When evaluating where we are in the housing cycle, it is often useful to evaluate fundamental valuation metrics and compare current trends versus historical averages. Below is a graph (click to enlarge) depicting the national price-to-rent ratio, which depicts how homes are trading relative to their rental values. This metric is similar to the P/E (price/earnings) ratio typically used in analyzing the stock market.
This graph uses the Case-Shiller Composite 20 and CoreLogic House Price Index, and sets the baseline period at January 1998, which is assigned a value of 1.0. The current ratio (as of October 2011) on both indices is at 2000 levels, indicating that we are very close to long-run historic average metrics. While foreclosures/short sales (lagging economic indicators) still account for a significant share of existing home sales, the good news is that delinquency rates (leading economic indicators) are gradually diminishing. As such, we can expect home prices to bounce around gently for several months, then gradually start to recover based on improving fundamentals.
In response to the National Association of Realtors (NAR) August existing home sales data, released here today showing that sales compared to the previous year are up and inventories are down, I issued the following statement:
“Although the year-over-year sales numbers look very positive, the reality is that last year’s August sales numbers were unusually low due to the post-Homebuyer Tax Credit hangover effect, so this year looks higher mainly by comparison only. We’re still below healthy levels.
We are seeing the foreclosure pipeline starting to open up again, which is good news. This will help achieve price discovery and equilibrium, which has been a huge problem over the past couple of years. In fact, the average home sold in a foreclosure proceeding has been delinquent for nearly 600 days, up from 478 days the year prior. In August, we started to see banks unload foreclosures and arrange short sales at a higher pace. Homes at risk of foreclosure accounted for 31% of sales in August, up from 29% in July. And because distressed sales occur at substantial discounts, this explains the median price decrease for August.
Overall, I believe these numbers continue to show that the housing market is now basically at the bottom, and although the August numbers appear positive, I don’t believe they foretell ongoing positive movement in the short- or medium-term.”
In response to the National Association of Realtors (NAR) data, released August 18th, showing that existing home sales slipped nationally and regionally in July, I issued the following statement:
“The research released by the National Association of Realtors showing a decrease in existing home sales reflects a continuing fall in the housing market, which is now basically at the bottom, with little or no movement expected in the short- to medium-term. The reason for the continuing decline in July can be attributed to negative jobs data throughout the month of July, as well as a crisis of confidence related to the debt ceiling impasse. In addition, when purchasing a home, buyers often look to capturing the “sweet spot” between low pricing and low interest rates. The Fed’s announcement last week to keep the short-term rate at near-zero for another two years removed any urgency for buyers who now have the convenience of waiting out the market to see if prices will in fact get a bit lower before pulling the trigger. Although July 2011 sales compared to July 2010 are up, this increase is misleading, as last July was the first month of sales data after expiration of the homebuyer tax credit, meaning sales were pushed forward into the months leading up to July 2010, causing that month’s sales to be unusually low. As such, a significant increase was expected.”
Here is the link to the official release: NAR Official Release
M.P. McQueen’s recent piece in The Wall Street Journal highlights a concept that I routinely teach in my “Real Estate Finance and Investments” course at UCLA: the incremental cost of borrowing. This concept basically conveys the importance of knowing the cost (or interest rate) on each additional dollar of financing.
In class, the example I typically use is to compare an $80,000 loan at 12% interest with a $90,000 loan at 13% (both loans are 25-year fully amortizing, with monthly compounding). While the difference may not be immediately intuitive, the additional $10,000 under the larger loan carries with it an interest rate of over 20%! In other words, you can conceptualize the $90,000 loan as being comprised of an $80,000 loan at 12%, together with a $10,000 loan at just over 20%, to equal a $90,000 loan at 13%. Feel free to contact me should you wish to see a more detailed explanation of how to calculate the incremental cost of financing, but in the meantime, check out the article below, where I discuss a case study that applies this concept to “cash-in” refinancings. This is a critical issue given today’s market dynamics:
Cari Tuna’s piece in today’s Wall Street Journal discusses a fascinating method of economic analysis: scouring oddball data to uncover trends before official information is available. In some ways, this method represents a reversion to the use of simple bottom-up observation to uncover emerging trends, in many cases before formal data is released. It bears a strong resemblance to Peter Lynch’s famous approach towards stock investing, as explained in his 1989 book, “One Up On Wall Street.” Lynch wrote, “If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them.” For example, Edward Leamer of the UCLA Anderson Forecast uses simple observation of diesel fuel sales along Interstate Highway 5 as a leading indicator of construction activity in California. While it is difficult to place total reliance on such one-off measures, these observations are nevertheless very useful when taken as a supplement to reported information, much of which by definition is incomplete and retrospective in nature. See link below:
I had stumbled upon this great little video a while back, and have been sharing it with many of my students, particularly those new to real estate and the secondary markets. It provides a very entertaining, yet fairly factual account of the events that led to the collapse of the financial markets toward the end of 2008. It was created by Jonathan Jarvis, a design student out of Pasadena, as part of his graduate thesis. Perhaps a tad simplistic, but still conveys many key points. I particularly get a kick out of the “subprime family” caricatures. I hope you’ll enjoy it as much as I do.
Alana Semuels of the Los Angeles Times wrote yesterday about an emerging trend in distressed residential communities: banks allowing defaulting borrowers to stay put in their homes while making no payments.
The logic is that allowing borrowers to stay put reduces the likelihood of vandalism and protects the value of the bank’s investment, essentially allowing borrowers to act as caretakers of the property. At the same time, banks can explore various avenues in an effort to comply with government pressure to modify loans and keep people in their homes. Finally, with a glut of distressed inventory, banks are loath to dump too many homes into the market for fear of further depressing prices. According to the article, in the Inland Empire, over 100,000 delinquent borrowers are living rent-free. Link below:
RealtyTrac reports a 10% decline in foreclosures for January, compared to the previous month, yet the number is 15% higher than January 2009. “January foreclosure numbers are exhibiting a pattern very similar to a year ago: a double-digit percentage jump in December foreclosure activity followed by a 10 percent drop in January,” said James J. Saccacio, chief executive officer of RealtyTrac “If history repeats itself we will see a surge in the numbers over the next few months as lenders foreclose on delinquent loans where neither the existing loan modification programs or the new short sale and deed-in-lieu of foreclosure alternatives works.”
And while the well-intentioned Home Affordable Modification Program (HAMP) has targeted over 3 million borrowers, only 900,000 trial modifications have been extended, with only 66,000 of those having been made permanent. At a success rate of 7%, it’s tough to predict anything but a foreclosure log jam ahead…
Distressed debt is the obvious opportunity in commercial real estate these days, yet significant activity is frozen and most investors are not acquiring, but rather “just asset managing” their existing portfolios. Why is this? Most investors will dismiss the conversation with a catchy phrase such as, “the bid-ask is too wide.” Okay, so buyer and seller can’t agree on price, but why is this happening to begin with? Banks should be more than willing to work with opportunistic investors, shouldn’t they? Not exactly. First, banks know that if they sell off any distressed debt at a heavy discount, then the current accounting rules will require them to take a harsh write down on other similar assets, thus impairing their already stressed capital ratios. Banks have very little wiggle room.
To avoid having to face the music, banks will offer loan extensions to borrowers, in the hopes that employment, rents and occupancy will climb back before the new maturity date – ”extend and pretend.” So, the banks are building a bridge to some far off destination, coinciding with a better day. The problem is that the bridge will have to be exceedingly long to get us out of the human recession, led by unemployment of 10%, and forecasts released today by the Obama Administration predict a reduction of only one percentage point for each of the next three years. So how do investors strike deals with banks, and which banks should they target?
A solid piece of advice is to negotiate with banks less on price and more on terms. One solution would be to create a JV between the investor and bank, then sell the note to the JV and structure the payout streams within the JV in favor of the “overpaying” investor, to make up for the loftier purchase price. The lender could also seller-finance the sale into the JV, further facilitating the transaction. Banks would avoid the sharp write-downs, and would more willing to work with investors, whose long-term interests are now aligned with those of the banks. Lastly, investors in this type of deal would be viewed as partners rather than as vultures.
So which banks are the best to target? By process of elimination, my answer would be the “somewhat stressed, but still holding on” banks. The healthier “too big to fail” banks have no reason to cut deals. The smaller “about to fail” banks are flirting with death and have no room to cut deals. Moreover, as many of these banks are one Friday away from being seized by the Feds, selling off assets would only take threaten the jobs of existing employees. Hanging onto distressed debt ensures a need to keep staff on payroll in the event of a seizure. That’s an agency problem if I’ve ever seen one.
That’s all I got for now…
Bloomberg ran a great piece today on lenders pursuing borrowers for deficiency judgements after foreclosure of their homes. While several states are recourse states, California is non-recourse for purchase money mortgages. In other words, if the borrower defaults on the loan used to buy the home, the lender is left with only the collateral, regardless of whether it covers the loss on the loan. Many other states do not afford borrowers this privelege.
All this is out the window, however, if the borrower refinanced or put on a second mortgage. In these instances, the lender has recourse, and can pursue a judicial foreclosure, as opposed to a trustee’s sale, and seek a deficiency judgment. Should this happen, remember that California is a “single action state,” meaning that the lender can either pursue a trustee’s sale, or pursue a judicial foreclosure and seek a deficiency judgement, but not both. Finally, for short sales, I encourage sellers to consult with legal counsel and ensure that the lender waives its right to a deficiency judgment. This should be a point of negotiation in the transaction.