A View from the Cliff

The looming danger of the "Fiscal Cliff", the terms of the Budget Control Act of 2011 that will enact drastic spending cuts and end tax cuts affecting middle and upper income tax brackets, has apparently superseded the gains in the economy in 2012. Consumers and investors alike are focused on the negotiations out of Washington to address the federal deficit, and what the impact will be on their pocketbooks and investments. The real estate industry finds itself with much to gain, and quite frankly, with the most to lose depending on what steps are taken to prevent across-the-board cuts and tax increases from kicking in.

We’re all aware that what’s at stake in this debate: generating more revenue to pay down the debt through a combination of program cuts and tax increases. The possible expiration of Bush-era tax cuts on capital gains taxes at the end of 2012, for example,  has sparked a flurry of real estate transactions during the third and fourth quarters to take advantage of a more favorable capital gains environment than could be encountered on January 2nd. As a result, the metrics could paint a lopsided picture of strong activity in 2012 with comparatively little activity in 2013 as investors consider future tax liabilities.

What presents the most significant threat to our industry during these negotiations is the future of the mortgage interest deduction representing over $83 billion in savings for homeowners annually. This same savings also represents a potential source of lost revenue. Despite a fierce lobby from the MBA, NAR, NAHB and other related industry organizations, this most significant tax break for homeowners finds itself under the microscope.  The deduction, no longer just a partisan talking point during an election year, has recently been acknowledged by the President as being a possible casualty as a result of  the Fiscal Cliff discussion.   While the possible scenarios involving modification of mortgage deduction attempts to direct most of the burden to upper income households with a gross adjusted income of over $250,000, there will still be enough collateral damage to middle income household to make a significant difference and a change in the attitude of buyers in general.

Case in point: the proposal of a blanket $35,000 flat deduction to replace the standard itemized deductions inclusive of the mortgage interest and property taxes could actually move many middle-income homeowners  currently “on the edge” into higher taxes brackets. Another popular proposal to reduce the current mortgage interest deduction allowed from $1 million on the initial principal balance to $500,000 also seeks to shift more tax liability to affluent households. Remember that “affluent” is a relative, regional descriptor.  In primary coastal markets such as New York, San Francisco, and selected California communities, median home values are approaching and exceeding the $500,000 potentially bearing the brunt of the cap. Five California markets, Santa Barbara, San Francisco, San Jose, Salinas and Los Angeles, will see a significant amount of homeowners paying higher taxes, and homeowners will strongly evaluate if there is a cost savings in continuing to make a higher priced mortgage payment. Based on forecasts that home values will continue to appreciate over the next two years, more single-family real estate transactions in other markets will hit the cap.

Tampering with the mortgage interest deduction would have serious ramifications not only for the real estate sector, but for the economy as well. The NAR estimated that complete elimination of the deduction could reduce property values as much as 15%, wiping out all the gains of 2012. Rising equity this year gave homeowners hope, and combined with the benefits of the mortgage interest deduction, made homeownership attractive again. For the first time, the rebound in real estate played a contributing factor to nation’s growing GDP as a result of sales generated and jobs created.

It is clear that the rebound in values in most markets was heavily influenced by the investors moving in to acquire properties that can be rented while they wait for appreciation. However, there is the need of an exit down the road a bit and at some point there needs to be an influx of true homebuyers looking for a beneficial investment, and more importantly, a place to live. The elimination of deductions related to homeownership will make this day further off than most investors will wait. The risk then becomes that a new wave of selling hits the market further depressing the values and starting a new collapse in values.

We’re hopeful that lawmakers will soon get past the usual brinkmanship that accompanies the start of making difficult budget decisions. Then, when considering what’s best for the country and the economy, they can entertain the idea that the current mortgage interest deduction is not a sacred cow, but a path leading them away from the Cliff.

Moving Past the Election to Keep the Momentum in the Real Estate Recovery

With the election now behind us, the country and the economy now has a clearer idea of where they're headed for the next four years. Notably absent from most of the rhetoric from this fall's campaign was a sense of what the real estate industry could look forward to. The signs of improvement in the sector emerging at the beginning of the year have now been validated as a full recovery, but the significant drop in foreclosure starts, rising equity in American households with appreciating home values, and the return of a seller’s market were seldom mentioned. Now that the dust has settled, it’s time to turn our attention back to pressing issues put on the back burner that could make or break our housing recovery.

Some of the best news for housing in 2012 is the ongoing “undistressing” of the American homeowner. Higher employment numbers, the effects of a flurry of Obama Administration housing programs initiated in 2009, a landmark $26 billion settlement between lenders and states addressing past foreclosure improprieties, and a more aggressive mortgage workout strategy executed by banks has resulted in a 6 year low in foreclosures and more borrowers staying current on mortgage payments. Short sales emerged as one of the most popular solutions to foreclosure, and made arguably the most noticeable contribution to helping distressed homeowners. Lenders lose less on a short sale than a foreclosure, and more borrowers can take advantage of short sales now with an expansion of programs that include borrowers who are current on payments. What threatens to scuttle the gains short sales have achieved is a crucial tax benefit for borrowers currently on hold. The Mortgage Debt Relief Act, which addresses the difference between the original loan amount and the actual selling price of a property in a short sale transaction being treated as taxable income, is set to expire on December 31st. The Senate passed an extension of the bill, but no further movement has occurred to keep this important benefit to borrowers intact as the nation focused on selecting its next president. This is a huge concern for the continued recovery and short-sale acceptance by lenders. Recent indications are that the “REO rental” program has not been allowed to gain momentum because lenders are realizing that the short-sale is in fact a more profitable solution and they are holding off on selling at steep discounts to institutional private buyers with the rental restriction in place.

The Responsible Homeowners Refinancing Act (RHFA) is another example of pending legislation in Congress with great potential to solidify the recovery, but finds itself stuck in a holding pattern. Approximately 12 million homeowners could benefit from the bill that would extend refinancing opportunities to Fannie and Freddie-backed mortgagees current on payments but facing negative equity or other hardships. Introduced in September, the bill has languished in Committee with no further consideration. The RHFA could be the final component needed to power a sustained cycle to stabilize the current borrower base. Congressional movement on the future of the RHFA is crucial for us to move on in the development of the cycle.

The election- season freeze impacts arguably the most sought-after player in the current cycle --- the private investor. The future increase of capital gains taxes and the extension of Bush-era tax cuts is still undecided and could have a long term effect on investor participation on sustaining a fully-rounded recovery past 2012. Two investor camps have formed – one camp which was responsible for a short- term flurry of commercial real estate investment activity in the third quarter leveraging advantages of the current tax environment, and the other camp that assumed a more conservative “wait and see” approach and backed out of the market. The future of how taxation treats investor real estate profits is a major factor that keeps investors in the commercial real estate game through this cycle, or keeps them on the sidelines. Real estate needs private capital in the game to sustain the recovery from the commercial perspective. There is also the need for a post election relaxation of lending standards and compliance allowing the pendulum to swing back towards easier access to capital.

Given the growth in the nation’s GDP recently attributed to housing, and recent findings that real estate could continue to fuel the economy’s growth regardless of the election outcome, very little priority has been given to continuing the momentum. The industry’s progress could face new headwinds impacting homeowners and investors alike without fast action from the government now that November 6th has come and gone. It’s time to move forward.

Extending the Flow of Capital to the Small Commercial Investor

Just a little over year ago, gains on the commercial real estate ("CRE") front bolstered the recovery as home prices floundered.   Industry pundits touted CRE as the white knight to lead the real estate sector out of its economic purgatory. Fast forward to the fourth quarter of 2012 and it does seem that CRE advancement may be slowing– at least for rank and file investors seeking opportunities in smaller markets or asset classes.

In 2011, Institutional investors, large private equity funds, and deep-pocket investors possessed the capital to take advantage of the higher return on commercial backed securities and acquisition of trophy properties in Class A markets.  At the time, returns on CRE deals for selected transactions could average as high as 10-12%  when compared to much lower yields from equities, treasury notes, or other traditional investment vehicles.   Lenders, extremely risk-wary of interest revenue from the residential sector, felt more comfortable in a commercial sector that enjoyed solid price appreciation and had stronger underwriting procedures in place than its residential counterpart. Lender purse strings particularly favored institutional and large investors because of the size of the prime asset class and prime location.

This “love affair” between big lenders and big investors has barred small investors from the rally. Assets with great growth potential have been cherry picked from top markets,  forcing investors to scour smaller markets for riskier assets. The upside is that investors with a higher risk tolerance are finding some tremendous opportunities off the beaten path.  Unfortunately, lenders don’t see the same potential nor share the same risk tolerance as these investors. And this represents the current dysfunction in the CRE sector and is preventing it from moving forward at a healthier pace:  lack of available capital for commercial acquisitions in new markets as well as stringent credit requirements and guarantees by borrowers.  Without available capital, the once robust expansion of CRE is beginning  to cool down and exclude a significant sector of investors from finding the  financing it needs.

Compounding the issue is the billions of dollars in commercial debt maturing in 2012 for loans originated in 2007 and bundled into securities.  Major lenders, faced with the potential of future losses on old debt and gun-shy of financing assets in riskier markets, have constrained the flow of capital necessary for new acquisitions and thus contributed to the tepid CRE performance in 2012.

There cannot be a balanced recovery in real estate unless the imbalance in CRE capital availability that disfavors small investors is corrected.  In light of current lender sentiment, small investors would be wise to explore alternative debt structuring solutions. The real cure, however, is for traditional capital sources to extend the same underwriting latitude and trust to small investors as it does to their larger siblings. Recent trends indicate a thaw could be in the works for commercial lenders to do just that:

one of the unexpected by-products of the most recent round of Federal Reserve Quantitative Easing has created a new demand  for commercial – backed mortgage securities. To bring more CMBS product to market, lenders will need a supply of new commercial mortgages to collateralize.  This means less- expensive loans, less-restrictive underwriting guidelines and a willingness to lend on commercial properties in new geographic regions.

Real Estate’s current growth will be guaranteed a more sustained upward cycle with a stronger contribution from the commercial real estate sector. That can only happen by increasing the flow of capital to a larger cross-section of investors and product type.

Emerging Inflection Points as Real Estate Continues Down the Road to Recovery

As results continue to roll in on the state of real estate, there’s good news on all fronts.   Few now doubt the return of stability to housing.  Here’s a short list of notable gains in the past twelve month period:

• A dramatic drop in foreclosure starts
• Lower REO inventories and a shrinking "shadow inventory"
• The exodus of the all-cash buyer having been replaced by the return of the average consumer
• Increased demand (and revenue) for multi-family and single family rental units

 The most promising news is that the appreciation in home values is so solid that even the S&P / Case Shiller Home Price Index has now officially acknowledged it in its recent reports.

 

These are all encouraging developments that, barring significant setbacks in other areas of the economy (job growth, GDP) should sustain the recovery. It’s important, however, to watch for upcoming inflection points in isolated parts of the industry where progress in one sector has direct impact on another sector.  The recent trend of rising home prices is a good case in point.  

Multiple factors contribute to the current low supply of housing product, including reduced inventories of distressed properties as a result of bulk purchases, lower REO inventories, and sellers sitting on the sidelines.  As prices to continue to rise, watch for the inflection point when more sellers list properties.  Potential sellers are not just playing a wait-and-see game for a better return on their investment. Despite the current wave of loan modifications and refinancing opportunities, a significant cross-section of homeowners still owes more than their homes are worth.  Appreciating home values combined with principal reductions, loan modifications, refinancing, and other borrower relief programs should bring about a tipping point that will introduce more homes into the sales pipeline.  The perception that prices are rising could be enough to coax homeowners with entry-level homes to bring them to market to fill that important affordable niche of homes.

Short sales present another interesting scenario of an upcoming inflection point for the disposition of distressed assets.   After our many years of experience as well as lobbying with local politicians, short sales have come of age in 2012, finally gaining full support of lenders and servicers. With increased lender incentives, additional regulatory guidelines streamlining the process, limits on junior lien indebtedness and allowing even more borrowers to qualify, short sales are helping thousands to avoid foreclosure and reduce the flow of properties back onto bank and GSE balance sheets.   The inflection point: when the discount to lenders for selling off a bank-owned property matches or exceeds the discount for short selling the property before it’s foreclosed.  Recent data shows a margin of 3% between losses lenders incurred for foreclosures (25%) and short sales (22%), and the gap is narrowing.   However, when all is said and done, if REO enables lenders to start recouping losses faster than do short sales, the cycle could turn again.

Renting versus buying in today’s environment is probably the best-known example as an inflection point in today’s market.  Given the strong demand for housing generated by displaced families (a result of foreclosure or short sales) and new households that didn’t meet lenders’ strict underwriting standards to qualify for a mortgage, the rental market boomed.  Owning a home seemed improbable, if not impossible.  But rents have increased at such a pace that now, buying a home for many consumers pays off only after three years of ownership.

The recurring impact of home prices on all of these scenarios creates potential inflection points. 

 

If all factors come to play to nurture an environment that allows for the measured, consistent, and healthyappreciationof home values, the real estate secor should enjoy a long cycle of positive growth. It's clear that the dircion of home values has a powerful impact on affecting change in number of critical sectors in the real estate industry.