The sunny side of bad times

Publisher’s note:

New York – Here is a timely article: 2007 has been a difficult time for many Ethiopian-American home owners, as a large number have defaulted on their payments. However, there is a brighter side to the crashing real estate markets. In the following piece, Mesfin Ayenew, a former senior executive with Union Bank, Metrobank, Comerica Bank, First republic Bank and a developer of mixed use residential and retail developments, argues that the current bust can be a bonanza for smart investors.

Market Meltdown as a Buying Opportunity

By Mesfin Ayenew

The TV pundits and the headlines would have you believe that we are headed for economic armageddon. If you fall for such fear mongering, you would conclude that the only thing that makes sense is to sell all your assets and buy gold bullions and head for the covers.

But we have been through such scenarios many times over the last 30 years. It is precisely in times like these that the greatest opportunity exists! As one of the greatest investment minds of our time, John Templeton who created the Templeton Funds, once said that the greatest opportunities lies in times of maximum uncertainty.

Ironically, banks do not listen, let alone act upon the economic advice of the wise, like John Templeton. Instead, they are swept up along with the madness of the crowd, and lose their bearings when times look “hipper good” or hipper bad”.

Banks do not act counter cyclical to irrational behavior. Instead they fuel it. For one thing, the Government Regulatory Agencies, such as the FDIC, State and federal regulators pressure banks to cut their loses and run when there is bad news in the air and yet they seem to let them run unregulated when they lose their head and make idiotic decisions such as lending to mortgage companies that have no interest in economic prudence. To top it all, the banks see the profits the mortgage companies make and when the cycle is about to end, they too throw caution to the wind and jump in the same game. We have gone through this same scenario in the 70s, 80s, 90, and now repeated in ’07.

But look what has happened to economic growth, the values of stocks and real estate after each one of those economic panics has passed. Economic growth has been stronger and values have been higher than anyone expected. When times look good the pundits and the headlines are filled with endless optimism, and so the cycle goes on. It is said that the market is driven either by greed or fear. This is true. When the desert winds of fear have passed, most people will say, “I wish I had bought then!”

Advise You Can Bank On:
When the market is hot, banks lend excessively to developers. Since developers pay themselves a hefty sum of money from the loan proceeds while they are in the process of developing the real estate project, they have every incentive to keep building regardless of the over supply of inventory in the market.

In addition, the builders get their construction loans based on the future values of the condominiums or houses they propose to build. Therefore, they have every incentive to paint a rosy picture of demand for their products at ever higher prices as if prices go up in a straight line without any corrections. Herein lies the opportunity.

When economic reality hits, the banks panic; the regulators are embarrassed for not having done their job and the developers lose their credit supply and are pressured to sell their inventory as fast as possible. If the pressure is too high and the developer can not service the debt, they will simply give the property back to the bank. The bank regulators step on the accelerator and force the banks to write down the loan to what they believe is the “real” economic value of the units of inventory which of course is likely to be an over correction. If the bank ends up owning the inventory of condos, they are forced to report every quarter as to what actions they have taken to reduce the amount of inventory they are holding in their problem loan portfolio. This means the banks will take whatever measure they can to sell the units.

This will be the best time for you to negotiate with the banks or for that matter with the developer while they are under pressure from the banks to unload their inventory.

If the bank owns the condominium project, then the bank is paying for all the expenses of running the building such as taxes, utilities, insurance, security, maintenance and so forth. Since the bank now own inventory at a lower value than the developer estimated, and since they have the added burden of paying for all the monthly expenses, they have all the incentive in the world to bend backwards to sell the units to anyone that ventures to ask. You can buy the units at a much lower prices than the developer has been asking.

More importantly, you can ask the bank to finance the unit below market rate and you can ask the bank to pay the home owners association fees for your unit for a number of years or until the building is sold out! That can take several years. If you are among the first buyers in a development project, you may be able to negotiate as much as 5 years of no home owner’s association fees!

What all this means is that you are buying at near the holding cost of the bank which is probably 30% to 40% lower than the developer’s asking price and you get the bank to carry the home owner’s monthly fees for an extended period of time. When the market swings back you would already have built equity. When, once again, everybody begins to be swept up with greed, you will be in a position to cash out and wait for the next economic panic!

This strategy works best when the project is a big building complex where it takes the bank several years to unwind their ownership in the building. This is not about chasing one-off foreclosed properties that is hyped up by brokers just to get you in the door.

Mesfin Ayenew holds MBA from Drucker Management Center of Claremont University. His career in banking includes senior executive positions with Union Bank, Metrobank, Comerica Bank and First republic Bank. He also served as a senior executive with Worldspace Corporaton, a global satellite company. He develops mixed use residential and retail developments. He lives in Potomac, Maryland, with his wife and three children.

6 Responses to “The sunny side of bad times”

  1. 1 yonas Nov 16th, 2007 at 8:43 am

    Basic principle of making money in the markets: buy it cheap, and sell it dear

    But right now, how do you know we’ve reached the bottom of the market? Prices might still be undergoing correction as banks still haven’t finished coming out with their billion dollar write downs. And how long do you have to wait for the market to come back up again so that you can make your healthy profit? Questions to consider before making your move.

    Mesfin, aren’t you in real estate? Don’t you own/run I am slightly surprised that your intimate background in real estate has not been made clear by Tadias. Anyway, interesting article. Looking forward to reading more from you.

  2. 2 Mesfin Ayenew Nov 17th, 2007 at 12:09 am

    Dear Yonas,
    You are right about the basic principal of making money. In fact, the first law of economics is ” buy low and sell high” Which is the same as what you are saying.

    As to the write down by the banks, what is really compounding the problem is the fact that many banks hold in their securities portfolio mortgage backed securities. Even if the securities are performing well, the fact that market uncertainty has created very low demand for such securities, the market value of the bonds declines. Further more, there is a lack of liquidity for such bonds when the investors ( banks) try to sell them in the open market; which of course, drives the value even lower. Then the accounting rules kick in, which forces the banks to write down the value of those securities to the net realizable value. Therefore, when you hear of write downs, it does not mean write down due to foreclosures only.It is the fact that the banks are forced to write down the securities in their portfolio that is creating the big losses.

    Have we reached the bottom? I do not know if we have reached the bottom. My sense is that we are going to over correct some more before the values stabilize. We may not have much further to go. My guess is now is a good time to buy even if there is some more correction. When the market stabilizes, the likely hood is that it will bounce back about 20%; thereafter, you may have a more traditional real estate environment where the appreciation rate may be in the 3% to 4 % range per year.
    keep in mind that in the last 60 years, the US population has increased from 136 million to 300 million! The next 30 years is expected to increase by another 100 million. As long as population growth creates demand, the trend will always be upward for real estate values.
    If you have a time horizon of 5 to 10 years, it is time to buy now.
    Hope this is helpful,
    Best wishes,
    Mesfin Ayenew

  3. 3 yonas Nov 17th, 2007 at 7:58 am

    Mesfin, thanks for your insightful and helpful response. Much appreciated. And you’re absolutely right, real estate value will go up and up in the long term and if one plans to be in that business for the long term, then it does not really matter if we’ve reached the absolute bottom or not. Now is a good time to buy low.

  4. 4 Aklile H. Mariam Nov 18th, 2007 at 10:04 pm

    Selam Ato Mesfin:

    “When economic reality hits, the banks panic; ……”

    Thank you, for your informative and timely article. The last statement is the main point to all of these problems. The headline news about City Bank, Country Wide, Merrill Lynch, and other big banks that were involved in sub prime loans makes it difficult to buy a house in the current market, especially if you are a first time home buyer with low FICO score.

    I am a real estate professional. For me it would be easier and practical to talk about inventory, foreclosure and housing cost. Choosing from the vast numbers of empty houses makes it easy to choose and get a good deal. Two years ago, purchasers would be in line to buy new houses/condos development or sellers would have four or five offers above the asking price. Always the big question is, when is the right time to buy a house for first time purchaser and investors? Always, I tell my clients a quote that applies to any kind of investment properties that a smart business man said “Buy low, sell high”.

    Other advantages, from public information, are there are now more homes in foreclosure than there have been in the past 40 years. At the same time super-low interest rates make it easier to make the right choice.

    Just to add some statistics that are essential to know: According to the Federal Reserve, there are 128.2 million total homes in USA and the current value of residential housing is about $21 trillion. With this in mind and the population growth that are stated in the Mesfin’s article, housing is one of the best investments.

    Thank you,

  5. 5 Aklile H. Mariam Nov 19th, 2007 at 2:58 am

    Sorry, on the last paragraph Gross Domestic Product (GDP) for residential housing should be $2.1 trillion that is about 16.2 percentage of GDP.


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