Come one, come all! Speculators abound in today’s housing market. They are now taking title to over 50% of all homeownership turnovers. Find out the reason and what role speculation will play in today’s recovery.

Why the spectacle?

You’ve heard it on the news, from the government and your neighbors: now is a good time to buy a house. The reason given this time around? Interest rates remain low and prices have yet to return to the inflated levels of the Millennium Boom. But the financial ability to buy, and the willingness to do so, are simply lacking in most potential buyer-occupants.

Enter the speculator.

A real estate speculator sneaks in between the seller and the end user homebuyer – usually a buyer-occupant or long-term buy-to-let investor. Their goal is to purchase the home at a discount and sell soon after for a juicy profit when prices inflate. Their gamble is to buy now on the belief prices will increase by 50% or more in three years. All this is viewed as profit, minus the cost of acquisition, carrying costs and the cost to sell.

In a normal, healthy housing market, speculator transactions make up roughly 20% of all home sales. In mid-2013, the number is around 50%, including grant deed sales and trustee’s sales. Every day, more and more speculators are betting their cash on rapidly rising real estate prices.

Why are there so many speculators gambling on today’s market? And has it happened before?

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Speculation through the ages

The history of real estate speculation in the U.S. can be traced all the way back to 18th century New England. The price of land was rising fast and investors flocked to gamble their fortunes on ever higher prices. The price bubble quickly burst (as bubbles by definition tend to do), leaving those who gambled the most and got in last with nothing.

The cycle of boom and bust and the speculation occurring in between has repeated itself time and again since then. Speculation has always played a natural role in housing markets. And for good reason. When home sales volume sputters during times of economic chaos, speculators provide the much-needed support of cash and liquidity. But the magnitude of speculation sometimes increases to the point of instability, the situation in which we find ourselves today.

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What caused the Millennium Boom?

The most recent boom was caused by a number of contributing factors. However, it was all triggered by Wall Street money and mortgage default levels mortgage-backed bond investors never thought would come to be. Everyone believed that homes were, well, golden.

Someone on Wall Street became disenchanted with day trading and decided to put some money into mortgage-backed bonds. Soon, Wall Street types all flocked in the same direction, funneling money into mortgages, making home financing readily available to all. This became a financial accelerator, making it easy for anyone to get a home loan at ever greater home prices. All they had to do was step into a bank and sign on the dotted line, with a real estate agent or builder in tow.

Government deregulation of mortgages enabled the proliferation of no doc or liar loans with payments structured so everyone qualified – at the time of recording. Of course, the Federal Reserve (the Fed) allowed the economy to grow out of control in the first place by pumping money into the economy before the recession had time to cool the economic engines.

At the same time, Congress was deregulating mortgage bankers and administrative agencies were cutting enforcement staff. Builders were then able to sell new homes to those hordes of families who could not sustain payments on them. Prior to 2008, it was common practice for the builder to actually provide the minimum down payment required by the Federal Housing Administration (FHA) for an FHA-insured mortgage, and eventually conventional loans. These were sometimes called Nehemiah loans, all part of HUD deregulation from the late 1990s. Piggyback financing came into vogue allowing for no down payments.

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Come 2006, buyer optimism was sky high, and home prices rose higher. In this year — just as prices peaked and began their steep three-year descent — 81% of surveyed consumers in Alameda County and 75% in Orange County said it was a good time to buy. They believed home prices were likely to increase, according to the Brookings Institution.

Consumer expectations were improperly based on the price movement of the moment (which was up).  Like most, and at their peril, they ignored all other signs (such as falling home sales volume and yield spread) which unmistakably pointed to decreasing home prices by early 2006, with worse to follow.

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And so homebuyers and lenders continued to pour wealth into the failing housing market, not knowing that they would be the last in a long line of speculators to be holding the hot potato.

What role has speculation played in this recovery?

And so, like vultures circling over a still-wounded economy, speculators gathered en masse in 2012 to profit from the recovering real estate market. Some came to the market confused, thinking hard assets at whatever prices were better to hold than the U.S. dollar.

The speculator presence picked up significantly in mid-2012. At that time, the red-herring issue of low housing inventory was said by very senior people in high positions to be pushing home prices higher (the thought still persists today). Perceiving a long-term price shift in the making, speculators began to flood in, month after month, increasing competition to buy homes.

They flocked from home to home, all submitting offers the instant each came up for sale. Their bet was to make money on market momentum alone. End user buyers — the few out there — stood little chance in competing against cash-heavy speculators intent on buying everything in sight: a swarm of locusts that devours the landscape, no matter the size.

Today, speculators continue to disrupt home prices. They do not realize (or more likely they are just willing to take the risk) that home sales volume has not increased during the first half of 2013, that speculator participation has increased and that end user demand is only half of current homeownership turnover.

This combination of events does not support an ongoing price bump. Demand needed for speculators to profit by a resale is not supported by the present level of end users. They are insufficient in numbers for the speculators to go to the flip stage and cash-in on their bets. Worse, they will collectively move to cash in at the same time mortgage rates rise to cut into home pricing.

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What motivates speculators to gamble?

Homebuyers of all types generally purchase homes for four reasons. These are, in order of importance:

  • annual property income (in the form of rent which every property when leased generates);
  • equity build-up (as asset value increases with inflation and as principal on mortgages is reduced);
  • appreciation (as the location is sought out by more people or personal incomes locally rise faster than inflation); and
  • the tax benefits of reduced taxable income due to homeownership (effective  primarily for the wealthier, older population).

Speculators have this order of importance reversed. Their most significant motivation is the potential tax benefits of a purchase. Speculators are essentially day traders who think they’ve found an easy, tax-friendly investment. They take advantage of the federal government’s homeownership incentive — long-term capital gains tax — by owning a capital asset for at least 12 months before selling. Thus, three years is the typical plan to warehouse title before implementing the initial intent to dispose of it by resale.

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But not so fast – do speculators really qualify for the capital gains tax limit?

No, not really. In order to qualify, the property sold cannot be purchased with the intent to sell in the normal course of the speculator’s business. Said more clearly, the speculator cannot be a dealer of property, in which the homes collected and sold are considered inventory – held for resale. [Little v. Commissioner of Internal Revenue (1997) 294 CA9th 661]

So how do speculators get away with it? The answer is that many will not get away with it. If the Internal Revenue Service (IRS) audits these speculators, they will be asked to pay up.

Will today’s gamblers cash out at a profit? Or take a loss? For the most part, they will not experience the returns they want, before or after taxes.

Can speculation really drive a recovery?

Real estate speculators can assist a struggling housing market by providing cash – liquidity – bolstering sales volume. But the magnitude of speculation occurring in today’s market is damaging, as liquidity is not the problem.

For developing conditions, think of:

  • shadow inventory, held by speculators for resale and all of it to be sold at about the same time;
  • the artificial, rapid home  price increase the speculators’ combative acquisitions have brought about during the past 12 months; and
  • the inevitable increase in mortgage rates.

Speculators create the illusion of a quickly recovering housing market (an illusion media pundits and seminar promoters have latched onto). But by removing homes from the grasp of end users, they actually prolong the housing recovery! Can anything be done to suppress speculator activity (without unnecessarily restricting the housing market)?

Yes. Lenders have underwriting guidelines that restrict loan-to-value (LTV) ratios more strictly for speculators than for buyer-occupants (and yes, speculators have avoided this by paying cash). The FHA has guidelines against flippers, though these have been suspended since 2010.

Other suggested regulations include:

  • a down payment requirement of 30% (which at 20% may be realized in the soon-to-come qualified residential mortgage);
  • a restriction against flipping within 180 to 360 days of purchase;
  • an interest rate surcharge for non-buyer-occupants requiring financing (much like the mortgage insurance tacked on to home loans for more than 80% LTV); or
  • an income tax rate increase for a class of absentee homeowners who do not retain ownership or sell more than one home in four or five years.

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What will truly support an organic real estate recovery? It all comes back to jobs. Whether considering the value of a home or a commercial property – occupied space has rental value. End users require an income before lenders will fund home or business property purchases. And jobs are on the slow path to full replacement, set to arrive in 2016 statewide; sooner at the coast and later inland.

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Looking forward, 2013 will end with the exit of a majority of the buyer-speculators. At the first sign of faltering home prices, first one, then two, then soon the entire group will disappear, off in search of more profitable pastures.

Do not depend on the present speculator-driven price increase to fuel your real estate sales in the year to come. Look first at the jobs numbers as they come on line. A pickup in sales volume will follow, and so will upward moving prices, giving you a more complete picture of your local real estate market. Speculators are not here to stay, and interest rates increases are visible on the horizon.