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 cycle, 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 crisis and ensuing Great Recession. 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 speculator views the property and, looking to sit on the property until prices in the market move further upwards (a process known as flipping), 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 game.
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 Boom precipitated the calamitous financial crisis and the ensuing Great Recession. Real estate prices during the boom period were initially driven primarily by the financial accelerator 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 mortgage (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?
The case for speculator containment
Can the right to purchase and dispose of property be reasonably restrained by governmental intervention in sales, financing and renting?
It’s true that, in general, restricting the right of owners to freely sell or rent to whomever they wish (called the right of alienation) at any price they can get is against long-standing California public policy. [Calif. Civil Code §711]
However, can the prohibition against interfering with the right of alienation be countermanded to protect societal institutions from harm?
Yes! California courts lift the general prohibition against restricting the transfer of real estate when doing so serves the state’s greater public interest in providing low- to mid-tier housing and prevents speculation from undercutting that goal. This quantum of restraint theory, based on the reasonableness of government interference in the sale or lease of property, protects the low- to mid-tier income households historically favored by speculators in their flips. [Calif. Government Code 65580(a); for more information on the current Case-Shiller trends in California, see the April 2010 first tuesday Market Chart, California Tiered Home Pricing.]
Editor’s note — Typically, there are more buyers in the low-tier market than there are in the mid- or- high tier markets, thus the low-tier market experiences the brunt of the speculative influence, driving prices in that tier up and down much more violently than those in the mid- or high-tier markets.
Consider a condominium (condo) project subsidized by a city’s public funds to provide housing for low- and mid-tier income households. In return for the city’s government subsidy, the developer agrees to include a clause in the project’s covenants, conditions and restrictions (CC&Rs) requiring condo owners to occupy the condos and barring them from renting the property to tenants at any time or for any reason. The restriction is necessary in order to achieve a stable community of buyer-occupants in the condo project and to avoid the artificial cyclical price inflation brought about by speculators on a resale.
After purchasing a condo, a condo owner decides to vacate the condo and lease it to a tenant. The city discovers the condo owner’s intention to lease the condo against the restriction in the project’s CC&Rs and seeks to restrain the owner’s efforts to lease the condo.
The condo owner claims the restriction against his non-owner-occupancy is invalid since such a restriction is against public policy as it restrains the use of his right to freely transfer or lease his property, called the right of alienation.
The city claims the restriction against non-owner-occupancy is valid since it promotes public policy by preventing the price of housing set aside for low- and mid-tier income households from becoming inflated by speculator activity.
Was the restriction against leasing the property an invalid restraint against free alienation (here, being the transfer of possession of the property) of the condo owner’s property?
No! The court held the restriction against non-owner-occupancy and free alienation of possessory interests in the condo was valid since it upheld the public policy goal of barring speculative influence from the low- and mid-tier real estate market. [City of Oceanside v. McKenna (1989) 215 CA3d 1420]
Although it is generally repugnant to California real estate transactions, the restraint of the right of alienation is secondary to the more important goal of safekeeping the real estate market from the degrading societal side-effects of price speculation.
Handling mortgage-dependent speculators
Prohibitions such as those present in City of Oceanside are not the only means of barring speculator influence in the market. Regulations limiting the speculators’ sphere of influence already exist. Speculators who rely on lender financing already experience stricter underwriting standards and higher interest rates than do buyer-occupants who intend to occupy the properties they purchase.
Fannie Mae, for example, restricts a non-owner occupied buyer of a single family residence (SFR) to an 85% loan-to-value (LTV) ratio and requires a minimum credit score of 680. For a buyer-occupant who will occupy the purchased property as his principal residence, Fannie Mae allows up to a 95% LTV ratio with a 660 minimum credit score. [See the Fannie Mae Selling Guide Eligibility Matrix]
The Federal Housing Administration (FHA) also has a hand in managing speculators in various stages of the real estate cycle. On February 1, 2010, the FHA announced its intent to allow the flipping of an FHA-insured property within 90 days of its prior sale — an acknowledgement of the dearth of buyer-occupants in this vicious cycle of real estate to purchase FHA real estate owned (REO) inventory.
The relaxation of this 90-day speculator prohibition ends on February 1, 2011, allowing speculators just enough time to get into the market and keep sales moving, but not enough time to significantly disrupt a nascent virtuous cycle of real estate transactions. [For more information on the FHA flipping rule, see the January 2010 first tuesday article, Reduced FHA standards will encourage speculator interference in the market.]
Additionally, the FHA limits non-users to owning no more than seven units of real estate when applying for FHA-insured financing. [HUD Mortgagee Handbook 4155.1 Chapter 4.B.4.d]
Editor’s note — “Units” as used here by the FHA takes into consideration the number of rental units in a purchase property. A duplex, for example, would be considered two units, a triplex, three, etc.
On a wider scale, the Federal Reserve (the Fed) wields the power to cool off the real estate market by raising rates when it appears speculation is beginning to have a “bubble” effect, as Australia’s central bank did earlier this year. [For more information on Australia’s solution to the speculative bubble, see the April 2010 first tuesday article, Interest rates up in the land of (more) stable housing; for more information on the “Lean vs. Clean” argument, see the October 2009 first tuesday article, Preventing the next real estate bubble.]
Recently passed federal legislation establishes a mortgage watchdog in the Bureau of Consumer Financial Protection. While the Bureau of Consumer Financial Protection has yet to formalize its goals and procedures, the government now has another means of stemming the flow of speculators into the real estate market through the bureau. Some restrictions which could be mandated to keep speculator influence in check include:
- a federally-mandated 25-30% down payment requirement for non-users;
- a restriction against flipping within 180 days of the purchase; and
- an interest rate surcharge on properties for non-user borrowers.
Speculator checks and balances beyond the mortgage
The activities of mortgage-dependent speculators can be regulated by tightening their access to mortgage money. Cash speculators, on the other hand, have little to constrain their activity in the market. Even when cash speculators provide liquidity, their activity during recoveries must be moderated to prevent creating the over-priced conditions which produced the Millennium Boom. Government policy pushing owner-occupancy of SFRs by imposing adverse tax consequences on sellers for flipping must be put into place to intervene, should the hand of cash speculators (or, mortgage-dependent speculators who manage to obtain financing) grow too heavy.
One solution for keeping speculative interference in check is to institute a program similar to Fannie Mae’s First Look program. During the first 15 days of a Fannie Mae real estate owned (REO) property (called HomePath properties) listing, only offers from buyer-occupants will be considered. Paired with Fannie Mae’s HomePath Mortgage Financing program, a buyer-occupant-occupant can put as little as a 3% down with no mortgage insurance (MI) and no appraisal fees. [For more information on Fannie Mae’s First Look program, see the January 2010 first tuesday article, Fannie Mae reveals owner-occupied preferential program.]
Editor’s note — Optimally, to allow enough time for buyer-occupants to submit offers and respond to counter-offers, this 15-day period should be extended to 30 days.
The US Department of Housing and Urban Development (HUD) has as a similar program for its REO inventory, called HUD Homes. HUD Homes gives buyer-occupants a ten calendar day period to submit purchase offers for an REO property. After the ten calendar days have passed, all offers are then considered at once, and HUD then accepts (through its contracted asset managers) the best acceptable offer. If no buyer-occupant offers are acceptable during the first ten calendar days, HUD will entertain offers from both users and non-users. [For more information on HUD Homes, see HUD’s webpage, About Buying HUD Homes.]
A US House of Representatives Bill, H.R. 4582, would extend this buyer-occupant “first look” period to Freddie Mac REOs, proactively curbing the speculative interference by giving buyer-occupants a “speculator-free” offering period.
In addition, speculator penalties must focus on limiting the profits cash speculators may retain when they enter into the real estate market. The logic is that the more costly the transaction, the more speculators will further consider the offers they make, and so their interference will be tempered by their own financial self-interest (a powerful motivator indeed).
This type of limitation could consist of:
- taxing the ownership of a large number of multiple SFR properties, with an exemption for properties held as long-term income property;
- taxing the profit from the resale of a SFR at ordinary income rates rather than the more favorable capital gains rates if the speculator has not owned the property for at least a two-year period, unless it was acquired at a trustee’s sale;
- strict local code enforcement of ill-maintained vacant properties, with substantial daily penalties for failing to perform required yard and property maintenance;
- additional tax on properties left vacant for longer than six months after the date of acquisition; and
- hazard insurance underwriting restrictions for unoccupied properties.
Editor’s note — Several bills awaiting action in Congress which would create financial speculation taxes to curb the influence of Wall Street speculators. The idea of taxing detrimental speculation is not a new one.
A more thorough system of checks and balances would involve different restrictions depending on whether the real estate market is diagnosed as being in a virtuous or vicious cycle. Such an analysis could be completed by establishing a standard based on the movement of the Standard and Poor’s (S&P’s) Case-Shiller home price index. [For more information regarding the current Case-Shiller index, see the July 2010 first tuesday Market Chart, California Tiered Home Pricing.]
For instance, during a virtuous cycle (heralded by a Case-Shiller home price index increase of more than three times the rate of consumer inflation over an 18-month period), speculators making a purchase would be heavily taxed on any increase in the price they receive beyond say 1% for every month their SFR has been owned if it is sold within two years of the speculator’s purchase. Failure to adhere to a 1% increase rule would result in a 50% surtax on all his profit on the resale of the SFR. That certainly would keep the prices from accelerating further.
Such a 1% rule would be relaxed when the Case-Shiller index shows a decline to a price increase equal to the annual rate of consumer inflation during any six-month period. This type of risk-based policy is not uncommon in the real estate industry. [Internal Revenue Code §§121(a), 121(b)(1)]
These modifications would encourage a breed of buyer more involved in the properties he acquires, similar to a long-term investor who cares for his income properties. This type of involved buyer, more likely found during the vicious cycle than the virtuous cycle, rehabilitates property for resale instead of simply sitting on them to wait for market momentum to increase the price. [For more suggestions on speculator suppression and information on the difference between an investor and speculator, see the January 2010 first tuesday article, Buyer-occupant beware: the real estate game lacks fair play.]
Proposed exemptions to speculator suppression rules
Restrictions against speculation must also be carefully crafted to avoid stifling the transfer of real estate by long-term investors and buyers who improve or otherwise put the property to use, unlike the hit-and-run speculator. For instance, non-occupant sellers can be exempted from the penalties for speculation if they make an additional investment in the property beyond their original cost of acquisition (according to their settlement statement figures) of at least 10% towards cosmetically rehabilitating, upgrading or renovating the property before its resale. Building contractors and similar rehabilitators would fall into this group.
Likewise, an exemption should be written into speculator penalty regulations so active military personnel are not penalized for short-term ownership of property if they sell their properties due to their military deployment. Other exemptions which should be addressed are those for hardships, job relocation and health reasons as defined by the Internal Revenue Code (IRC) §121 for the two-year holding period required to receive the owner-occupied $250,000 profit exemption and minimize speculation. [IRC §121]
The user’s speculative mindset
If speculators must be brought around to reel in their sometimes deleterious effect on the market, so must buyer-occupants, the users of real estate. After all, speculators are not the only players in the real estate market who benefit from the current prevalent “investment mentality.” Buyer-occupants reap tax benefits instituted by state and federal governments. These benefits include the aforementioned principal residence $250,000 profit exemption, the mortgage interest tax deduction, property tax deductions and homeowner’s property tax exemptions, being merely a few of the many temporary legacy benefits of homeownership. [IRC §§121, 163]
Thus, when a user of real estate is lured into homeownership by the promise of tax subsidies and deductions, he is acting just as a speculator would who is lured into speculating by an easy way to profit. For most people, it is an emotional (read: irrational) sensation to avoid paying taxes.
In the buyer-occupant’s case, not only is pricing damage done when he gets into a bidding war for property to take advantage of tax subsidies, but also when he becomes the owner and quickly realizes he is in over his head — unprepared for the extra utility charges, maintenance costs, property taxes, insurance and financial responsibility tied to homeownership. He is lured into the market by the gatekeepers’ drumbeat of subsidized ownership, only to find himself a prime candidate for the role of a distressed homeowner when these subsidies disappear.
And disappear they must (as they have in all other industrialized countries). While ephemeral tax deductions such as the federal first-time buyer-occupant tax credit subsidy attempted to sustain prices in the real estate market in the short term while the economy recovered, permanent tax deductions lull homeowners into believing they are entitled to massive life-long tax relief simply by virtue of maintaining a home as a principal residence and staying in it for a minimum of two years. [For more information about the efficacy of the recent federal first-time buyer-occupant tax credit, see the May 2010 first tuesday article, Federal housing tax credits = success?]
Long-term, annual tax benefits needlessly subsidize buyer-occupants, contribute to an environment of frenzied homebuying and too easily distract buyer-occupants who then neglect fundamental financial considerations when making a home purchase. Among these deleterious long-term tax benefits of homeownership are deductions for:
- mortgage interest [For an argument for the removal of the home interest tax deduction, see the March 2010 first tuesday article, Getting rid of the housing subsidies: the mortgage interest deduction.];
- mortgage insurance (MIP/PMI), both front-end and annual;
- property taxes (except for payors of alternative income taxes); and
- loan origination points.
In addition, up to $250,000 of profit on the resale of a principal residence per person ($500,000 per married couple) is non-taxable. If there is loss on a resale — as is occurring now with the growing number of short sales and foreclosures — the government (in the guise of FHA, Fannie Mae and Freddie Mac) is responsible for the short-fall. It’s the privatizing of gains, and a socialization of losses — not a very capitalistic approach for the world’s greatest system of free enterprise.
Sound familiar? SFR buyer-occupants, as the highest and best users of SFR real estate, are rightfully the primary beneficiaries of real estate. After all, it was for them SFRs were built. That doesn’t mean, however, that buyer-occupant users should be given unmitigated financial benefits for their role, or the right to do what speculators are excoriated for doing. Neither party should be allowed to reap benefits from the real estate market at the cost of its long-term stability for builders, MLS members and buyers, regardless of the title given to the owner.
An agent’s role in speculation
When a speculator is a party to a transaction, the listing agent must be diligent in his inquiries of the buyer’s user/non-user status. If the agent learns the buyer is a non-user speculator, he is obligated to inform his seller of this fact so the seller will understand the speculator is paying a back-of-the-market price in return for taking the risk of waiting out the market for a better price. Failure to provide a client with this information, when known, exposes the listing agent to liability for his seller’s losses due to the non-disclosure. [Jorgensen v. Beach ‘N’ Bay Realty, Inc. (1981) 125 CA3d 155; see first tuesday Form 119]
The situation is further complicated when an agent who owes a fiduciary duty to his client (be they seller or buyer) succumbs to the desire to himself act as a speculator. Special restrictions above and beyond the mere negative effects of speculation exist when an agent who represents sellers or buyers engages in price speculation. [For more information on the agent-turned-speculator, see the June 2010 first tuesday article, Agency duties: the flipper’s quandary.]
More importantly, the listing agent must protect his seller by voicing concerns about the undue influence of speculators on pricing and availability of property in the market. Agents already tend to do this by labeling speculators who make back-of-the-market offers as “bottom-fishers” or “low-ballers.”
As a professional matter, agents need to know and understand the dichotomy of the speculator: on one hand, speculators provide liquidity — cash for sales — in depressed and slowing sales markets, and employment with fees for those in the real estate industry when buyer-occupants are scarce; on the other hand, speculators are a force undermining the stability and thus the durability of the virtuous cycle when they are unchecked during periods of recovery.
The protections afforded by better regulation of the speculator’s influence not only help clients looking to buy or sell homes they will or do occupy and the agents who represent them, but also the speculators themselves. More than one speculator went underwater and took a terrible loss on a property for the unwise decision to buy after late 2005 at the height and end of the Millennium Boom frenzy. Although that out-of-the-game speculator is one fewer to worry about during the next hot housing market, that same underwater speculator is one fewer keeping the real estate market afloat during a bust when the vicious cycle rears its ugly head.
As the voices of the real estate industry, brokers and buyer-occupants can influence their legislators and representatives to strengthen the laws regulating participation of speculators in the real estate market. Stability in the real estate market must be the bottom line allowing for the existence of speculation, and not merely a wistful afterthought when that existence is allowed to run amok.