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“Buy Land, they’re not making it anymore” – Mark Twain

Every modern day economic downturn can trace its origins to careless and excessive debt creation. Leverage has helped and hurt investors since credit was first introduced during the reign of Hammurabi, King of Babylon around 1792 BC. Mark Twain’s advice about buying land may have sounded like good advice at the time, but it couldn’t save him from bankruptcy. Twain lost nearly everything during debt-induced Panic of 1894.

Before we make our case for an unconventional approach to finding distressed real estate opportunities, here are a couple of closed-end funds to consider that have been hammered…

ING Clarion Global Real Estate Income Fund [IGR|IGR]: Interesting under $7.00

The ING Global Real Estate Fund is a closed-end investment company that invests primarily in real estate equity securities. The fund has a current distribution rate of approximately 7.8% and sells near a 6% discount to its underlying net asset value. The fund is broadly diversified with exposure to shopping centers, healthcare properties, office properties and apartment complexes. The fund traded at a high of more than $24 per share in early 2007. Since then the shares have tumbled more than 70% to their current level. We view IGR as a diversified way to gain exposure to the recovery in real estate assets.

Alpine Global Premier Properties [AWP|AWP]: Interesting under $6.75
Similar story, but different management and investment mix. Shares have been selling at a 13% discount to NAV.

Single Family Homes at Half Price

Real estate investors are conventional bargain hunters. Let’s consider an unconventional approach to bottom feeding. Instead of competing head on with thousands of investors hoping to find a great piece of property on sale, consider going where the crowd is unlikely to be looking. If you’re interested in making money buying and selling single family homes below replacement value, abandoned property is likely where you’ll find them.

When starting out, investors often take the conventional route and go through a realtor. They soon learn that investing is an extremely competitive endeavor. Go thru the listings, and if you find a great property at a great price, you will suddenly discover that there are already 5 or more offers on the same property. As a result, the price goes up or the terms may call for an all cash purchase at a premium. In this familiar scenario, you’re competing with motivated buyers. Just like the stock market, the real bargains in real estate come from motivated sellers.

Unconventional Wisdom – Little or No Competition for Abandoned Property

Abandoned single family homes in middle and lower-middle class neighborhoods have boarded up windows, surrounded by dying lawns and over-grown weeds. No realtor can rent them, and no one wants them. The owners or the banks are desperate to unload them, and are unwilling or unable to spend the time or money to improve them. The real estate road less traveled is exactly where the Fallen Angels are. Before we discuss a methodology for buying and selling distressed single family homes, I think it’s important to review a familiar cycle.

The 18 Year Real Estate Cycle

I know this may sound like numerology, but whatever the reasons, real estate prices have followed an 18 year cycle in the United States for over 100 years. Generally we get 9 rising years, followed by 9 years of contraction. This has certainly been the pattern in my lifetime. I’ve seen this real estate wheel of fortune turn several times now, and I have to agree that a declining market offers the best chance you may ever have to accumulate significant wealth over time. It’s been so for a long time on Wall Street and Main Street. If you’re interested in learning more about the research behind the 18 year real estate cycle, read the books left behind by former statistician Edward Dewey (www.foundationforthestudyofcycles.org).

How and Where to Find Abandoned Property

If you live in any major metropolitan area, chances are good you will find dozens, perhaps hundreds of abandoned single-family homes within a twenty mile radius of your home. These are perfectly good two and three bedroom houses in working class neighborhoods. During a real estate down cycle, you’ll find them by the hundreds in newer communities where owners simply walked away and left the lender’s keys in the mail box.

The Ideal Price-Earnings Multiple for Real Estate

As you’ve seen, human beings are prone to wild sentiment swings. We’re influenced by economic conditions, and also cyclical forces unseen like those Dewey discovered in nature, value is a moving target. No one is really certain as to what constitutes the best and most realistic deal, where value and price are in equilibrium. Eventually we find out when another potential buyer comes along and makes us an offer, something which occurs millions of times every day in the stock market. Because prices change quickly in a very transparent marketplace, it’s obvious where the public thinks stocks are fairly valued at any one time. When the world is in an optimistic mood, and the economy is expanding, prices go up. Even “value investors” change their price-earnings assumptions based on sentiment. Real estate is not much different in this regard.

Some popular assumptions about value have held up reasonably well over the years. For real estate, the rule of 15 has endured. With this metric, fair value for a house or any property is ultimately based on what rental income can be generated from it. What will the people pay to rent from you? Let’s say you have a house that would rent for $2000. per month, or $24,000 per year. $25K times 15 equals a fair price for your home of $360,000.

In a real estate bear market values and rents decline. In my experience, houses are a terrific buy at 10 times gross rental revenue. Or in our example, $24K times 10 equals $260,000. This metric is usually described as a Capitalization Rate. Own the property free and clear, and what can you expect as a return. Of course, there are taxes and maintenance costs which are essential, so if you want to be conservative, use net (after expenses) rental income times 15 (or lower) when making your offers. Generally, houses have been over-priced when they sell above 15 times gross rental income. Like stocks, housing prices are based on a combination of value and momentum.

From the new book “Wisdom on Value Investing: How to Profit on Fallen Angels,” by Gabriel Wisdom (Reprinted with permission of John Wiley & Sons Inc., Copyright 2009 by Gabriel Wisdom, all rights reserved) Available at amazon.com and barnesandnoble.com.

Gabriel Wisdom is a Founder and Managing Director of American Money Management. He is also the President of AMM Funds, which includes two publicly traded no-load mutual funds. A long time student of the financial markets, he has helped to refine a value and momentum strategy based on fundamental, technical, and sentiment indicators. Gabe’s views regarding business, investments, and markets are regularly broadcast on national radio, and are archived at www.BusinessTalkRadio.net.

Disclaimer: The opinions expressed are those of Gabriel Wisdom and Michael Moore and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This letter should not be considered investment advice. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything.

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