How to Protect Yourself Against Market Decline
As more and more information points to the bursting of the real estate bubble, consumers are wondering how to protect themselves. There’s never an exact response to this inquiry, but keep in mind that the residential real estate market is cyclical — it goes up and down — and there are certain steps you can take right now we head into a downward slide.
First, in case you don’t want to take the word of this writer, here is why the real estate party is ending:
People are jumping on the real estate bandwagon: The low cost of debt has increased speculative real estate investment. The market for secondary homes is now at the relatively high level of 15% of all home sales. Just like in the Internet stock days, when the speculators jump on the bandwagon, it’s usually time for the wise to get out.
There’s going to be overcapacity in the market: At the beginning of 2005, new housing starts hit their highest levels in over 20 years. In other words: there are too many houses for sale! At some point, we’re going to run out of willing buyers, and residential real estate prices will tumble.
Rising interest rates are on the way, and will bring lower home prices: Interest rates can’t stay low forever. The most obvious contributor to high real estate prices has been the prolonged period of unusually low interest rates we’ve enjoyed.
Eventually, incoming Fed Chairman Ben Bernanke will have to raise interest rates beyond the current Fed rate-raising campaign. When that happens, a dangerous chain reaction will occur: Money will be tighter, and those who used cheap debt to buy houses beyond their means will have to sell out at lower values to maintain their liquidity. There will be less money available for speculators, and in conjunction with an above-capacity housing market, these factors will put declining price pressure on the market.
This can be depressing. Rather than fretting, however, remember: you can protect yourself from the impact of the bursting bubble. Here are some ways how:
Buy within your means: Don’t keep up with the proverbial Joneses, or you may be matching their decline in housing values. Instead, stick to houses costing no more than three times your combined household income.
Avoid over-leveraging: If you have Adjustable Rate Mortgages (ARMs), you should be particularly careful, because ARMs allow a much higher amount of loans relative to income levels. Therefore, you need to make sure you have enough income to cover unexpected rises in interest rates.
Buy value: A good indicator of housing value is to compare it with similar rental properties in your market. This is known as comparable sales. If a house is selling for below 150 times monthly rent, you’ve found yourself a good deal. If it’s selling for over 200 times rent, the property is probably overpriced. Another way to approach this equation is to simply find out how much the same property would cost to rent - if it is much less than a mortgage payment, the home is overpriced.
Leave the speculating to speculators: Unless you’re in the real estate business, it’s probably not the best time to try your hand at real estate speculation when the markets are at their highest levels in ages. Don’t think you can make money in a deflating real estate market. Look for the next big growth area instead of trying to catch up with one that has passed.
Diversify, diversify, diversify: This is good practice under all market conditions, but especially appropriate when there’s pressure to dive into a “hot” market like real estate. The bubble bursting won’t just affect the your real estate values, so make sure your other financial holdings don’t suffer either.
Get out of stocks that are closely linked to the residential real estate market, like those involving homebuilding, developing and home improvement. Avoid longer term debt instruments, like 30 year bonds. A principle to know well is that as interest rates rise, bond prices fall. Also, a real estate downturn can affect the entire US economy, so diversify into stocks of international companies to decrease your exposure.
Hogs get slaughtered: Lastly, if you don’t see investments out there that you’re comfortable with, it’s perfectly OK to simply hold a good portion your assets in the form of cash. Remember, investments are like trains, there is always another one coming and if you try too hard to jump on a train going too fast or which already left the station, you will be hurt. I have been there — trust me on this one. You worked hard for your money, and there’s nothing wrong with keeping money in the bank until there are investments out there worth making.
These words of wisdom are important to heed, but aren’t as applicable for those in The Sunshine State right now. As we’ve detailed, Florida home loans aren’t in as rough of a shape as other markets across the nation.
