Real Estate Is Hot…Don’t Get Burned.

f the 1990s were noted for irrational exuberance in the stock market, certainly the early 2000s will be remembered for hysteria in real estate. How hot is it? Sales of existing homes in the western United States rose 5.1% to a record-breaking annual rate of 1.66 million units changing hands in January 2003—3.1% stronger than January 2002—according to the National Association of Realtors (NAR). With it went the median existing-home price, which soared to $219,600—an amazing 10.4% spike from the same month a year earlier. In the Northeast the median existing home price was $175,000, up 14.9% from a year ago. With the stock market still in the doldrums, it’s no wonder people are considering home buying a better bet. But is it?

Whether the exuberance in today’s residential real estate market is rational or not, only time will tell. In the meantime, how should CPA/financial planners advise their clients in this volatile climate? Should clients buy houses and “flip” them like so many poker chips? Can houses be expected to yield returns like other investments? This article answers those questions and highlights some of the areas where CPAs can guide home buyers and sellers to a smooth transaction.

“Generally, we CPAs don’t like debt,” notes Bob Doyle, CPA/PFS, a partner in Spoor, Doyle & Associates in St. Petersburg, Florida. “Now that tax and interest rates are so low and itemized deductions are limited, the tax benefits of debt are not as attractive as they used to be.” Despite the absence of these benefits, Doyle is having a hard time telling his clients not to borrow for 30 years at 5%. “Even though the client pays much more interest on a 30-year vs. a 15-year loan, with rates as low as we’ve seen in a generation, I feel compelled to support my client’s borrowing plans.”

However, there has been less argument for recommending adjustable rate mortgages (ARMs) in this market. Ciullo says the interest rate on an ARM is fixed for a short period, say three to five years. After that, the rate floats based on an established index, such as the one-year Treasury bill rate. “Mortgage bankers love ARMs,” says Ciullo. “But adjustable rate loans are wise only in the short term,” he says, since rates could start heading up. That possibility puts the borrower “constantly at risk” unless he or she refinances, with all the associated costs of doing so. Ciullo’s bottom-line advice: An ARM is not a good choice unless you know you will occupy the home only for a short time.

Doyle agrees: “I don’t think there’s a lot more downside potential left in rates. The trend seems to be more toward the upside. So why use an ARM if you’re going to be in the home for a long period of time?” Eventually, homeowners who don’t pay off the debt quickly or sell their houses have to refinance to a fixed-rate loan—usually after rates have started to climb. At that point, what had seemed like a cheap, quick and cheerful way to grab low interest rates may come back to bite them.

The CPAs interviewed for this article agree with this rationale, up to a point. “You don’t want to be the most expensive home on the block,” says Doyle, who also serves as chairperson of the AICPA personal financial planning executive committee. “People want to live next door to better—not lesser—houses. When it’s time to sell, the lower-priced houses in the neighborhood also could compete against you.”

Besides, says Doyle, in this market “people already are expecting to pay an arm and a leg for a fixer-upper. Why put anything into it unless you’re planning to stay for awhile?” CPAs should advise clients to make large-scale improvements only if they plan to stay in the home long enough to enjoy them, perhaps 5 to 10 years. Since most home improvements don’t translate dollar for dollar to an increase in property value, remind clients they are making the renovations for themselves, not the next owner.

FIRST-TIME BUYERS
The low rates also are tempting some younger clients to become first-time home buyers: Some 42% of 2001 buyers were in this category. Many CPAs have clients who have decided that buying a house—despite the sellers’ market—is the best decision for them. And while this isn’t an entirely bad decision, accountants may want to suggest a little caution.

NAR President Cathy Whatley, owner of Buck & Buck Inc. in Jacksonville, Florida, says even with the strong momentum the association expects a temporary drop in home sales. “About a fifth of the country was essentially shut down for the better part of a week in February due to the huge snow storm in the East, so we shouldn’t be surprised to see a negative impact on home sales,” she said. “However, the disruption will only postpone transactions and we should see strong housing activity throughout the rest of the year.” While that’s encouraging, of course it’s not a guarantee.

For many first-time buyers, affordability is a big issue. With interest rates at record lows and banks eager to lend, clients may qualify for a great deal of mortgage money, perhaps even more than they can carry comfortably. Should CPAs recommend clients borrow all they can in this low-rate environment? Ciullo recalls clients who were eyeing a luxurious $700,000 house, for which the bank recommended a 20% down payment. With help from their parents, the couple could have even gone to 40%. Or the couple could have put down only 20% and borrowed over $500,000.

But the monthly mortgage payment on such a loan would come to about $2,300 plus escrow for taxes and insurance, and the utility costs of maintaining a large home would be high. The couple’s projected finances didn’t make it under Ciullo’s general rule: one-third of pretax income for house and mortgage, one-third to live on and one-third for taxes. So he advised them to put 30% down and reserve the balance for improvements.

How can CPA/financial planners ensure their clients—first timers and repeat buyers—survive today’s real estate market? The process can be complicated and involve bidding wars, affordability, financing, contract negotiation, inspections and warranties. Here’s what some advisers are telling their house-hunting clients.

COMPETING FOR WHAT YOU WANT
“Two things matter to the seller—price and terms,” says Phyllis Bernstein, CPA, of New York City-based Phyllis Bernstein Consulting Inc. “He or she wants the highest price possible and the best terms available. Both of these areas leave room for negotiation. Just because a seller is entertaining multiple offers doesn’t mean the client will lose the house. The offer just has to hit the right note with the seller—the one the other contracts don’t.”

Bernstein says: “The seller will accept only terms that meet his or her own needs, so CPAs should advise a buyer to keep contingencies to a minimum. The buyer should ask his or her agent to find out from the seller’s agent what terms the seller will view most favorably. If a buyer can’t get there first, he or she should be competitive and flexible.” Bernstein says this includes offering to pay some of the seller’s closing costs or being willing to accommodate as many of the seller’s wishes as possible, including move-out and closing dates.

For example, the buyer might be willing to let the seller rent the property until her job transfer is complete or agree to pay certain closing costs.

The reality in today’s real estate market is that everything is linked, says Doyle. “I’ll buy this, if I can sell that. If I’m a seller and have a buyer who doesn’t have to apply for a mortgage—who plans to pay cash—that means the deal is not contingent on his or her selling a house. Even if that buyer is offering $3,000 less than someone else, I may take it.”

Conversely, a buyer may need a mortgage contingency in the contract if he or she thinks the appraisal may not come up to the purchase price less the promised down payment. Let’s say your client is buying a house as-is for a purchase price of $200,000 and plans to put 20%, or $40,000, down. The mortgage company wants something done—a new roof, a new porch and some masonry work on the driveway—and devalues the appraisal by the estimated $15,000 cost of that work. With a $185,000 appraisal, the bank will lend 80% of that amount, or $148,000. If the client was counting on borrowing $160,000, he or she could be short of cash on closing day. Depending on the contract, the buyer could also risk losing his or her deposit due to default. A contingency clause allows the buyer to back out if the lender lets them down. (Most banks will lend more than 80% of the home’s value if the purchaser acquires costly mortgage insurance.)

Prospective buyers can get a leg up on the competition by being preapproved for the mortgage they will need to buy houses in their price range before they start to shop. For example, buyers looking in the $250,000 to $300,000 range may want to get preapproved to borrow up to $275,000 depending on how much they plan to put down.

Getting preapproved is as easy as calling a local lender and answering a few simple questions about income and assets and agreeing to a credit check. CPAs should recommend a client get the approval in writing. Sellers entertaining competing offers will frequently ask to see it and may favor buyers who already have mortgage financing lined up. The buyer is under no obligation to use this lender for the final mortgage and is free to shop around after signing the contract.

Lenders have a ceiling on what they will lend on homes in a given area, broken down by square footage, age, history and other factors. This limit is based on an appraisal formulated from current market analysis, tax-roll data and gut instinct. Bernstein says that if the comparables don’t justify the price, “the lender may refuse to take a chance on being the first to raise the loan limits on a certain neighborhood or home. If that happens, you might as well throw in the towel. But sometimes a lender’s refusal can be the kick in the pants a seller needs and she or he may agree to a lower price when confronted by the voice of reality.” The bottom line for CPAs is to recommend buyers set a maximum price they are willing and able to pay for a particular house before they enter any negotiations and stick to it. It’s the best insurance against overpaying.

A SELLER’S MARKET?
Many experts say sellers have most of the advantages in today’s hot real estate market. But sometimes selling isn’t the best option for clients who like their neighborhood, schools and home but simply need more space. According to Bernstein, many homeowners decide that with a little remodeling, their existing home will offer them most of what they need. She says “expert remodeling work can add comfort and space as well as enhance the value of a home.” Bernstein cautions, “Given the cost of relocating, remodeling is almost always more cost effective than moving.”

When clients ask for advice on whether to sell or remodel, here are some questions Bernstein recommends CPAs ask them to consider:

How does the location of your present home compare with areas to which you are considering moving?

Try to imagine your present home after you remodel it. How does it compare with the home you might purchase?

How much will it cost to purchase things such as furniture, appliances, landscaping and window coverings for a new home?

What costs will you incur for things such as real estate commissions and presale fix-up to sell your present home?

How long have other houses in your neighborhood stayed on the market before they sold?

How much will you have to pay in closing costs to buy a new home?

How do these expenses compare with the cost of renovating your home so it meets your needs?

Bernstein says sometimes moving to a new home in a new neighborhood is the best decision. But for clients happy with the area where they live, their commute and amenities such as shopping and recreation, remodeling will be the right choice—even considering the cost and disruption associated with making large-scale changes to an existing home.

Bernstein says CPAs should caution clients not to remodel if they plan to move soon or because they believe they will recoup their investment when they sell. She cites a survey by Remodeling Magazine which shows that while a minor kitchen remodel will enable a homeowner to recoup 94% of his or her investment, remodeling a bathroom will only add 77% of the cost to the resale value and replacing windows only 68%. The bottom line, Bernstein says, is that “not all home improvements are equal.”

FINANCING ISSUES
Today’s lending market is so competitive that some qualified buyers can even borrow the down payment—something unheard of in the past. “Lenders are being much more creative,” says Grant. “If the loan-to-value ratio is not high enough, often the same lender will give the client an equity loan for the difference. The bank splits it into two loans.”

Even down payments are low today. “They’re usually only 5% to 10%,” says Jack Mondel, owner of American Mortgage Express Corp., a Cherry Hill, New Jersey-based mortgage banker, which manages more than $1 billion in mortgage money. (Mortgage banks actually loan the money, whereas mortgage brokers act as middlemen to get financing for clients from other lenders. Most brokers are compensated by the lender for bringing in a new client.)
The best way to ensure a good deal for your money, says Mondel, is to pay points. These are a percentage of the loan amount, usually 1% to 3%. This money goes directly to the lender, lowering the risk of the loan. The lower risk is reflected in a better interest rate for the life of the loan. The more points the buyer pays, the lower the rate.

However, if the applicant lacks adequate income or has poor credit, that will increase the rate. Typically, on smaller loans consumers also will pay higher points or a higher interest rate. Since points are generally tax-deductible, the buyer can apply the lump payment to reduce his or her taxes in the year of the purchase. Other typical borrowing costs include an appraisal, a credit report, an application fee as well as title insurance and escrow deposits. In some states the buyer retains a lawyer to advise on the transfer. Closing costs can range from $3,000 to $5,000 depending on location.

With interest rates so low, experts generally recommend fixed-rate loans. However, balloon mortgages, which borrowers must pay off with a single “balloon” payment after a set number of years, are very tempting to some consumers because of low rates that today start at 3% to 4%. Variety is definitely the name of the game today, says Grant, who cites five- and seven-year adjustable rate mortgages, as two examples. They offer fixed low rates—right now 4% guaranteed—for a short period followed by an indexed rate tied to the London interbank offered rate (Libor) or the 11th District Cost of Funds. Since the average person stays in a home only about seven years, Grant thinks these may be preferable to long-term fixed-rate mortgages. For those who plan to be in their homes for a long time, conventional fixed-rate loans are the best option.

Web sites offered by banks and other mortgage lenders can give prospective buyers an idea of how much house they can afford based on their income and available down payment. CPAs also can direct clients to other sites that help prospective buyers get an idea of what housing prices are like in their target areas. See the exhibit for a list of some of these resources. By analyzing three factors—mortgage, down payment and home prices—clients can make sure they don’t overextend themselves by biting off more home and mortgage than they can afford.

In addition to affordability there’s another reason why clients shouldn’t go whole hog on a house. Some people forget they still need to reserve some of their income for the future—to save! “It could be the main reason people fail to achieve their financial goals—overallocating assets to their residence,” says James Shambo, CPA/PFS and founder of Lifetime Planning Concepts in Colorado Springs, Colorado, which specializes in retirement and investment planning.

“The best question clients should always ask themselves is: ‘What could go wrong?’” Shambo says. Citing job security issues, economic uncertainties and war, Shambo asks his clients: “How secure are your income streams? You’re only as secure as the largest employer in your region.” Shambo has a rule for home expenditures. “Never mortgage 40% of your income,” he says. “Anything above 30% is a heavy burden.”

USE COMMON SENSE
For many Americans the home of their dreams is just around the corner. CPAs can help those dreams become a reality by advising clients to use caution in shopping for a home, staying within their budget and selecting a loan and lender. While most of the advice offered here may seem like just common sense to some, clients buying homes too frequently give in to the emotion of the moment and sacrifice good judgment as a result. CPAs can help make sure a new home purchase doesn’t become a nightmare because the client overpaid, accepted unfavorable terms or selected the wrong mortgage.