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This article outlines the regulations necessary to limit the destabilizing influence of speculative interference in the sale of California single family residences (SFRs) during times of boom or bust.
Speculators shut out buyer-occupants
When buyer-occupants – users – are scarce in a slow resale or recessionary real estate market (called the vicious real estate cycle), speculators provide liquidity – cash – to the market by buying properties from sellers who must sell but cannot find users willing to buy. In exchange for a deeply discounted price, speculators give sellers the means of passing off the risk of waiting for a buyer who will pay a higher price. [For more information on the recent scarcity of qualified borrowers in the real estate market, see the July 2010 first tuesday article, Low-ball offers slow housing sales.]
However, while speculators provide a benefit to the real estate market in a virtuous cycleThe economic climate during a period of growth, in which property owners gain by selling (referred to as a seller's marketA real estate market characterized by high homebuyer demand and low housing inventoryProperties available on the market through the multiple listing service (MLS)..)., when the market is full of users in the form of ready, willing and able buyer-occupants, speculation has the potential to severely disrupt the long-term stability of the real estate market, as affirmed by the recent financial crisisAn economic downturn resulting from the failure of banking and government agencies to regulate and adjust to developing market conditions. and ensuing Great RecessionAn economic event triggered and controlled by the Federal Reserve to maintain the sustainability of economic growth.. The disruption becomes absolute over time as ever more speculators crowd in, causing a buying frenzy environment which pits buyer-occupants and speculators against one another in an inevitably destructive pricing war.
Consider a prospective first-time buyer-occupant looking to purchase a home. The buyer-occupant is ready, willing and financially able with sufficient savings to make a 20% down payment on a property in a specific price range. He enters into an agreement with a selling agent to help him locate a suitable property to purchase.
After a few weeks, the agent locates a house the buyer-occupant wishes to purchase. Through his selling agent, the buyer-occupant makes a full-price offer to purchase the property with a 20% down payment and several contingency clauses to cover financing, inspections and property disclosures affecting value withheld by the listing agent.
At the same time, a speculatorA real estate investorA purchaser who holds a property long-term on a buy-to-let basis as an income-producing investment. Contrast with a speculator who buys-to-flip a property for fast profits, rather than annual income. who owns property short-term, sandwiching themselves between the seller and end user of the property. views the property and, looking to sit on the property until prices in the market move further upwards (a process known as flippingBuying and quickly reselling a property to obtain a large profit, the basis of speculation.), puts in an offer directly to the listing agent for a purchase price far less than the buyer-occupant has offered to pay. However, the speculator’s offer contains no contingencies and the price will be paid in cash, promising a quick closing. The distressed seller, seeking a fast sale, accepts the speculator’s offer over the buyer-occupant’s offer. [For more information about the flipping process, see the April 2010 first tuesday article, Flipping: contracting to assign or double escrow the resale transaction.]
The sale is completed and the speculator lets the property sit fallow. The bare minimum of maintenance is completed to keep the property from being vandalized while he waits for the momentum of the rising market (a phase known as the virtuous real estate cycle) to increase the price he can get for the property.
After a few months, the market momentum drives prices upwards as anticipated, and the speculator lists the property for sale at a price much higher than he paid. He sells the property to a buyer-occupant and pockets the profit on the flip. Thus, the transaction withdraws money from the real estate market, depriving the users of the property (the original seller and the eventual buyer-occupant) of that financial benefit — a market zero-sum gameA situation which occurs when one person's profit comes at the cost of another person's equal loss, as occurs when "value" added by market momentum is quickly withdrawn by flippers on a sale..
During vicious cycles, sellers need the speculators to break the gridlock of the illiquid market.
Alone, the flip of a single property merely diminishes the financial position of the original owner who sells the property to the speculator and the buyer-occupant who purchases his home from the speculator. Both these parties give up money to the speculator in the transaction: the seller since he does not receive market price for the highest and best use of the property — owner occupancy — and the end buyer-occupant since he subsidizes the speculator’s profit when he purchases his home at a higher price than he could have paid to the original seller.
During vicious cycles, sellers need the speculators to break the gridlock of the illiquid market. Speculators are needed until users and lenders are available in sufficient numbers to keep the inventory of homes in the active market between 90 and 120 days, a reasonable time period for agents to make a match between buyer-occupants and sellers.
However, when flipping is allowed to run rampant in a momentum market driven by an abundance of mortgage money, the result is a self-destructive time bomb of bidding wars and over-inflated sales prices. Worse, the rush towards financing encourages misbehavior and inefficiencies which become embedded in every sector of the real estate industry and its supporting service industries.
The latest repercussions of this behavior during the Millennium BoomThe years 2000-2007 leading up to the current economic recession, characterized by loose lending practices and unsustainably high property prices and sales volume. precipitated the calamitous financial crisis and the ensuing Great Recession. Real estate prices during the boom period were initially driven primarily by the financial acceleratorThe cyclical phenomenon of increasingly larger loan amounts based on increasingly inflated prices of the same collateralTangible assets attached to a loan which are worth more than the cash value of the loan.. effect of Wall Street Bankers pouring excessive money into the mortgage market in ever greater amounts without regard to the irrational change in value of the collateral (i.e., the real estate). [For more information on the financial accelerator phenomenon, see the April 2010 first tuesday article, Sink or swim? Whether to strategically default on a home loan.]
Speculators leapt into the over-priced, money-flush market. The frenzy of buying and selling created an appearance of market activity which in turn fueled ever more building, speculation and mortgage lending. When defaults from the adjustable rate mortgageA variable interest rate note based on a particular index, often starting out with an introductory "teaser" rate, only to reset at a much higher rate in a few months or years. (ARM) smorgasbord began to pile up, the party wound down and the real estate market players found themselves staring at a wasteland of bad mortgage debt, underwater homeowners and excessive inventory.
Thus, the seller and buyer-occupants of real estate, real estate licensees, long-term real estate investors and those employed in the industries relying upon a stable real estate market (construction, escrow, title, home inspectors, etc.) must strive to keep the influence of the speculator secondary to the interests of users — the buyer-occupants — at least in rising markets when the need for liquidity is not of concern to any seller.
California’s speculator outlook
The Southern California 23-month yearly average for cash sales is 14.1%. In May 2010, 24.5% of real estate sales in Southern California were cash-only, a tell-tale sign of speculator activity. Earlier in the 2010, the figure was at 40%, while the mad rush to buy and receive a subsidy had ill-informed first-time buyers flocking to buy without governmental protection from the interference of speculators drawn by the subsidy-created frenzy. The rest of the state also continues to experience a higher-than-average level of speculative interference.
While the mid-2010 real estate sales market is slow and flat-to-lower than one year earlier, California can afford to be generous to speculators; they provide a means of keeping the market churning. Buyer-occupant users (and income property investors in low tier properties) are currently not filling the sellers’ need for buyers. But what happens when the virtuous cycle begins and the market heats up, as it inevitably will in the coming years?
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