By Mike Heayn Real Estate 101
IF YOU HAVE BEEN LISTENING TO THE news the last few weeks you must have heard about the lack of liquidity in the marketplace and the current credit crunch. Many economists use these terms, but does the average person know what they really mean? I will try to shed some light on these abstract terms.
Liquidity is defined as the ability to convert assets to cash quickly. Real estate, excluding the last five years in Southern California, is an illiquid asset, meaning it takes time to convert into cash — and for good reason. Real estate involves two or more parties, has legal consequences and involves a great deal of cash.
Some of the wealthiest Americans have high net worth in the billions, but what they usually do not have is easy access to billions of dollars in liquidity. A person’s net worth is determined by adding all of their assets together and subtracting their liabilities — usually debt. The lower the total value of liabilities and the higher the value of assets, the higher the individual’s net worth. However, net worth is paper wealth. With changing markets come changing asset values. For example, if a real estate investor owns 10 properties, each worth $1 million with $500,000 of loans on each property, the investor’s net worth would be $5 million. However, if the same investor’s property values dropped by 25 percent, or $250,000 a property, the investor’s net worth would drop to $2.5 million.
The concern with liquidity in the real estate market has to do with availability. If real estate owners cannot convert assets into liquidity, they have to borrow or have credit extended to them. Most individuals who invest in real estate attain some sort of financing, meaning some part of the purchase price is borrowed. Financing usually involves a loan, which is to be paid back at a specific rate, over a specific time, with other terms and restrictions. One of the reasons this country has grown and become prosperous is because of financing. Borrowed money has been used for productive causes such as the construction of new schools, libraries, etc. A win/win situation is provided with financing — a borrower attains money for a cause which can be paid back over time, while the lender achieves a return on the lent monies.
The main cause of the credit crunch is due to subprime loans. These were loans given to people who would not be able to pay the loans back once the rates adjusted. As a result, banks make it harder for borrowers to get loans, which prices potential real estate buyers out of the market. The effect of the subprime mess leaves borrowers who cannot refinance their home (due to a reduction in value) forced to pay a higher payment (due to an interest rate adjustment increase) or have their home go into foreclosure. On the other hand, a person who can afford the new higher adjustable rate has capital going toward the payment, which restricts their ability to spend that money on other items. Capital needs to be directed back into the economy or the economy does not grow.
The availability of credit seems unimportant until the larger picture is viewed. With time, the credit crunch will pass and liquidity will return to the market place. Hopefully lessons will be learned and lenders and borrowers will be more prudent moving forward.
MIKE HEAYN is a Washington Mutual Multi- Family Loan Consultant. He (310) 428-1342, or e-mailed at
Originally published in the Santa Monica Daily Press print edition on December 12, 2007. Read the original PDF.