By RYAN TAYLOR

In this two part series, Cirios’ Valuation Guru Ryan Taylor offers an insider’s look into the nuances of investing in foreclosed homes. Please click here for Part 2.

From Beverly Hills to Detroit, the term REO is quickly becoming part of our country’s vocabulary.

REO, or Real Estate Owned, refers to a property that has already been through the foreclosure process, was unable to be sold at a public auction and has reverted back to the bank. For most of us, the previous sentence is a gross over-simplification and requires more explanation.

Similar to many aspects of life, we are skeptical of things we don’t understand. Since most potential home buyers are unsure of what an REO is, they tend to shy away from even considering REO properties that are for sale. More often than not, this “fear” is unjustified because an REO property does have value, and can prove to be a great investment for those willing to do their research.

Foreclosures, while an unpleasant part of the real estate and mortgage business, have jumped to the forefront of the country’s current economic predicament.

After a bank determines they can no longer depend on a borrower to make their mortgage payments, it begins the legal proceedings necessary to repossess the house. In California and other states where trust deeds are the preferred instrument for securing home loans, the foreclosure process usually culminates with a Trustee sale, where a lender-appointed representative puts the home up for public auction. These sales take place at the local court house, which is why you sometimes hear foreclosure sales described as occurring “on the courthouse steps.”

The lender will typically provide the trustee a minimum bid amount, and if no buyer shows up with the requisite cash, the home reverts to the bank and becomes REO.

Tight credit markets and falling stock prices over the past 15 months have created an environment where the vast majority of properties that enter the foreclosure process eventually end up REO. Even savvy investors, burned by the steep home price declines of recent years, are reticent to bid aggressively for distressed properties. As a result, banks are inundated with these homes, most of which are in extreme levels of disrepair. Banks have never had to deal with so many REO properties at one time and are ill equipped to manage their growing inventory of homes.

The supply of REO properties greatly outweighs the demand, and banks often can only sell them at fire sale prices. Their reluctance to realize further losses leaves these homes neglected, clogging up the real estate market with unsold and unattractive inventory. As long as economic conditions continue to deteriorate for banks, the number of REOs will remain high.

For prospective buyers — and indeed anyone who owns a home — it is essential to become educated on how to understand the current and potential value of an REO property.

The fact of the matter is that recessions create opportunities for those willing to do the work and research. Purchasing an REO property as either a home or income producing property can be a great investment. However, there are numerous pitfalls and market timing continues to be important as home prices continue their slide.

In the second article in this two part series, we will examine the risks involved in purchasing an REO property either an owner or investor.

By AUSTIN NELSON

In today’s fast paced, data-driven world, it’s easy to get lost in the morass of statistics flashing across our TVs and computer screens at a sometimes maddening pace.

Government officials, bankers, retailers and snake oil salesmen alike throw out statistical arguments at the drop of a hat, telling you why their pitch is the only one worth listening to because they have the data to back it up. But before accepting what you hear or read at face value just because some nameless research institute did a study, stop for a minute to ponder the complexities of even the most seemingly innocuous of statistics: The average.

Let’s first assume some particular data being quoted were reliably gathered and analyzed (This is almost never a safe assumption, but that’s a topic for another day), then examine how the average and another so-called “descriptive statistic” –- the median — are used in the data reports we see every day.

While on the surface it may seem that these two statistical measures could be interchangeable (indeed they are often used interchangeably with no explanation), they tell us very different things about the data they describe.

The median of a given group of data is its middle value. For instance, if your dataset has five data points and you lined them all up from smallest to largest, the third value would be your median. On the other hand, the average, or mean, of a dataset is determined by summing all values and dividing by the number of data points.

For example, suppose you are looking at real estate sales in a certain area within a certain time frame and you had the following 5 values: $300,000, $320,000, $320,000, $450,000, and $1,200,000. The median of this set is $320,000 (the middle value). The average is $518,000 (2,590,000 / 5). As you can see, even in this simple example, the two descriptive statistics are significantly different.

Real estate sales are often represented by the median value. The reasons for this are varied, but center around the fact that a few sales at extremely high levels (like that $2 million house on the top of the hill) can easily skew the average of a dataset towards those properties, even though most homes in the area are selling at lower prices.

For example, in Temecula, CA where most homes sell at modest levels (by California standards) but some homes sell for significantly more, the average sale price in 2008 was about $435,000. The median price, on the other hand, was around $359,000. That’s is a difference of over 20%.

Contrast that with areas where home prices are more homogenous, like Daly City, CA, where the average and median values are more closely in line. In 2008, the average sale price for Daly City was around $562,000 while the median was about $558,000 – a much smaller spread (<1%).

So which is better? Average or median? As can be seen from the examples above, neither.

Both display different aspects of the same set of data points. In Temecula, where median and average wildly diverge, using the average skews the data towards a much higher level. An individual from out of state looking to buy there might incorrectly assume they couldn’t afford to do so. On the other hand, solely looking at the median leaves out the fact that there are million dollar plus estates in Temecula available to buyers looking for that sort of thing.

When the National Association of Realtors releases their monthly sales statistics — which is the real estate pricing data carried by most major news outlets — they present sales price data as both median and average values. These values are used to track sales prices over time to identify trends in sales activity nationwide and regionally. While both median and average values are freely available to anyone with internet access, the median values are often the ones quoted in the popular press.

By focusing exclusively on median values, however, one can miss interesting trends.

For example, on a nationwide level and in three of the four regions identified, median and average home sale prices have been tracking at around the same relative spread since 2005. In the West region, however, the median sales price has been falling faster than the average price.

This widening variance helps tell the story of what’s been happening in Western real estate markets in the past few years. In most markets, high-priced homes have retained their value better than homes that are closer to, or below the median. Since so many lower end homes are being sold, many after foreclosure, the sheer volume of these transactions is dragging down the median figures. The average, on the other hand, is propped up by the few expensive homes still being sold.

This analysis then begs the question, why does the trend only exist in the West? As other regions decline, can we expect the same pattern to play out? Why are higher priced homes holding up better? If expensive homes begin to lose their value, what would that do to the median and average sales prices? What does the data look like on a city or zip code level?

It’s easy to see that just by comparing the median and average sales price trends, much insight — or at the very least another list of questions — can be gained.

I could go on all day about the wealth of information that such a seemingly simple statistic as the average can provide those with the patience and curiosity to “drill down” past the headlines. But my point is simply this: Pay attention! Don’t let the evening news or your favorite web news source gloss over the statistics to prove whatever skewed point they want to make that day. Spend the time to think critically about the information or you run the risk being fleeced regularly for the rest of your life.

At the very least, pay close attention to the source of any information you are receiving, particularly when that information comes in the form of a statistic. If you are being presented with a descriptive statistic like an average or a median, notice which one you are being given and pause for a second to think about why they used one and not the other.

Furthermore, if you notice that a single set of data is being described interchangeably by median and average, this should throw up a huge red flag as to the reliability of the information and its source.

By ANDREW JEFFERY

This post first appeared on Minyanville.

Is it a buyer’s market?

Ask most real-estate professionals the above question, and the response will almost certainly be an emphatic “Yes!”

After all, they quickly explain, inventory levels are at all-time highs, sellers are desperate to get out from under their rapidly depreciating homes, and mortgage rates are at historic lows. What more could buyers ask for?

How about not losing their shirts, for starters.

The traditional definition of a buyer’s market is one where supply outstrips demand, pushing down prices: Buyers have the upper hand. As the bull market begins to wane, however, buyers lose their enthusiasm and become concerned about price. The market cools down and buyers shy away, forcing sellers to make concessions and lower prices. This, in turn, creates an environment where buyers can shop around, be picky, and patiently waiting for their dream house to come on the market.

As demand returns, sellers start upping their list prices, refusing to pay for closing costs and holding out for a better offer. Buyers, fearful they might miss out on the next boom, bid up asking prices and ask for fewer concessions. Now that sellers have the upper hand, the market favors sellers as prices move upward. Such is the cyclical nature of real estate.

This story has played out for decades as real estate plodded along, homebuilders like DR Horton (DHI), KB Homes (KBH) and Toll Brothers (TOL) supplied the market with new construction and home prices marched steadily upward, outpacing inflation by the narrowest of margins. A little more than 10 years ago, however, that relationship started to come unglued.

The recent housing bubble turned the prevailing view of real estate on its head. Homes, long viewed as the most stable of all assets, became a speculative tool for even the most unsophisticated investor. The mania, fueled by lax monetary policy and Wall Street alchemy, helped contributed to the financial crisis currently gripping our country. As property values have careened back to earth, real estate assets of all kinds have become toxic.

Nevertheless, the National Association of Realtors (or NAR) and its dedicated minions have tirelessly peddled their lies that ours is a buyer’s market. Let’s take a quick jaunt back in time to some recent headlines and where that traditional assessment of a buyer’s market got us:

Las Vegas: It’s Definitely a Buyer’s Market
USA Today: July 5, 2006
“Real estate looks like one of the biggest gambles in Las Vegas.”

How true. Property values in Vegas have fallen 33% since summer 2006. Not to be outdone by their peers at USA Today, ABC ran this piece just weeks later:

Take Advantage of Real Estate’s Buyer’s Market
ABC News: July 31, 2006

“The National Association of Realtors said that the number of homes for sale has reached new heights, which is good news for buyers. After years of a seller’s market, it’s finally a buyer’s paradise in Phoenix, AZ.”

Anyone who bought in that “buyer’s paradise” in Phoenix has seen their home’s value fall by more than 30%.

The point isn’t to criticize realtors for arguing it’s a buyer’s market: After all, one should expect nothing less from a group whose entire existence is based on convincing buyers it’s a great time to buy – irrespective of the truth. Just ask Gary Keller, whose new book, Shift: How Top Real Estate Agents Tackle Tough Times, advises agents to “find every way possible to overcome the media-driven real-estate malaise.”

The traditional definition of a buyer’s market needs a bit of a makeover. A more sensible definition is a market where buyers have ample opportunity to make good investments. To be sure, a home is more than just an investment; it’s a place to raise one’s family, to grow old, to spend time with loved ones. However, as far too many American families have learned in the past three years, homes can become a debilitating burden if bought at the wrong price.

In today’s market, there certainly exist attractive investment opportunities. But to label the market as a whole as one where buyers should be rushing out in search of the American Dream is borderline lunacy. Throughout much of the country, home prices are still too high: Real incomes don’t support prevailing property values, even after the historic declines we’ve already seen. Supply, despite remaining at record levels, is likely to remain so for the foreseeable future. Home prices are undergoing a much-needed correction, and will continue to do so until fundamental demand catches up with supply.

This isn’t to say every home on the market is overpriced, or that every buyer in the past 36 months has gotten a raw deal. There are deals to be had if one knows where and how to look – and, most importantly if the purchase makes good financial sense. To borrow a theme from Toddo, “financial staying power” should be at the forefront of any prospective buyer’s mind.

So ignore the hype, both good and bad. As often is the case, not until the most ardent bulls turn in their horns will the bears return to hibernation. So, as soon as realtors concede it may not be a buyer’s market after all, voila! A bottom we will have.

By ANDREW JEFFERY

This post first appeared on Minyanville.

The road to over-regulation has begun.

In an effort protect struggling homeowners, Senate Democrats are advocating new bankruptcy laws that allow judges to alter mortgage terms, known as a “cramdown,” during a Chapter 13 bankruptcy filing. Lawmakers hope the new rules will prevent foreclosures, help borrowers in danger of losing their homes, and begin to stabilize the reeling housing market.

Despite good intentions, however, these efforts will raise the cost of borrowing for everyone, reduce the availability of mortgage credit and prolong the housing market’s recovery.

According to the Wall Street Journal, the proposal’s backers won a major victory when Citigroup (C), which has received $45 billion government capital since last fall, withdrew its opposition. Big mortgage lenders like Citi, Wells Fargo (WFC), JPMorgan (JPM), and Bank of America (BAC) have been resistant to the changes, since courts would gain the power to force losses on altered loans. But with the government snatching up pieces of the country’s biggest banks, their ability to resist such regulation is diminishing.

Democrats now hope to include the bill in President-Elect Obama’s $800 billion economic stimulus package.

The proposed rule-change applies to Chapter 13 bankruptcy filings, which allow individuals to gradually repay debts as the work their way out of economic trouble. Under the current laws, judges are provided leeway to alter the terms and payment schedules of credit cards, auto loans and other consumer debt. First mortgages, however, are off limits. Even though courts can’t wipe out home-loan debt or reduce interest rates, a homeowner doesn’t necessarily lose his house in a Chapter 13 filing. As long as the borrower can keep making payments, the bank can’t take the house.

Advocates of the bill believe relaxing cramdown restrictions will shelter homeowners who otherwise would lose their homes by effectively forcing loan modifications. And since the success of government-backed modifications programs have thus far been disappointing, bureaucrats are eager to press the issue.

Mortgage rates, when compared with other type of consumer debt, have historically been kept low because lenders are secured by a home: When the homeowner defaults, the bank gets the house. Miss too many car payments, on the other hand, and a bank is left looking for an asset that’s far tougher to chase down. For as painful as foreclosure is for the borrower, this lender protection keeps mortgage money flowing to the rest of the economy.

The proposed rule change, which lawmakers also hope will encourage lenders to modify mortgages on their own before courts get a chance to hack up a loan’s terms, greatly reduces a bank’s financial incentive to giving out mortgages at low rates. If borrowers have the ability to file for bankruptcy and plead their case to a judge for lower payments, banks will be reticent to lend. If they do give out loans, they’ll charge higher rates for the privilege.

As is typical of recent government-sponsored economic initiatives, lawmakers ignore long-term implications in favor of immediate good press. This over-aggressive consumer protection directly counteracts efforts by the Federal Reserve and Treasury Department to push down interest rates – and further illustrates bureaucrats’ ineptitude at effectively managing an economy. As soon as they actually manage to get mortgage rates moving down, another wide-eyed economic simpleton tries to start them in the opposite direction.

But such are the pitfalls of a planned economy – and this, unfortunately, is just the beginning.

By ANDREW JEFFERY

This post first appeared on Minyanville.

From expansive estates in the Hamptons to mansions on the Malibu cliffs, the rich are watching their vast real-estate wealth evaporate before their eyes.

Perhaps no market epitomizes the ultimate surrender of high-end real estate than the island of Manhattan, where housing prices had held relatively stable until quite recently, despite broad declines across the country.

Turmoil on Wall Street, the collapse of Lehman Brothers, and layoffs at big employers like Citigroup (C), JPMorgan (JPM), Morgan Stanley (MS) and Goldman Sachs (GS) have finally taken their toll on the once-proud market for overpriced, undersized refuges from the concrete jungle.

The Wall Street Journal reports housing inventory in Manhattan jumped 39% in the fourth quarter as sales plunged – even as prices managed to eke out a 3.1% gain from a year ago.
Meanwhile, condominiums and cooperative apartments currently under contract to be purchased are selling at a whopping 20% below the prices paid just last summer. As sales data reflecting those transactions emerge in the coming months, Manhattanites may finally wake up to the reality that their housing market is no longer immune from the afflictions the rest of the country knows all too well.

Compounding the effects of an abysmal bonus season throughout the financial industry, ongoing job cuts, and generally weak economic conditions, lenders continue to scale back the availability of so-called jumbo mortgages. These loans, too big to fit within the ever-narrowing lending guidelines of Fannie Mae (FNM) and Freddie Mac (FRE), don’t qualify for a government guarantee.

Banks take on more risk by originating these loans, and charge higher rates for the pleasure. Bankrate.com (RATE) reports jumbo rates remain more than 1.5% higher than their smaller, conventional counterparts.

Since most Manhattan condos and co-ops are purchased with jumbo loans, these persistently high rates mean prices on the island are being only marginally supported by recent, aggressive moves by the Federal Reserve and Treasury Department to spur home buying.

Wells Fargo (WFC), now the nation’s largest mortgage lender after completing its acquisition of Wachovia, isn’t helping matters for high-end buyers. The California-based bank announced yesterday it would stop offering jumbo loans through its wholesale (or broker-originated) channel. MortgageDaily.com reports Wells cited low market demand and higher risks in its decision to suspend jumbo offerings for mortgage brokers.

The ongoing financial crisis, which arguably originated in the narrow winding streets of Wall Street, has now come full circle. The same bankers, traders and financiers who levered houses up beyond all rationality are now seeing the dark side of structured finance gone awry.

Some will wisely sell now, while they still can, take their lumps and move on. Others, stubbornly clinging to their former glory, are likely to go down with the ship.

By ANDREW JEFFERY

It should come as no surprise that with headlines screaming financial Armageddon and the stock market making new lows seemingly every day, last November wasn’t exactly a great month for the housing market.

This morning, the National Association of Realtors, or NAR, released its Pending Home Sales Index, which measures signed contracts that are expected to turn into sales. The data were abysmal, showing a 4% decline month-over-month to a reading of 82.3, the worst since the data has been tracked. Unsurprisingly, economists — who have been squarely behind the curve at each step of the ongoing financial crisis — expected a mere 1% drop, despite widespread turmoil in financial markets during both October and November.

Yet even with the continued slide in home prices, our good friends over at the NAR are optimistic for 2009 (Ahh to be a lobbyist and completely detached from any shred of reality). This outlook should come as no surprise, as the group has been wearing rose colored glasses since the housing downturn began in late 2005.

To counteract the negativity in their Pending Home Sales Index — which is inconveniently based on actual data rather than farcical forecasting — the NAR also released a report today predicting home prices will be flat in 2009. It even went so far as to forecast an increase in the median price of new homes.

The prediction displays the sheer audacity of a group whose very existence relies on convincing buyers its a great time to buy, irrespective of actual market conditions.

Despite an increase in buying activity in certain distressed markets, home prices are falling, and will continue to fall until supply and demand become rebalanced. This will not happen as long as homebuilders keep building, companies keep laying off employees and banks keep tightening lending guidelines.

And while it’s certainly beating a dead horse to say the decline in home prices will persist, sometimes the horse needs to be beaten.

Too many prospective buyers, eager to jump on attractive deals, will step in too early and be underwater (owing more on their house than it’s worth) almost immediately after the receive their new keys. This unenviable position traps a homeowner, making a job loss or other economic misfortune that much more dire.

There will be more than ample opportunities to buy houses on the cheap when prices have stabilized, and prudent buyers should continue to wait, save their pennies and let others, bolder yet perhaps less wise, catch the falling knife.