Let the Housing Cycle Run its Course - Without the Training Wheels

The housing recovery is in an interesting stage. Even as more reports affirm a positive direction for the real estate recovery cycle, the push for additional government support is gaining momentum. Granted, intentions are noble, however, additional activity to assist the cycle could, in reality, bring headwinds to slow its progress.

What we’ve seen so far in 2012 is a dramatic reduction in mortgage delinquencies and foreclosures compared to 2011, due in part to a host of government programs and legislation already implemented throughout the mortgage crisis. Government influence began with the Obama Administration’s “Home Affordable” program suite of cures providing short sale incentives, loan modification help, and refinancing relief for homeowners in negative equity -- known as HAFA, HAMP, and HARP, respectively, and culminated with a landmark $25 billion settlement between individual states and big lenders providing relief on the state level.

Additionally, states have enacted their own strategies to slow the progression of distressed homeowners into the foreclosure pipeline. California being a case in point with the recent passage of its “Homeowners’ Bill of Rights” which affords homeowners increased protection from foreclosure above and beyond actions taken on a national scale. These steps have not only prevented more borrowers from reaching the foreclosure stage, they’ve also served to shrink the flow of distressed homes into the “shadow inventory” of residential housing, resulting in less distressed properties depressing overall home values. These are great developments. Not only are fewer people losing their homes, existing homeowners are seeing the value in their homes begin to rise and buyers are returning to a market now struggling to keep up with demand. Not all markets have seen this phenomenon but it is clearly becoming more frequent in most major markets.

Bottom line: existing programs to help borrowers, combined with small gains in the overall economy, are proving sufficient to support a healthy recovery. Additional intervention at this point could prove costly. Case in point: more widespread application of principal reductions at the GSE level striking a resonant chord with consumers, politicians, and the media, comes at a taxpayer cost and could drive private investors out of the market. Recent analysis from the FHFA, the conservator for Fannie Mae and Freddie Mac estimates principal reductions would prevent $1.7 billion in defaults, but cost taxpayers $2.1 billion in implementation and incentive payouts.

At the local level, recent Eminent Domain proposals allow municipalities to purchase loans at “fair market value” and pass on the savings in the terms of principal reductions. Championed by the newly- bankrupt California city of San Bernardino as a way to protect its distressed homeowner base and stop the hemorrhaging of tax revenue, if implemented; these plans could ultimately incur significant losses for private investors in securities collateralized by any of these mortgages. Moreover, principal reductions through Eminent Domain or at the GSE level provide little backstop for losses on homeowners who simply cannot make their mortgage payments.

Future prescriptive actions by the government could only serve to continue taxpayer participation in the recovery, prolong the recovery, or both. Where the housing sector can benefit, however, is by lenders playing a larger role. Borrowers in 2012 understand the responsibilities (and consequences) of a mortgage payment better than their predecessors of the previous housing cycle, and as such represent a better credit risk. It’s time for lenders to relax underwriting guidelines and qualify more borrowers for loans. In addition, while lenders have made significant strides in working with delinquent borrowers, they can do more to streamline the short sale process to dispose of properties before they come up for auction or end up contributing to an REO inventory.

Government has proven itself a strong ally in breathing life into the housing cycle. It’s now time for the cycle to run its natural course. The fundamentals are in place for it to succeed.

The Short Tunnel for Real Estate's Recovery

The overused "light at the end of the tunnel" symbolizing the arrival of the real estate recovery may just have gained some credibility as we enter the last half of 2012.  Or at the very least, the tunnel's gotten much shorter.  The guarded optimism that the downward cycle is over is being supported by some very encouraging news on a number of different fronts. While it’s still premature to proclaim the official demise of the housing crisis, encouraging trends developing over the first six months of the year may portend overall good news for the real estate industry for the last six months of the year.

A housing market described so often as distressed for the past four years is currently getting relief that is constant, sustained, and showing measurable signs it’s providing a cure.  Predictions that lenders would ramp up foreclosures at a rapid scale in 2012 as a result of a landmark settlement with states simply haven’t materialized.  Aggregate foreclosure starts, especially in non-judicial states, dropped over 18% on an annual basis.  The widespread acceptance of short sales by both lenders and borrowers have served a dual purpose in keeping borrowers off the foreclosure rolls and preventing properties from ending up as REO on lenders’ balance sheets.  Moreover, the distressed borrower of 2012 is more qualified, educated and proactive than in years’ past to take advantage of lender solicitations and government programs to modify their loans.  As a result, mortgage delinquencies are at all-time lows, and more borrowers are avoiding Notices of Default.

The non-distressed sector provides some of the best signs of a sustained recovery as well.  In short, buyers have returned.  When bargain-price homes weren’t enough to jumpstart sales, record-low interest rates enticed buyers back to the market.  In fact, selected markets have even seen the return of multiple offers on properties, and the scarcity of housing product is contributing to modest appreciation of home values in selected areas.  We are certainly experiencing this market improvement in our immediate area in the western San Fernando Valley and the Westside of Los Angeles.  In a direct parallel to the distressed borrower of 2012, the prospective homebuyer of 2012 is better prepared for the responsibility of a long-term mortgage commitment and making more prudent choices regarding what they can afford and the right type of loan program to finance the purchase.

Investors have reason to smile as well as they furnish housing for a specific niche of the market not able to take advantage of the aforementioned buying market.  Today’s rental market is booming, generating strong returns for both multi-family and single-family property investors.  The forward-thinking all-cash buyer of SFR bargains in 2010 and 2011 foresaw the environment would be more conducive to generating revenue through renting as opposed to flipping. This strategy has been extremely popular in 2012.  Moreover, the slowdown in new apartment construction during the height of the housing crisis paved the way for a shortage of available units now that has brought back demand.  Low vacancy rates and higher rents prevail.  As a welcome footnote, new building starts and permits for new construction are on the rise to feed the appetite for new rental units.

Yes, for all practical purposes, it appears that real estate’s recovery has begun.  But at best, it is a fragile recovery that can be derailed by any new bumps in the economy.  Job and GDP growth, key metrics indicating economic stability, have improved but at tepid pace.  And a rash of recent near-defaults of foreign economies poses a lurking threat to ours.  Any unexpected economic shocks caused by unemployment, poor retail performance, European recessions, or any combination of these factors will serve to undermine real estate’s stronger performance this year.  The good news is that after six months of shrinking foreclosures, lower interest rates, more buyers returning to the market, rising rents, contracting REO inventories, and new construction activity, we’re significantly through the tunnel. The positive momentum of the first two quarters in 2012 may just be enough to propel real estate through any new headwinds it could encounter for the rest of the year.  

The Truth Behind the Numbers on Declining Foreclosures

Recent first quarter research from numerous sources supports industry sentiment that the bottom of the current real estate cycle has been reached, and the new cycle has begun. In an unlikely alliance, government, the private sector, and even the media have all identified the unrelenting wave of foreclosures as the source of the problem and directed all of their efforts to hunting down the beast and killing it. Based on recent numbers, the foreclosure crisis could appear to be contained. According to the numbers:

• Overall foreclosure filings are down 19% -- their lowest level in four years.

• The volume of “pre-foreclosure” sales hit a record 109,593 transactions as homeowners and banks adopted short sales as a preemptive strike to losing their homes.

• Analysts monitoring mortgage delinquency rates, the accepted metric predicting foreclosure volume, are reporting continuing month-over-month declines in delinquencies.

• Credit-reporting agencies, well known for keeping falling FICO scores top of mind, are now proud to report that consumers shed mortgage debt to the tune of $350 billion over the last year and are continuing to trim the fat.

• The Obama Administration’s assault on the housing crisis through no less than 12 separate programs since 2009 have provided millions of distressed homeowners permanent modifications, refinancing opportunities, forbearances, short sale incentives and even in some cases, mortgage forgiveness.

While these are impressive metrics, the real estate industry would be wise to season its interpretation of the data with a dose of skeptical pragmatism. Too much emphasis is being placed on surveys and reports to validate a recovery instead of taking a hard look at what is transpiring on a day-by-day and case-by-case. Albeit mitigated, the foreclosure crisis is still very much alive and well.

When the pundits are silenced, and the analysts are deprived of their spreadsheets, what remains is a staggering number of homeowners, over 3.5 million, having lost their homes since 2008. No metric accurately represents this devastation on families, their surrounding communities, and the overall economy. Granted, foreclosure filings are at record low levels and continue to fall. Nevertheless, nearly 200,000 new borrowers received Notices of Default during the first quarter of 2012.

Looking at the crisis from the lender perspective, the numbers don’t fully portray the battle lenders face to minimize losses. While data publicizing lower defaults points to a possible end to the drag of REO on lender balance sheets, that end is years away and the current cost of loss mitigation has proven to be expensive. Case in point: recent settlements with individual states over foreclosure improprieties cost lenders $25 billion, and still provide loopholes for more claims. Tougher standards implemented to avoid lax processing of foreclosure filings require more auditing and personnel to implement. And clearly, lenders have been forced to accept larger losses on REOs and to embrace short sales to prevent further hemorrhaging. In short, the numbers use a wide brush to paint a possible outcome of the foreclosure crisis, but ignore the present reality that homes are still being lost today.


A more holistic approach is needed to properly measure the effectiveness of the war on foreclosures. To be fair, the real estate industry and consumers alike should feel real hope as a result of data showing a consistent downward trend in new foreclosures quarter after quarter. The housing industry is at its strongest place in three years and is getting stronger. However, we shouldn’t allow backwards-looking or forward-projecting reports distract us from the ever-present reality of the severity of the foreclosure crisis. Conditions are improving, but the battle is far from over. Success is measured not by aggregate numbers, but by one homeowner at a time who avoids a foreclosure.

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.

Foreclosure Settlement Falls Short

As published in the Los Angeles Business Journal, March 5, 2012:
 

The recent landmark foreclosure settlement between the nation’s five largest lenders and 49 states has certainly captured the headlines. After over a year of intense brinksmanship between the involved parties to mitigate bank liability while setting a realistic level of restitution to compensate victims of the robo-signing debacle, an agreement emerged.  The resulting accord may have minimal impact on the final wave of projected foreclosures still on the horizon, and won’t provide a meaningful boost to help real estate. At best, it’s a punitive solution for past abuses that will not be adequate to actually help the industry recover.

To be fair, any part of the settlement that provides relief for struggling borrowers can provide a stimulus to the market.  An estimated $18 billion of the $25 billion total settlement amount will go to California, with $3.92 billion of that earmarked for Los Angeles County.  Over 59,000 foreclosure filings occurred in Los Angeles County in 2011.  While awards up to $2,000 for borrowers wrongfully foreclosed on won’t bring back their homes, it at least provides some compensation to begin a fresh start. 

Recent estimates suggest that approximately a million borrowers in California alone who are currently underwater could be eligible for up to $20,000 in principal reductions thus making payments much more affordable.  An ancillary benefit to lower payments or any principal reduction on the senior deed could occur in situations where a 2^nd trust deed exists on properties and borrowers would be encouraged to stay current on payments giving life to lenders on the verge of being wiped out by foreclosure.  At first glance, this could appear as welcome news.

Deeper analysis reveals that the agreement falls short of addressing the 180,000+ REO inventory in Fannie and Freddie’s possession or the borrowers separated from these homes through the foreclosure process. Nor does it address the thousands of underwater mortgages held by the GSEs to which the GSEs are resistant to enact refinancing solutions.   Moreover, mortgage lenders now face a new wave refinancing applications generated by homeowners seeking to qualify under the new agreement. 

Borrower Backlog

One lender has already been quoted as citing processing times as long as 90 days for refinancing applications. Borrowers not qualified for refinancing under the new proposal could create such a backlog that eligible borrowers would be forced to wait. Or worse still, the market could see the return of higher interest rates to slow and manage the flow of mortgage applications.

Private capital has long been courted as the white knight to lead the recovery.  While prevailing sentiment would hardly characterize the private investor segment as a “victim,” the principal reductions proposed in the current agreement which would significantly affect investor returns, could result in the mass exodus of private capital from the market. Remember, too, that private capital is comprised not only of private equity firms and high-net-worth individuals, but also of insurance, pension and other institutional investors seeking maximum return for their beneficiaries.  Private investors provide a necessary back stop that if removed, may require more taxpayer and / or government intervention to fill the void.

While this $25 billion mortgage settlement plan gives genuine hope to many Angelenos to receive compensation or even lower monthly payments, it truly serves to provide regulators, lenders and government with a concrete example they can point to confirming that they took definitive action to restore economic equilibrium. There are some substantial cracks in the pavement, however, that will limit the true intent of the settlement in providing real help to the real estate market.

Consumers: The Missing Fundamental

"Market fundamentals" are often cited when evaluating the real estate industry. Indices measuring home values, cap rates valuing commercial properties, office vacancy "absorption rates," REO inventory, are great examples of accepted standards used by the industry to measure success. What's missing from this list is the influence consumers and small business have on core fundamentals, and they could arguably be the most critical component in driving the real estate recovery.

Let’s start by looking at the distressed homeowner segment as one example of how consumers are contributing to the recovery. Armed with more information and options than ever before, borrowers are confronting and no longer running from delinquencies. Their proactive efforts to modify loans, refinance underwater mortgages to lower rates, and accept a short sale as a foreclosure alternative are having a positive effect on containing non-performing assets held by lenders. At the other end of the spectrum, consumers with less debt and on more stable financial footing are feeling more confident in their ability to handle the obligations of a mortgage. Realtors, builders, and loan originators alike should soon see their numbers improve as more buyers are enticed into the market by low rates, more affordable homes and evidence of an improving economy.

Fundamentals in multi-family real estate are also improving thanks to the rise of the latest “renter nation,” a new generation of younger and more transient households not interested in the overhead of a mortgage. As a result of this new demand, developers and investors with positions in multi-family projects are seeing a much needed jump-start in apartment construction.

And finally, as more consumers get back to work, small business expands in pace with current economic growth, and construction of new office product is at a standstill, office vacancy rates will continue to contract and generate more healthy returns for owners / investors in the office and retail sectors.

The real question at this point is, as consumers and small business are in the drivers’ seat of the recovery, what can the industry and government policies do to ensure the recovery moves forward?

• Let’s start with government policy. Efforts should continue for crafting workouts for borrowers who could afford to keep their homes under loan-modified circumstances, and toward removing barriers for short sale or other foreclosure alternatives for homeowners who cannot afford to keep their homes.
• Realtors should better adapt to service a market heavily-influenced by distressed properties. Short sales and REO sales are projected to dominate the market through 2012. Major stumbling blocks in 2011 were protracted short sale negotiations and pervasive litigation. As expertise is required, realtors should partner with specialists familiar with the unique lender-buyer-seller process to facilitate more efficient, litigation-free sales.
• Investors and developers have an opportunity to step up to meet the growing demand for affordable rentals through new multi-family projects, and by participating with GSEs in bulk REO purchases and converting them to rentals to meet the demand for affordable housing and limiting the “for sale” inventory.
• Lenders need to step up the most. Without the flow of credit, the system simply stops working. Lenders must not only be a reliable source of capital for the investor class, they need to loosen restrictions for consumers as well. Easing restrictions and making loans more accessible and financially-viable to today’s new class of buyers and business owners who understand the responsibilities required of long-term credit commitments, is the glue that will make this recovery stick and move forward.

So goes the consumer and small business, so goes a recovery in real estate. This “fundamental” concept cannot be ignored.