Last month, we discussed the role confidence plays in the housing market. The better Americans feel about the economy (using the stock market as a barometer of the country’s economic fortunes), the more likely they are to go out and buy a house.

Sticking with the theme of market psychology, let’s now examine the other side of the transaction: Sellers.

In today’s market, sellers basically fall into two categories: Those who can, and those who can’t. In other words, if you still have equity, you can sell. If you are underwater on your house, you can’t.

The decision for the latter of whether to sell is, unfortunately, pretty simple. So let’s consider the former, those fortunate homeowners who still have equity left in their homes.

Selling into a weak market is a drag. With so many homes to choose from, buyers can drive a hard bargain. And thanks to unrealistic expectations and bad advice from Realtors trying to win clients with lofty promises, thousands of sellers over-listed their homes and subsequently chased the market down throughout 2007, 2008 and 2009.

Very few voluntary sellers dipped their toes into the market because it was just so bad. The only true sellers were those who had to sell for some reason or another.

So what now? Housing isn’t nearly as bad as it was this time last year, and in many markets the worst of the price declines are likely over. Stocks rallied fiercely last year, rebuilding many damaged nest eggs. And even though there are looming threats out there to our nascent - and very governmentally influenced - economic recovery, things are not nearly as dire as they once were.

We wrote back in May 2009 that “Willing and able buyers are pouring back into the market. And as they do, sellers - buoyed by newfound confidence - are prepping their homes for the market.” Although inventory remained constrained throughout 2009, the percentage of distressed sales relative to regular sales is slowly dropping.

Recent data is seeping out that supports our view, and the trend is picking up steam so far in 2010. The graph below, courtesy of SocketSite, shows active listed inventory in the city of San Francisco. Notably, the black line representing 2010 has reached to the orange 2008 line … and check out that slope!

Anecdotal evidence supports the data. Sellers are trying to get in ahead of the summer buyer season, particularly with the (latest) expiration of the homebuyer tax credit just around the corner in June.

While we at Cirios are constructive about real estate investment opportunities, we remain cautious. A backlog of eager sellers is one of a host of factors that looms on the horizon.

If you were a seller, what would you do?

Given the historic home price declines seen in the past four years, few investors have been focused on deferring taxes on real estate gains because, let’s face it, there just haven’t been many gains. However, as investors begin to wade back into the real estate market (cash investors accounted for more than 25% of existing home sales in January), they should be well-versed in State and Federal laws and tax codes that allow investors to minimize the pain of taxes.

One useful tool is the like-kind exchange created by 26 U.S.C. Section 1031 of the United States Internal Revenue Code. Or, as is more commonly known, the 1031 Exchange.

A 1031 Exchange allows an investor to sell an income, investment or business property and soon thereafter purchase, or “replace” it with a like-kind property, ie, another income, investment or business property of equal or greater value. All gains from the resale of the first property are deferred, so long as the IRS rules governing 1031 Exchanges are closely adhered to.

Several types of real estate properties can qualify for a 1031 Exchange. Real estate held for income, business purposes or investment can qualify, whereas personal residences and, for the most part, fix-and-flip properties do not qualify. Vacation homes and second homes that are not held as rentals also do not qualify, unless specific tests for “usage” set out in the IRS Code are met (consult a CPA or other expert before attempting a 1031 Exchange with a vacation home).

Today, most 1031 Exchanges are facilitated by what is known as a “Qualified Intermediary,” or QI. IRS rules are very strict about what can be done with sales proceeds that are to be rolled into another property in order to qualify for the 1031 Exchange, so QIs were designed to ensure all regulations are met for an approved exchange. The QI facilitates the transaction by acting as the investor’s agent when he or she sells the original property and buys the replacment. This is all above board, as regulators created this type of entity to try and standardize the process by which 1031 Exchanges could take place.

Upon the earlier of the deed recording or possession transferring to the new buyer, an investor seeking to do a 1031 Exchange has a non-extendable 45 days to close on or identify in writing a potential “Replacement Property.” After identifying this Replacement Property, the investor has a maximum of 180 days from the date the first property was transferred to the new owner to close the purchase of the Replacement Property. An important caveat: If the due date on the investor’s tax return for the tax year in which the original property was sold is earlier than the 180 day deadline, then the due date for the tax return is the final deadline for the closing of the new property.

If an investor fails to meet either the 45 day identification or 180 day closing deadlines, the 1031 Exchange is disqualified and taxes will be due on the capital gains from the sale of the property.

Once a Replacement Property is identified, the QI - not the investor - acquires the Replacement Property from the seller at closing. Once closed, the QI transfers the Replacement Property to the investor. This is done to ensure that 100% of the sales proceeds are rolled into the new investment and not used for any other purpose, which would disqualify the exchange.

Sound complicated? A bit. But 1031 Exchanges are a critical tool to building wealth in real estate by deferring tax obligations and using the savings to build more wealth. And, as always, investors should consult a CPA, attorney or other tax expert before attempting to perform a 1031 Exchange with your valuable investments.

DISCLAIMER: Cirios Real Estate is not a tax, financial or investment advisor. All investments carry risk. Before considering any investment options, including 1031 Exchanges, consult your investment advisor and tax professional.

San Francisco Building Owners Sell Winners, Keep Sinners
(San Francisco Business Times)
There’s an old saying on Wall Street that you shouldn’t sell your winners to finance your sinners. Landlords in San Francisco, apparently, didn’t get the message. 303 Second St., just blocks from the freshly constructed One Rincon Tower, was just listed and is expected to fetch north of $200 million. Along with another new listing at 333 Market St., which is a few blocks from the Embarcadero and 100% leased to Wells Fargo, the activity supports the view that building owners are looking to raise capital by selling strong performing assets. SF landlords are likely hoping they don’t end up like former brokerages like Bear Stearns and Lehman Brothers, which shed high quality assets to stave off a cash crunch. Oops.

(Read more here: http://tinyurl.com/ciriostrendsmar1)

Bay Area Home Sales Slip in January
(San Francisco Chronicle)
It’s not unusual for home sales to fall from December to January; the holidays are a notoriously sleepy time in the housing market. But this January was abnormally slow, as transactions in the Bay Area fell 4% from a year ago, marking the first year-over-year drop in sales in 17 months. Some chalked up the slowdown to the dearth of listings on the market, while others raised the possibility of a hiccup in the housing market’s recent strength. At least within the San Francisco city limits, we at Cirios have noticed a meaningful pickup in new listings in the past month (supported by the data presented on the first page). Opportunistic buyers should be licking their chops, but, as always, picking their spots.

(Read more here: http://tinyurl.com/ciriostrendsmar2)

Hotels Slash Prices to Keep Occupancy Up
(San Francisco Business Times)
Sure, you’re broke, but it’s never been a better time to visit San Francisco. Hotels, smarting from an excessively weak tourism market, are slashing rates to keep their rooms full. Northern California as a whole saw room rates slip 13.2% from last year, while San Francisco’s decline approached 16%. Meanwhile, occupancy in San Francisco held relatively steady, off only 4.3% from 2009. Contrast this with apartment buildings, where landlords let units sit vacant rather than dropping rents. This is especially true in San Francisco, where tenant-friendly rent control laws means it can take years for landlords to recoup lost rental income.

(Read more here: http://tinyurl.com/ciriostrendsmar3)

Santa Clara Residents Undecided on 49ers Fate
(San Jose Business Journal)
Less than a month after the Santa Clara city council paved the way for a June vote on a nearly $1 billion stadium for the San Francisco 49ers, voters aren’t so sure. In a recent poll, Santa Clara voters are split right down the middle on the subject, with 45% favoring the plans and an equal portion opposed. This contrasts another poll done last month which shows just 40% of Santa Clara voters in favor of the stadium, with 54% opposed. San Francisco is still holding out hope that they’ll get a shot at keeping the team, but only time, and votes, will tell.

(Read more here: http://tinyurl.com/ciriostrendsmar4 )

This month’s zip code spotlight moves to what can truly be called the heart of the San Francisco Peninsula. Nestled between South San Francisco and Burlingame, San Bruno is a suburban haven only minutes from the city.

Homes in the area range widely in cost, from $1.3 Million dollar mansions on the hill to affordable, $300,000 row homes closer to the bay. In the midst of all this, a solid core of reasonably priced (by peninsula standards) homes provides an excellent alternative to more expensive south peninsula locales. The median listing price currently rests at around $650,000. For this price, homebuyers can get a reasonably large 3 bedroom home with a good sized lot.

With a housing stock largely consisting of homes built in the 1950’s and 60’s, opportunities abound for rehab investments. Foreclosure activity has been on the rise in the area of late, while prices seem to have leveled off somewhat. As you can see from the graph below, the moving average sale price for homes has actually increased slightly over the last 6 months. During that time, supply has come down from its spike in 2008 but is still slightly elevated from traditional levels, likely due to the increase in foreclosure activity.

What this means is that home values in the area are increasing despite downward pressure from increased supply. This is a good indicator for the medium term prospects of San Bruno real estate, as it indicates that demand is higher (relative to supply) than it has been traditionally in this area. If supply does taper off, prices should go even higher. In the meantime, we feel that price stability for this area is very likely, making rehab investments in the area quite attractive.

Opportunity Overview:2730 Sherwood Dr., San Bruno, CA 94066
For many people familiar with the Bay Area, the Peninsula is a place where only the wealthy can afford to live. And while this holds true for most areas, there remain some desirable areas that still afford first-time buyers a place to call home. One of these towns is San Bruno. Known more for its poor weather than affordable homes, San Bruno often gets a bad rap: There are plenty of neighborhoods that aren’t buried within the fog belt. San Francisco International airport is close (although in some cases too close), and job centers are a short drive North or South. Homes frequently sell for less than $600,000 which, on the Peninsula, is downright cheap.

Property Details
Bedrooms: 3
Bathrooms: 2
Living Area: 1,140 square feet
Lot Size: 5,432 square feet
List Price: $549,000
Sale Price: IN ESCROW (8 days on market)
List Date: 2/12/2010

This property was purchased at Trustee Sale on January 4, 2010 for $444,000. In just over 30 days, the buyer was able to relist the property for more than $100,000 above acquisition cost. The quick turnaround indicates that improvements were more than likely cosmetic in nature. Given the lack of equivalent homes on the market, it ‘s safe to assume this property will sell at or above its asking price.

Here is one potential scenario of how an investor would make out:

(Note that the cost figures below are estimates)

$444,000: Purchase price
$30,000: Repairs and remodel
$1,520: Taxes
$3,500: Insurance
$5,000: Escrow costs
$484,020 Total Investment

Although a $30,000 budget is not especially large, given the small size of the home, many high quality improvements could have been made. The final numbers in our scenario look like this:

$570,000: Sale price (estimated)
$28,500: Less Real Estate Commissions
$484,020: Less Total Investment
$57,480: Profit
11.9% ROI

A return of 11.9% is not as high as other deals we have seen come across the steps, but escrow is scheduled to close on March 11th, so the deal took just under 70 days from purchase to eventual resale. The annualized return on this deal was meaningful, indeed.

As the infamous “Summer Buying Season” looms a few months out, it remains to be seen whether or not recent market strength can continue. In a way, the housing market has been turned on its head in the past year: The weakest markets are now the strongest, while some of the most well-to-do areas remain shaky and illiquid. The bifurcation in today’s housing market is persistent, and we believe will continue to be the dominant trend in 2010. Taking a look around the Bay Area, data support this theory, as can be seen the charts on the following pages.

Alameda is truly an island unto itself. It is after all, an island. And in some ways a whole different world. The western half of the island is dominated by the quasi-vacant Alameda Naval Complex, which is part maritime ghost-town, part industrial development opportunity in the making: Years of potential development deals have hung over the area, which remains one of the choicest pieces of undeveloped land in the Bay Area. Meanwhile, strong schools, a bustling downtown and a unique sense of community draw middle class families from around the Bay to call Alameda home. As the chart above illustrates, Alameda has seen its share of price declines, but this decidedly middle class town has experienced decidedly middle of the road housing troubles. With prices off “just” 24% from the peak and stabilizing of late, homeowners couldn’t have asked for a much better outcome from the worst housing slump since the Great Depression.

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We at Cirios have shown chart upon chart, graph upon graph, data upon data to illustrate that low end housing markets have been the first to recover, while high end markets have remained troubled. At first, we were called loony, since conventional wisdom knows that when housing starts to recover, it’s the strong markets that bounce back first. Not so this time. It has now been well documented that luxury real estate is still under pressure even as distressed markets start to stabilize. In case you weren’t convinced, we offer you yet another fascinating example of why buying in the high end can still be a risky proposition if not done smartly. The graph above shows condo prices in Burlingame, one of the most desirable locales on the Peninsula. There aren’t a ton of condos in the town in the first place, as evidenced by the spotty dots, but the trend is clear: Prices have come down, but not by much, and if the cluster of dots below the trend line in 2009 are any indication, stability isn’t likely in the cards in the immediate future. Flip the page to see the polar opposite situation across the Bay in Concord.

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Wow, now that is a chart. (Commodity-watchers of recent years will recognize this pattern, to be sure). The price correction above was nothing short of spectacular. Unless, of course, you owned a condo in Concord. In addition to all the other factors pushing down prices, as condo buildings got into financial trouble, they were crossed off the FHA and Fannie Mae Approved list, effectively locking buyers out of financial options. When your only buyer is an all-cash investor, prices really crater. Dig into the data above at the complex-by-complex level and you can literally identify the point at which the complex got removed from the Approved list. But as rental yields once again started to make sense, investors returned to the market. With prices having tumbled all the way back to 2000 levels, even though Concord doesn’t have the caché of Burlingame (nor the schools, of course), where would you rather put your money?

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Just like the statement “the housing market has bottomed” is meaningless to anyone but the most macro-focused economists, trying to look at even city-wide home price trends is often a fruitless endeavor. And while sometimes even zip codes hide the true trends (as we saw last month with Menlo Park, CA), zip codes are the only way to even begin to examine home price trends effectively, especially within large cities. For example, the question “How far off the peak are home prices in San Jose?” is impossible to answer. The chart above shows the zip of 95127, which lies to the east of Highway 680. From the peak, prices are down more than 50%, all the way back to levels not seen since 1999. Note also that there was nary a pop during the dotcom bubble, which means this area isn’t chalk full of technology execs, to say the least. Flip to the next page for a very different perspective from a very different part of town.

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The zip code of 95120 is home to the Almaden Valley, one of the most desirable parts of San Jose, and, by extension, Silicon Valley. All one needs to do to is look at the spike in expensive homes sold in this area during the peak of the dotcom craze to get a sense of the area’s demographics. Prices in 95120 are off a mere 20% from the peak, which occurred a full year after that of our previous area of 95127. Interestingly, Almaden has seen a touch of stabilization since the beginning of last year, and even a small rise in prices. But, with prices only back to 2004 levels, during the height of the housing boom, we would caution that it’s more than likely that 2010 could bring some pricing pressure, as a weak job market begin to stress Silicon Valley’s more well-to-do residents.

If someone were to wake up from a 5-year coma and ask about the state of our country’s economy, the chart below pretty much sums it up.

The past five years in the housing market, the financial market and the economy have been anything but boring.

With respect to the housing market, we are at a critical juncture. Pundits and so-called experts are lining up on opposing sides of the recovery debate. Optimists will point out that after historic price declines, affordability is at all-time highs and government support for the housing market has helped mitigate the negative effects of tightened credit and mounting foreclosures. The bottom, they say, is in.

Meanwhile, pessimists urge caution. Foreclosures continue to rise, more borrowers are falling behind and the government is considering removing some of the programs that have kept interest rates low.

Ultimately, both arguments have merit. But they both miss the point.

Take another look at the graph above. It’s no coincidence that during the time of most uncertainty in the stock market (2008), the housing market experienced its steepest declines. It’s also no accident that the recent bottom in stocks (March 2009) matches almost exactly with the turning point in housing.

The answer to the riddle is simple: Confidence.

In a new book called This Time is Different, economists Kenneth Rogoff and Carmen Reinhart dissect hundreds of years of financial crises and try to assess how societies keep getting themselves into the same mess over and over again.

A common thread in the discussion, specifically surrounding debt crises like the one we experienced (and indeed are still experiencing), is the notion that confidence plays a far larger, and far less understood role in economic panics than most people think. According to Rogoff and Reinhart: “Economists do not have a terribly good idea of what kinds of events shift confidence and how to concretely assess confidence vulnerability.”

Since most people equate the stock market with the economy, swoons on Wall Street send the message that all is not well with our economic future. Accumulate enough of these swoons and confidence gets punctured to the point where people start acting differently. As risk aversion grows, consumers delay purchases, businesses delay expansion and banks stop lending.

In March of last year, the housing market was beyond bleak. Liquidity dried up and buyers were terrified. Ditto on Wall Street. But as stocks recovered through the spring, hope emerged that maybe the worst was behind us.

Now, as the recent surge in stocks is tested, so too will the surge in home buying: The two are far more linked than most understand.

At cocktail parties and around the water cooler, the familiar refrain that “now is a great time to buy,” is piquing the interest of even the most casual real estate investor. For many, however, taking advantage of “distressed” real estate opportunities remains difficult, at best.

For some it’s a simple question of economics. Buying a distressed property often requires an all-cash purchase - a daunting task with high Bay Area home prices. And after the stock market’s swoon in 2008, it’s seemingly untenable recovery in 2009 and a recent blip downward to kick off 2010, many investors are just trying to get back to where they started.

However, for those with a desire to diversify away from the limited transparency afforded by investing in stocks, tax-protected retirement money can be used to invest in real estate.

It’s a well-kept secret that money held in IRA accounts can be invested at the owner’s discretion. Brokerages and money managers earn money from controlling IRA investments for their clients. This gives them little incentive to provide information on “self-directed IRAs,” which give investors the ability to diversify their retirement savings, while still retaining IRA tax protection.

Only tiny fraction of the trillions of dollars that are in IRA accounts are self-directed. And with cash-flush investors stepping back into the housing market, an increasing share of deals are being snatched up by buyers using tax-protected retirement funds at the closing table.

Not surprisingly, the IRS keeps close tabs on this sort of investment, so anyone considering this option should seek the advice and consultation of an investment and tax professional.

IRS regulations require that either a qualified trustee or custodian hold self-directed IRA assets on behalf of the IRA owner. Most big wealth managers offer the service while a few firms that specialize in self-directed IRA investments have been gaining market share in recent years.

Custodians and/or trustees facilitate investment transactions and hold the assets in trust for the IRA owner, just like a traditional IRA. The primary difference is that the owner, not the manager, calls the shots.

Once a self-directed IRA is opened, the custodian or trustee permits the client to engage in a broad range of investments that are approved by the IRS. These options include: real estate, stocks, mortgages, franchises, partnerships, private equity and tax liens. There are rules for each specific investment type, but it’s easier than you think to diversify away from the stock market and into other asset classes.

One important aspect of self-directed IRA custodians is their inability (legally) to provide investment and tax advice. They act simply as intermediaries, not advisors. The idea is to give investors control; there are plenty of options to pay someone to professionally manage your retirement money, self-directed IRAs are
designed for investors who want to be 100% in control of some portion of their retirement funds.

Of the restrictions on real estate investments, one of the primary ones is that the property cannot be for personal use. That is, you can’t move up into that mansion you’re family has been eyeing with cash set aside for retirement.

So even though retiring baby boomers can’t pick up a getaway in Hawaii, they can opt to invest in something a bit less volatile than stocks. Low-risk opportunities abound to make smart real estate investments in this environment, you just have to know where to look.

DISCLAIMER: Cirios Real Estate is not a tax, financial or investment advisor. All investments carry risk. Before considering any investment options, including a self-directed IRA, consult your investment advisor and tax professional.