Jeff Ciesla had watched people making money in the real estate market long enough.
So, when he and his wife, Quinn, recently decided to trade up to a larger home, he made his move. Instead of putting their Canton, Md., townhouse on the market, the couple cashed out $22,000 in equity to buy a Harford County townhouse with double the space and kept their city house, betting that its value would continue to grow.
“We had the conversation of wanting to buy a big single-family home, but we’d basically pay the mortgage and be house poor,” said Jeff Ciesla, 29, a pharmaceutical sales representative. “We decided, why don’t we keep this place a little while? We’ll be getting rental income, and people will help us pay off the mortgage while the place continues to appreciate.”
With home values rising and interest rates still relatively low, more homeowners like the Cieslas are hanging on to their current houses. Rather than following the traditional move-up pattern of selling one house to buy another, they use their swelling equity to cover the down payment and closing costs, rent out the first house and figure that in a few years they will be able to cash in big time.
But there are risks to “leveraging up,” piling on debt based on the value of property on paper–money that isn’t real until the house is sold. Some buyers compound the roulette game by using interest-only and adjustable-rate loans and counting on getting out with a substantial gain before their mortgage payments balloon beyond their ability to pay. And regulators worry that the practice could increase volatility in the hot housing market.
“It’s been going on the last 18 months to two years, especially in the suburban markets,” said Kenneth R.C. Wenhold, director for Maryland and Virginia for Metrostudy, a national real estate consulting firm that tracks market trends. “Just through appreciation, they can qualify for the bigger home.”
A 2004 survey by the National Association of Realtors found that 9.4 percent of homebuyers–about 638,000–planned to keep their residence when they bought their next house, according to Walter Molony, a spokesman for the organization.
That survey question is not one routinely asked, so comparative data was not available for prior years, he said.
Realtors say there is plenty of anecdotal evidence that people are taking advantage of healthy appreciation and low interest rates to become dual homeowners.
That’s because it makes sense, said Barry Glazer, a broker for Century 21 Downtown.
“What makes it appealing is the real estate market is doing so well,” he said. “If you can offer a cash contract, it puts you in a much better negotiating position. A lot of these contracts fall through, so if you’ve got a sure thing, that’s sometimes worth several thousand dollars.”
Tempting investment
Real estate’s current status as a hot investment is drawing homeowners who in the past would have never considered keeping their current house, said Pat Hiban, broker of Pat Hiban Real Estate Group.
“It used to be only a small percentage of people used real estate as an alternative investment vehicle,” Hiban said. “Now it’s the masses.”
That’s fostered a newfound comfort level. The idea is, “Everyone is doing it, so it’s safe,” he said.
Also a factor in the equation is that rental prices haven’t escalated at the same pace as home prices. That makes renting an attractive option for many people, increasing the likelihood of finding tenants.
“Rentals haven’t kept up with the housing market,” said Scott Smith, a Realtor in Baltimore and Baltimore County for Keller Williams Realty.
Properties in hot locations with strong demand command good rents, he said. He gave neighborhoods such as Federal Hill, Canton and Locust Point as areas where rentals are at a premium.
While Baltimore’s rapidly rising home values–the average price of a city home last month was up nearly 30 percent from a year earlier–gave the Cieslas the leverage to become dual homeowners, the couple is counting on the rental market to make their plan work.
The Cieslas bought their townhouse on South Curley Street in Canton for $165,000 in 2002 and used a $35,000 home equity loan to add a master bedroom and bath addition. The home was recently appraised for $335,000, Ciesla said.
When the couple decided to buy a three-bedroom, 2,300-square-feet Bel Air townhouse for $273,500, they took out a new interest-only mortgage on the Canton house. That covered their remaining $192,000 debt on the Canton house plus the money they needed to cover a 5 percent down payment and closing costs, Ciesla said.
The couple hopes to rent the townhouse by mid-November or the first of December for between $1,800 and $2,000 a month, based on rentals of nearby properties. That would cover their interest-only mortgage payment, plus the $250 in principle they plan to add to that each month, and still leave several hundred dollars, Ciesla said. And it would also allow Quinn Ciesla to remain a stay-at-home mom for their 1-year-old daughter.
“It blows your mind what’s going on in the city,” Jeff Ciesla said. “It really does allow us a lot of freedom.”
Cash-out refinancing has picked up significantly in the past two or three years in California, Florida, the Northeast and the Mid-Atlantic, said Patrick Lawler, chief economist with the Office of Federal Housing Enterprise Oversight, which oversees mortgage giants Fannie Mae and Freddie Mac. Though there are no restrictions on the use of funds from equity loans, the trend has caught the regulator’s eye.
More Top Picks Best Portable Saunas For Home Use
“It’s something that bears watching,” Lawler said. “It adds an element of speculation to the housing market. It makes the future of housing prices a little more uncertain.”
Lawler’s concern is that when the value of the collateral is more uncertain, it raises the risk of owning and guaranteeing mortgage loans.
“More volatile house prices mean you know a little less precisely how much your house is really worth. If there are a lot of people speculating in the same way at the same time, it may push prices above where they can stay,” he said.
Frank Nothaft, chief economist at mortgage giant Freddie Mac, said good underwriting and adequate cash flow are key to making dual ownership work. But home equity lines of credit are going up, he said, which means borrowers who tapped them are likely facing higher payments.
Borrowers who have conventional mortgages, which build equity each month, will have more cushion than people with interest-only loans in case of a downturn, he said.
“You might just be living in a market that goes into a recession,” he said. “If you’ve been paying interest only, your equity might be wiped out by the price decline.”
People need to understand that real estate, like other investments, is a gamble, experts say.
“Once it becomes an investment opportunity and not a shelter, then you are subject to all the risks of an investor,” said Nicolas P. Retsinas, director of the Joint Center for Housing Studies at Harvard University.
A market with a high percentage of investors is more subject to ups and downs, because those investors will sell if they start to see the market slowing, he said.
“You say, `I don’t want to be the last one leaving on this train,'” Retsinas said.
The biggest danger lies in the fact that people have short memories, he said.
“The problem is in the housing market we’re in, people assume that what’s happened in the past year will happen forever,” Retsinas said. “It can’t.”
Stephen S. Fuller, professor of public policy at George Mason University in Fairfax, Va., agrees that such investments can be risky–the uninitiated often make mistakes.
“The problem is, if anything happens to their revenue stream, they’re in trouble,” Fuller said.
People don’t realize all the costs cash flow must cover–the rental property mortgage; taxes, which increase as the property appreciates; maintenance; the cost of any unrented periods and other incidentals–in addition to the mortgage on their primary residence, he said
“Most people don’t do all the math,” Fuller said. “They’re looking at the asset appreciation, and that’s compelling in the Baltimore market. Individuals who do this tend to mix up the long-term returns and the short-term risks.”
There are dangers for lenders, too, he said.
“They’re making their money on origination costs, so they’re happy to make loans, and in a way they may not care if it’s a bad loan,” Fuller said. “But any kind of slowdown in the market threatens the lenders that have made loans on these houses with little or no down payment. It’s a house of cards, and it makes the banking system vulnerable.”
Jonas Lee, managing partner of Redbrick Partners LP of New York and Washington, which buys and rents homes, said inexperienced investors often underestimate the true cost of owning a property.
“People often think your cost is only 35 percent, not 50 percent, and they’re basically just wrong,” Lee said.
Novice investors often lack the sophistication to get the most favorable interest rates or pile on too much debt, Lee said, and many don’t know how to manage property.