Real Estate's Mid - Year Report Card for 2011: Hard Grades for Tough Times

The real estate industry looked with optimism to 2011 as the year of renewed growth and rejuvenation. Now that we've passed the halfway point, the industry's performance as a whole has been a mixed bag. Commercial real estate investing scored best thanks to a healthy multi-family sector, while bullying from a tough economy and lending-averse banks kept consumers from reaching the front of the class. But a business as broad as real estate is truly a sum of its parts. To truly tell if real estate is passing or failing at midterm, we need to look at the key markets and the factors influencing their progress this year:

Investors
• Distressed properties at bargain prices - Typically engaging in all-cash transactions, great deals abound this year in banked-owned and short sale properties.
• Increase in value of multi-family inventory - As homeownership loses favor to renting, vacancies have dropped and rents have risen to make apartments a profitable investment. Offering a safe return, the cap rates have been amazingly low on quality projects.
• Increased value in office properties in top urban markets – Prime office space values are climbing forcing investors to widen their search into suburban commercial space.
• Access to credit - In contrast to the residential market, banks are starting to return to the commercial market as a source of loan origination, and have more confidence in securitizing commercial loans. The qualification process is difficult but getting better.
• Rising delinquencies on old commercial debt - Securities backed by commercial loans originated between 2005 and 2007 are showing increasing signs of impairment in contrast to loans originated in 2011.

Consumers:
• Falling home values seem to be stabilizing – Downward pressure will continue as a result of the flood of foreclosed homes and short sales anticipated. High loan-to-value mortgage holders are suffering the most.
• The cost of the average mortgage - The good news: average mortgage rates remained below 5% for the first two quarters of 2011; the bad news: loan closing costs are nearly 9% higher than in 2010.
• Tighter credit – More stringent underwriting guidelines implemented by major lenders this year has kept many first-time buyers from obtaining mortgage loans.
• More homeowners facing foreclosure - Despite recent statistics showing a drop-off in foreclosure starts, industry experts agree the trend is a result of continuing bottlenecks in the servicers’ processing track. Consumers continue to face the threat of foreclosure in the coming years as lenders address internal issues and resume foreclosure filings in full force.
• Loan modifications gaining traction – Even with the specter of a wave of new foreclosures, the number of both federally-sponsored and proprietary loan modification programs has increased substantially this year helping more borrowers stay current.


Which brings us back to how is the industry doing? Over the past thirty-five years, I’ve seen the ups and downs of a number of cycles. With this current cycle, there are now guarded signs of an upward trend in all markets. Investors are clearly the best positioned to see strong returns in a safe environment with multi-family properties and single-residence rentals standing to gain the most in a longer-term outlook. Today, delinquent commercial loans present opportunities for those investors who specialize in purchasing distressed notes. Servicers have begun addressing the inadequacies identified in their foreclosure process procedures and have reluctantly embraced short sales, loan modifications, and other cures as options to remove distressed properties from their foreclosure pipelines; which brings us to the consumer. As lenders receive more pressure to relax credit criteria and if rates remain low, homeownership should become more attractive during this unprecedented era of deflated home prices.

It won’t be easy for real estate to end the year overall with a good grade, but it is possible. If investors continue to sustain the market and if lenders make it easier for consumers to participate in a rebound, we may see the next upturn more quickly than anticipated.

To build or Not to Build?

A tough question in light of today's stubborn economic recovery. Even though we've spotted a few bright spots on the economic horizon (a shrinking foreclosure rate, a growing cash-investor class taking advantage of bargain distressed property prices, rising values of existing commercial properties), tepid job growth and an inventory of unsold REOs seem to negate any optimism.

Arguably, the building industry has suffered as much as any other sector. Construction of new homes, one key indicator of economic health, posted its largest decline in 27 years and finds itself struggling with rising material costs in an environment not conducive to raising prices to cover costs. While conventional wisdom suggests that investors should distance themselves from the building and construction industry, first impressions could be misleading. A strategic return to the sector could yield great returns for the smart investor.

The secret lies in pinpointing specific demand and if enough demand exists to drive growth. UCLA’s Anderson School of Business’ recent findings echo findings from a number of other sources indicating a consumer “shift” is occurring to affordable rental units from the traditional single family home. Higher down payment requirements, tight credit and other factors make renting a more practical choice for current homeowners and the growing segment of “Echo Boomers” – defined as children of Baby Boomers born between 1975 and 2000. Fannie Mae estimates that the currently available 15.2 million rental units will not meet the growing demand for affordable housing for this group in the future. Similarly, on retail and office market fronts, analysts predict shortages in retail office spaces as businesses expand. While the fate of the traditional single-family home may be unclear at the present time, the need for affordable apartments and commercial square footage is increasing. Demand exists.

The economic downturn crippled the construction industry. The credit vacuum created by the voluntary exit of lenders and the FDIC shutdown of banks with non-performing construction loans brought building to a virtual halt. New project starts diminished and ongoing developments that lost financing stalled. These factors combined to stymie the supply of units brought to market.

Now that demand is showing signs of returning, some mothballed projects may begin to make sense at today’s prices. The initial infrastructure work leading up to construction (permits, environmental studies, plans, etc.) that comprise the up-front costs and take years to complete, new investors can now obtain for pennies on the dollar. Private equity funds and large banks are once again injecting new capital into projects. Activity is increasing at construction sites nationwide to meet projected demand, providing much-needed jobs to their immediate communities. We recently completed a development project that was able to sell at attractive current levels based on the fact that we saved on both the land cost as well as benefited from existing infrastructure. This in addition to the short time frame from investment to repayment, made the difference.

The key factor is to begin in the areas that were located within good markets and avoid those areas that were on the outer rim of the growth pattern. If the project is well located it should achieve a fair return using very conservative projections.

Is it time to build again? The answer depends on finding the right location at the right price at the right time when land is cheap and the up-front costs have already been absorbed by previous investors. The heavily discounted infrastructure and approvals, in my opinion, are the key elements

The All - Cash Investor -- Bringing Balance to the Housing Crisis

Supply, demand, and price — the three indisputable factors of economics on display during our current housing crisis. The supply of unsold homes, high unemployment, a sluggish economy,

restricted lending, and the emerging renters’ market work together to affect both the consumers’ ability to afford a home and pushes down demand.
As a result, prices on unsold inventories fall in the hopes of stimulating demand to reduce supply, which in turn affects the equity of surrounding homes. President Obama recently declared the housing market as the biggest “headwind hurting the U.S. economy.”

It’s no secret that the inventory of foreclosed homes isn’t going away any time soon, and the glut continues to send home prices downward. However, a new class of all-cash investor has emerged to bring balance to the equation and inject some much-needed hope into the housing industry.

According to the National Association of Realtors, approximately 1 million homes were sold to investors in 2010 and the 1st quarter of 2011 saw even more activity from deep-pocket buyers. Las Vegas, holding the unenviable title of “Foreclosure King“ with 1 in 9 homes in default at the end of 2010, saw all-cash investors snap up almost 5,000 homes just this past April alone. The same trend played out in California, where all-cash buyers accounted for nearly 31% of sales in January of this year. Sales activity in these two states clearly illustrate that the harder a market is hit with defaults, bargain prices are bringing a higher percentage of all-cash deals. The housing crisis has presented real estate investors with opportunities not seen in years, and investors from all over the world are stepping up to the plate.

The current property buying spree is not only providing all-cash buyers with profitable investment vehicles, it’s also providing significant support for a floundering residential real estate market waiting for the economy to improve enough to allow “average” consumers back into the game. All-cash investors accounted for as much as one-third of all home sales this year which helped bolster real estate sales figures and keep realtors employed, not to mention the impact of clearing the backlog of distressed properties from lenders’ books. As lenders’ tight credit standards make it more difficult for buyers to obtain loans, the all-cash buyer fills an important void in the purchase cycle. Moreover, with rehab needed on many of these distressed properties, investors are driving much needed business toward contractors to prepare properties for a future sale or rental. All in all, all-cash buyers have definitely given the housing industry a much needed boost.

Analysts predict that the inventory of foreclosed properties will continue to place downward pressure on home values through 2012. While the economy is showing signs of recovery in many sectors, that recovery has not fully extended to residential real estate. All-cash investors are a crucial component in maintaining the equilibrium in the real estate supply-demand-price formula. And as a result of this pivotal role, they’re not only keeping the industry moving, they also stand to be rewarded with strong returns and a great upside potential.

Commercial Real Estate Shows Signs of Life in 2011

I am confident in stating that we are clearly seeing the foundation for a sustained commercial property recovery.  The geographic results may vary, but there seems to be a consistent positive outlook. Nobody is saying they expect prices to skyrocket anytime soon but a fundamental floor is evident.

In a sign of the new times, the Mortgage Bankers Association recently sold its Washington D.C. headquarters to an investor group for $41.3 million.  In February 2011, that same investor group sold the building for $101 million. This is just one example and I can add another recent example:  one of our own deals that was acquired as a distressed note acquisition. The market stalled for the developer and we were able to complete the project and sell the property with multiple offers.  These examples illustrate how, over the past couple of years, commercial real estate values have appreciated as much as 30% in some markets.

At the height of the mortgage meltdown, while economists, Federal officials, lending institutions, and investors held their collective breath waiting for the other shoe to drop - the collapse of the commercial property markets - it never materialized to be the end-all collapse most had forecasted.  Due to more stringent underwriting and higher capital levels required for investments, commercial real estate held steady.  Today, with the resurgence of securities collateralized by commercial loans, major financial institutions’ actions underscore investor confidence.   Analysts project $13 billion in commercial-mortgage-backed securities (“CMBS”) will have been issued in the first quarter of 2011 alone. We are seeing a consistent stream of lenders who pulled out, re-enter the lending arena with large capital commitments for this sector. Commercial real estate is enduring the economic turmoil and remains a sound choice for many investors.

Thawing credit markets are breathing life into small and medium-size business growth which is fueling an increased demand for office space.  Although vacancy rates remain historically high in many markets, the trend is clearly going to the side of absorption. This increased demand for office space combined with a decline in new office building construction, has lowered overall vacancy rates, stabilized rents, and generated dependable returns.

Profitability in the multi-family sector is directly related to developments in the single-family housing sector.   For the average consumer or first-time homebuyer, stiffer underwriting guidelines, higher loan-to-value requirements, and higher interest rates have made it more difficult to afford a home.  Despite favorable “buyers market” conditions, only investors with cash in hand are truly taking advantage of market opportunities.  Many Americans, for the first time, are questioning the long-term value of homeownership.  Recent surveys indicate that the numbers of Americans who believe homeownership is a safe investment is decreasing annually. Moreover, homeowners displaced as a result of foreclosure or other loss mitigation activities such as short sales and deeds-in-lieu have created a new class of renter.  The outcome: vacancy rates for apartment rentals are plummeting and rents are increasing accordingly based on simple supply and demand. Analysts predict a mere 5% rental vacancy rate by 2012 with an increase in rental charges as much as 10% or more in major U.S. markets.

Capitalization rates further underscore the increased value of commercial property. The lower the “cap” rate, the higher the projected rental revenue.  In a recent Fannie Mae report, capitalization rates on multi-family properties remained low through 2010 indicating strong returns for the sector.  And, as the Federal government seeks to end government involvement in insuring mortgages, current proposals include continued government backing of multi-family loans due to their low default rates. The multi-family sector has been recognized as the first to recover.

All the signs point toward the commercial sector as being the one to watch:  unlike their single-family counterparts, commercial properties are appreciating in value; markets for commercial-backed securities are returning to favor; the resurgence of small business signals an increased demand for office space; factors stifling a recovery in the housing industry are generating revenue for apartment owners; and the government’s assessment of the stability of commercial mortgages is positive enough to keep it in the game of insuring them.

At the Peak Corporate Network, we believe that in a hindsight scenario, 2010-11 will be viewed as the “turnaround.”  We are seeing this firsthand with increasing demand for space and the improving performance of our properties after several years of decline. We are actively seeking to acquire investments and JV opportunities in this market.

The handwriting on the wall is clear - commercial real estate, for the savvy and patient investor, continues to be the smart investment.

The Implications of a World Without Fannie and Freddie

$321 billion -- the total estimated cost of keeping Fannie Mae and Freddie Mac on life support since both government-sponsored enterprises (GSEs) went into conservatorship in 2008. Given the high price tag, it's not surprising that the Obama administration has proposed plans for phasing out the programs over the next seven years. While the White House and Congress spar over a variety of partisan issues, they find common ground on the idea of getting the government out of the mortgage business. Recommending the end of Fannie and Freddie may sound like a sensible step to reduce the deficit and Federal exposure to the risks of mortgage backed securities, however, it also poses significant implications for the economy and a currently-struggling real estate industry. The biggest factor is additional uncertainty and insecurity in a market that has been unable to regain a stable footing.

In February, 2011, the U.S. Treasury Department recommended three options to phase-out the GSEs. The first option is predicated on mortgages guaranteed completely by the private sector. The second option is similar, but calls for some government involvement as a “backstop mechanism” which would be funded by premiums charged to a selected segment of higher-priced mortgages, the level of which needs to be determined. The final option relies on the private sector as primary guarantor, however, the government upon approving selected insurers and instituting strict underwriting oversight, would provide capital, if needed, funded by premiums charged to a select mortgage segment.

Under any scenario, FHA insurance would remain untouched; the government would only be divesting itself of the GSEs. Government insurance for mortgages secured for low-to-middle income borrowers by the FHA, the U.S. Department of Agriculture, and the Veteran’s Administration would remain in place under all three options.

The top tiers of the mortgage market could still encounter major headwinds with the phase-out of GSE backing. Adding private sector insurance with its associated higher premiums (undoubtedly passed on to borrowers) to the mix of sluggish home sales, depressed prices and rising mortgage rates could further postpone a full recovery in the real estate market.

Important to note as well is that the government’s proposals regarding the demise of Fannie and Freddie do little to address the inventory of toxic securities taxpayers have been burdened with since taking over their conservatorship. While the hope is that in time, these securities can be sold off, the options presented take a “go-forward” approach to prevent future catastrophes with no real strategies to deal with existing losses. The U.S. taxpayer holds an 80% stake in both GSEs, estimated to have a combined debt of $5 trillion which currently represents about 50% of U.S. first liens. While shuttering these two giants may achieve the long-term goal of extricating the government from the expensive business of mortgage insurance, it will fundamentally change the way loans are bought and sold in this country.

Can we act upon the headlines?

It’s 2011, and with the beginning of a new year comes new hope for a year better than the last one. If you believe the headline statistics touted by retailers and economists, we’re in store for a rebound. Here are some of the signs heralded as indications of an economy on the road to recovery:

• Retail sales for the 2010 holiday season were at an all-time high
• Auto and Banking industries are repaying bailout funds from 2008 to regain companies
• At the end of 2010 unemployment claims nationwide dropped, and in California stabilized
• Sales of existing homes increased in 2010
• In 2010, foreclosure activity saw a 14% decrease nationwide, according to data tracking from RealtyTrac

Unfortunately, relying on 2010 statistics as a basis for optimism could be misleading, especially when looking into the statistical support for some of them. If one just accepts the statistic that foreclosures sales have fallen dramatically it will not be a true picture. We need to examine the drivers behind decreased foreclosures. As a result of “Robogate”, which exposed the practices of lender middle managers signing affidavits allowing banks to repossess homes in default without fully reviewing the documents, major lenders and loan services halted foreclosure proceedings last fall to evaluate their document review process. It’s now 2011, and financial institutions are gearing up to resume foreclosure activities. What also looms on the horizon is another round of adjustable rate mortgage resets to higher rates in 2011 which could potentially contribute to higher foreclosure numbers if borrowers can’t make increased monthly payments. Or worse still, borrowers faced with higher mortgage payments could decide they owe more than the property is worth and simply walk away in mass numbers.

With all the talk of a rosier outlook for 2011, it’s clear that borrowers are still facing the issue of losing their home. However, loan modifications and short sales still exist as viable options for homeowners to keep their homes while the economy stabilizes. The simple fact remains that lenders don’t want the cost of REOs dragging down their balance sheets, and invite alternatives to keep borrowers out of delinquency. They will invite alternatives that enable their books to show a positive direction. Many insiders are concerned about the prospect of an additional price decline although most that I have spoken to do not feel we should expect another large decline.

The reality is that as long as lenders keep their very tight lending criteria we cannot expect that any increase in values is just around the corner. At some point the reality of profits will need to translate into looser lending.

All the talk of an economic turnaround could lull homeowners facing distressed situations into a false sense of security. But borrowers facing delinquency or foreclosure do have options at their disposal to keep them from becoming the next bad statistic. Short sales and loan modifications are alive and well in 2011, and can help people stay in their homes or at worst have a solid chance of a fresh start.

Is this the time to invest in houses?

I am regularly asked this question - . Should I take my very valuable saving and buy a house, rent it, and hold it for a good return?

The answer is simple; for sure, maybe, probably not, or no way!! I believe that covers it all.

Let us explore these answers and you can decide what to advise or perhaps what to do on your own.

The correct answer directly correlates to risk, expectations, need for money, alternative investments and available time. An investor who wants to buy will have to identify the right asset for a lease / hold strategy and hold it in an investment portfolio as a separate class in the basket. Let’s explore the data and forecasts to help make this decision.

Existing home sale statistics have been rising over the last year but most recently are showing some weaknesses. According to NAR (including SFR’s & Condos) in June sales fell over 5% from May, but are still almost 10% higher then in June 2009. The supply is much higher then we would like to see. But the overall pricing is stable due to such a severe drop. The prices were higher in 10 of 18 metro markets in 2010 versus 2009. Condo values were flat in most markets year to year. In a broad brush approach – northeast values decreased slightly around 1%, Midwest – down 1%, South – unchanged, West was up 1.5%. It does appear that conditions have become more balanced. It is likely that a balance can continue since the tax credit expired and jobs remain a problem. The job situation may be the most important factor in a specific area if we try and forecast future values. This of course is considered along with the release of new distressed inventory by lenders “holding back.” There is also all the recent press about a “double dip” recession projecting future value declines.

Home value volatility and associated risk remain very high. It seems that the stabilization phase with government policy intervention may have run its course now. There is a strong possibility that we could see further price declines as the economy remains weak.

Digging further into values, according to Core Logic’s year to year home price index for June the following is important: The top 5 states with highest appreciation were South Dakota +6.9%, Maine +6.4%, California +5.9%, Virginia +4.7%, Washington DC +4.3%, Top 5 depreciation; Idaho -9.1%, Alabama -3.8%, Oregon -3.5%, Washington -3.4%, New Mexico -3.2%.

There are some factors that show reason for optimism in value expectations. The inventory of new homes being built and released to sell is actually at a very low level. In addition, we have interest rates being offered by lenders that feel like the “limbo” – How low can they go? They are at historical lows and we find 30 year fixed rate loans at around 4.5% to be extremely attractive.

So now having digested the various statistics and investigations, we need to ask if the investor is right for this investment and what a buyer should expect both in return on investment, time commitment, and other issues.

As SFR defaults continue and the housing market seems to stabilize, will SFR lenders increase their strategy to “rent & hold” property rather then dump them or leave them vacant? For many lenders this strategy makes sense even if they are reluctant landlords. A concern for any investor is that these rental homes will become your competitor as well as the multi-family building in the immediate area. Both of these will hold rental values down until the homes are sold and apartments fill-up. This increase in rental unit availabilities can cause a downward spiral for investors holding homes for rent.

As managing director of the Peak Corporate Network, I was recently interviewed by 2 reporters for a cover article in the L.A. Times, August 20th. I was able to provide details due to Peak’s expertise in the default area including our financing products for investors buying houses and our default services. The reporters were responding to reports that institutional investors / funds are jumping into the “trustee sales” investment world. We have seen this directly as we are regularly approached to finance or joint venture in such acquisitions. I believe that the demand to place money is very high now and the property returns on buying at the trustee sale support the “high yield” requirements for many fund managers. I bring this up because it may soon be the case that the way to get the higher “sales price” is at the trustee sales. The same factors that led to previous bubbles with too much money being placed in home loans can lead to too much money chasing the same deals at the footsteps of the courthouse. I can tell you that some of our property loans that have gone to sale have been sold to 3rd parties at prices considerably higher than our analysts advised we wound net at full payoff or as an REO after eviction, repairs and sale costs. This is an interesting phenomenon and will be worth watching. The inventory being acquired may ultimately disappoint the investor and lead to a wave of dumping these homes in 1-2 years.

The days of easy flipping single family homes may be coming to an end according to many savvy realtors and investors. I agree that the markets have in fact “cooled off” as so many remain unemployed and pessimistic. According to one research group, prices will go down even further over the next 18 months by as much as 5-10%. Anyone looking for a short term gain by selling a property is probably heading for trouble. Flipping is going on for sure, but fewer investors will be able to pull it off for a nice profit. Flipping a property requires “cash in hand” with an investment for repairs, holding and selling expenses. The idea of buying it and selling it “as-is” is becoming very difficult to accomplish.

The lenders policies are making it so difficult to close a loan. We regularly make loans for borrowers who simply could not obtain conventional financing in this market even though they are well qualified. Timing is usually the main issue.

Regardless of the roadblocks, investors are buying. The latest NAR figures show that 14% of all transactions in May were by investors. The majority of those being distressed properties that would still be empty if not for the investor.

Is the investment right for you or your client? Investor expectation is the key variable. Banks today are paying from ½ to 2 ½ % for their safer deposits. If we look at real expectations it does not take much of a return to match or beat the alternatives. If one is satisfied with little or no actual net cash flow and is willing to ride out this cycle, we can all agree that values will surely go up from their current levels. The problem of course is where we are in this cycle. I do believe the large downside risk has been stabilized and we are at most within 5-10% of the floor in most major national markets. There could be further declines but some risk is always to be expected and must be assumed. Most properties at these values and current rates cannot throw off cash flow in excess of 5% actual annual returns. In this calculation you have vacancy, cost of funds, repairs, maintenance, taxes, and insurance.

It is a reality that if you are a landlord “things” happen. The same borrowers who had sub-500 fico are now renters. They could not pay their mortgage so why would you expect a good payment record if they are your tenant? This means eviction cost and delays, vacancy, repairs and costs of re-renting. A break in occupancy, even for a short period, will eat up any expected cash flow and probably will result in a “cash call.”

This now brings us to the “time” concern. How available is the investor to handle such issues. Turning the house over to a management company is a solution but it does have a high price tag as well.

Now that we determined that expectations are good and the investor has the capacity to handle the rental I want to give a few tips to help maximize the potential return on investment.

- Talk to top local rental agents about the area and rental conditions.
- Read newspaper ads – How much is being charged for rentals?
- Consider schools and amenities (Shopping / Transportation)
- If Condo – check out HOA restrictions
- Before you rent – maintain it, clean-it up and make it livable.

In conclusion, the concerns are similar if one hopes to flip it or rent and hold. Values are very attractive and if an investor has the wallet to “ride it out” there is a great opportunity to get a very good return at the end. Keep your expectations in line, be ready for surprises and make some money.


Gil Priel, Co-Founder
Peak Corporate Network



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