usually, buying for cashflow is not quite so risky, but then again, our government usually does not manipulate home mortgage interest rates to such low levels to clean up after a housing bubble.

One of the first problems of the developing bubble was identified by bubble watchers as early as 2003; the widespread use of adjustable rate mortgages during a period of low interest rates. Once interest rates go up, so do the payments on ARMs, and so do the foreclosure rates.

There are three types of ARMs: (1) amortizing, (2) interest-only, and (3) negatively amortizing. When prices reached the practical limit of fixed-rate mortgages, many people turned to adjustable rate mortgages to increase affordability because they have lower interest rates. At first people turned to amortizing ARMs, but that soon gave way to interest-only ARMs and finally to negatively amortizing ARMs.

When the FED aggressively moved to lower interest rates, many cheered that the ARM crisis was averted; at best it was delayed.
The assumption most people made is that all the ARMs written are amortizing ARMs. There is no payment shock with an amortizing ARM unless interest rates rise; unfortunately, reality is that very few of the ARMs still utilized
by borrowers are amortizing ARMs.

The first wave of the foreclosure crisis was subprime. That wave has crested, and its devastation is nearly done.

The second wave that is building now is caused by the deteriorating economy and ARM mortgage recasts (Calculated Risk has a good post on this). As I wrote in The ARM Problem, it is not the reset of interest rates that is the problem, it is the recasting to a significantly higher payment caused when the mortgage goes from interest-only to fully-amortized. The negatively amortizing ARM, also known as an Option ARM is shown in
yellow on the chart above. It is the most toxic loan product ever
conceived. The Option ARM and the interest-only
ARM–and their associated recasts to amortizing loans–are the two loans responsible for the second wave of the
foreclosure crisis.

The third wave will come when everyone still clinging to their adjustable rate mortgage is wiped out by higher interest rates. Everyone who does not refinance into a fixed-rate mortgage while interest rates are this low, and the fools who actually buy a property with an ARM while rates are at historic lows will all be wiped out during the third wave of the foreclosure crisis. The timing of that wave is much harder to predict because nobody knows when interest rates will climb.

Four and one-half percent interest rates almost guarantee a third wave in the foreclosure crisis. Perhaps everyone will purchase with or refinance into a fixed-rate mortgage and this crisis will be averted. I doubt it. Based on what is still happening in our mortgage market, it looks like this third wave is still coming.

Asking Price: $425,000

Income Requirement: $106,250

Downpayment Needed: $85,000

Monthly Equity Burn: $3,541

Purchase Price: $565,500

Purchase Date: 10/28/2005

Address: 97 Weepingwood, Irvine, CA 92614

ALL CAPS

This guy did not abbreviate the word “throughout.” Hurray!

Today’s featured property was purchased on 10/28/2005 for $565,500. The owner used a $452,400 first mortgage, a $56,550 HELOC and a $56,550 downpayment. After opening a few other HELOCs, the owner finally consolidated into a $116,500 HELOC on 10/31/2007.

The total property debt is $568,900. If this sells for its current asking price, and if a 6% commission is paid, the lender stands to lose $169,400.

{book4}

They tried to build a nation, greater than anyone
But what they didn’t know was that someone else would have control
The mob starts infiltrating, at gunpoint they will roam
They show no mercy and the government is on their payroll
No compromising, a nation going blind
The leaders are on their knees
The third wave has just begun

The whole world is corrupted, it’s spinning out of control
The third wave is on the roll
It’’s slipping through our fingers and rising to the top
The third wave is on the roll
Roll with me, roll with me

The Third Wave — Pain

It is possible to significantly lower buyer’s commissions, but it will take a change of buyer behavior to do it. Today’s post shows how this could be done.

Asking Price: $189,900

Address: 365 Orange Blossom #140, Irvine, CA 92618

The Soup Nazi — Seinfeld

No soup for you! Next!

All businesses create expectations for service with their customers. The Soup Nazi is the best known example of a business owner whose product was so desirable that customers were willing to do whatever was necessary to get it.

Have you dealt with an attorney lately? Attorneys have trained their customers to expect to pay large retainers and to be billed enormous sums for every passing thought the attorney has about the client. They are second only to the Soup Nazi for training their customers to succumb to their wishes.

Realtors have done the poorest job of any industry that I can think of at setting appropriate customer expectations. The customers of buyer’s agents have been trained that it is OK to demand unlimited hours of an agent’s time to be driven around to look at dozens and dozens of properties for no compensation at all. Agents are actually willing to do this because they hope for the possibility of compensation if the looker actually becomes a buyer. As a result, buyers of real estate are subject to paying an inflated cost to cover the cost of those who look but do not buy.

For an agent, real estate commissions are like playing roulette; you don’t know when you will get compensated or how much it will be, but since commissions are so large, it is a game many are willing to play. It is the size of commissions that encourage realtors to play this game, and it further serves to create poor customer expectations.

Lowering buyer’s commissions requires reframing the compensation system to encourage a more efficient use of a realtor’s time. It starts with customers realizing one important point: when you pay a realtor a 3% commission, you are not just compensating them for the time you spent with them; you are compensating them for the time they spent with the other clients who did not buy a property and generate a commission.

This fact has two important implications for developing methods of reducing commission rates: (1) realtors can charge much less if they know they are going to get paid, and (2) realtors can charge less if they do not have to invest large amounts of time in non-paying customers. This efficiency is best achieved if compensation moves away from a commission basis to a pay-per-services model.

If the buyer and the broker have established a billing rate for the services performed, the buyer knows what they are paying for, and they are likely to be more judicious in their demands on the realtor’s time. For those who judiciously use their broker’s time, they will receive a commission rebate at the close. For those that go over their allotment, they may pay up to the typical 3% commission, but the commission will never exceed the amount specified in the listing contract.

What follows is not a service offering. As you may recall, we are in the process of forming a brokerage, but we are not DRE approved yet, so what follows is a hypothetical of how such a structure could be achieved.

What a buyer’s broker does

When you examine the tasks of a buyer’s broker, there are really only four major tasks they perform: (1) research properties for buyers, (2) show properties to buyers, (3) prepare formal bids and negotiate deals for buyers, and (4) coordinate the outside professionals during the escrow process. There is plenty of routine communication with phone calls and emails between broker and client during the process, but the four items listed are the ones that consume most of a broker’s time.

Once the key tasks are identified, a broker could establish a billing rate for each of these tasks and charge accordingly. Depending on the assurance of getting paid, the rates would be different, but the connection between time invested and compensation would be apparent to both the broker and the client. Once clients see that their actions have a direct association with how much they ultimately will pay for the service, they are incentivized to be more efficient in their use of a broker’s time; both parties benefit.

Traditional Commission Program

Many people will not want to be cost conscious when they purchase a property. They will want to take their time, look at many properties, and feel no obligation to be efficient with using a broker’s time. There is a commission structure for everyone, and those people will pay the full 3% (or whatever commission is specified in the listing contract) for full service.

Billable Hours Program

Lowering the commission is relatively easy with a pay-for-services model. In this model, the services demanded of the buyer’s agent are recorded, and a running total of billings is tracked. If a transaction takes place, the broker will be paid at the close of escrow for amounts billed up to the commission amount specified in the listing contract. If no sale occurs, the prospective buyer is not obligated to the broker for any of the billable time.

This model provides an incentive for buyers to be judicious in their use of a broker’s time, but it does not provide assurance that the broker will get paid. Due to the uncertainty of payment, the billing rates will seem rather high, but as previously noted, buyers who complete a transaction are paying for all those who do not.

The billable hours commission structure could work as follows:

• A minimum fee of $8,000 is charged at the close of escrow for coordination of the escrow process and other miscellaneous unbilled services provided during the sales process.
• Showings cost $200 flat fee plus $200 per property viewed on each tour.
• Brokers Opinion of Value reports, which are required before first written offer, cost $600 for each property.
• First written offer on each property costs $600.
• Subsequent written offers cost $400 each.
• The overall commission is subject to a 1.5% minimum charge. Any funds due to buyer’s broker from the listing contract in excess of the amount billed are returned to the buyer.

Example of a Billable Hours program:

Assume a buyer has a budget for properties in the $800,000 range. During the course of the search, they go on 3 home tours and visit 8 properties. They write offers on 3 properties, and after 5 counteroffers, they end up buying a property worth $780,000. How much would their commission be?

$600 – three showing appointments
$1,600 – view eight properties
$1,800 – first written offers on three different properties
$2,000 – five counteroffers required to close the deal
$8,000 – escrow coordination and realtor compensation
========================================================
$14,000 – total broker compensation

$23,400 – listing contract buyer compensation at 3%
$14,000 – fee to broker
========================================================
$9,400 – refund to buyer after closing

The buyer would pay a total fee of $14,000 to the broker. Since the commission paid at the closing table would be $26,400, the buyer would receive a check for $9,400 from the closing ($23,400 – $14,000 = $9,400). That works out to a 1.8% commission.

Billable-hours programs such as this one are most favorable to high-end buyers because the fees will quickly consume a 3% commission on a low-cost property. Despite this disadvantage, the potential is there to reduce commissions at most price points.

Retainer Program

To get to the lowest possible price point, a broker must know they are going to get paid for the time and effort invested in the process. Since buyers are so accustomed to getting this service for nothing, a typical billable-hours scenario will not succeed because people who do not buy simply will not pay the invoices when the bills come due. However, if a billing rate is established up front—a lower billing rate than the non-retainer structure due to the assurance of compensation—and if a buyer is willing to put up a retainer to guarantee payment, then a low-cost minimum compensation structure can work for both parties. This will be most advantageous for a buyer who (1) knows with certainty they are going to purchase, (2) does most of their own research, and (3) will not be lowball bidding on dozens of properties. A buyer who fits these criteria can get a significant refund at the closing table.

The Retainer commission structure could be structured as follows:

• A minimum fee of $4,000 is charged at the close of escrow for coordination of the escrow process and other miscellaneous unbilled services provided during the sales process.
• A retainer of at least $4,000 is required to qualify for this program.
• Showings cost $100 flat fee plus $100 per property viewed on each tour.
• Brokers Opinion of Value reports, which are required before first written offer, cost $300 for each property.
• First written offer on each property costs $300.
• Subsequent written offers cost $200 each.
• The overall commission is subject to a 1.0% minimum charge. Any funds due to buyer’s broker from the listing contract in excess of the amount billed are returned to the buyer.

Example of a Retainer program:

Assume a buyer has a budget for properties in the $500,000 range. During the course of the search, they go on 4 home tours and visit 10 properties. They write offers on 3 properties, and after 4 counteroffers, they end up buying a property worth $480,000. How much would their commission be?

$400 – four showing appointments
$1,000 – view ten properties
$900 – first written offers on three different properties
$800 – four counteroffers required to close the deal
$4,000 – escrow coordination and realtor compensation
========================================================
$7,100 – total broker compensation

$11,400 – listing contract buyer compensation at 3%
$4,000 – retainer paid in advance
$7,100 – fee to broker
========================================================
$8,300 – refund to buyer after closing

The buyer would pay a total fee of $7,100 to the broker. Since the buyer paid $4,000 in advance, and since the commission paid at the closing table would be $11,400, the buyer would receive a check for $8,300 from the closing ($11,400 + $4,000 – $7,100 = $8,300). That works out to a 1.5% commission.

In general, the retainer program will result in the lowest commission rate. If this same example is repeated for the $880,000 property in the first example, the commission would be subject to the 1% minimum charge.

{book7}

Bottom line is that people must be compensated for their time, or they will not perform the task. This is not greed or avarice, it is just a fact of life.

What is stated above is not a service offering; it is a hypothetical example of how alternate commissions could be structured to make the industry more efficient. Perhaps some area brokers reading this post will implement these ideas, perhaps not. As with the post, The New Real Estate Sales Business Model, a discussion of ideas in the public realm is a good thing. The 6% commission model is broken, and its days are numbered. The industry needs to start looking for alternatives to take its place.

Asking Price: $189,900

Income Requirement: $47,475

Downpayment Needed: $37,980

Monthly Equity Burn: $1,582

Purchase Price: $300,000

Purchase Date: 11/24/2004

Address: 365 Orange Blossom #140, Irvine, CA 92618

If you were going to stage a picture to make the kitchen look as small as possible, could you do better than today’s picture? This place isn’t fit for hobbits.

P.S. Check out the post at South Coast Homes. Kelli Hart has picked up the story on the Laguna Beach HELOC abuse.