Those of you who watched this week’s Democratic Party debate will note that the current foreclosure mess was an oft repeated theme. The candidates are trumpeting what they’ll do if they win in November, but two bills are already before Congress that will impact lenders and consumers.

The somewhat awkwardly named Emergency Home Ownership and Mortgage Equity Protection Act of 2007 and the Foreclosure Protection Act of 2008 are both being debated. Both are focused properties with nontraditional (neg am, interest only, etc) mortgages or subprime mortgages. Mortgage balances and monthly payments would be reduced based on how much a home’s value has decreased.

These won't impact investors directly, since they only applies to owner occupied properties. However, the measures are defiantly of interest to investors since it’s likely that it will impact the cost structure of the entire industry. The measure might decrease the number of underwater owners who walk away from mortgages, but essentially it forces the bank to eat the cost of the market downturn, instead of owners.

This is reform on the cheap, since short term the banks will be shouldering the cost. But the medium/long term effects won’t be good for consumers:

• Banks who are already reeling will be dealt an additional blow. This will lead to a real bail-out, paid for with real taxpayer dollars. The short term “reform on the cheap” won’t stay cheap for long.
• Banks are already recalibrating the way they quantify risk. But the current model assumes that a when a buyer purchases a home then said buyer will both enjoy the benefits of appreciation and the risk of a decrease in value. This assumption no longer holds, and the banks will be justified in charging accordingly. Home ownership will slip further out of reach of an increasingly large segment of the population.

Reform on the cheap doesn't work.  The banks will fix their own messes.  Some should fail - we should let them.  And if the government determines that citizens who are in trouble need help, we shouldn't fool ourselves that this can be accomplished without the government pulling out it's checkbook and spending some tax dollars.  Coercing the business sector to take an altruistic step will backfire in the end. 

Mortgage payments are on the rise.  Prices have collapsed.  "I'm outta here."

Over on Money.com there’s an interesting piece on when is it ok to walk away from your mortgage, which reports on the deluge of homeowners who are upside down on their mortgages and are simply sending their housekeys back to the banks and walking away. "Jingle mail" they're calling it. 

Well the idea was enough to push me into a state of moral indignation, thinking about the great American blame game and the general lack of accountability in our society.

But, having though about it a bit, I’m not sure so sure...

But look at it a different way. The rules of the game are clear: you sign, you get the house, you pay. And just like in sports, the penalties for violating the rules are clear as well; in this case, if you walk away you get a nasty-gram in your credit file.

The banks know this when they sign up homeowners. That’s why they charge higher interest rates on riskier loans – rates which they themselves set.

So perhaps my moral indignation was...a bit misplaced.  And I think my opinion was changed a bit by reading some of the 1,000+ comments submitted by readers (and yes there are a lot of stupid comments in the mix as well – to be expected). Upside down borrowers who walk away stick it to the banks – and that in turn forces the banks to reevaluate their algorithms for evaluating risk. And that in turn forces them to get better at the game of offering competitive rates to creditworthy borrowers and also realize that peddling high-margin negative amortization loans isn’t good business in the long run.

So does a financially troubled homeowner have a moral obligation to keep paying the note on a property that suddenly has negative equity and a resetting ARM payment? What if the stress of making the payments threatens his marriage and/or pushes him towards bankruptcy?

So perhaps a homeowner who makes $50k per year and walks away from the $300k mortgage on a house now worth $250k that the bank financed for him using a zero down ARM is doing the system favor by sticking the bank with the loss and nudging it just a bit close to a sounder lending policy.

This isn't painless for the borrower, who sees his or her credit in tatters - but there is an argument that says that banks who make bad lending decisions deserve to get burned. 

Thoughts?

Media stories on real estate fraud often focus on the markets that flew highest, like Las Vegas and Florida.  But there was a story on today's All Things Considered tells of a scam of Akron, Ohio. 

Towns like Akron, as it turns out, were a fertile feeding ground for illicit activity during the boom.  Even during the headiest days property values were appreciating too slowly to make a fortune quickly, so unfortunately there were some operators who combined greed and easy credit into a formula to bilk novice investors and, sometimes, the banks that financed the deals. 

Worth listening to.

Related stories:

• Real estate shell game :: Recognizing fraud
• Real estate shell game :: Part II
• Real estate shell game :: Part III

Roof. Heating/ventilation/air conditioning (HVAC). Plumbing. Foundation. These are the four big ticket items when you’re evaluating a the structural integrity of a potential purchase.

Most of us investors are part timers. And lots of us are somewhat handy and know something about houses (we live in houses ourselves, don’t we?) So those first three items are things we can generally get our collective heads around. We see roof jobs every day. We change the filters on our own AC system. Most of us have replaced a faucet or two in your time. So problems, both big and small, might not phase us when it comes to the roof, the AC system, or pipes.

But foundation problems? Woah Nellie. A sloping floor or suspicious cracks in the plaster will send most investors scurrying on to the next prospect. But this might be an opportunity. Less competition = fewer bids. Fewer bids = a lower price. And we like low prices when we’re buying, don’t we?

But not all foundation problems are created equal. Here in Texas (and perhaps where you live, as well) you’ll tend to find two types of foundation: slab, and pier & beam. If you tried to dig a basement in Houston you’d be playing table tennis underwater; Houston is essentially a paved over swamp with the water table a few feet below ground. In other parts of the country you’ll have other options – a crawl space foundation or a full basement. I don’t have any first hand experience with the structures I’ll I won’t say any more about them.

What I will say, however, is that pier and beam foundation problems scare me a lot less than slab foundation problems. Slab foundations mean buried pipes and no repair access. Fixing them is expensive. Last year I had a problem with some tree roots which grew about fifteen horizontal feet under a slab foundation and busted up the plumbing under a commode (lots of nutrients down there, I guess). Visualize jackhammers and annoyed tenants.

So I probably wouldn’t consider a property with major foundation issues if it had a slab foundation. A pier & beam foundation, however, is another matter. This is the preferred method for older homes, in which the home is constructed on beams which sit on piers which are driven into the ground for stability. I own a fourplex that was built in 1935: a hurricane-proof all-brick tank of a building. I wish I had ten more just like it. But it had some foundation problems a few years ago, but with a pier & beam foundation this was cheap to fix. So if you run into a prospect like this then you might want to give it a second thought before you put it in the “too hard” box and cross it off your list; you might be passing up a property you could snag at a bargain because it scares off all the newbies.

But make sure you get a structural engineer to take a look (not a foundation repair specialist, who will be trying to sell you something). The bottom line: a prospect w/ foundation problems might be worth another look if it’s a pier & beam structure. Go ahead and wave your arms and declare the house a disaster to the seller and to your Realtor, but know in the back of your head that this is a problem that most serious part-time investors can tackle.

Note: Graphic illustration includes diagrams taken from the Foundation Repair Network. 

Being a good investor is all about having a vision for where you want to be, taking a view on the market, and running the numbers. When these three elements don’t line up then smart investors stay on the sidelines.  But when they do line up then it’s time to act.

Having a vision, taking a view, and running the numbers: the three pillars upon which you’ll build your ability to make sustainable decisions which will, over the long run, help you to achieve your financial goals. Well forming the vision is the fun part; we all enjoy thinking about where we want to end up in life. And you’ll have lots of help in taking a view; everyone and there dog is out there making predictions about what’s next for the real estate market – your task is separating the wheat from the chaff.

But what about running the numbers? How many of us get really excited about running economic models? Well in my view looking before you leap is the best way to keep your momentum as an investor, and that means having an idea about what to expect from an investment in terms of rate of return, cashflow and net present value.

But analysis is like aspirin, or fine wine, or just about anything, for that matter. A bit of it can make a big difference – but that doesn’t mean that a massive dose is a good idea. More isn’t necessarily better.

So how do you strike the right balance? Well watch out for two traps – 1) becoming infatuated with the analysis and forgetting about the underlying uncertainties (no analysis is perfect) and 2) becoming infatuated with perfecting the analysis to the extent that you never get a deal done. In other words: don't get paralyzed.

Both of these problems happen, probably more than you’d think.

So - how to avoid these issues? Again, it depends on your goals as an investor and your personality type, but I’d suggest a few rules of thumb:

• Remember: your analysis is based on your assumptions. Unless you have a working crystal ball you’re never going to get it all right. Your analysis will give you your base case. When you get your results ask yourself “is this target a good result? Does the potential reward justify the risks?” if the answer is “yes” then drive on and figure out how to make the deal work – don’t spend too much time fine tuning. 
• Analysis is a process: I worked for a while in strategic planning with a major corporation. We spit out huge, detailed plans. And we never followed them. Is this a bad result? Well, not necessarily, because the planning process in itself is hugely valuable. It forces executives to examine their assumptions, communicate their goals, and crystallize their thinking. The planning process helps organizations to articulate their vision and set their course, even if they don’t follow the resulting plans to the letter. Real estate analysis is similar: running the numbers will force you to consider the big questions around vacancies, rental rates, repairs, and other risks that you might not consider before jumping into the investment. 
• Evaluate the sensitivities: Don’t just look at the final “answer” – look at the sensitivities to understand how much risk you’re taking. Ok, you’re forecasting a 5% appreciation rate...but what if it’s -5%? Or 10%? Most investors who bought in 2006 didn't predict today's market - but there are a handfull who at least evaluated the risk of a downturn.  Investors who consider future risks are investors who are prepared to take action when things don't go right. 
• Be honest with yourself: There are two camps that you want to stay out of – the overly conservative camp that kills every deal that comes along by handicapping them with excess costs, and the rose-colored-glasses camp that tweaks all the variables up until they get the result they want. Nervous Nellies do no deals, and Pollyannas do bad ones. 
• Remember that once you’ve made your bed you’re going to have to lie in it: A single fortuitous event (a new rail line) or misfortune (a mold infestation or a disastrous tenant) will radically impact the performance of your investment. You’re still going to have a lot of uncertainty to manage once you make your investment; the purpose of the analysis is simply to ensure you’re pointed in the right direction before you pull the trigger.

Well go check out Positive Real Estate News, a site dedicated to accentuating the positive and eliminating the negative, as Baloo the Bear says in Jungle Book.  So if the bubble bloggers have you down and you're tired of the histrionic media hype then give this site a try. 

You can expect a pretty heavy Realtor spin on things, but that's ok in my book; if you want a balanced worldview then it helps to hear both sides of the coin.  I'm a guy who gets his news from the Wall Street Journal (on the right) and the New York Times (on the left), so I believe that it's important to be open to different points of view.

As investors we’re not out there spinning the roulette wheel; we’re looking at the underlying fundamentals and taking measured risks. That said, investors do need to take a view of the future in order to make decisions in real time – and BusinessWeek’s recent cover story gives the housing market a timely and even-handed overview.

You’ll see some of the boilerplate that you’ve read before, but pay attention to a reference to an influential paper written by Harvard economist Gregory Mankiw which back in 1989 predicted a precipitous decline in housing prices. The premise was that a shrinking body of first-time buyers along with a glut of downsizing baby boomers will collectively pull lots of demand out of the market, leading to an excess of supply and a sticky plunge in prices.

Regardless of whether or not you pay any attention to the experts’ predictions it’s important to have a view on what’s next; you can’t invest without having an opinion about the future. Personally, as prices slide and interest rates drop I’m actively pursuing multi-family opportunities. I don’t know that prices won’t continue to drop, but locally I’m also seeing strong demand for rentals and, in some cases, higher rental rates. According to the National Housing Council , rental rates are up 3.36% in Houston. Combine that with the fact that housing prices have slipped by 2.38% over the last year and you have a market in which an already competitive rent-to-value ratio has gotten even better. That, for me, is an acceptable risk.

Rental rates in some major markets are up even more: 8.87% in Dallas (accompanied by a big 6.18% slide in property values). Notably, some higher value markets like San Diego and Miami are showing strong double digit increases in market rents, but even with a little help you’re unlikely to find buying opportunities that will yield breakeven cashflow in those areas.

I’ll talk a bit more about the Center for Housing Policy’s recent press release on housing affordability in a post tomorrow.