|More Amass Big Debt
To Buy Real Estate
By JAMES R. HAGERTY and RUTH SIMON
Staff Reporters of The Wall Street Journal
From The Wall Street Journal Online
A year ago, Ryan Epstein and his wife had whittled down the mortgage
on their four-bedroom colonial house in North Beach, Md., to $130,000.
Then Mr. Epstein had a chat with a mortgage broker.
The broker helped the Epsteins refinance their home, valued at about
$300,000, to take advantage of lower interest rates. He also
encouraged the couple to take out extra cash, a popular technique
called a cash-out refinancing. The Epsteins used that cash, $25,000,
as the down payment to buy a rental property. That purchase swiftly
led to others. Today, Mr. Epstein says he has about $1.4 million of
equity in nine dwellings -- and $2 million in mortgage debt.
Those rapid profits reflect surging house prices, rising at a
double-digit rate in the Epsteins' area near Washington. "It's a
wonderful market out there," Mr. Epstein says.
Five years into a housing boom that has boosted U.S. home values an
average of 50% and added an estimated $5.5 trillion to the total
market value of residential real estate, many Americans no longer
think of their home as just a place to live. Instead, it's a cash
machine that can be used to rapidly build wealth. To that end, a
growing number of people are tapping into their home equity to invest
in more real estate.
That's a lot like using a margin account -- a line of credit backed by
securities in an investor's portfolio -- to buy stocks. During the
1990s, many investors used such accounts to buy shares in fast-rising
tech stocks. When the dot-com bubble burst, the value of the shares
bought on credit cratered and investors' borrowing worsened their
losses. Economists say today's debt-fueled investment binge in real
estate is fanning the flames of an already overheated housing market,
and making demand from people who actually need houses to live in seem
stronger than it truly is.
In some markets, this buying is adding to a glut of rental housing and
causing rents to fall, which will make it more difficult for investors
to break even. Already, there are signs that a few investors are
starting to get burned.
On Friday, Federal Reserve Chairman Alan Greenspan suggested that
house-price inflation in some parts of the country is starting to look
excessive. "At a minimum, there's a little froth in the market," Mr.
Greenspan said in response to a question at a lunch hosted by the
Economic Club of New York. "We don't perceive that there is a national
bubble, but it's hard not to see that there are a lot of local
bubbles," he added.
He played down the idea that the market could suffer a dramatic crash
like the bursting of the dot-com bubble, in part because homes don't
sell as quickly as stocks do. Also, most people still have plenty of
equity in their homes, he noted, so the prospect of mass bankruptcies
in the event of a housing-market decline seems far-fetched.
Others express more anxiety. Dean Baker, co-director of the Center for
Economic and Policy Research, a think tank in Washington, says many
Americans are being "incredibly reckless" in assuming that real-estate
prices will keep rising or, at worst, flatten out. "It's a classic
phenomenon you expect to see in a speculative bubble," Mr. Baker says.
He is so bearish on housing prices that he sold his own home last year
and now rents.
In another sign of growing concern, the Federal Reserve and other bank
regulators last week issued guidelines calling for lenders to tighten
their criteria for making loans backed by home equity by looking more
closely at borrowers' ability to repay under various possible future
market conditions. The regulators are starting work on similar
guidelines covering mortgage loans used to purchase homes. Among
regulators' top concerns: the surge in popularity of interest-only
loans, which allow people to pay only interest in the initial years
and face the burden of paying back the principal later.
For now, however, so many Americans are racking up such huge paper
profits in real estate that herds of new investors are crowding into
the market every day. Thanks to rising home values, they have lots of
money to spend.
Precisely how much home equity is being used for real-estate
speculation and investment is impossible to determine because there
are various ways homeowners can tap into their equity, and lenders
often don't know how the money is being used.
What economists do know is that Americans are extracting huge sums of
money from their homes, and mortgage brokers say more of that money is
being funneled into real-estate investments. According to Economy.com,
Americans pulled out roughly $705 billion of equity from their homes
last year, up from $266 billion in 1999.
The bulk of that money came from capital gains made by people selling
houses, and these profits often are used to purchase another
residence. Many people also use some of the extracted cash to pay off
credit-card debt, which is widely viewed as a sensible way to use
equity. Another large chunk of the equity withdrawn goes into home
improvements. Spending on such projects totaled $138.3 billion last
year, up 38% from five years before, according to Harvard University's
Joint Center for Housing Studies. Many people justify such projects on
the assumption, not always correct, that money spent on new kitchens
or decks will lead to commensurate increases in the value of their
homes -- a mild form of real-estate speculation.
A riskier and more aggressive way to use home equity is to plow it
into investment property, as the Epsteins did. A survey by SRI
Consulting Business Intelligence, a research firm in Menlo Park,
Calif., found that nearly 2.2 million households used their home
equity to buy additional real estate in 2004, up from roughly one
million a decade earlier. "As long as there isn't a major change in
the marketplace or a bubble burst, it will go up again," says Larry
Cohen, director of the SRI division that does financial-services
research and consulting.
What Americans are generally not doing with their equity is letting it
build, as homeowners traditionally did. The huge rise in home values
translates into more equity for homeowners. But many of them have
extracted those profits from their equity, and many people buying
homes now borrow a larger share of the price than they did years ago.
So mortgage borrowing has grown even faster than home values have. As
a result, homeowners' equity as a percentage of the market value of
all homes declined to 56% at the end of 2004 from 57% five years
before, according to data from the Federal Reserve.
Financial-services companies promote the idea that home equity is
available for spending or investment. "Your home is one of your
biggest assets," says a brochure from Merrill Lynch & Co. "It's also a
powerful borrowing tool." A Merrill spokesman said the home-equity
loans it offers to consumers are "prudent."
Mark Balderston, a chiropractor in Shawnee, Kan., recently refinanced
his home to extract money for a down payment of about $50,000 on a new
home he and his wife are buying as a rental property. Mr. Balderston
says he got the idea from a fellow chiropractor who has built a
fortune on such investments in California. Though he's taking on more
debt, Mr. Balderston figures that real estate is far less risky than
the stock market. "If we can get a 5% or 6% return on our money every
year, that's attractive to me," he says.
Why are people like the Balderstons so confident of strong returns
from real estate even amid growing warnings about the dangers of a
housing bubble? "People form their expectations on a backward-looking
basis," says Jan Hatzius, an economist at Goldman Sachs in New York.
Based on the experience of recent years, they tend to see real estate
as a very promising investment, he says, adding: "That's probably not
correct.... You should think pretty hard about whether you want to
increase your exposure to real estate at a time when it is trading at
historically high valuations."
Like the Epsteins, who used their home equity to buy rental housing in
Maryland, many real-estate investors see the stock market as far
riskier. "If you buy stocks," Mr. Epstein says, "the next day they can
tumble in the toilet." Home prices can't fall nearly as quickly as
stocks, he reasons, because people tend to hang on to their real
estate when prices are weak and await an upturn.
And unlike those who buy stocks with borrowed funds, home buyers don't
face margin calls, or demands from their creditors for additional
funds, when prices fall. Besides, many investors believe immigration
and baby boomers' demand for second homes will keep the market solid.
Mr. Epstein, 48 years old, wants to continue building up his
rental-housing investments, which already account for more than 90% of
his net worth. He is keeping his day job as a manager at a
home-building company, but his wife, Kelly, plans to leave her sales
job to focus full time on managing the couple's rental units and
pursue further investments. They rely heavily on advice from their
mortgage broker, Bill Deavers of First Metropolitan Mortgage in Prince
Frederick, Md., who also invests in rental properties. The Epsteins'
favorite technique is to buy houses from people who are on the verge
of losing their homes to foreclosure. The sellers then often become
tenants of the Epsteins.
Tim Gamber had $35,000 in his retirement account when he used a
mortgage on his home to buy a piece of investment real estate nearly
seven years ago. Mr. Gamber started buying property as a sideline five
years ago and made it a full-time job after he lost his job as a title
examiner two years ago. "I started leveraging myself as much as I
could," he says. "I was really scrambling to secure my financial
independence." Today, he owns about 40 properties that he values at
about $25 million; he puts his debt load at $15 million to $16
To make the deals work, Mr. Gamber turned to so-called option
adjustable-rate mortgages, or option ARMs, which carry introductory
interest rates of less than 2% and give borrowers multiple payment
choices. Option ARMs can be particularly risky because the interest
rate adjusts as often as once a month. If rates rise, borrowers who
elect to make the minimum payment can see their loan balance grow, a
plight known as negative amortization.
But for Mr. Gamber, they are a way to maximize his buying power.
Buying real estate "wouldn't be as attractive" without the option
ARMs, he says. With the low rates, option ARMs increase his cash flow,
allow him to "leverage and buy more property and bet on appreciation,"
Mr. Gamber says.
Some investors are already tripping up. Bruce Drogsvold was desperate
to find an investment property last summer when he spotted a
five-bedroom, three-bath home in Boulder, Colo. Mr. Drogsvold, a
real-estate broker, and a partner had earned $30,000 apiece on a
previous real-estate investment. Their plan was to fix up and flip
three or four homes a year.
The pair purchased the house in Boulder for $340,000 last June, then
spent about $25,000 on improvements. To finance the purchase, each
partner took advantage of a home-equity line of credit, tapping the
appreciation in his existing home. By July, the refurbished house was
back on the market, priced at $410,000.
But selling the house proved more difficult than expected. The pair
cut the asking price to $389,000. Meanwhile, the Fed was pushing up
short-term interest rates in an effort to hold down inflation. Because
home-equity lines are typically tied to the prime rate, the Fed's
moves raised the partners' borrowing costs. "We are starting to
bleed," Mr. Drogsvold said in February as his outlays rose. By March,
the monthly payments on the two credit lines had climbed by a total of
roughly $500. They finally sold the home that month for $380,000, for
a loss of about $10,000 after calculating their financing and other
he experience hasn't soured Mr. Drogsvold on real estate, though.
Next time around, he says, he will figure a year's carrying costs into
the equation. "I have a big line of credit on my home," he says. "If
something juicy comes along, I want to be able to act on it."
What makes this get-rich-quick formula more dangerous is that many
investors are willing to buy properties on which the rent is too low
to pay for financing and other monthly costs. Their bet is that rising
property prices eventually will make these deals profitable.
Others invest with no immediate prospect of rental income. Jaime Nack,
an event producer in Santa Monica, Calif., recently used a home-equity
line of credit on her one-bedroom condo to come up with a $27,000
deposit on a Miami condo that will soon begin construction. She's
hoping that the Miami condo will be worth more when construction is
completed in two years.
When will this frenzy die down? "The way the consumer operates, they
usually don't back away from winners until they become losers," says
Joseph G. Carson, chief economist at Alliance Capital Management LP in