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21 May 2013

Preparing for the next bubble

The real estate bubble burst of 2008 was generally caused by overpriced properties and mortgage problems. Many experts are now seeing that this won’t be the last as home values continue to reach uncontrollable levels. There are, however, methods to help prepare for a possible repeat.

To start with, a brief background of the previous housing collapse is important. During 2000, the average fixed rate mortgage dropped from 8.0 percent to 5.5 percent in 2003. This caused many homebuyers to borrow more than 25 percent. In 2000, in addition, data from the S&P/Case-Shiller showed that the average housing price index increased by 12 percent. This was later on followed by 65 percent increase in price in 2006. Eventually, the sharp spike spurred the housing burst, especially after the stock market crash. As a result, housing values declined by as much as 30 percent in 2009.

Some factors are to be blamed for the damage of the 2008 housing burst. First, the debt allowed several investors to enter the market. The low interest rates were attractive and those rates brought with them higher debt ceilings. These boundaries where raised even further by variable rate and interest-only loans.

Aside from the debt limit, tax incentives and capital gains added to the problem. The 1986 Tax Reform Act removed the deductibility of credit card interest. This caused homeowners to use their home equity loans more frequently. The Taxpayer Relief Act of 1997 also fueled the collapse by eliminating the $125,000 capital gains exclusion of sellers over 55 and instead placed a $250,000 exclusion.

These contributing factors helped hasten the housing collapse.

Currently, the country is seeing a strong performance in the real estate market. Compared with the labor market, the housing sector has been growing fast in since 2012. Many investors are experiencing advantages in this growth as profits and returns also increased. However, as many real estate properties become overpriced, investors are advised to tread the market carefully due to uncertainty in the future of the country’s economy. Interest rates may surge along with home values and some properties will be left unattractive.

How home values are set is an important consideration when looking into the possibility of a next bubble. A single-family home is typically priced in comparison to other homes in the area. Rental properties, on the other hand, are valued based on the returns it can produce for the owners. Lease terms, quality of the tenants, rent rolls, leverage and occupancy level, to name a few, are some of the factors included when assessing the value of a rental property.

One alternative, however, is given to assess the value of a portfolio. The net asset value method is commonly used for setting the price on real-estate holding companies. Through this method, the value can be determined by the company’s real estate assets, adjustments for other assets and removing liabilities. Furthermore, the NAV method is asset-based and focuses on the balance sheet. The goal is to convert all assets into cash and liabilities in order to arrive at a net asset value.

There are three steps in calculating the NAV:

  1. Cap rates for each rental property in the portfolio including the geographic considerations of the net operating income must be applied.
  2. Add assets and adjust if necessary.
  3. Deduct the liabilities to arrive at a net asset value.

After arriving at a net asset value, it is also crucial to accommodate for bankruptcy. Certain market conditions should be considered to help fully prepare for any unforeseeable outcome.

Debtors acquire enough space to cope with terrible market conditions in the event of a bankruptcy. There are several issues that must be understood before filing for bankruptcy. These may include the scope of the homestead exemptions, if there is equity or not, and how to protect other assets from the creditor.

Single asset real estate entities are also important considerations when dealing with bankruptcy. According to the Bankruptcy Code, a SARE is “a single property or project, other than residential real property with fewer than four residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental.”

Such considerations must be further analyzed in order to help shield those assets which can still be salvaged. Although the housing market is showing good signs of growth, there is still the question of whether a bubble can once again happen or not. Many experts believe that the current trend is already creating a mini-bubble. While there are still a few signs pointing towards that dismal directions, the most important thing to remember is to always be prepared. Understanding how the past real estate collapsed is crucial. Using that knowledge is another issue.

By Mark Michael Ferrer

Selda Kirkan
phone: +1.954.3056424