The Law of Diminishing Returns as Distressed Housing Becomes a Footnote in our Current Cycle

It was a perfect idea that may have run its course the way ideas often do in the real estate market. Distressed single family homes saturating the market in 2011 and 2012 proved a sure bet for private investors and larger private equity funds alike. GSEs even saw an opportunity to shed toxic assets through bulk sales to qualified private equity firms. The plan was successful. Too successful. Today, investor participation has effectively driven prices to an inflection point where finding undervalued properties is becoming harder. Distressed housing no longer yields strong enough returns to remain top on the list of options for the investor community.

“Buy and Hold” was the prevailing strategy of the previous cycle with investor participation shoring up the market. Investors firmly positioned themselves to benefit when prices would eventually appreciate, and in the meantime enjoyed revenue generated by a growing single family rental market. Meanwhile, larger institutional investors garnered much of the attention resulting from government partnerships involving bulk distressed real estate sales in California, Las Vegas, and other areas hard-hit by foreclosures. Independent investors found room to participate as well. It’s estimated that investors have injected up to $15 billion in capital into the housing sector since 2011 in pursuit of distressed properties. Peak has also participated in accumulating a pool of these rental homes in the Las Vegas and Los Angeles areas.

Fast forward to 2014. More than Federal programs, monetary policy, and an improving jobs market – all cash investor activity in the housing market has arguably had the most impact on bolstering home values and boosting the economy. As private capital returned to the financial ecosystem, homeowners saw equity return and distressed borrowers displaced through foreclosure or other actions had the opportunity to regain their footing through the availability of single family rentals. The market has now reached a point where “Buy and Hold” is generating diminishing returns resulting from:

• Rising home prices. Investor purchases provided a much-needed floor for home prices that halted plummeting home values and provided the groundwork for equity to return.  Unfortunately, as prices rise on existing inventory, investor returns fall.

• Reduced inventory. An improving economy, government programs, and more proactive lender workout programs have resulted in the lowest numbers of foreclosure filings since 2007. In addition to rising home values deterring investors, the supply of available distressed opportunities are simply drying up as the cycle shifts.

• The “own versus rent” choice for households. Strong rental revenue for investors simply translates to higher monthly rents for dwellers. Despite higher interest rates, higher home prices and new underwriting criteria, current renters are exploring options to trade in their rent check for a mortgage check. Moreover, “boomerang buyers” – homeowners displaced by short sales and foreclosures during the last decade have regained their economic footing and are looking to buy again. Investors are encountering a plateau on rising rental revenue. Additionally, the cost of turnover, repairs, and down time for rentals is eating into the return as the properties and the investment sits.

Patterns are emerging signaling an end of this cycle as major players who acquired thousands of properties early in the game are now cashing in the chips. First, investors are scaling back pursuit of foreclosed properties. Second, investors have taken notice that home appreciation is slowing, and see this as the perfect opportunity to “hold” no longer and to sell. In Las Vegas, once dubbed the “Foreclosure Capital of the U.S” where prices at one time appreciated as much as 25% in one year, private equity firms are exiting the market.   

We’re currently evaluating our portfolio, and see merit in pursuing disposition of the residential side, while pursuing other acquisition opportunities on the commercial level. While there will always be a distressed sector and opportunities, it’s time for investors to evaluate if the cycle is winding down an acquisition strategy for their own long term goals. 

The Qualified Mortgage Rule - Who Truly Wins?

As Washington continues to find ways of scuttling our economic recovery, the real estate recovery has fallen out of the spotlight for a moment. Delinquencies continue to fall, home equity is on the rise, and investors continue to find a more stable haven in real estate than traditional investment vehicles. What’s proven to be real estate’s missing piece has been credit -- a meticulous balancing act of making it available to sustain housing growth at an affordable price while at the same time maintaining fail-safe protocols to deter abuses rampant in the last cycle.

January 10, 2014 looms as yet another housing industry witching hour with implementation of the Qualified Mortgage Rule (QM). QM carries with it the potential to restrict consumers as well as traditional sources of capital for the market, which will inevitably impact growth in our sector. However, QM aspires to bring stability and additional credibility to a mortgage industry often cited as a key factor in the recession of the last cycle. Restrictions versus credibility --- that’s the question to ponder today.

Broadly defined, QM sets specific criteria for a home loan that meets certain standards set forth by the federal government as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010. Interpretation and implementation of QM is overseen by Consumer Financial Protection Bureau (CFPB), the agency created as part of that legislation for enforcement purposes. After more than two years of discussion and debate, the following provisions stand out as key concepts of QM for lenders to follow.  These in turn will provide legal protection against borrower lawsuits as well as increased confidence that GSEs won’t require “buybacks” of defaulted loans that have been guaranteed by Fannie or Freddie:

• Elimination of "low doc" or "no doc" loan programs
• Adherence to "ability-to-pay" provisions, inclusive of tighter underwriting based on borrower's ability to pay over the long term
• Elimination of interest-only, negative amortization, teaser-rate, or other loan programs deemed "exotic"
• Loan term not exceeding 30 years
• Debt-to-income ratios not exceeding 43%
• Total disclosed fees not exceeding 3%

While QM hopes to rid the mortgage industry of risky loan products and ensure that borrowers have the ability to meet their mortgage obligations, it poses three very clear and present dangers that can’t be ignored. First, QM excludes a huge segment of borrowers who have difficulty meeting stricter underwriting standards, but aren’t necessarily credit risks. Second, while more risky products will be eliminated as a result of QM, so are the choices borrowers have in choosing loans that fit their budget and lifestyle. Remember, our current culture of tight credit has made “exotic” loans harder to qualify for as well, so our current environment has actually generated a strong class of qualified borrowers with less likelihood of defaulting on a mortgage. Third, and potentially crippling to the industry, is the 3% fee cap. Mortgage brokers stand to suffer the most from this cap. Already operating under tight margins as well as a host of regulations limiting what they can charge, broker fees may not be able to exceed 1% of the proposed 3% total disclosed fee rule on conforming loans. Today’s mortgage broker fills an invaluable niche for borrowers who don’t fit the standard underwriting mold. We could lose yet another borrower financing avenue if there is a new shakeout in the mortgage broker industry, and this could eventually impact demand with fewer borrowers in the mix.

It appears, then, that QM is more about choice --- from the borrower perspective --- than it is about restrictions or credibility. While GSEs and lenders win by only writing loans for a predefined criteria, borrowers that don’t fit the criteria lose. Peak has been exploring a number of opportunities for 2014 to create more options for borrowers that find themselves even more disenfranchised by lender and government standards. A healthy housing sector requires a strong mix of investors, inventory, credit, and buyers. More choices of credit for buyers equates to long-term stability for the housing sector.