in the road”. Closed transactions are at an all time low and inventories of new and used houses for sale and their days on the market are at an all time high… but of course…. it’s just a bump in the road….yeah, right!

First of all, let me clearly state that I agree that real estate is local and what is happening in Miami-Dade is not necessarily what is happening here or in other counties or markets across Florida… or the country for that matter. But conditions within each market have consistent and universal governing factors.

No market operates in isolation. Real estate values do not move upward or downward just because people want to own their own homes. That is a factor of course; but there are many more factors at play. Most often, these factors creating or affecting valuation lead to bubbles, distorting the real value of real estate. And my good readers, that is where we are at. The value of real estate has NEVER been more distorted.

In order to understand real estate in general and real estate bubbles in particular, you must make a distinction between “valuation” and current “market value”. These two are not necessarily the same, although the terms are often mixed up and errantly used by real estate agents and other real estate professionals. Most tend to think there is no difference.

Valuation is an assessed or appraised price for real estate based upon logical comparisons and costs. In a real estate bubble, valuation may become distorted by artificial demand and other causes, leading to a rapid increase in market value, which, eventually and inevitably has to be corrected. If you haven’t noticed, the correction of this distorted market is the main order of business of Florida’s State Legislature since the last election. It is a matter of huge importance. Ironically, these legislators are the same people that allowed the distortion to occur, reaped all the revenue benefits from it and are now trying to fix it. Ah, yes…politicians!

Market Value is simply the price that a buyer and seller agree to. In an orderly market, a property’s market value will be based on appraisals and valuation principles. But in a real estate bubble, the principles of valuation may be suspended or ignored and replaced by greed and speculation.

To grasp how speculation works, it is useful to examine how speculators think, and how illogic can drive prices unreasonably high. There are all types of economic factors at play in our market places; however the simple fact is that greed drives the real estate bubble. I use the Miami-Dade pre-construction condo market as a prime example:

Speculators heard that investors were doubling their investments by purchasing pre-construction condominiums and re-selling them before the construction was completed. What happens? The greed factor kicks in; the real estate agents jump on board; the local governments turn a blind eye to the wanton development; and, builders/developers take order after order for new units. The feeding frenzy and orgiastic profiting makes the financial news and the early and savvy speculators are in and out of the market with surgical precision. Their pockets are fat and they are on to new ventures, leaving nothing but destruction in their wake.

When investors and speculators see prices rising, they want to get into the market and get a piece of the action. The more speculators, the greater the artificial demand; the bubble feeds itself until it cannot grow any longer, and then it bursts.

Suddenly, it becomes apparent, that nobody is buying these ordered units. It is determined that the speculation has resulted in an inventory of units that, even in a great market, could not be depleted in 10 years!

Now we see the body count. We see the damage now that the blinding whirlwind has settled. Across the landscape are strewn the bodies of the investors that got in too late and couldn’t get out; the builders that have dumped their bloated, over-priced inventory for a fraction of what they had in them…and died on the vine anyway; the sub-prime lenders that abandoned lending principle and loaned money to anyone with a pulse; those borrowers whose only credential was that pulse, that watched their interest-only and adjustable rate mortgages swell like road-kill raccoon in July and become impossible to pay; the real estate agents that, once again, thought the good times were here to stay and bought those Cadillac’s and BMW’s and fancy Mercedes Benz’s; and alas, the poor homeowner that watched his taxes and insurance rates rise to unbearable excess.

Let’s take a look at the most basic form of bubble, the pyramid scheme, because real estate speculation is not all that different from a pyramid scheme. The basic idea for a pyramid scheme is that people pay money in over a series of levels, and at each level the number of people grows. If the pyramid begins with one person collecting one dollar from six people, he makes $6 profit. If those 6 each go to six other people (total of 36), the level and the number grow, so in theory, by the time the pyramid reaches 13 levels, everyone gets rich:

LEVEL PEOPLE

You see, if each person at each level gets six other people to each pay in one dollar, everyone can get rich at the end. At the end of 11 levels, over 362 million people are involved at one dollar each and that is a fantastic amount of money. Unfortunately, this number is greater than the population of the United States; and the 13 billion people at Level 13… well that’s more than the population of the entire planet!!!

By definition, a pyramid scheme is the exchange of money without any underlying tangible value. As such, it is illogical. It is also a good model of an economic bubble. It is impossible for wealth to be created out of nothing, yet this is the false logic driving the real estate bubble. Only those few people at the very beginning of the chain make money; most lose.

A real estate bubble is created by an appeal to greed. As we see with the pre-construction condo market in South Florida, the novice or inattentive speculator does not pay attention to facts: they do not appreciate the growing rate of construction which is approaching a decades worth of demand; nor do they stop to question where the run-up of prices will end. Simply put, because profits have been made recently, speculators refuse to ask questions, downplay the dangers and invest all they can. So the bubble grows and grows. Until….. POP!!!

Just as money cannot be created and expanded indefinitely through a chain letter pyramid scheme, real estate values cannot continue upward without end. Eventually, the artificially inflated bubble will burst… and I believe it has.

So the question is now asked: How does the more cautious, steadfast investor make money in real estate when the bubble has burst? The burst has created a new landscape and how does the serious investor best navigate through the debris?

For starters; one needs to pay attention to what is going on in your local market. If you are a serious investor, you have already been following certain indicators and noticing trends. Indicators like the current inventory of homes or land for sale, the spread of listed price to selling price, and time on the market are very revealing and useful. It represents the pulse of your local market.

If you track these trends locally, you will gain a sense of how the market is changing. You will be able to recognize what triggers the trends and you will become an expert in timing your decisions to buy and sell within your local market.

Not every real estate cycle consists of a rapidly expanding bubble, followed by a deep recession. That is actually the exception to the rule. It is far more likely that the cycle will lead to price growth in the real estate market. So it is possible to track the fundamental trends in real estate and identify the time to stay out of the market. This is a concept foreign to most speculators and investors. There really is a time when you should stay out of the market and move your capital elsewhere.

The problem of course, is in making these determinations in a timely manner, or developing foresight that is as astute as hindsight. Every real estate cycle has a unique rhythm to it. This does not mean you can time decisions perfectly. It is the very uncertainty about cyclical movement that makes timing most difficult. But you will begin to recognize repetitive tendencies.

When real estate prices are rapidly rising, you can speculate on the trend without risking great sums of money. You can purchase options from current owners, knowing that you might lose the money placed into the option, but knowing that this is preferable to actually buying the property only to lose a larger sum of money should your timing to resell be mis-judged. With an option in hand, you can find a buyer, go to escrow, and complete a buy-and-sell at the same time without risking any equity. This works when market prices are rising, but you would be smart to establish the point where you will need to exit from the position. For example, you might identify a percentage or net dollar amount that is your baseline. Without a competent and well thought out exit strategy, it is far too easy to give in to greed, wait too long and end up missing the opportunity.

When prices have fallen, people tend to rely on their fear. They become desperate to sell, thinking that prices will continue downward. By keeping a cool head, you can find real bargains at such times. When it’s a buyer’s market, you can demand and get deep discounts from asked prices and acquire real estate well below market value. Remember, even when people are fearful about real estate trends, falling prices are usually a temporary situation. The actual precipitous drop in prices is rare. However, when that does occur, it presents an even bigger opportunity for the buyer who is able to keep a cool head. I believe we are reaching that point with our Florida markets.

We are in a deep buyer’s market – have no doubt about that!

There are three primary strategies that the investor should employ when attempting to work in a deep buyer’s market. These are:

1. BUYING RENTAL PROPERTIES.

When prices are down you can find bargains; when prices are flat, current owners are most times fearful. The tendency is to believe that when price increases stop, the trend will never turn around. Despair, grown from fear, motivates people to sell their properties for less than what they are worth.

When you buy rental property, the immediate goal is to create a situation in which rent income is high enough to make your mortgage payment and to cover all expenses. You are less likely to have vacancies when the rental market is strong. Even when housing prices fall or go flat, the rental demand market is separate and may remain strong. This is a great time to get into the business of holding property as an investment, covering expenses through rents, and waiting for prices to return to the upside.

There are two ways to enter the investment market in housing. The first and most obvious way is to purchase property through conventional methods. The higher your down payment, the lower your monthly mortgage obligation and the easier it will be to make a positive cash flow. But at the same time, the more capital you tie up in a single property, the more opportunities you may have to pass on, and the higher your risks. Buying rental property is a dilemma because you need to balance the requirement of positive cash flow against the desirability of leveraging your capital.

An alternative method – and one that makes a lot of sense when the local market is depressed – is using the lease option. When current owners are in despair because prices have fallen, they are more likely to accept an offer of a Lease Option Contract – because they do not believe they are going to be able to sell the property for a high price. The psychology of any investor or property owner is most likely to operate on the basis of greed (on the way up) and fear (on the way down). At the market bottom, an offer of a lease option solves many problems for a property owner:

2. BUYING FIXER-UPPERS.

In addition to buying and holding property or speculating in real estate, another method is to buy property, fix it up, and sell it. This is not necessarily the same as flipping the property.

For those who know how to identify the attributes of the right property, this can still be a lucrative market. Here are several things to consider in this type of situations:

3. PROPERTY-FLIPPING STRATEGIES.

One of the most effective techniques for profiting from real estate while bubbles are growing is flipping. However, once the bubble has burst or when prices level out, property flipping strategies can still be executed but with a different emphasis. Assuming that property values fall after a bubble, current owners may panic and sell their properties quickly. Fearing further declines, bargain pricing may follow and, even when sellers advertise a specific price, they might come down even more.

Post-bubble conditions are going to be characterized by an excess of properties on the market. This can make flipping less practical than in conditions when prices are driven higher by an excess of buyers. Even so, those likely bargain prices present an opportunity. Your property flipping strategy may need to be extended beyond the short-term approach.

You can seek depressed fixer-upper properties and try to resell, but in a soft market it is unlikely that you will be able to make the profit you would earn in a stronger market. The most likely alternative when prices are depressed is to pick up bargain properties and rent them out. If you can cover your payments and expenses through rent, this is a perfect strategy for waiting out the post-bubble cycle.

Real estate – as an investment and in terms of any bubble situations – has to be kept in perspective. All investments are characterized by specific market activity and action, and investors behave in specific ways. But in all markets, a few things never change. These include these three important observations:

Two markets worth consideration outside of real estate are stocks (direct ownership or mutual fund shares) and the money market.

You have numerous choices of where and how to invest. Don’t be fooled into thinking that as an investor you are limited to purchasing real estate only. It may be a great time to not be involved in real estate at all. This depends on your level of confidence in your local market as well as the reality of the local market itself.

Or maybe you should be looking for some middle ground. Take a good look at your asset allocation and find a ratio that works for you. My suggestion is a 50-250-25 ratio of allocation:

Stocks 50%

Real Estate 25%

Money Market 25%

The bottom line and gist of this newsletter is just this:

Come to terms with the fact that this wonderful bubble has burst and the market is becoming a nightmare for buyers and sellers alike. Take a good look at how you are dong business. Run the numbers…see where you stand… and be proactive