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Risk; Let’s talk about risk a misunderstood concept September 29, 2008

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This week is risk week at Uncommon Financial Wisdom.  I will post all week on risk, what it is, what it isn’t, how to manage it.  But first let’s talk about what risk is!

I divide investment risk into four areas, strategic risk, systemic risk, emotional risk, and longevity risk.  Today we will talk about strategic risk.

Strategic risk is a variable that often gets left out of the discussion. It is the risk that your strategy will not give you the needed returns to reach your goal.

It easiest to understand by using specific examples. Let us begin by saying you have built a wealth plan that requires you to get a 10% rate of return from your investments in order to reach your goals. Now you look at the world of investments and you note that the stock market has returned 10% since WWII, real estate has returned 6%, and bonds 6%. So you figure equities is where you want to be.  However, what are the chances you can get this rate of return?  That is the risk.  Since, you can’t buy the whole stock market you settle for a broad based indexed mutual fund.  However, all mutual funds have expenses.  Now we know that the average mutual fund has returned around 7.5% over the last 35 years. Not bad, but we can’t find a single mutual fund that has returned that high over that long of time period, and certainly we can’t find one that has returned 10%.  So that forces us to trade mutual funds searching for funds that are doing well while our existing one is not in order to try to pump up the return.  But research has shown that active trading, on average, lowers our rate of return.  So for this investment we see there is a large amount of strategic risk.

Lets look at real estate. On the face of it a 6% return will not get us anywhere close to our 10% requirement. But, we can safely use leverage with real estate. Lets say we purchase our re investment with a 80% Loan to Value mortgage, so we are leveraged 4 to 1. Now there are huge swaths of the country where putting 20% down will give you a positive cash flow, but lets be conservative and say our expenses equal our costs for this real estate.  For the time being lets not count our depreciation, real estate taxes, and mortgage interest, tax savings.  And lets say we allow our loan to value to go to 50% before we put that equity to use again so we have a two to one average leverage over the long run.  With a two to one leverage situation for every 1% appreciation we get 3% rate of return.  So if over the long run we get the historic average (6%) our rate of return will actually be 18%; well more than we need to reach our goal.  Now what is the strategic risk with real estate? If the long term real estate return is only 4% (33% less than the historic average) we still make our goal with some to spare.  Would we say that our strategic risk is exponentially less than with mutual funds? I would!  Comparing odds, what are you chances of getting 25% more than the historic average for mutual funds compared with getting 33% less than the historic average with real estate? And remember we set aside the tax advantages for real estate, and did not count any positive cash flow that would likely accumulate!

Here is another quick example. The historic average over the last 40 years of an average mutual fund (can’t really find a mutual fund that has been around that long with the same money manager) is 7.5%.  The historic average for Berkshire Hathaway over that same time period is 21%.  What are the odds of that Berkshire Hathaway going forward produces returns 1/3 as high as its 43 year history?

Note that financial planners never talk about the strategic risk of any given investment. Nor do they build plans that give you any idea of what the needed rate of return will be to obtain goals. Now you know why.


Let’s me teach you how to build the bridge to your goals instead of that bridge to nowhere!

Double Edge Sword September 9, 2008

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Today we have Jeff Brown giving us another great guest post.  Jeff is as experienced in investment real estate as you will ever find.  Hope you enjoy!

A Makhaira (ma – ki – rah) is the name used, in Koine Greek, (Created, in part by Alexander the Great as the “common language” for his huge military), a dead language, for sword. It was often used, (to the confusion of many) when talking about the sword used by Roman soldiers. They actually used, for 2-3 centuries, a sword referred to as gladius. Keep the faith — slowly but surely, this will dovetail into real estate investing for retirement. The gladius was different. It’s design aided the Roman legionary’s battlefield tactics. First, it was much shorter than what we’ve come to know as a sword. The blade was usually only 19-20″ long. Second, it was double edged, able to cut savagely both ways — a huge improvement. Third, its design went away from the oft used leaf shape, to a simple, straight blade. These changes were a result of Rome’s enemies modifying their defenses. I won’t bore you with the details here, but here’s a description of what a legionary was now able to do in battle. While holding his shield with one hand, he held the gladius in the other, like most soldiers of the time. However, his sword sported a much shorter blade, which helped him get inside his opponent. Also, if his first downward slanting-cutting motion missed his target, it wasn’t necessary to raise his sword arm to try again. He simply reversed the motion, essentially a backhand, and saved precious time, (if not his life) by wounding or killing his opponent that much more quickly. Also, because he was working with the relatively shorter blade, and was therefore more easily able to get inside his enemy’s kill zone, it was far easier for him to thrust into the abdomen, an almost guaranteed kill shot. It was a truly effective (read: nasty) weapon, made possible by it’s planning, vision, knowledge of the enemy, and ultimately, design. Where’s the Roman legionary’s flexibility? His javelin, known as a pilum. It was roughly seven feet long. He used it for both throwing, and thrusting. He had a weapon for close, savage, infighting in the gladius. His javelin gave him the option of dealing with his enemy from a longer distance. The goal was, however, the same for both weapons — victory on the battlefield. And yet… Most military historians agree — the gladius wasn’t really the primary reason for Rome’s military dominance. It was their vision, forward planning, objectivity, but most of all — their massively superior training — which produced brutally reliable discipline. Their vision, planning (Purposeful?), and objectively focused discipline, not only carried out that superior training — but created the ability to be flexible when confronted with (sometimes rapidly) changing circumstances.

Here’s how we can look at this from a real estate investment viewpoint. Leverage, the right financing, solid location, quality construction, tax shelter, tax deferred (1031) exchanges, are all examples of the investor’s gladius and pilum. But they’re not what makes an investor victorious. What provides ultimate victory, defined as a magnificently abundant retirement, is vision, Purposeful Planning, objectively executed, while seasoned with flexibility. BawldGuy Axiom: Don’t mistake the weapons in your arsenal as the way to victory.  What will, in the end, provide you with your dream retirement: vision — plus Purposeful Planning — combined with objective execution and flexibility.  Create your own empire. First though, you have to ask yourself what you want it to look like. What does your retirement look like? Or rather — what does it look like if you keep doing what you’ve been doing?

Thanks Jeff.  You have a way with words!

Real Estate Bottom? September 3, 2008

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In the county I live in Florida, real estate prices went up 1.6% last month.  This is after two months of flat pricing.  So, for the last three months we see a 1.5% uptick.  Nothing to write home about, but definitely a change from the 10% drop the quarter before.  So have we hit bottom here?  Not one to make predictions on market bottoms, but the environment has certainly changed.  I certainly wouldn’t argue that the real estate market is healthy again. 

So where are we now.  Well credit for all those with little credit issues has gotten more expensive.  Those with big issues are locked out now.  Down payments are now required, even by FHA (After October1).  Rates are still historically lower than average.  Supply is still high, meaning it is a buyers market.  Foreclosures are still an issue, although this seems to be more about recent job losses than anything else.  Credit issues is general are being seen in all credit markets (credit cards, auto’s, mortgages) lending credence to the thought the business downturn is the cause. 

Rents still have some downward pressures.  And of course some areas of the country are much stronger than others.  However, if we are starting to see trend reversals in my county in Florida, which has been one of the worst hit by the real estate downturn and unemployment, then other areas can’t be far behind.  Why is this important?  Well, as real estate goes so does people’s attitudes.  And it is peoples attitudes that will change the economy.

Just some thinking points for folks out there.  Have a great day and increase your wealth!!!!!

Notes from the Investment World. August 20, 2008

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Haven’t posted in a few days due to being out-of-pocket for some meetings with a real estate developer I am invested with and doing work for.  Thought I would post some quick thoughts today:

1.  I have said it before, but this summer has really driven it home to me.  Real Estate is LOCAL. While everyone is my circle of friends in the real estate business is doing poorly in Florida, and those who have houses for sale are dropping prices in a desperate attempt to sell their houses, in Massachusetts it is a very different situation.  Three folks in my circle have sold their homes at asking prices in less than 45 days.  All these houses were at different price points and in different towns.  Not to say that the real estate market in New England is booming, just that the situations are completely different.  A real estate investor must keep the fundamentals in mind and not limit their investments to their particular geographic living situation.

2. Emotions rule the day for the stock market.  Makes it incredibly important to think long term and globally about stock investments.  Trying to out-guess the emotional movement of the market is simply impossible, leaving only luck as your guide.  If you have done your homework and have good long range thinking, then you simply apply your buying strategy methodically (The Buffett Way).

3. The list of folks who started their businesses in a recession is long.  It simply doesn’t matter as long as you have enough starting capital and a good business plan.

4. Layoffs are so commonplace now, that unless the numbers are huge, it doesn’t rate even mentioning in the main-stream press.

5.  Looks like we are going to see a whole DECADE of zero growth for the S & P 500 stock index.  This is devastating for the largest group of baby boomers as they were trying to play catch-up with their retirement funding.

6.  This stock market issue is also creating huge problems with local municipal pension funding.  Raise taxes or lower benefits or worse!  I expect this to be the next crisis the media exploits.  Anyone that thinks taxes are going down or even remaining stable needs to take a look at the pension responsibilities!

7.  Once again the “experts” and “talking heads” are failing to see reality for what it is, demonstrating mid-20th century thinking, in an environment that needs mid-21st century thinking! 

Analyzing Real Estate; The Basics July 31, 2008

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Ok, so the mass media is pummeling real estate every day with more bad news.  All you need to know about real estate is that it is in trouble, right?  Well, no!  Today I will go over real estate as an investment.  Regular readers know that wealthy people have their largest chunk of their net worth in real estate.  They also know I love real estate as an investment for the middle class because of the leverage one can use.  Suffice it to say that the data is conclusive when it comes to investing in real estate.  It is a great investment as long as it is done correctly.


First let talk about types of real estate investment.

1. Your Primary Residence.  There is debate as to whether this should be considered, but I think since the data indicates that most people have significant savings in the form of home equity it should be included.  First let me say this, if your home is the only form of savings you have, you are in big trouble.  You should be considering equity management practices, which I have posted about before.  Now owning your primary residence is a good idea is most cases, although there are some exceptions.  My advice is buy close to your work, within walking distance if possible, buy small, use equity management strategies, and realize real estate is a long term investment.  The point is to minimize your cost of living so you have more money to invest.  If you spend all you have for housing, then you have created a situation where you are house poor and investment poor.  With the cost of gas, living  close to work can save you hundreds of dollars a month, which can be put to use acquiring assets.

2. Real Estate Investment Trusts.   There are three types of REIT’s.


  • Equity REITS, the most common type of REIT, invest in or own real estate and make money for investors from the rents they collect; 
  • Mortgage REITS lend money to owners and developers or invest in financial instruments secured by mortgages on real estate; and 
  • Hybrid REITS are a combination of equity and mortgage REITS.

Some REITS use leverage and some do not.  I only invest in leveraged REITS.  REITS are traded on various stock markets making them easy to buy and sell or liquid.  They have their own accounting regulations that require them to pay out the rent they collect.  Speak to an accountant for an in-depth discussion of REIT accounting.  You have dividends paid out each year, which can be reinvested.  The value of the underlying real estate backs up the investment and the rents along with the real estate value determine what the market prices their shares in the long run.  Because they are so liquid, they are subject to the whims of investors on a daily basis.  The REIT I own currently pays a dividend of 6%.  Over the last 10 years REITs have outperformed all other classes of stocks.  Positives include liquidity, someone else managing the properties, some leverage applied, access to larger properties than one would normally have, and potential for double digit returns.  Negatives include daily price fluctuations, limited leverage, and the passive nature of the investment.  Since I am a big believer in long term real estate investing, I keep a good percentage of my assets in REITs.

3. Owning investment real estate outright.  Perhaps the best way to take advantage of the various tax and leverage pluses of real estate is to buy real estate and rent it out.  This can range from single family homes to duplexes to apartment complexes to commercial property.  I can think of no better way to have a comfortable retirement than this strategy.  Beware, this is not the place for amateurs going it alone after attending some seminar.  You need an experienced hand to help you. I suggest talking to Bawld Guy first, if this is your intention.  Just click on the Brown & Brown link to the right!

The matrix for investment real estate is very different than the one for buying a personal residence. Here are some basic considerations:

CAP Rate: Net Operating Income/ Purchase Price.  This is a great tool for comparing properties.  Net Operating Income is the total of all rents received minus maintenance expenses, vacancy expense, taxes, insurance, repairs, management fees.  Cap rates are usually in the single digits.  The higher the better.  But this is only one metric to look at.

Cash Flow:  Add up the total of all expenses plus the mortgage cost for the year and divide by 12.  Compare this number to the total monthly rents collected X .8 to account for vacancies.  If this number is positive it is said to cash flow.  Never get in a situation where there is a negative cash flow.

Leverage:  How much money do you have to put down in order to have the property cash flow.  Generally the less you have to put down the better it is because you are using leverage.

Return on Investment:  Cash Flow + Appreciation/Down Payment.  If you put down $20,000 on a property that cash flows $2000/year and appreciated $4000 then you have a return on investment of 30%.

Market Demand:  First, what is the market demand for rental properties in the specific area you are thinking about buying?  Does this area of a net inflow of population?  Can they afford the rents you are asking?  How does the rent you are asking compare to other rental properties?  Are you trying to rent a one-bedroom apt. in an area dominated by families who are looking for multiple bedrooms?  What is your target renter? etc.    Now, how about appreciation in the area.  Is this an area where there was an extreme bubble.  Net inflow of population?  Area trends?  Affordability factor?  Jobs in the area? This is where an experienced hand really comes in handy!

Management:  Are you going to manage it yourself?  This is not recommended because it limits your investment to areas close to where you live now.  How much will it cost you?  6% seems to be a good number to aim for.

Location:  Can be anywhere the analysis leads you to.  Most likely not going to be in your backyard!

Once again don’t let this intimidate you, hire an experienced investment real estate person to guide you.  Remember, only a small minority of real estate folks specialize in investment RE!  Use only them.

Positives: Tax deductions, Leverage, Accessible to most of the middle class.  Negatives: not liquid, requires active participation, high learning curve (can be offset by using Bawld Guy!).

4.  Private placement investments.  Many groups form LLCs to invest in real estate.  Also land developers are always looking for capital.  If you can hook up with good experienced people, then you can get outsized returns.  Usually, this only happens after you have been an active investor for a while and meet people in the industry. This is not a place to start investing.  But to experienced real estate investors it is a place that can be very fruitful.  Positives: Outsized returns, limited time required (half way between active and passive investing), leverage.  Negative:  Higher risk, high level associations needed.

5. Second Homes.  Generally not a great investment, but if leveraged can get double digit returns if price appreciates 4%/year.  If you rent it out part of the year, you can get some cash flow, but generally they are cash flow negative.  Being totally dependent on price appreciation is not the best place to be, but can work out in the long run.  I put this under life style investing.  Instead of driving that Lexus, which will depreciate, own a Toyota and buy a second home.  You will get more pleasure out of it and will make money in the long run with it.

6. Raw Land.  Extremely speculative and long term.  Think in terms of your children and grandchildren.  Don’t expect to ever see the money in your life time.  If you do, then lucky you! 

Hope this helps folks.

****This is only the ramblings of the village idiot, who does not have a license to sell real estate or securities.  Go to a professional for real estate advice.  Go to an accountant for accounting advice with regards to real estate ownership.  Go to a stock broker/financial planner if you want to hear what Wall Street thinks about any individual security.  Once again this blog and this post are for amusement purposes only and does not represent any offer to sale or buy real estate or securities or offer any advice as to what the reader should do.  Do your own independent research as I have done before making any financial decisions.*****

Pessimism and You July 25, 2008

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Not to sound like a refugee from “The Secret,” but pessimism is an emotion that needs to be eliminated from an investor’s psychology.  Why?  Isn’t it a reaction to reality?  Well, no.  Currently, the pessimists are having a field day with the real estate market.  Indeed, the numbers look bad.  But remember the numbers are backward looking, so what they are telling us is that the real estate market in some areas was really bad.  Well, duh.  But, what those numbers don’t tell us is that real estate has always come back.  Let’s be honest, they aren’t making anymore dirt, people still need a place to live, and the emotion of home ownership is as strong as it ever was.  Bought your home in 2006, upside down?  So what?  Where you planning on moving?  Probably not. How many people buy a house with a 2-3 year time horizon?  The only thing that matters is that you take care of business so you can make those payments.  Real estate pricing will come back. 

Depending on building up home equity as your retirement plan?  Yes, I know that is the plan for the majority, but it is just dumb.  Now we see why, as you watch it disappear.

Less than a year ago I made a real estate investment.  It is about to pay off handsomely ahead of schedule.  How can this be, the real estate market is for fools?  Nope, many people are making huge profits in real estate, just not the pessimist.  My REIT went up 11% last year, plus paid out 6% in dividends.

Money is made is any market, just not by the herd!  Call me or e-mail me dave@shaferwealthacademy.com if you want to learn about building wealth the way the wealthy folks do!

Fresh Thinking on Investment Real Estate, Rent, Home Ownership July 24, 2008

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Recently had an interesting conversation with a young man.  He was wondering if he should buy a house in his area to live in.  I asked him some basic questions like why he wants a house.  He answered, for an investment!  Further he said he was happy with renting the place he lived in because it was ideally located for him and relatively cheap.  He couldn’t afford to buy into the same area he lived in, so he was looking into some less desireable neighborhoods to buy.

So I suggested he treat this transaction as what it is, an investment.  I explained to him that the decision matrix for investment real estate was very different that for a personal residence.  It was like a light bulb went off in his head.  He had been struggling because he was approaching this decision from the wrong direction.  He really didn’t want to move.  I sent him off to do some research and gave him a couple of names of trustworthy folks that understand investment real estate. 

This is, of course, anathema to my real estate agent friends, but renting can make sense for people.  And since people aren’t trained to think like a real estate investor, they are unprepared to make good decisions about real estate.  Like my client who was paying $600/month for a place he was comfortable in and finding a similiar place to own would have cost him $2000/month.  Now he is free to look all over the US to find a investment property since he is not limited to being close to work.  He can still bike to work and own an investment that will give him double digit returns putting him in good stead for his future!

I talk with another Successful Investor July 17, 2008

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Yesterday, we went to visit one of our Florida neighbors whom also has a summer place up here in New England.  Frankly, I knew vaguely what this person does for a living, but have only heard bits and pieces over the last few years.  While we were canoeing and swimming with my son we had a chance to talk more extensively.  I thought the readers would like to read his story:

 He had started working on the Jersey shore during summers at 14.  Eventually, he went to work for IBM in Jersey.  After many years of working for Big Blue, he decided that working for someone else wasn’t getting him where he wanted to be.  So he moved to Florida.  Taking his savings he started to buy property and fix it up.  His formula was buy three houses a year and sell one.  Eventually, he owned 20 properties.  He hired a full-time maintenance guy and worked hard at keeping his houses in good condition and rented to good people.  He had a rule that he would never raise the rent of someone while they lived in his property.  This worked well as he had loyal renters who, for the most part, didn’t try to destroy the properties.  He tended to buy properties in the less expensive parts of town so he could set the rent in the affordable range.  Slowly at first, but accelerating in the 1990’s, rents increased, dramatically increasing his income.  He had become very successful as a real estate investor through simple hard work and treating folks fairly!

For some personal reasons he started to sell out in the last decade.  He now is down to 6 properties.  However, he hasn’t had the same success with his capital, trusting financial planners and stock brokers.  One lost some of his capital, while another one had his money for 4 years and left him at the same place he started at.  We laughed about the thought that the only people making money from his capital were the financial planners!  He told me sheepishly (and this was totally unsolicited) that the best retirement vehicle he had [outside of his real estate] was a life insurance policy!

He also invested in some raw land in North Florida on the coast, with the thought of building a house and living there part-time.  However, he met his wife and she had a job tied to St. Pete so that never happened.  He picked it up for a pittance in the 1970’s.  In 2003 he sold most of if for a profit of around $400,000.  He kept a couple of lots.  At the time he checked with a broker and found that the lots were worth $400,000.  Because of tax considerations he did not put the land on the market.


So he still has considerable capital in real estate which he will sell out in the near future as real estate in Florida rebounds.  Then, he will be retired comfortably!  Well, very comfortably!  He is an example of exactly what we teach at the Shafer Wealth Academy.  I consider him a mentor as well as a friend.  His story makes me even more determined to bring folks into the Shafer Wealth Academy, helping them to the life and retirement they deserve.  Note, that he didn’t do it without any mistakes.  Making mistakes is part of the game.  Note that he didn’t get greedy.  Getting greedy hurts you in the long run.

I asked him if he thought his success could be duplicated today?  He felt that taxes and insurance were too expensive currently, so he wouldn’t buy in St. Pete.  However, he felt other areas that didn’t have the same tax and insurance issues it could be done.  He felt if you paid attention to the basics, treated folks fairly, anyone could do it.


During this conversation I realized that it didn’t take incredible luck nor superior analytical ability to become a successful real estate investor.   It takes what I call “want to and know how.”  Add in a little “treat people fairly” and you got the recipe for success!  An average person with a little capital and the willingness to learn and go out there and do it can build a fruitful and meaningful life. 

Fannie and Freddie; Oh Yea. July 11, 2008

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The internet has gone bonkers over the latest reporting that the administration has developed a plan in case Fannie Mae and Fredie Mac have liquidity problems.  Meanwhile regulators say there is no such danger at the two major mortgage buyers.  So what is it, the begginning of a depression, like the internet philosophers think, or contingency planning?

My best guess is Freddie and Fanny will survive intact and their stock prices will go up dramatically but not immediately.  After all comforming loans, the one’s that F & F buy, still has a foreclosure rate of less than 1%.  So why all the teeth knashing?  Because of a change in accounting rules and the drop in real estate values.  F & F needs to have a small amount of reserves to cover the foreclosure losses.  Since there is uncertainty how much those losses might go to, the market has reacted with a vengence dropping the stock prices down to almost nothing. 

Remember any loans made and bought by these two that had a loan to value of over 80% had to have mortgage insurance.  So F & F has a 20% cushion.  Oh, you say real estate values have dropped over 20%.  Well yes, from peak pricing to now, but only a small percentage of folks bought at the peak.  Bottom line for conforming loans 98% still have positive asset value compared to the loan value. 

So let’s put it all together; 1% of conforming loans are in foreclosure, 98% of loans have a positive loan to asset value combined with the insurance,  real estate values are starting to descend less abrubtly (not enough months data to call this a trend), regulators insist that F & F have proper capitalization.

Seems to me to be a safe bet, that this is a stock market issue, not an issue of these companies going out of business.  But the future will tell us!

EDIT:  Apparently I missed the fact F & F bought some sub-prime and alt a bonds.  15% of their portfolio is in these two areas.  However, they report that these are the cream of the crop for sub-prime and alt-a and only .62% of their portfolio is in serious delinquency (90 days past due).  Bottom line, original thoughts still hold, even though losses might mount for the sub-prime area.  Mea Culpa for the wrong info.

Real Estate and Mortgage Issues July 8, 2008

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Just wanted to post on the most recent RE and Mortgage Issues.  First as I have been saying for a long time now foreclosure rates are being pushed by the sub-prime loans. Even though sub-prime and FHA loans account for only 20% of loans, they account for 60% of foreclosures.  And even in this class the foreclosures are driven by two states, Florida and California which have 21% of loans outstanding and 36% of the loans in foreclosure.  These two states had the most speculative action and the largest run-up  in prices, so now we see them leading the way back down.  Now here is the important part.  This was a predictable event.  When you see pricing marching upward 20-30%, then you know there is a bubble and the equity returns will descend to the mean.  When you loan money to folks who have no reserves and poor credit scores, there will be a large group of them fail to make payments.  Its not rocket science folks!  Indy Mac, a large lender in the option arm market has now stopped lending and will probably fail.  Regular readers know my opinion of option arms by now.  If you entice folks by telling them they have a 1% mortgage rate and/or they don’t have to pay back even the interest on the loan, then you are going to get folks that take you up on that and end up in foreclosure.

As far as values, outside of a few speculative areas and a few areas where jobs have vanished, values remain pretty decent.  Here is a video on Manhattan real estate for those interested in high end markets: http://www.dottieherman.com/video_mmo2_long.htm

Bottom line, is that lending has gone back to what was standard before 2002 and rates remain historically low.  You are going to need some capital (as well as you should) to buy a home except for FHA loans.  Don’t try to time the market, make decisions based on a well thought out plan.  Remember the calculus for personal residence and investment properties are completly different.  For your home, save some money up for at least a 10% down payment, get credit scores above 700, and take your time (there is much inventory).  Remember people who don’t own their own home rarely have positive net worths at the end of the day.  Investment property figure cap rates, cash flow, local rental histories, and area job growth.  Do your homework and don’t overpay just because the area is hot!