The bull market of the past six years is the result of four factors: (1) There was a technological explosion. (2) Interest rates trended to a lower level. (3) Favorable tax legislation put more money into the consumers’ pockets. (4) Favorable mortgages created a strong demand for residential housing and drove market prices higher creating huge equity value for homeowners.

2007+

You can trace all of the past market corrections to the creation of artificial value, its subsequent adjustments, and the accompanying unintended consequences. You’ve had the tulip bust, oil bust, silver bust, tax bust, stock market bust, etc. We are in the beginning stages of a residential mortgage bust. The extent and length of this current correction will depend on the type of changes that take place in numbers 1, 2, and 3 above.

How did this correction happen? The goal and responsibility of a lender or an investor in debt is to make reasonably certain that the principle will be returned and the interest payments will be made.

Let’s look at a subprime residential loan. There is no down payment and there is no equity. In most cases the costs for processing the mortgage are added on to the principle. The result is on day one, the principle is approximately 102% of the property’s appraised value. Now if the property has to be sold, the normal sales costs will add 7% more to the initial 2% for mortgage processing. That means in an unchanged housing market the lender can expect to get ninety one cents on the dollar. Add to this a large borrower base with a poor credit rating, and you have the ingredients for an artificial value.

What should real estate investors do? Follow a simple three-point program. Although there are exceptions to every rule, this program applies to most real estate.

1. After consideration of reasonable market debt (40% to 70%), does the property under consideration have cash flow (not including depreciation and non recurring expenses)? If not, discard the property and move along to the next one.

If number one passes muster, then move to number two.

2. Determine the quality of income. Expenses are very important and need to be carefully examined, but the success or failure of most properties will ultimately be determined by its income. The quality of income means exactly what it says. How sound is the income? What is the financial strength of the lessees? How committed are the lessees to staying at the property? How efficient (financially) is it to replace a lessee?

If number two passes muster, then move to number three.

3. What is the future growth of the income stream? Do the leases have annual bumps? Will lease increases be consistent with the market or will negative gaps develop? Are there sound reasons for believing that current and future lessees would pay more rent?

If number three passes muster, move forward and perform a more detailed due diligence of the property. The importance of good due diligence cannot be overemphasized, especially during a market correction. NetGain is a leader in this field. Its Economic Valuation System (EVS) is the #1 proactive due diligence system on the Internet and can be accessed via afree subscription.

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