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The Lender's Dilemma

lendersminiThere are no Black Mondays (so far) in real estate. Despite discussion about "When will the bubble burst?" real estate price inflation does not suddenly burst. Instead, several interrelated forces combine to squeeze the "air" out of prices gradually. The forces include (a) buyer demands for return, (b) loan underwriting requirements, and (c) interest rates. When the money from buyers and lenders shrinks so do prices.

In the graphic we see these forces depicted as capitalization rate ("cr"), a proxy for buyers' return requirements, loan-to-value ratios ("ltv"), whether explicit or implicit through restriction of loan amount based on debt coverage, and interest rate ("i"). To make the graphic easier to interpret, the contour plot in the center has been projected to the sides of the box enclosing the plot. The red point is the only permissible transaction unless something else changes. As interest rates rise, and capitalization rates and ltvs shrink there is no room left for further price increase. The green points require the buyer to put in more money. If they refuse the only remaining direction is toward the black point where the price falls.

The time-worn axiom "buy low, sell high" still applies. Talented real estate investors measure the inflation in any real estate price bubble and base their expectations on computation rather than rumors.