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Real estate markets sending signals

Is the real estate bubble about to burst?

It is almost impossible to read a business or financial periodical without seeing that question raised. There are many who say that the time has come. Because so many of you ask me that question I feel that the time has come to give you my opinion. And that is all that it is — my opinion.

Actually, it is more correct to say that I have an observation — OK, three observations — instead of an opinion.

Before forming your own opinion I suggest that you read chapter five, “Demographics and the Outlook for Real Estate,” in Harry S. Dent Jr.’s latest book, “The Next Great Bubble Boom” (Free Press, 2004). You might want to pay special attention to the bold print on page 123, which states, “If you are thinking about selling your home in the coming years, certainly do so by 2009, or 2010 at the very latest.”

Knowing (and not knowing) the market

Observation number one: When a market is overheated, lenders who know the local market will be the first to stop making loans.

Back in the 1980s, real estate prices on County Line Road in Jackson were climbing so fast that local real estate developers could not believe it. A few bought property only to find that before they could begin construction another developer would come along and offer them a much higher price than they had paid. It was boom time.

Then one day a developer built a small strip shopping center and there were no tenants waiting in line to rent space. The same thing happened to another developer. Suddenly, there were a couple of “see-through” buildings. The roofs and walls were there, but no windows or interior finishes. The bubble had burst on County Line Road. A developer friend gave me a sly grin and remarked, “You notice that none of the lenders on these projects were from around here.”

His comment was right on point. The last investors/lenders in a hot local market will be those who do not know the market.

Solely for tax shelter purposes?

Observation number two: When investors are in it solely for tax shelter purposes the market is about to change.

Again, back in the ‘80s, a knowledgeable friend told me that he knew that the Tax Reform Act was going to pass because so many of the real estate buyers were doctors. “What are you taking about?” I asked.

He said that when the doctors come in, it is time to get out. His reasoning was that some wealthy investors invest only for the tax benefits, and not for the profit potential of the investment. The tax benefits of investing in real estate in the mid-1980s had gotten so great that it was possible to come out ahead even though the property lost money.

Appreciation rather than performance

Observation number three: Investors are investing for appreciation instead of performance. A recent Wall Street Journal article (May 23, 2005) discussed the current situation of homeowners going into debt to buy real estate investment property. They see skyrocketing local real estate prices and moan that they are not in the game.

Some financial services companies promote using the equity in one’s own home to refinance and get cash for spending or investment. The article profiles a chiropractor who refinanced to get $50,000 to invest in rental property. He said that the reason he was doing it was because the real estate market is less volatile than the stock market, and that he knew a fellow chiropractor in California who had made a fortune doing it.

There are many cases where buying something based on mere appreciation of the investment is a proper strategy. Collector cars, art and even professional sports teams are examples of investments that did not necessarily provide positive cash flow, but appreciated substantially in value.

Real estate is an imperfect market. Those with special knowledge do well in such markets. Those who do not know what they are doing tend to get burned.

Breeze is picking up

Taking those three observations into account, and then knowing that real estate is a market sensitive to interest rates and demographic demand I would say that now would be the time to start thinking about selling that rental property that was purchased solely for appreciation.

Again, all real estate is local, so I would not expect a burst nationwide. Also, all real estate is not affected in the same way. Commercial property is different from residential rental property. Second homes are different from industrial property.

The red flags are flapping in the breeze. And the breeze is picking up.

Phil Hardwick’s column on Mississippi Business appears regularly in the Mississippi Business Journal. His e-mail address is phil@philhardwick.com.

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