The Whitwell Report is back!
What is going on with U.S. real estate? Everyone is asking!
This is getting a lot of press in newspapers for the reason that individual and institutional investors have increased their real estate investment activity in the last five years – in some sense, and for some people, this is the drug that replaced tech-stocks-injections.
Why all the sudden jitters?
First, there has been a lot of negative publicity focusing on “sub-prime loans.” In addition, there have been many articles about the slowdown in singe family home purchases, which in turn is having a dramatic effect on the financial performance (and stock prices) of the major national home builders. Doom and gloom.
Second, at the institutional level, concerns are arising because of how low “cap rates” have gotten. Most notably, we saw the multi-billion dollar purchase by Blackstone (major private equity player) of Equity Office (Sam Zell’s commercial office REIT) at a price that reportedly was just slightly more than a “5 cap.” One of my companies sold a 35 year old apartment building last year at a price that I would never pay. Why are people paying these high prices?
Let’s address these topics one by one and start with the punch line: the U.S. is way too big to refer to it as a ‘single market’ as in “the U.S. real estate market is [insert adjective please]”. Some markets (Ft. Lauderdale) are having issues and others (Austin) are doing great. Remember the real estate phrase “location, location, location” – well it is true.
The discussion also needs to be specific to the type of real estate in a particular market. For example, Ft. Lauderdale condominiums may be a weak due to overbuilding but retail there may be doing well on account of the increasing population.
Whitwell Rule: smart investors focus on specific areas and product types in deciding what is going well and what is not – (instead of USA Today headlines).
Let’s jump into some of the specific discussions taking place in the press.
First, is “the real estate market” at risk because of the single family home slowdown?
Not in my opinion. First, some of the markets (like Phoenix) which have experienced a recent slow down are not systemically at risk. The builders overbuilt relative to current demand and not surprisingly prices have retreated. The fundamentals in Arizona still look good, people continue to enjoy living there and more people are moving there by the week, so we know the excess inventory will be sold. This will cause pain, yes, because mortgage brokers, real estate brokers, builders, closing attorneys, title companies will all make less money this year than they were planning and although it will be disappointing for them to readjust expectations, this does not constitute a national real estate crisis.
Second, some markets, like California, are experiencing issues for slightly different reasons. California continues to benefit from being a desirable place which has limited supply. This is, in fact, one of the problems – California has experienced such crazy appreciation the last seven years that many people in California could not afford to purchase the homes in which they live today. In California, this is compounded by the fact that a large percentage of home purchases in the last three years have been financed using high leverage (90-100% of purchase price) loans, negative amortization loans (loans where the balance increases each month to offset low minimum payments) and interest only loans.
Will these over-extended loans cause pain? Yes. Were some of the borrowers duped into these loans by aggressive mortgage brokers who thought everything would be fine since California real estate ‘always goes up’ (cough, cough)? Yes. Are borrowers totally innocent? No. Borrowers need to own the fact that they did not read or think about the fine print and that they were speculating with bank money. Will there be a lot more articles about these issues in the coming months once the foreclosures increase? Absolutely. Does this constitute a national real estate problem? No.
Third, just because some of the national home builders are getting hurt, this does not mean that the entire construction business or the broader economy is in trouble. There has been so much wealth created in the construction business the last ten years that there would have to be a prolonged period of substantial losses among all of the construction companies before it would become a national issue. Since some of these companies are publicly listed, you will hear plenty of screaming and see plenty of kicking while they are losing money. No national emergency.
Fourth, in the last month there has been increased attention paid to the growing delinquencies in the “sub-prime” market – this in turn has increased the scrutiny that these portfolios are getting from the bank regulators, who by the way, are a tough crowd (and for good reason).
“Sub-prime lending” is a fancy lending term that encompasses three types of borrowers: (a) poor credit quality borrowers (b) good quality borrowers with highly leveraged loans and (c) good credit quality borrowers who are borrowing money with no verifiable documentation (“stated income loans” or “no doc loans”).
The issue of sub-prime lending is more complex. It is an important area and worth delving into in a little more detail. I am going to help you understand three key issues: social ramifications of decreased sub-prime lending, the feared multiplier effect and foreclosures/bankruptcies.
1. Social ramifications of decreased “sub-prime” lending by banks: there will be racially unequal access to capital if banks stop lending to lower credit borrowers across the board instead of discriminating between people generally in that group (who should have a fairly static delinquency rate) and the over-extended speculators (who are driving up the current delinquencies). Unfortunately, banks do tend to move in knee jerk fashion and the instinct of banks and regulators alike will be to indiscriminately shut off the spigot (facts: major lenders such as countrywide, Option One and Wells Fargo have already announced plans to discontinue certain high CLTV and stated income loan programs and over thirty sub prime lenders have closed shop since late 2006). Home ownership is a core American value and we owe it to those with less means to help them maintain access to reasonably priced capital. If banks do continue to reduce lending, then the interest rates to lower-income borrowers will materially increase because the remaining lenders will have the power to do so and justify this in the name of increasing profits. Socially, I do not think this is an equitable outcome and the brutal irony is that a lower income family that is of the character to make payments regularly is far more likely to face financial distress if they are borrowing at 12% than if they were borrowing at 7%.
2. The feared “multiplier” argument: if we stop providing high leverage loans and no-document loans, this will hurt the overall demand for new homes and this will in turn hurt the economy because home owners tend to spend a lot of discretionary income on home-related improvements and furnishings (the multiplier effect). I do not buy this argument and here is why: I think that a lot of the pure speculators who have purchased homes did not invest much into their homes by way of furnishings and improvements. The people who spend this money are people who actually make these houses their homes. Incidentally, I think the refinancing boom had a very real multiplier effect, but this a radically different situation. Statistically, many house buyers in the last several years have been second and third (investment) homes. I have some insight into this because I run a property management company that manages thousands of units – from single family homes to larger apartment complexes. I can assure you that most owners today who are purchasing their real estate investments with high leverage loans are not investing much money into their properties.
3. Foreclosures: will increase dramatically in percentage terms and this will make fantastic headlines. The increase in supply from these foreclosures will not, in my opinion, be statistically significant at the national level, but it will create colorful hype because motivated sellers (desperate owners and banks) will surely sell their real estate at below market rates – and this will fan the flames of fear and encourage speculation about the direction of “the market.”
On the other hand, this will create great opportunities for people who have access to cash, know their neighborhoods well and are experienced enough to know how much of a discount is needed to balance the risks. Nobody wants to catch a falling knife. Real life example: Tierra just helped an investor buy an apartment building from a lender who had foreclosed on the borrower -- a spectacular deal (see more below).
The other major question pertains to the health of the commercial real estate market. A-class assets are trading prices at “5 caps” which means that if you purchased the asset using all-cash (no debt), then if everything went perfectly in your operations the next year you would earn a 5% return (higher prices computationally mean lower cap rates and as a buyer, the higher the cap rate the better). This is less than what I can make in my CD account – with no risk and no time required to sweat all the details. Are commercial assets priced too high?
The argument as to why these prices might make sense relates to the theory that it is wise to purchase assets if you can do so well below replacement costs. If you are an insurance company and purchasing assets to hold for 30 years and you are buying them at a 5% cap rate, and your offsetting long term liabilities hover around the same rate, then over the long run buying these well located assets probably makes for a sensible investment thesis.
On the other hand, there is no guarantee that rents will substantially rise and even if you were to purchase these assets well below replacement costs, buying these assets using leverage could turn out to be an unprofitable or excessively risky investment. Only time will tell and in the meantime, it is a fact that the cost of construction has been going up substantially because of increasing demand for the commodities from which many home component parts are made (oil, wood, steel among them), which is being driven, in part, by the growing demand for commodities by China.
Fortunately, most of the buyers of these A-class assets are well capitalized. Should their investment strategy not prove fruitful, they have the financial capital to sustain a loss without substantial impact on the national economy. On the other hand, the $68 billion dollar health care liability on GM’s balance sheet is a far greater concern to me, since it portends a more systemic issue that is shared by many industrial behemoths in this country.
Real life concern: one problem which I am seeing over and over again is that relatively inexperienced investors who have made a lot of money in single family homes in California, Nevada and Arizona are buying small (less than 100 units) apartments in Texas (and elsewhere). These smaller apartments are almost always 30-40 years old (almost impossible for a developer to build and develop a smaller project like this and make money in major markets) so most new developments are at least several hundred units) and almost all of them have old, inefficient mechanical systems (HVAC), low energy efficiency windows, poor insulation, and almost always deferred maintenance. These properties are also too small to be properly staffed: they are too small to bear the load of a full salaried person for maintenance and onsite management, so they are very difficult to profitably manage. Even if you have a small portfolio of these (or use a property management company that does) to spread the overhead across a larger number of units, there is still a fundamental management problem: property managers who have numerous properties to manage tend to do less well at proactively managing the properties than managers who are onsite and feel that that specific property is their sole focus (in contrast to a manager that manages three properties in different locations and travels to the properties from the main office). In theory the workload might be the same but the logistics and focus issue tends to be measurable.
The reason I bring this example up is that as cap rates for Class-A product have decreased, we have seen the pricing for Class-B and Class-C product also become correspondingly higher. In my opinion, the lower the cap rate among all three quality classes, the bigger the cap rate spread (Class-A cap rates – Class-B cap rates for example) needs to be. In today’s market, I am seeing very little differentiation between class-types and this causes me some concern. I routinely see stabilized Class-C apartment buildings in Texas being sold for 7% cap rates by the listing broker, which means that in reality, based on my experience, the real cap rate eventually calculates to be somewhere between 5-6% (actual results, measured one year later). I think that unless you finance Class-C product with generous portions of fixed rate debt and have extremely high-inflation expectations, that in all likelihood, your returns will be on the lower end of your expectations. However, given the issues that arise with older properties, I can assure you that the amount of time you spent will be on the higher end of your expectations.
Real estate – if purchased well – continues to be one of the best investments you can make. Professional asset managers are increasingly allocating capital to real estate at the expense of bonds and stocks. To the extent that we do see some area specific real estate market dislocations, this will provide for additional buying opportunities for well capitalized and astute investors. Even in healthy markets, there are a variety of human circumstances that lead to highly motivated sellers, which is one of the best places to find bargains in otherwise highly priced markets.
Whitwell Rule: if you buy an asset for a low enough price, the wrinkles relating to older properties do not matter as much.
For example, Tierra just helped an investor to buy a 100+ unit apartment complex in the Ft. Worth, Texas from a special servicing company (the asset management arm of a non-recourse lender which provided the original loan to the owner and then foreclosed on the loan in order to minimize their loss) at a substantial discount. It is an interesting story. The original owner got into a spat with the City of Ft. Worth. The City then revoked the Certificates of Occupancy which are needed to legally run your apartment and lease to tenants. The occupancy then fell to 10%. The owner then gave the keys back to the bank since he had a non-recourse loan and did not want to “let the City win.” The Bank then asked the City to reinstate the COs and the City said they would only do that once the Bank finished a long list of improvements desired by the City. The Bank made almost all of these improvements and twice had it under contract, but buyers were concerned that they were buying an apartment complex that was nearly empty and did not have COs, which would in turn make it very difficult to insure, which is important when you are talking about a $1,500,000 purchase and also given that crime is much more prevalent on vacant properties, which in turn increases insurance premiums. Long story short, our investor purchased the apartment complex at the beginning of the year and we are busy doing minor renovations to the interiors, working with the City to obtain the rest of the COs and lease the remaining units. It is in excellent condition (new roof, new paint, good foundations). The overall area is probably a “C” but this property’s market value is easily twice what was spent to buy it and improve it. Once it is fully leased, we are going to help our investor refinance it (it was purchased all-cash since the lending terms for an empty apartment with no COs were not that favorable) and enable the investor to get back all of his cash, leaving him with an excellent cash flowing property which he intends to hold for a minimum of five to ten years.
This illustrates the flipside to foreclosures. It creates opportunity. You can either read the newspaper and get scared and depressed or you can get out there and turn lemons into lemonade. Tierra is in the lemonade business. We enjoy finding the right projects and creating additional value for ourselves and our co-investors.
If you like real estate and are willing to invest some of your time finding the right opportunity, I think you will always be able to find ways to make money. As can be heard on the trading floors in New York: sometimes you can profit by “fading the news” (doing the opposite of the expected reaction to an anticipated news announcement).
Feels great to be back – let’s keep our eye on the ball and keep Making It Happen!
Regards,
Stefan Whitwell
