THE BUBBLE HAS BURSTED!

Sorry this one is long...

The Beach Bubble

For those of you in the SE, you know what has been going on in Florida over the last 4-5 years with beach front property, for the rest of you I will try to explain it quickly. All along the coast of Florida (and elsewhere I assume) the price of beach front property has soared and developers are throwing up "skyscrapers" full of condos on every square inch on land they can get their hands on.

It is estimated that more than 70% of all beach front property owners are speculative investors. Many are taking advantage of the perceived buying power associated with ridiculously low adjustable interest rates and interest only loans to purchase property that they feel certain will bring them a financial windfall.

As long as conditions remain ideal for borrowing money, demand will remain high as more and more people decide to get in on the action. If demand remains higher than supply then you will, of course, be able to make a profit. Here is the problem, when interest rates start to rise, as they are starting to do now, you will witness a quick and bloody exit from the beach market. This will resemble the rise and fall of some of the .com stocks from years past. Many of which were also inflated in price based purely on speculation rather than solid financials.

Let me start by introducing a basic and key fundamental in real estate market stability… Demand. In the Residential Real Estate market basically 3 types of Demand exist. First, “Real” Demand is created by JOBS which in turn create a NEED for housing. This is the most basic and reliable type of Demand as it is predicated on necessity. Second, “Supplemental” Demand is created by secondary or vacation home owners purchasing a property in a recreational location primarily for personal use. Supplemental Demand is less stable than Real Demand as it is based on wants rather than needs. Third, “Artificial” Demand is created as pure speculation replaces either Real or Supplemental Demand and property values rise above a level that is supported by underlying fundamentals. Artificial Demand builds momentum as increased demand outstrips supply. This is the least stable of the group as it is based almost solely on consumer confidence.

In a "resort town" you can watch Supplemental Demand develop as the economy improves and people feel that they have more expendable income to purchase vacation homes. If demand builds too rapidly it creates a phenomenon that draws in speculators and armchair investors alike creating a condition of Artificial Demand. If money remains “cheap” then this condition can continue to build for some time. The hitch to this is that the lone exit strategy for these speculative investors relies on continued market fever and limited supply driving other individuals to purchase their property at an even more ridiculously inflated price. When market conditions change, demand begins to subside as supply rapidly increases. The bloodbath that ensues can be devastating.

The catalysts of this market downturn will be as follows:

Catalyst 1-As the interest rates rise, a large majority of people that were considering buying beach property will suddenly decide that, given the rising interest rates, they can't afford to own a second home. Supplemental Demand will begin to dry up.

This will be a wake up call for people that have already leveraged themselves to the teeth with interest only-adjustable rate mortgages as a means of affording their beach property. They will find that their payments have risen dramatically on their primary residence as well as their "investment" property/vacation home. They will have to sell one of their properties in order to keep their heads above water. Not too much of a shock that about 99.6% of these families will sell their resort property first. So almost over night (actually over several months) you will have a huge influx of sellers into the market and that pool of sellers gets progressively larger with every up tick of interest rates while the pool of buyers conversely gets smaller and smaller.

Catalyst 2-During this phase, the better financed investors that CAN afford to hold on to their property in the face of rising interest rates witness the market downturn. They also decide to dump their property rather than watch all of their equity evaporate as property values slide to the point that they would have a negative equity position. This, of course, drives up supply even more as demand continues to shrink.

Catalyst 3-Remember the developers that I mentioned earlier that are building condos everywhere you look? They have ramped up their production to try to take advantage of increased demand and are now churning out units at a blistering pace. Many of those developments take 12 to 18 months to complete. As a developer, you can not stop in the middle of the project because demand has dried up, you must finish the development. This means that after the market starts to turn and everyone starts selling, the developers will continue to pour huge numbers of condos, Town homes and single family residences into the market for at least 18 months past the point of market reversal.

As you can see, this scenario can be a recipe for disaster for many small investors and 2nd home owners. As investors, this market downturn will represent a substantial opportunity. Their will be a healthy number of foreclosures to deal with in the aftermath and banks will be in a very accommodating mood from a short sale standpoint. The cautionary note here is to wait until the market has fully corrected. Jumping in too early may cause you to be sucked down with the falling market.