Is real estate a real investment? Are you contra cramdowns? All about arbitration? CAR devotees listen up: we are putting these dangerous myths to rest.
In the real estate industry there exists both an explicit code of conduct and a culture of conduct. In a perfect world, analytical thinking and the culture of real estate professionals would be perfectly aligned. Unfortunately, this isn’t a perfect world.
The culturally acquired misconceptions regarding proper conduct and productive reasoning predominate. This can trigger a vicious cycle for real estate, where political or theological prejudices impede the healthy flow of real estate deals. As a much-needed shot in the arm, we offer a dose of iconoclasm to debunk the noxious myths circulating in today’s real estate culture.
The mythical investment
As California home prices continue to soar above the historical mean price, now is an opportune time to address the myth of housing as an investment.
There is often some confusion as to what we mean by investment. First and foremost, an investment is a place to store wealth. An individual making an investment implicitly expects a return on that investment. While there are many ways to invest in real estate in expectation of a return on investment (ROI), buying a single-family residence (SFR) as an owner-occupant is not one of them. Each SFR buyer-occupant forgoes the chance to place their wealth in a different, more lucrative investment. This foregone opportunity is known as the homebuyer’s opportunity cost.
The fact is, over the long term, SFR prices track consumer inflation. Prices fluctuate above and below the trendline, which is influenced by consumer inflation, and population densities. Consumer inflation (CPI) has and will likely run around 2% annually, compounded. CPI tracks annual income levels which in turn set the amount the employed can pay for goods and services. Population growth of around 1% annually adds an additional 1% annually to SFR pricing over consumer inflation.
This means a buyer-occupant who chooses to place their wealth in an SFR can consider it a piggy bank of sorts. The SFR will produce enough of a “return” to hedge against inflation. This, however, only accounts for price inflation and does not include costs of ownership, which may result in a net loss over time when compared to the SFR’s rental value.
Real estate professionals have a deeply entrenched habit of pitching SFR ownership as a “good investment”, silently implying that buyers will receive a substantial return when they choose to sell. As anyone who bought or refinanced in the 2000s will tell you, this just ain’t so. Prices today are not low. Be honest, they are where they belong – at the mean price level.
It’s time to pitch your sale honestly: SFR ownership is a good place to park your wealth if you plan on holding the asset long term, but don’t expect any annual 5% to 10% windfall profits! Oh, and don’t forget about interest rates. They’re low now, but they will inevitably rise for the next couple decades to dampen the inflation hedge inherent to housing?
Dismantling the tyranny of CAR
Contrary to popular opinion, the California Association of Realtors (CAR) is not the final word in real estate conduct.
Many real estate professionals, especially those new to the industry, are confused by what appears to be CAR’s omnipotence. In reality, CAR is merely a trade union that offers services for a fee.
Among the most popular misconceptions is that one must be a member of CAR in order to participate in the Multiple Listing Service (MLS). Many fledgling agents are even under the impression that one must be a member of CAR in order to practice real estate in California! This misconception arises when agents fail to understand the difference from CAR and the California Department of Real Estate (DRE).
It seems like it goes without saying, but obviously it must be said: It is not necessary, required or even preferred that a real estate agent or broker join CAR in order to practice real estate. An agent need only have access to the MLS. Brokers and agents in the know can save over $500 by skipping CAR membership and opting to be MLS-only members.
Even with this myth debunked, many employing brokers will require CAR membership since it is “standard practice”. In a recent first tuesday poll, 70% (470 voters) agreed that CAR does not provide valuable services in exchange for the hefty annual dues.
We ask you, then, dear reader: why is CAR membership still considered “standard practice”?
The acceptance of arbitration as a “standard practice” is transmitted through the ideological intermediary of CAR. Unlike first tuesday, CAR includes a binding arbitration provision in its real estate purchase agreement (among other forms!).
Real estate professionals have become inculcated with the notion that arbitration is faster, cheaper and more effective. This is the rhetoric that rains down from the Very Serious Persons at the top of the trade union. It’s just “coincidental” that arbitration tends to benefit those at the top of the corporate structure.
Buyers, sellers and agents, on the other hand, suffer from:
- frequent misapplication and misinterpretation of the law;
- erroneous awards;
- a bar to discovery in preparation for hearings;
- waiver of the right to judicial review to be assured a fair decision; and
- a lack of legal precedent produced – case law – to guide future conduct of buyers, sellers, brokers and agents.
This final point is truly at the core of a reasonable opposition to arbitration. The results of arbitration hearings are not considered legal precedent. Without meaningful additions to the corpus of real estate case law, the law becomes stagnant and fails to best serve the people.
In the interest of encouraging dynamic real estate law, as well as to best protect buyers and sellers, all first tuesday purchase agreements include mediation provisions. Mediation is, indeed, the faster and cheaper alternative to arbitration or litigation.
Under mediation, neither the agent nor the clients forgo their rights to judicial review if the parties are unable to come to a resolution during mediation. Constitutional rights remain intact, for those that care. In cases of great import or complexity, the legal system remains at hand to properly adjudicate the dispute.
Solving the mysteries of “moral hazard”
We can resolve this misconception with one sentence: moral hazard does not exist in matters concerning the mortgage trust deed. Thus, the so-called strategic default as well as the cramdown are both viable, rational solutions to an economic problem. No morals involved; it’s mortgage law, period.
The California trust deed is a highly evolved legal document that makes perfect economic sense when it comes to anti-deficiency laws and the buyer’s put option provision .
Editor’s note — Although the trust deed fully addresses the issue of buyer default as a put option to force the lender to buy the property, it is not perfect in our eyes. Currently, the trust deed includes a due-on sale clause, which eliminates the seller’s right to convey their property subject to the trust deed, along with its interest rate, upon a sale to a buyer.
Thus, when interest rates inevitably rise, lenders will impede the flow of real estate transactions by discouraging sales. first tuesday has covered this issue thoroughly over the past four decades. For our most recent critique of the due-on sale clause, see our January 2012 article, The due-on time bomb.
The loudest Very Serious Person condemning cramdowns belongs to the Federal Housing Finance Agency (FHFA) director Ed DeMarco. DeMarco takes a theological attitude toward the issue of housing finance, insisting that reducing principal balances on Frannie-owned loans will trigger a wave of intentional defaults, leading to financial Armageddon. DeMarco continues to insist on the moral hazard of cramdowns even after the FHFA released a study detailing the benefits of widespread principal reductions.
Do not let it be forgotten that Congress, in 2005, revoked bankruptcy court judges’ authority to cram down a mortgage to the market value of the SFR. In turn, the right was also taken away from homeowners whose negative equity renders them insolvent — more debts than assets. Thus, one’s underwater home becomes their debtor’s prison.
This is truly where our argument comes full circle. Those who decry the cramdown will now be quick to cite rising home prices in 2012 as the ultimate solution to the ongoing negative equity crisis. The thinking is that property values will rise to meet a healthy loan-to-value ratio (LTV) for those who are chained to their single-family prisons.
However, if the current price level (particularly for low-tier homes) is viewed rationally for what it is (the short-lived result of speculator activity), it’s clear that negative equity still remains an unsolved long-term crisis that has yet to be addressed.