We Buy Houses

In my favorite book, Zen and the Art of Motorcycle Maintenance, Pirsig describes a process he calls analytic description. Such a process "discusses things in terms of their underlying form". He then gives us an example by describing a motorcycle:

A motorcycle may be divided for purposes of classical rational analysis by means of its component assemblies and by means of its functions.

If divided by means of its component assemblies, its most basic division is into a power assembly and a running assembly.

The power assembly may be divided into the engine and the power-delivery system. The engine will be taken up first.

The engine consists of a housing containing a power train, a fuel-air system, an ignition system, a feedback system and a lubrication system....

And so on... This is a classical approach to understanding something. You take it, you divide it up into pieces. Then you divide those pieces into more pieces, and keep going until you feel you can divide no longer. The "it" in this process can be a thing, a role, an idea, or even a process itself. Scientifically the goal of such a practice is to accurately describe the components of whole. Philosophically the process can be used to "Look Closer" and force yourself to see things that your mind has been filtering out.

For example, the goal of real estate investing it creating value. Value can be realized either at the time of purchase or the time of sale.

At the time of purchase value can be realized by purchasing undervalued property, which can be divided into buying from a "motivated seller", buying in a soon-to-be-improved area where prices will climb, and buying a distressed home.

Buying from a "motivated seller" can further be divided into buying a foreclosure from a bank, buying at an auction and buying from a seller in financial trouble.

Of course, once, we've finished dealing with all the subsets of motivated sellers, we have to go back up to describing the process of buying in a soon-to-be-improved area, and eventually we need to go all the way up to the top and describe the means by which value can be realized in selling. I hope you can start to see the interest in such an exercise, because I'd like to stop here and discuss one of the "motivated sellers" I described.

One of the time honored business models for buying discounted homes has been the "We Buy Homes" model. You've all seen the signs on the side of the road, variations of "We Buy Homes in a very short time and pay cash!"

The purpose of such a business model is to find sellers in dire financial straits who are either currently facing foreclosure, of will likely be so soon. Then you can swoop in and offer to pay cash for their home (usually at a 70-80% discount, from what I hear). Why would a seller ever agree to that?

Let's imagine for a second that you are a hard working American. You bought your house 10 years ago (say for $100,000) and have seen properties rising all around you. Unfortunately a medical disaster has crippled your finances and the creditors have come calling. You don't have enough money to make your house payments. The bank is threatening to foreclose. The rising property taxes is only making the situation worse.

Then a buyer comes knocking on your door and offers you $200,000 for your house. Other houses in the neighborhood are selling for $250,000. If you accept their offer you will walk away with $100,000 cash (more since you have paid down some principle on your mortgage through the 10 years).

Now the situation is not quite as dire as you think. If the bank forecloses on your home, they will then sell it (first through a realtor, and then at auction), and after they've paid all creditors who have a lien against your home (which it typically just them and any second mortgages), they have to turn over the balance to you. However, it's uncertain on when the home will be sold, what fees will be paid to Realtors/auctioneers, AND there will be a foreclosure on your credit report for the next 7 years.

So by taking the buyer's offer you are trading the possibility at some extra money (depending on the offer, it could be a considerable sum), for the certainty of money now and the prevention of a foreclosure on your credit report. For many people this is a very fair deal, often people in these circumstances have far too much uncertainty in their lives already and could use help in resolving a couple of their issues.

The business models is certainly a sound one, but it relies on a few conditions that are going to be harder and harder to meet in the coming years. It's my belief that this model will struggle greatly for the next 3-5 years, and may never quite recover due to the recent revolutions in the finance industry (and personal financial habits).

First I feel it is my duty to mention that one of the conditions of making this model work is having enough cash to pay for the home outright. Because the deals you are offering have to close very quickly, there often isn't time to bring in a mortgage, and the appraiser, and the paperwork... etc. This is not a model to follow if you have "No Money Down!"

But the number of people with enough money to make this model work is only growing, as is the number of individuals who are unable to make their mortgage payments and are facing foreclosure. So why is this model in trouble? Because it relies on one last, crucial, condition. The distressed home owner must own a reasonable level of equity in their home to make this work.

The home owner's equity is everything. The value you get is the equity that the home owner is willing to forfeit to make the deal go quickly. The value the homeowner gets is the remainder of their equity in cash form. If the home owner has little, or no, equity the deal simply can't be done. What homeowner is going to accept $200,000 for a home when they owe $225,000? At that point you are facing trying to accomplish a short sale, which is a completely different set of circumstances.

So the problem with the We Buy Homes business model is that the number of potential sellers is declining rapidly. It used to be that everyone bought a home with 20% down, guaranteeing a certain level of equity. Today 100% mortgages are one of the fastest growing loan types. Owning a home for 5 years used to mean at least a small level of equity with a fixed rate mortgage. Today, with interest-only loans and negative amortization loans, there's no guarantee. Even someone who has owned their home for 15 years isn't guaranteed to have any equity built up thanks to the proliferation of refinancing and home equity loans...

Since the vast majority of foreclosures we'll see over the next 5 years will tied to people with crazy ARM loans, who bought houses at inflated prices, it's unlikely that a discount investor will find many deals out there pre-foreclosure, if any.

Could this business model make a comeback? Possibly, but that would rely upon two things happening:

1. American home prices stabilizing. A wild market (which is what we've had for the past 6 years) is not good for this type of investing. To ensure a profit, we need to understand the home pricing within the area, which means somewhat stable growth.
2. Americans getting wise about their finance. We've become too much of a consumer society, where we're completely unafraid to sell our future for a toy today. As long as that mindset persists, the odds of actually finding a distressed seller with actual equity is very slim.

The first is extremely likely. Housing markets, like every other market, follow a cyclical pattern. After the current housing slump, it's likely that we'll get many years of solid, stable growth, and then have another boom, followed by another slump. The pattern is definite, the timing is not.

The second is very hard to predict. I would hope that American society at large would eventually settle down from it's consumer binge and enter an era of fiscal responsibility. But trying to predict whether or not that will happen is an exercise in futility. If the above model interests you, then the best you can do is try to build up your cash reserves and prepare yourself for a time when you can find distressed buyers with equity.