5 risky real estate moves to avoid now

Liz Pulliam Weston

There's no crystal ball when it comes to the real estate market. Don't make yourself more vulnerable by getting into risky loans, dicey rental properties or other perilous positions.

Overconfidence can be an investor's most deadly flaw. Yet many people are displaying plenty of overconfidence when it comes to real estate.

They're sure home prices can only go up -- or that values will crash tomorrow. They're committing to risky loans and not thinking about how they're going to make the much-higher payments to come. They're gambling their current wealth on future, speculative returns without truly understanding the risks.

"I'm nervous," said financial planner Delia Fernandez of Los Alamitos, Calif., who says she sees plenty of clients act as if they have a crystal ball. "We know we can't sustain this growth rate … but nobody knows what the future holds."

If you're considering any of the following risky real estate moves, you might want to think again.
Risk: Timing the market -- with your home
Some pretty smart people are seeing real estate bubbles, and a few are backing up their intuition by selling their homes now in hopes of buying again later at bargain prices. Doug Duncan, chief economist for the Mortgage Bankers Association, and Dean Baker, the director of the Center for Economic and Policy Research, are among those taking their profits to the sidelines in anticipation of the bubble popping.
Should you follow suit? Probably not. There are plenty of problems with the concept of "shorting the market" by selling your home. For instance:

• Prices may not crash. While double-digit home-price increases aren't sustainable for the long term, your particular housing market could well experience slower growth rather than an actual decline. That means you could be priced out of your desired neighborhood or wind up paying a lot more for a similar house.
  
  
• Bubbles tend to persist. Even if there is a crash, it may not happen for years. Remember, there was a three-year gap between Alan Greenspan's infamous "irrational exuberance" comment and the actual bear market in stocks.
  
  
• The cost of pursuing your hunch is high. Selling your home will cost you about 6% in real estate commissions, plus the expense of moving. When you eventually buy your replacement house, you'll face closing costs and possibly higher interest rates on your new mortgage. In the meantime, you'll be paying rent to some landlord -- perhaps for years. That could eat up a lot of the profits you're trying to protect.
  
  
• You may freeze. Some people who've sold their homes assume they will boldly swoop in to buy other people's foreclosures when the crash comes. (That's what Duncan did during Washington, D.C.'s, last slump in the early 1990s.) But a declining real estate market is a frightening thing, and many find themselves paralyzed on the sidelines, unwilling to buy with prices still sliding.

If you're intent on timing the market, at least consider waiting until your area shows some signs of weakness, such as prices actually falling in the higher-end ZIP codes.

"Prices in real estate don't come down overnight like the stock market," said economist Delores Conway, director of the Casden Real Estate Economics Forecast for USC Lusk Center for Real Estate and a veteran of the Los Angeles market crash of the early 1990s. "If (real estate values) come down, they come down gradually."

Risk: Stretching to buy a home with risky loans
It's one thing to take on a big mortgage if your payment is fixed for 30 years, since inflation will eventually ease the strain of making your monthly nut. It's quite another to stretch using a loan that can explode in your face if you hang onto it long enough.

Interest-only and "flexible payment" or "option" mortgages typically give you the choice of making relatively small initial payments. Interest-only loans don't require principal payments in the early years, while flexible payment loans typically give you four options each month: an interest-only payment, a regular payment, a regular payment plus an additional principal payment or making no payment at all.
If you stay in the home long enough, though, you'll be required to start paying down principal, and your payment can soar. Higher interest rates will affect most of these loans, as well, because few have a fixed rate. With flexible payment loans, interest rates can change as often as monthly, and your mortgage amount can actually grow over time if your payments aren't sufficient. (For more details, read "Could you handle an interest-only loan?")

Interest-only loans made up more than 45% of total lending last year in San Diego, Atlanta and San Francisco, according to BusinessWeek Online and LoanPerformance, a San Francisco-based real estate information service, and they made up a third of the loans in 10 other hot markets. (Similar figures aren't available for flexible-payment mortgages.)

That's scaring many mortgage-rating companies, such as Fitch, which fear higher interest rates will lead to a spike in foreclosures on these loans. Falling real estate values could hurt these borrowers more than others, because many of them won't have built much, if any, equity and could become "upside down" on their mortgages, owing more than their homes are worth.

Risk: Buying money-losing rentals
In most markets, it's smart to choose property that commands rents that are at least high enough to cover your out-of-pocket expenses. (For details, read "How to find good investment property.") This is especially important in bubbly markets that could burst.

Some people think rentals will be in higher demand if foreclosures rise, but history has proven otherwise. Many of those who lost their homes in previous real estate busts lost their jobs first, Conway said, since economic downturns are what triggered the drops in home prices. People without jobs tend to leave the area in search of better prospects.

Los Angeles County, for example, lost more than 200,000 jobs a year for three years in the early 1990s, which set off the state's first-ever "out-migration" where more people left the Golden State than arrived. Rents tumbled as vacancies soared; foreclosures on rental properties climbed as landlords tired of losing both money and equity.

You can give yourself some protection by making sure your investment property has positive cash flow in good times. If you have to cut your rents, you may still get enough of a tax break to stay afloat (thanks to depreciation and deductible expenses).

Risk: Draining your home equity for other investments
Financial planner Fernandez isn't dead set against using home-equity loans to buy other investments. Some of her clients have successfully built profitable real estate portfolios this way. But using home equity to supplement a stock or mutual fund portfolio is a possibility only for the most risk-tolerant investors.

What concerns her are people who are diving in without considering the potential costs, or those who are "doubling down" by buying more property in the same, highly appreciated area where they own their primary homes.

Some want to use variable-rate loans like home-equity lines of credit to fund their ventures, not realizing spiking interest rates could make the deals unprofitable. (For more, read "5 tips for wisely tapping your home equity.")

Investors need to be reasonably confident their future returns will exceed the costs of borrowing the money, Fernandez said, and that they can handle any volatility that comes.

Most people, though, are probably better off funding their investments out of current income rather than borrowing to buy more, Fernandez said. If you do decide to borrow against your home, keep a cushion of 20% equity and consider a fixed-rate loan to lower the risks.

Risk: Owner-financed second or third mortgages
Some sellers prefer not to realize their profits all at once because that can trigger a major capital-gains tax bill. (Profits exceeding $250,000 per person on a primary residence are potentially taxable, as are all profits on rental property.) Instead, these sellers become lenders, allowing the buyer to make payments to them over time. This helps sellers stretch out their tax bill over a period of years, rather than having to realize the gains all at once.

This strategy isn't incredibly risky when the seller is in "first position" on the home -- in other words, when the seller is providing the primary mortgage. At worst, the seller will get payments for a few years until the buyer defaults. The seller might have made more money selling outright, but at least he gets his home back.

Those who finance second or third mortgages, though, might not be so lucky. If the borrower defaults, the primary mortgage lender gets first crack at recouping the loan. Only if there's equity left do the lenders in second or third position get paid off. In a declining market, those lenders can be left out in the cold.

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