How Reducing Foreclosure Inventories Impact the Real Estate Recovery

Nearly halfway through 2012, the real estate industry is making headway in finding prescriptive solutions to return to some state of stability. An improving economy and increased government involvement in modulating anti-foreclosure programs has caused many real estate pundits to declare the housing crisis near its end. And while these factors play a pivotal role in restoring equilibrium to the market, what could be the most significant indication that the” light at the end of the tunnel” is not just a myth is the slow and steady erosion of the inventory of distressed properties on the market.

It’s no secret that the saturation of distressed assets on the market has driven home values down, underwriting standards for new mortgages higher, and prospective buyers out of the market during the first years of the housing downturn. As the dust of 2011 settled, however, we saw the emergence of certain forces continuing into this year that are helping to shrink the numbers of distressed assets. Lower distressed home values gave rise to the all-cash investor with a voracious appetite and deep pockets for bargains. The government even stole a page from the investor playbook by piloting a bulk REO to Rentals program in 2012. Investors are enjoying healthy returns as a result of the popularity of single-family residential housing over multifamily housing, and are on the lookout for more deals.

Ironically, the banks themselves proved the next major force that emerged as a key factor in reducing distressed inventories. Or more accurately stated -- a shift in bank policy toward previously-disdained workout solutions. Banks finally did the math that everyone else did and realized it was cheaper to accept a lower value through short sales than let a property languish on its asset sheets. Banks not only embraced short sales, they proactively reached out to distressed borrowers to consider short sales as a way out with huge incentives in store for them if they sold. Moreover, other workout solutions such as deed-in-lieu or “cash-for-keys” programs gained favor with lenders as they sought more drastic solutions to reduce existing inventories. One lender is even experimenting with a long-overdue twist to the deed-in-lieu solution by taking back title and renting the property back to the distressed homeowner at a rate lower than their mortgage payment.

The combination of private investors and lender initiatives, with a healthy dash of regulatory pressure has resulted in such an alarming decrease in housing inventory that values on non-distressed properties have not only bottomed out, but risen in select markets. And while not nearly approaching the volume of the housing boom in the last decade, multiple offers on properties have returned. Shrinking foreclosure inventories coupled with other key indicators such as falling mortgage delinquencies and more promising employment statistics seem to reflect a healthier real estate sector.

What does this mean for real estate professionals? Agents, brokers, and other ancillary real estate service providers should see increased activity compared to 2010 and 2011, but to make the most of new opportunities must be able to handle complex transactions involving distressed assets. Any investors that have been sitting on the fence waiting for a true bottom to hit to find even more bargains may miss their window of opportunity if they don’t throw their hat into the ring now as the availability of discounted properties as investment vehicles will become harder to find. And as conditions improve, more sellers will be enticed to bring their homes to market demanding (and holding out for) a higher asking price. While a renewed sellers’ market with stronger pricing would of course be the best scenario for housing, investors will have to shift their strategy to take advantage of the market.

There’s indeed reason for renewed optimism that the worst of the real estate downturn is in the rear view mirror. The road ahead for real estate should prove less treacherous in the next cycle if travelled with a cautious strategy that includes finding more ways to liquidate distressed assets from the marketplace.

Experts Agree: Commercial Real Estate Endures through Tough Times and is Poised to Grow

At a recent USC-sponsored conference featuring many of the top minds in the commercial real estate sector, the "end-of the-world" scenario predicted for the commercial sector was given last rites. Almost all were in agreement that all indicators reflecting the downward spiral in the sector are bottoming out and recovery is around the corner. This new recovery will be more measured, unlike the artificially-stimulated growth of the last bubble. Most feel that a new real estate “Peak” will be the norm around 2015.

As an improving economy led by job growth, affordable home prices and growing commercial opportunities opening in tertiary markets, the general consensus of the conference affirms the trends we’ve identified in the market – that new lending sources are opening up daily, the flow of credit is increasing and significant improvement is being made in making more loan products available to meet both residential and commercial demands.

2012 should also see a release of properties being held by both regional and large banks in the $10 billion and $50 billion in assets range. As the FDIC turns its scrutiny from the larger banks to smaller institutions, these banks recognize that to meet the minimum capital ratios required to pass stress tests they will either need to shed assets or set aside large reserves to cover potential losses on questionable assets. Asset disposition will be the preferred method over large loss reserves, and as a result of improving balance sheets, financial institutions are in better financial shape to sell assets at a discount. This means more properties will be coming to market but not to be dumped at fire-sale values. Larger private equity firms are fully-funded and are aggressively scouring the market for discount notes and assets.

Conference attendees also affirmed the potential for more activity in the acquisition and disposition of distressed notes. Over $350 billion in vintage 2007 commercial loan originations are expected to mature this year, and it’s projected that half of these notes will not be able to meet refinancing criteria and will be classified as distressed or non-performing assets. While this may constrain full market expansion, it presents some real opportunities to acquire commercial notes.

Commercial real estate investors are now finally experiencing an uptick in acquisition opportunities after several years of limited options. Investors generally expect the note market to remain active for another two to four years. In the next five years, close to $1 trillion of commercial loans will mature, putting additional pressure on US banks to step up efforts to shed more than $100 billion of non-performing loans currently on their books. They also cited the high number of construction, acquisition and development loans made by regional and local banks nationwide, now labeled as distressed. Two-thirds of potential loan purchasers last year completed their transactions. In the previous year, less than 50 percent were successful.

The Conference also highlighted some emerging trends that have the potential to hinder a robust recovery:

• The financial strength of municipalities and pension funds. Retirement obligations that are coming due will bankrupt many institutions that are already in trouble. Taxes, taxes and more taxes will be necessary thereby creating a recessionary impact.

• The loss of manufacturing jobs. This is a huge problem as is the outflow from California of these valuable jobs. Manufacturing jobs present one of few opportunities for disenfranchised groups to move out of a lower-income status into the middle class. As these jobs disappear, so will middle class productivity and wealth. A sobering statistic: 65% of U-Haul’s business in 2010 and 2011 was moves out of Southern California.

All in all, the tenor of the Conference was the over-whelming feeling that commercial real estate is working its way back; good news for all.

Cautious Optimism for Market Recovery

The country has gone from one extreme — lax oversight in financing — to the other, making it nearly impossible for potential homeowners to qualify for loans and purchase property resulting in a large inventory of homes and unstable markets. It’s now up to the banks. The only way for the residential real estate market in the U.S. to recover is for the banks to return to more flexible lending processes. At the commercial level, however, deals are taking place as pent-up cash rushes to well-priced real estate.

At Peak, we are more optimistic in the real estate market’s recovery and see buyers ready to commit to developments in both residential and commercial property, creating both opportunities and new jobs. We lend our own capital and are committing to new townhouse developments and shopping centers nationwide.

Three trends to watch in 2012:
1. Banks will increasingly embrace both short sales and modifications to loan principals. Over the past few years as new bills were introduced to protect homeowners, it’s become harder for banks to foreclose on properties, though in California alone over 800,000 properties were lost to foreclosure in the past five years, according to property information service DataQuick.

In reality, legislation has only delayed the inevitable foreclosure, exposed banks to legal issues and provided no real motivation for lenders to make the system move again. Banks have several options available to them to maximize cash flow in 2012 including short sales, which allow a third party to buy the property and the bank to recoup more of its investment than with foreclosures and loan principal modifications which incentivize homeowners to not abandon property and keep paying mortgages while recalibrating the system to current fair market values. With California’s Bill SB 458 signed into law in July, we’ve seen an uptick in short sales as homeowners feel protected against any future lien holder payments on the property. In 2011, the number of federally-sponsored and proprietary loan modification programs increased substantially despite the wave of new foreclosures.

2. Demand will return and necessitate new construction. While the building industry has suffered along with every other sector of real estate and construction of new homes – a key indicator of economic health – recently posted its largest decline in 27 years. Smart investors see potential in the building and construction industry.

Analysts at Fannie Mae and other organizations predict that the available rental units many consumers are turning to – away from single family homes – will not meet the growing demand for affordable housing. Also, on the retail and office front, as businesses expand, there will be shortages in commercial square footage. With new capital from private equity and large banks, selecting the right location to build in good markets is key to achieving a fair return on investing in new construction.

3. Revolutionary ideas will help kick-start the industry. From sanctioning Freddie Mac and Fannie Mae to act as landlords, effectively managing and renting distressed properties, to razing large numbers of homes to reduce the sprawling inventory and stabilize home prices, there are a number of expert recommendations on how to save the real estate industry. Enticing home occupancy to improve a community’s overall property value may be the best option. Without it, properties will depreciate.

As the natural cycle of short sales, loan modifications, and foreclosures runs its course, coupled with new construction driven by demand and implementation of strategies to liquidate the governments’ inventory of distressed properties, we feel a market recovery benefitting homeowners as well as investors is within reach.