Following the crash of the equity indexes in 2000, money started flowing into real estate across the country. Investors were just fed up with “paper” gains on intangible assets. The thinking was, and I heard it repeated over and over “At least with real estate, I own something..it can never go to zero”. So there it started, gradually at first, but the interest soon started to grow exponentially.
At the same time, mortgage rates on 30 year mortgages were trending downward to historic lows. With investors eager to invest in real estate and “cheap” money available, the game was on. The obvious choice for most was to buy a second home or investment property in a nice resort area, maybe even a place they had vacationed at in the past. Many flocked to Florida, California, Las Vegas, and Arizona. Even if their investments did not earn a return, it surely wouldn’t lose any money and they would still have something that they could use.
That’s how it started, in the beginning, these buyers came down, found a property that they liked, and bought it. The supply of homes and condos in resort markets started to slowly disappear. The available inventory was quite high but prices did start to appreciate…4%-8% per year. As the market prices increased, developers started to see an opportunity to build new homes and condos.
The developers needed large sums of money in order to get their projects off the ground. Typically, the banks would require the developers to “pre-sell” a certain percentage of the units in a complex before they would close on the construction loan with the developer. The challenge for the developers was to convince weary buyers to make a commitment on a project that was yet to be built. Remember, these buyers wanted something tangible, and looking at a set of drawings and blue prints and listening to a slick presentation was a tough sell. To overcome this, developers marked their units at prices that were typically 10%-15% below the current market price. This did the trick and many buyers made the commitment.
The funny thing is that the buyers weren’t committing much money in the first place. All they had to do was complete a reservation. Typically, $5,000 to $10,000 was enough to hold a place in line for a $500,000 condominium. The reservation was non-binding and the buyer could cancel at any time. Once the developer was ready to start construction, the buyers needed to come up with a total of 10% cash and obtain an irrevocable letter of credit for 10% from their bank. These were fairly easy to get at the time. So to summarize, $50,000 would put you in line for a $500,000 purchase.
Many would-be buyers decided that if one was good, then three or four must be great. And great it was, the first pre-construction buyers (purchasing 10-15% below market value) saw their investments increase 30%-40% during the 2 + years that it took for a condominium complex to be built. Many of these investors sold their properties before the building was complete, making hundreds of thousands of dollars in the process. This was called flipping.
Mainly, through word of mouth, the message spread: Buy pre-construction properties, leverage your cash, flip it, and get rich!
Buyers went from reserving a couple of units to dozens of units, spread among several different builders. With so much excitement, buyers didn’t even notice that developers had changed their pricing models. The units were now priced 10% over current market value. Their friends and family had already told them it was an easy way to make money so they didn’t have to do their own due diligence.
As a result, advertisements for new condominiums popped up overnight in the major newspapers and internet. Amazingly, the projects would often sell out in a matter of hours. In fact, many had waiting lists and utilized a lottery system to award “lucky” buyers with a condominium. Buyers were so eager to get their hands on a pre-construction deal that they didn’t even bother to look at the details. They didn’t care that the new units were smaller, had fewer amenities, or were in secondary locations…No sir, they just wanted pre-construction.
The point is this, buyers became irrational. They didn’t ask where a unit was in a building, they didn’t care how it was to be finished, they didn’t care about the reputation of the developer, and they didn’t ask if it was a good value. They just sent the reservation back with their $10,000. The majority didn’t even read the contract that they signed.
Believe it or not, buyers are starting to exhibit some of the same behaviors now. No, not with pre-construction, but foreclosures. Yes, bank owned foreclosures have become the new buzzword in the real estate industry. Buyers are so convinced that foreclosures are a great deal that they don’t want to look at anything else.
Often times when a new foreclosure comes onto the market, there are multiple offers and the winning bid is often greater than the list price. These buyers aren’t doing market analysis, aren’t accurately estimating the repairs that are needed, and typically overlook critical value affecting factors. Again, they are behaving irrationally and making uninformed decisions. It seems the ego boost of telling their friends that they bought a foreclosure is more important than actually getting a good deal.
While some foreclosures represent good value, not all do. Don’t get caught up with the herd and run off the cliff!