Four and one-half percent interest rates create some unique opportunites, defer some big problems, and create other problems. The policy will probably save the Federal Reserve’s member banks billions of dollars, and that is all they care about anyway.

Asking Price: $425,000

Address: 97 Weepingwood, Irvine, CA 92614

{book6}

The Third Wave — Pain

No compromising, a nation going blind

The leaders are on their knees

The third wave has just begun

When I first wrote about the impact of 4.5% Mortgage Interest Rates, I decried the idea because the subsidy is obviously going to be temporary, and the removal of the artificial props will cause prices to resume their decline. The impact of rising interest rates on future home prices is dramatic.

With more time to contemplate the impact of 4.5% interest rates, I now see they open up unique opportunities for cashflow investors. People buying for cashflow are not concerned with resale value because they do not intend to resell. Profit and loss for a cashflow investor is determined by its income not its resale costs decades into the future. The Federal Reserve with the blessing of the Treasury Department of the US Government is orchestrating 4.5% interest rates to entice cashflow investors back into residential real estate. Without cashflow investors this mess will never get cleaned up.

If prices fall low enough, and if interest rates drop low enough, returns to cashflow investors become very large. In fact, they come to be greater than all competing investments in the marketplace. Under those circumstances, money will flow back into residential real estate, and the plethora of foreclosures both on the market and in the pipeline can be absorbed by cashflow investors seeking superior returns. The next several years represent a once-in-a-generation opportunity for cashflow investors to pick up long-term holds generating superior cash returns. If lenders are stupid enough to inflate another real estate bubble later, profiting by appreciation would be a nice bonus to the cashflow investor.

The very low interest rates also create opportunities for people to purchase 20+ year homes at or below rental parity and avoid the pain of further price declines; however, this is the harder play. Few properties in Irvine are trading at or below rental parity, but they are common in desirable areas of Riverside County (Yes, there are desirable areas there). This NOT a play where you overpay today and wait for appreciation to catch up to you. It only works if you are saving money over renting.

If there are properties in which you would be willing to live for the long term, and if they can be had for at or below rental parity, then you are only hurt by rising interest rates and declining prices if you must sell while resale values are depressed (an event that happens more often than most believe). Eventually–cue the 20 year holding time–fundamentals will rise to support prices at higher interest rates. On an inflation adjusted basis, you can never recover from overpaying up front, but in nominal terms, there will come a point when you can get out at breakeven. Keep in mind, you are trapped in an underwater situation once interest rates start going up and values start going down; however, you are trapped in a property that still costs you less than renting, so you are far better off than the typical homedebtor trapped in their homes today.

Do I recommend this play? No. But it is a legitimate way to acquire a property with 4.5% interest rates and not get burned. I still recommend waiting until (1) prices are even more depressed, (2) the foreclosure crisis begins to wane and (3) interest rates are higher. You will get a better price, and you have the possibility of refinancing into a lower payment if interest rates drop again. You can refinance into a lower payment, but not into a lower debt.

If you look at the cost of ownership for today’s featured property, you see that it costs about $2,200 per month to own. With 4.5% interest rates, this is at least at rental parity and probably below it. If someone can find a rental listing where an updated 1500 SF 3/2 can be rented for $2,200 in Irvine, please post the link in the astute observations. I believe this property is at rental parity–not that people would want to live here for 20 years.

To illustrate why this play does not work for any property other than a very long term hold, consider the impact of an increase in interest rates to 7.25% illustrated below. The long term historic average for mortgage interest rates is 8%. It is realistic to think we will see 7.25% interest rates in the future. When and if that happens, the value of this property would drop another $100,000. Is this property nice enough to be trapped in for 20 years?

Everyone who understands credit cycles knows interest rates are going to rise, it is only a matter of when and how far. As I outlined in Real Estate’s Lost Decade if the FED can somehow control the rate at which interest rates rise, they may be able to hold prices relatively stable. If they lose control (likely) and interest rates rise too fast, then prices will resume their descent. Buying at 4.5% interest rates is fraught with risk; however, many people will buy once prices are at or below rental parity. Usually, buying for cashflow is not quite so risky, but then again, our government usually does not manipulate home mortgage interest rates to such low levels to clean up after a housing bubble.

One of the first problems of the developing bubble was identified by bubble watchers as early as 2003; the widespread use of adjustable rate mortgages during a period of low interest rates. Once interest rates go up, so do the payments on ARMs, and so do the foreclosure rates.

There are three types of ARMs: (1) amortizing, (2) interest-only, and (3) negatively amortizing. When prices reached the practical limit of fixed-rate mortgages, many people turned to adjustable rate mortgages to increase affordability because they have lower interest rates. At first people turned to amortizing ARMs, but that soon gave way to interest-only ARMs and finally to negatively amortizing ARMs.

When the FED aggressively moved to lower interest rates, many cheered that the ARM crisis was averted; at best it was delayed.

The assumption most people made is that all the ARMs written are amortizing ARMs. There is no payment shock with an amortizing ARM unless interest rates rise; unfortunately, reality is that very few of the ARMs still utilized

by borrowers are amortizing ARMs.

The first wave of the foreclosure crisis was subprime. That wave has crested, and its devastation is nearly done.

The second wave that is building now is caused by the deteriorating economy and ARM mortgage recasts (Calculated Risk has a good post on this). As I wrote in The ARM Problem, it is not the reset of interest rates that is the problem, it is the recasting to a significantly higher payment caused when the mortgage goes from interest-only to fully-amortized. The negatively amortizing ARM, also known as an Option ARM is shown in

yellow on the chart above. It is the most toxic loan product ever

conceived. The Option ARM and the interest-only

ARM–and their associated recasts to amortizing loans–are the two loans responsible for the second wave of the

foreclosure crisis.

The third wave will come when everyone still clinging to their adjustable rate mortgage is wiped out by higher interest rates. Everyone who does not refinance into a fixed-rate mortgage while interest rates are this low, and the fools who actually buy a property with an ARM while rates are at historic lows will all be wiped out during the third wave of the foreclosure crisis. The timing of that wave is much harder to predict because nobody knows when interest rates will climb.

Four and one-half percent interest rates almost guarantee a third wave in the foreclosure crisis. Perhaps everyone will purchase with or refinance into a fixed-rate mortgage and this crisis will be averted. I doubt it. Based on what is still happening in our mortgage market, it looks like this third wave is still coming.

Asking Price: $425,000

Income Requirement: $106,250

Downpayment Needed: $85,000

Monthly Equity Burn: $3,541

Purchase Price: $565,500

Purchase Date: 10/28/2005

Address: 97 Weepingwood, Irvine, CA 92614

Beds: 3 Baths: 3 Sq. Ft.: 1,582 $/Sq. Ft.: $269 Lot Size: – Property Type: Condominium Style: Other Stories: 2 Floor: 1 Year Built: 1983 Community: Woodbridge County: Orange MLS#: S545417 Source: SoCalMLS Status: Active On Redfin: 256 days

CLARIDGE MODEL,HARDWOOD FLOORS THROUGHOUT DOWNSTAIRS, TRAVENTINE FLOOR

AND COUNTER AT KITCHEN, NEW SINK AND FAUCET, STONE REMODELED FIREPLACE

IN LIVINGROOM, NEW EXTERIOR PAINT. BONUS ROOM DOWNTSTAIRS CAN BE 4TH.

BEDROOM.

ALL CAPS

This guy did not abbreviate the word “throughout.” Hurray!

Today’s featured property was purchased on 10/28/2005 for $565,500. The owner used a $452,400 first mortgage, a $56,550 HELOC and a $56,550 downpayment. After opening a few other HELOCs, the owner finally consolidated into a $116,500 HELOC on 10/31/2007.

The total property debt is $568,900. If this sells for its current asking price, and if a 6% commission is paid, the lender stands to lose $169,400.

{book4}

They tried to build a nation, greater than anyone

But what they didn’t know was that someone else would have control

The mob starts infiltrating, at gunpoint they will roam

They show no mercy and the government is on their payroll

No compromising, a nation going blind

The leaders are on their knees

The third wave has just begun

The whole world is corrupted, it’s spinning out of control

The third wave is on the roll

It’’s slipping through our fingers and rising to the top

The third wave is on the roll

Roll with me, roll with me

The Third Wave — Pain