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Patrick Killelea: What Every Homebuyer (and Homeowner) Should Know Now

user profile picture Adam Taggart Nov 03, 2012
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For many, the collapse of the housing bubble was the trigger that began the era of economic slowdown Americans find themselves mired in.

But recently there have been growing reports in the media of a housing "recovery." So we've invited Patrick Killelea, founder of the popular housing site and author of The Housing Trap: How Buyers Are Captured and Abused and How to Defend Yourself, to clarify the situation.

The short answer is this: While there are some markets where home prices are back in line with both fundamental and historic norms, buyers still need to exert caution when making a purchase.

First, to the reports of "recovery":

Prices at the low end are definitely rising. All measures are showing that. But I don’t like to use the word “recovery,” because it implies there’s something good about rising prices. Rising prices are a kind of inflation. I’d be delighted if reporters would use the correct term and say "housing inflation return." But back to the point, prices are rising at the low end. But it’s not really an organic growth.

What’s happening is that a lot of investors realize two important things. One is that the price of a house in the biggest bubble areas like Phoenix fell well below the price implied by the rental evaluation. So these guys want to make a profit and they realize, if we buy up these houses and rent them out, we’re going to get a better return on our money than we can get anywhere else, especially with interest rates being as low as they are. The return on a rental property, often referred to, as “capitalization rate” can easily be 10% in these areas. And that’s huge. So that drew the attention of not only little investors, but also actually even big hedge funds. Although recently a lot of those have announced that they’re getting out of the game. They seem to have picked over a lot of these places, and there aren’t the deals that there were even a year or two ago.

At the other end of the spectrum are really expensive places like New York City. The crash was very muted, and it was hardly a crash at all. It was a downward trend in pricing. But what that means is, it’s still difficult, or maybe even impossible, to buy property in New York City and rent it out for a profit. You can’t do it. You’ll lose money. So if you were buying there, you’d be betting truly on appreciation that’s not justified by the underlying fundamentals. 

I said that investors realized two things. The other thing investors realized is that they have cash. Ordinary buyers, families, don’t generally have enough cash to buy outright. So that gives the investors a huge advantage, especially since lending is still pretty tight. Even with the low interest rates, it’s still considerably harder to get a mortgage now than it was in the big bubble years, 2004 and 2005.

So I’d say it’s an investor-driven recovery. And that recovery is really only in the places where they had a huge bubble and a huge crash. I’d say that it’s safe to buy in those areas, especially in places where the house is lower than the rental equivalent cost.

Patrick goes on to share the key elements to keep in mind when buying a house, including price-to-rent ratios, leverage limits, construction quality, and diversity of the local economy.

Beyond that, he shares his concerns about how the playing field when buying a home is slanted against the buyer's interests. He warns of numerous tactics the industry employs, most notably information asymmetry, that consumers need to be aware of, including:

There are all kinds of tricks that agents play. I list a lot of them in my book, but it would probably take several more books to cover it all. There is a lot of psychological manipulation of buyers. Agents are used-house salesmen. That sounds harsh, but it’s true. They are kind of like used-car salesmen: they’re not there to provide value; they’re there to get a commission. That’s their goal. And if you don’t buy, they don’t get paid.

A typical trick of theirs would be first taking you around and showing you extremely ugly and overpriced houses. And then they show you the one that they think you’ll buy. Maybe it’s overpriced as well, but not as bad. So you’ve got an anchoring effect, and it makes you a little more susceptible.

There are all kinds of other and evil games that are played. And because the whole housing market is very non-transparent, it’s very hard to pin them down. You don’t have any way of knowing if there are any other offers at all, because you’re not allowed to look at the other offers. You don’t know that they exist. So agents can lie with impunity and say, oh, there are twenty offers, and people just believe it. They think why would the agent lie?

Clearly, they’re not thinking hard enough. The agent has a motive to lie. And if you can’t prove that they’re not lying, the agent has the means, motive, and the opportunity to deceive you for profit. That would be enough to convict them if they were in court. But it’s normal business practice in real estate, so nobody seems to think twice about it. 

And agents and house inspectors often have a cozy relationship. Maybe a little too cozy, where the agent recommends an inspector, and the inspector sort of passively agrees he’s not going to find anything. He gets business from the realtor, and the realtor gets the recommendation that you should buy it. You should really separate those things. Don’t take the realtor's recommendation for an inspector. Find your own inspector, preferably one who has nothing to do with that realtor. 

Patrick also shares insights from his analysis of years of national home purchases. These include: don't sell too often (the transaction costs will kill your returns), don't upgrade too frequently (it's more costly than you think), and it's worth it to transact without an agent if you're able to do so.

Click the play button below to listen to Chris' interview with Patrick Killelea (39m:55s):

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