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Al Jacobs
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A. B. Jacobs is a professional investor with four decades of first-hand involvement in intricate business and investment activities.
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investing Articles by Al Jacobs Observations of a Bubble - Article by Al Jacobs

The subject of real estate is seldom discussed today without mention of the omnipresent housing bubble. From all reports, it seems certain to burst, bringing with it a cornucopia of misfortune for millions of souls. Judging from the incessant flow of articles and commentary, it is a national obsession. Publications of such stature as Reuters and Businessweek and persons as prominent as Federal Reserve Board Chairman Alan Greenspan are regularly addressing the problem. The questions that must be posed, of course, are exactly what is this bubble and how does it threaten America?

The first of these two questions is the easier to answer. The bubble is a result of a real estate frenzy in which home prices rose rapidly. According to a recent government report, U.S. home values are 55 percent higher than five years ago, which reinforces a study by investment bank Credit Suisse First Boston indicating that home buying is increasingly driven by speculation. In light of current marketing practices that include zero down payments, adjustable mortgage loans with initial negative amortization, and unrealistically lenient loan qualification, the rapid escalation in values is understandable. Such speculative booms traditionally end as the speculators begin to cash in or when credit tightens. There is nothing unique about this scenario, last observed in the early 1990s.

It’s the second question, how America is threatened, that’s not so simply perceived. The reason is that this nation is remarkably diverse, with the factors that characterize one geographical area often entirely different from another. My locale, Orange County, California, with the county’s median priced home affordable by only 11 percent of prospective buyers, illustrates an overheated market. One striking example: On July 18, 2002, a 3-bedroom, 2½-bath, condominium in a 245-unit complex in the county’s largest city, Santa Ana, was purchased for $170,000. On June 14, 2005, that unit sold for $480,000 to a purchaser who, in my opinion, will be hopelessly unable to make the contracted mortgage loan payments in the event of the slightest misfortune. And to get a sense of the home-owning climate in this exceptionally prosperous county, multiply the situation just described by thousands more exactly like it. We can only speculate on what the future holds for a substantial portion of the populace here. But as precarious as it may seem in certain metropolitan areas, most notably New York, Boston, San Francisco, Los Angeles, and Washington, D.C., that recently experienced price explosion, other regions are unaffected. If you’d care to acquire a home in the delightful community of Inkster, North Dakota, just twenty-five miles west of the Minnesota border, you may purchase a particular 3-bedroom detached home on 6th Street for $17,731, which was about the cost for the same house ten years ago. There is no observable real estate bubble in Inkster. Similarly, there are communities across the nation that have observed little or no price appreciation over the past dozen years. Whatever economic problems the residents of these areas must deal with, inflated home values are not among them.

This now gets us to the basic intent of this article: to provide guidance for those concerned with the bubble and the possible misfortunes that may result. First and foremost, resolve not to be a victim. If you reside in an area that experienced rapid home price escalation, you’re aware of the prevailing pressures and influences. You’ve no doubt been deluged with solicitations from mortgage lenders eager to refinance your home with an easy qualifying adjustable rate mortgage that will put cash into your pocket. I suggest that you avoid any such overtures. With short term interest rates currently rising, the likelihood is that longer term mortgage rates will continue to follow suit. The only refinancing that makes sense is in switching from an adjustable rate to a fixed rate, and I recommend that you not increase its principal balance.

With the rudiments behind us, let’s now take a moment to concentrate on one other aspect of the bubble, which I’ll preface by quoting the first line of the first chapter of a recent book: “There is no disaster that is not someone else’s opportunity.” In simple terms, how might those of us in or near areas of unrestrained speculation profit from the coming cataclysm? Our best guide is to look back at a past real estate collapse, and compare the common elements. Perhaps a testimonial is in order.

In the 1980s America experienced a real estate boom not unlike what we’ve seen since the turn of this century. And as night follows day, during the period 1990-1993, home values declined throughout much of the nation as lenders foreclosed on massive numbers of homes, with no area more severely affected than Southern California. However, not until early 1995 did these unsold inventories begin to be dumped on the market. There appears to be a delay of two or three years after the bottom is reached before bargain properties become available. It was during the years 1995 through 1997 that I acquired dozens of vacant residences at clearly distress prices. I concentrated my efforts on real estate held either by government agencies such as the VA and FHA, or by commercial banks and mortgage insurance companies. Clearly these hapless owners wanted quick and unfettered disposal, and my bids accommodated them: purchase price all cash, property condition “as is,” no contingencies, and escrow to close in fifteen days. Thanks to a strong rental market, I enjoyed a nice cash flow until disposing of them one at a time. As you might guess, it turned out quite profitably.

Let me conclude with a prediction and an admonition. Prediction: In areas where current home prices are clearly irrational, there will be a massive readjustment downward. Admonition: Don’t try to anticipate the market. Wait until the distress is clear to everyone before seeking bargains. There will be plenty of opportunity when that time arrives.

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Al Jacobs has been a professional investor for nearly four decades. His business experience ranges from real estate, mortgage, and securities investment to appraisal, civil engineering, and the operation of a private trust company. In addition to managing his investments on a day-to-day basis, he is a featured financial columnist for both online and print publications. He is the author of Nobody’s Fool: A Skeptic’s Guide to Prosperity. You may subscribe to his financial Newsletter, "On the Money Trail," at no cost or obligation, by visiting On the Money Trail

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