Rising Prices and Rising Rates - And the Recovery Continues

If there's one thing about cycles - what goes down eventually comes up. We are enthused to be involved with a number of residential projects as a capital partner in Southern California during this "Conservative Renaissance" of real estate. The great response from the market to these single family offerings clearly affirms our sentiments that a recovery is in full swing. This in addition to our commercial holdings, clearly supports the conclusion that the recovery is across the real estate product types. But as always, smart investors practice cautious optimism even during a positive period. The road ahead looks promising for continued growth in real estate, but a few trends are worth keeping our eye on that could impact the cycle down the road.

We all recall too well the dark days of the housing crisis characterized by plunging property values and growing shadow inventories before disparate forces in real estate actually converged to create opportunities investors are currently enjoying today. First, strong government initiatives in the form of legislation, regulatory reform, and programs benefitting distressed homeowners mitigated the flow of foreclosed properties ending on the auction block or as REO. Second, monetary policies and other market conditions maintained a low ceiling for interest rates, allowing investors and consumers (that could meet strict underwriting guidelines) to borrow at cheap rates. Third, the economy following its own cycle of growth finally showed sustained month-after-month improvement, with the much welcomed inverse relationship of falling unemployment and rising GDP. The result has created a market of increased demand caused by the lack of distressed properties available at a discount, affordable mortgage payments due to low interest rates, and more consumer confidence that they will have an employment base to support a mortgage.

Vista Urbana, an affordable home project in the Ventura area is one of our success stories.  Peak served as the capital source for the endeavor. Construction commenced in October 2011. The affordable housing development consists of 156 condominium units, recently completing phase I and II of construction with all units reserved or sold. Units in phase III, currently in the final phases of construction, have all been pre-sold. Oak Terrace, a mixed townhouse / single-family residence project in Thousand Oaks catering to a more upscale audience is another Peak capital project that boasts 84 units upon completion. With almost 50% of units built and occupied, the remaining units have also been pre-sold. In both of these ventures, favorable market conditions have contributed to their success.

Rising interest rates is the one factor posing a potential threat to the current momentum. So far, the market has been able to operate smoothly in light of tight inventories. The upward pressure this is applying to home values is starting to entice more homeowners to sell, and some analysts anticipate home values to appreciate more than six percent in 2013. However, rates have incrementally increased over 100 basis points in a year, and some fear the combination of higher rates with higher valued homes could price many consumers out of the market. Moreover, investors could begin looking for better returns in other investment vehicles. 

As affordability decreases, urgency increases. Rising home values, along with rising rates,can continue the momentum by spurring ambivalent buyers that can afford to participate into the market while they perceive they can still afford to buy. That, coupled with increased inventory generated by new sellers benefitting from rising equity in their homes, should prove to modulate the increased cost of homeownership in line with continuing improvements in the economy. In light of appreciating home values and interest rates, we’re confident we are still at the beginning of a great cycle for real estate, and are anticipating great returns from additional residential projects we are involved in as financing partners that should complete construction in the next twelve months. Investors and consumers alike can both benefit from today’s market. Appreciating values and rates reflect the fortitude of a market and economy that can support it.

What Could Be Looming in the Rear View Mirror as Housing Recovers

What a difference two years makes. While the media and other pundits proclaimed loudly and often the end of our industry as we know back in 2011, the smart money should have been on the analysts and economists that recognized real estate was in the throes of a downward cycle that would eventually correct itself.  Granted, this was no ordinary cycle and there is still blood on the streets. A recession initiated by an over-inflated real estate market imploding almost proved the media and pundits right. But a full court press comprised of a combination of monetary policy actions, government programs, and the “X” factor of cash rich private investor participation gave housing the foundation it needed to rebound.  Today we enjoy a much more stable market. To sustain the industry’s current prosperity, we should take note that the issues that haunted us during the darkest moments of the housing crisis, while mitigated, are still factors that require action. 

One example is the recent extension of the Obama administration’s Home Affordable Mortgage Program (HAMP). Originally set to expire at the end of 2013, the program was extended for two years through 2015. To date, over a million homeowners have received permanent modifications under HAMP since the program’s inception in 2007, with over 42,000 modifications granted this year. While at first glance, the program appears to have justified extension by helping huge numbers of homeowners afford their mortgage, approximately 1/3rd of loan modifications executed under the program have re-defaulted according to a recent government report. This implies that significant cross-numbers of distressed homeowners are still on the threshold of foreclosure. 

In addition to a less-than-perfect long term track record on loan modifications, ongoing lender foreclosures that comprised the dreaded “shadow inventory” should not be taken for granted in light of our current recovery either. Granted, an improving economy combined with proprietary and successful government loan modifications has put a virtual ceiling on mortgage delinquencies and Notices of Default filings; 2013 has seen the largest drop in foreclosures and 30 and 60 day late mortgage payments in six years. However, while small and getting smaller in comparison to past years, there remains a steady stream of homeowners going into default. In reaction to heightened regulatory scrutiny to ensure that proper protocols are being followed in dealing with distressed homeowners, major banks have put their thumb on the foreclosure “pause” button to ensure procedures are being followed to avoid running afoul of any potential processing errors. At some point once these institutions are confident they are meeting regulatory guidelines, foreclosure filings will resume. 

As the current recovery cycle continues thanks to heavy investor participation, a potential exit of this group could be on the horizon as real estate values continue to rise.  Clearly, smaller independent and larger institutional investors stopped housing’s downward spiral by buying up billions distressed and undervalued assets. The good news --- investor activity sustained housing while government modification and refinancing programs, lender settlements with regulatory agencies, and an improving economy kicked in to help cure the crisis. The not-so-good news:  bulk investor purchases have also contributed to shortages, which in turn are driving prices up to a point where investors won’t enjoy the strong returns they once did and could start looking elsewhere for higher yields. The steady injection of private capital has been a key ingredient to the success of our current cycle. We’re nearing a critical inflection point where the mass acquisition of property by investors that proved such a boon to the industry is now creating so much appreciation that those same investors could leave. At the end of the day there needs to be real homeowners that acquire a property with the intention of staying. I have clearly seen large samples of homes being sold by investors to a new group of investors. As the price is increased, the affordability factor has declined to the ultimate user.

In some circles, there’s an impending air of euphoria concerning the upward trajectory of this new phase of the real estate cycle with appreciating values in both residential and commercial sectors, increased purchase activity, increased construction to meet demand, and an overall new respect for the contribution housing has made to the economy. Let’s not forget a similar time ten years ago where a different type of euphoria permeated the industry leading to the now infamous “bubble and bust” phase that played a role in one of the most devastating recessions of our age.  We as an industry have learned some hard lessons. And as a result, this current period of growth has great potential to be more sustainable and fundamentally sound.  But it’s important to keep one eye on the mirror and an ear to the pavement. The issues that led to the housing collapse have not been eliminated, only contained. There are still prescriptive solutions that must be applied to truly put the housing crisis behind us for good.

The Impact of Inventory on Both Ends of the Housing Spectrum

Inventory, Inventory, Inventory. The return of housing to better days has mainly been attributed to lower interest rates, fewer defaults and a gradually healing economy. But what has brought the biggest smile to the face of analysts and homeowners alike is steady appreciation in home values as part of this new cycle. Since the end of 2011, home values have risen over 5% nationally, and are forecast to rise at least 6% over the next five years. The increases have been much higher in many major cities. It all has to do with supply, or the lack thereof, that’s driving home values north. While everyone is encouraged to see the return of equity of home values, a protracted period of tight inventories could have a negative impact on the current cycle. Simply put, if buyers can’t afford to buy, the process stalls.

Attaining the right balance of all the ingredients that have led to the current recovery phase can be tricky. The combined result of fewer foreclosures and mortgage delinquencies combined with brisk all-cash investor activity is effectively containing the specter of a looming shadow inventory of distressed homes that had once been seen as one of the major headwinds preventing a full housing recovery. The downside of this is, of course, an overall reduction in available, affordable homes on the market.

Fortunately, those developers and investors wise enough to understand the nature of the real estate cycle foresaw the scarcity in inventory and the resulting opportunity as they brought more units online. Investors in new multifamily housing flourished in 2011 with units becoming available now, and overall construction in housing for both apartments and single family dwellings actually helped to boost the economy out of recession. We have been involved in a number of new projects in Southern California aimed at bringing affordable units to the market. Case in point: we served as a major capital partner for a 156 unit condo development in the Ventura County area that broke ground in the 3rd quarter of 2011, and the developer is currently in the second phase of development to meet demand with most of these units already pre-sold. Another project we’re involved in is a 10 unit townhome subdivision in the Tujunga community that will be bringing 10 new homeowners into that market shortly. We are also online and committed to begin a residential gated development and a Thousand Oaks home development in the area.

What’s often ignored in the inventory equation is the participation of the “move-up” buyer and having available product to meet demand. For a fully functioning housing cycle to occur there has to be an upward migration of current homeowners to larger homes to allow first-time home buyers and growing family households an opportunity to purchase at affordable prices. Of course, as the last period saw home values depreciate, the cycle stalled as homeowners found themselves held hostage by falling equity and the inability to leverage it toward a larger purchase. Today paints a different picture, as homeowners are starting to test the waters with rising home values and multiple offers on listings. Inventory now becomes a welcome problem to have at the affluent end of the housing scale. In March, homes sales over of $800,000 are up over 33% from last year in Southern California. The current housing cycle requires adequate supply for move-up buyers to continue its progress. We have positions in the affluent market as well as the primary partner in a 20 acre, 15-estate equestrian development project in the Sunland community.

Home values for entry level as well as larger homes are skyrocketing, to the delight of homeowners, potential sellers, real estate professionals affirming that for the long term, real estate is and always has been, a sound investment choice. Additional housing units coming to market to balance the supply/demand equation won’t dampen appreciating values, but should modulate increasing values just enough to allow more new buyers into the market and persuade more owners that they can locate replacement properties if they list their current home.

The Online Auction Process: The New Frontier for Real Estate Investors

It's a simple concept found everywhere --- volume purchases equal volume discounts.  And, during the last recessionary cycle, both GSEs and investors learned to leverage the concept to their advantage. Fannie and Freddie's pilot "REO to Rentals" program that moved thousands of distressed assets off their books through bulk sales to investors captured industry headlines in 2012. Other examples include savvy private equity firms with deep pockets sweeping up multiple foreclosures at bargain prices at courthouse auctions, as well as the FHA employing the same strategy to shed underperforming notes in bulk deals. We’re seeing that a previously underpublicized conduit for disposing of distressed assets is gaining traction among both lenders and private investors as a way of moving distressed assets in volume --- the online auction process. It comes along at a great time to continue housing’s forward momentum.

Along with other industry watchers over the past few years, I’ve been following the progress of the “shadow inventory” comprised of increasing delinquencies, rising foreclosures, and REO. Today, year- over-year mortgage delinquencies have fallen. Short sales, loan workouts, and new state laws are slowing the flow of distressed assets into the foreclosure pipeline.  The all-cash investor has emerged as the white knight rescuing lenders and servicers from their toxic REO problem. The online auction process currently serves to connect volume REO sellers and qualified volume buyers in an efficient manner to dispose of distressed assets. The auction process has shown itself indispensable in removing huge blocks of extremely nonperforming REO from lender and servicer balance sheets at steep discounts, and the online auctioneer is carving out a special niche as a new type of servicing agent to the housing industry.  As a result, sellers win by disposing of assets, and a new type of servicer solidifies its presence in the industry. But most of all, private investors have found a new way to participate in the market. Government -run bulk sales programs carried with them the expected baggage and inefficient red tape that is ultimately less-profitable to investors. Acquiring bulk assets through the auction process allows investors a faster return on their money as they can get property to market more quickly to either generate rental revenue, or flip faster for sale to take advantage of our current environment of rising equity and tight supply.

Some real estate analysts and professionals have argued investor participation at the bulk level could be counterproductive to nurturing a fully-balanced and healthy housing climate. It’s no secret that the current rise in home values is directly related to low supply of available homes for sale. The REO inventory currently moving through the online auction conduit could possibly modulate appreciation in select markets by preventing abnormal price spikes and keeping values at more affordable levels if sold on the open market. This argument doesn’t take into consideration three important factors. First, scarce inventory is mainly the result of existing homeowners still sitting on the sidelines waiting for the right moment to sell.  Second, much of the REO inventory sold via the auction channel requires substantial work to get it to market standards, and investors can leverage the capital necessary to do so. Third, many investors are following a “rent and hold” strategy with acquired properties, which fills a very important gap in housing by creating affordable single family homes rentals.

Recently, through our escrow services, we have been actively involved in the auction process by facilitating some of the back-office administration and closings for hundreds of bulk transactions. We are optimistic that the quiet yet positive impact it is having on the industry will continue to mate investors with opportunities, continue to deplete distressed inventory, and ultimately facilitate new sources of affordable housing.

The Balancing Act between Affordability and Inventory

What a difference one year makes in virtually changing the course of real estate. The specter of the shadow inventory and its predicted drag on the industry has been dispatched in a flurry of workout solutions, bulk REO to Rental strategies employed by GSEs, and the influence of all-cash investors snapping up bargains at a rapid pace. When combined with cautiously optimistic reports on the economy’s performance and improved consumer sentiment, the average American homeowner is enjoying the return of rising equity. What has not seen improvement at the same pace is the availability of affordable housing for rank and file consumers.

In today’s market, affordability is an elusive target due to the number of factors that define it. What homeowners applaud as “increasing equity” as the price of homes in their neighborhoods rise, potential buyers perceive as homes pricing themselves out of reach requiring a larger mortgage. The 30-year fixed rate mortgage benchmark is inching its way north of 3.5% as the economy improves, becoming another barrier to affordability for potential homeowners. Affordability is equally a concern for rank-and-file renters who face the never-ending cycle of rising rents, as demonstrated by the greater Los Angeles market where rents have increased by nearly 30% since 1993 while renter incomes have decreased by 6% over the same time period.

The real culprit here is not affordability, but available inventory, or rather, the lack thereof.  One of the consequences of the last cycle was a contraction in single-family and multifamily construction as developers felt the crunch of a debilitating housing downturn. Moreover, the growing numbers of foreclosures and REO created the new “shadow” inventory class that gave the perception of surplus housing units available to the market. But that same downturn created opportunities for cash investors to snap up those distressed bargains in bulk from lenders and government entities. Additionally, foreclosure prevention activity initiated on both the state and government level capped the flow of new distressed assets into the available inventory. Now with a perceived end to the housing crisis and a return to stability, the industry finds there are simply not enough housing units at reasonable prices for renters and entry-level homeowners to comfortably afford. We are currently partnering in an affordable housing condo project in Oxnard, California and can attest to the overwhelming demand we have experienced from qualified buyers unable to find any housing.

If affordability is tied to available inventory, investor participation is absolutely critical to restore equilibrium. During the darkest moments of the housing crisis, multifamily property activity was the one bright spot in a lackluster housing market providing housing for those displaced as a result of foreclosure or other relevant lifestyle shocks. Developers in the single-family sector have already begun to seize the moment of a post housing crisis with new projects. New projects require fresh sources of capital. While the “thawing” of traditional capital channels via commercial lenders is continuing, lenders should bring more to the table in terms of flexible credit conditions to support more development in both multifamily and single-family arena.

Bringing more new units to market overall should also coax more existing single-family units into the housing supply. Many potential sellers are still waiting on the sidelines waiting for prices to appreciate even further before listing their property with an agent. As prices stabilize with new inventory, sellers should be motivated to put their property on the market before values begin to level off. The principles of supply / demand economics should modulate appreciating home values in such a way to allow more buyers into the market with more homes for sale.

This market is on the verge of a breakout year, but only if more buyers gain access to the market with available inventory to meet demand. The market must create favorable conditions not only for sellers with fair home values, but also for buyers whose purchase power can afford the homes on the market.

Real Estate's Temporary Reprieve with Fiscal Cliff Legislation

The threat of falling off the fiscal cliff has been averted for 2013 -- Or at least, the consequences that could have triggered wide-spread recession. The real estate industry received a reprieve through extension of key components of the American Taxpayers Relief Act of 2012 signed on January 1st of this year.  A major concern was the Mortgage debt forgiveness rule that ensures that lender losses through short sales, foreclosures and principal reductions don’t end up as taxable capital gains for distressed homeowners was extended for yet another year, along with the private mortgage insurance (PMI) income tax deduction. On the flip side, expiration of Bush-era tax cuts and a 5% hike on top marginal tax rate for capital gains have many investors evaluating their options for 2013, along with weighing the consequences of a new 3.8% tax on investment income to subsidize health care reform.  In addition the state tax rate and new associated taxes have increased further creating a chilling effect on contemplated real estate investments. Opportunities do exist for both consumers and investors in this “post-cliff” cycle, but it requires a different perspective to make the most of them. I feel comfortable saying that the momentum will continue to be favorable due to the cliff avoidance unless further unknown developments take us down.

Allowing the Mortgage Debt Relief Act to expire would have signaled the beginning of the end for the housing’s recovery, and it was a prudent choice on the part of lawmakers to extend it. The impact of short sales on helping lenders and servicers cure their non-performing asset problem more than proved itself in 2012, and the extension serves to continue that momentum. Both distressed homeowners and lenders win. And, by allowing the deduction for PMI to continue through the end of 2013, first-time buyers without the traditional 20% for a down payment receive some relief from the additional premium MI adds to their mortgage. With 46% of first-time buyers utilizing FHA loans with mandatory MI in place during 2012, there are widespread effects of the deduction. In light of still-constrained underwriting standards for conventional loans, originators have found a way to offer mortgages to borrowers that don’t meet their minimum criteria through FHA-backed loans. In this case, first-time homeowners and lenders benefit.

Opportunities for investors in 2013 may seem a bit more elusive. Anticipating changes in the capital gains taxes this year, many investors that didn’t take a “wait and see” stance scurried to finalize transactions by the end of 2012. Those wishing to take advantage of opportunities in 2013 still have options at their disposal. Smart investors will embrace the benefits of the 1031 Exchange process that allows an investor to sell a property and to reinvest the proceeds in a new property as a way of deferring all capital gain taxes. The 3.8% Medicare tax from the investor perspective will have significant ramifications as the “investment income” qualification includes net gains from property held by investments.  While most homeowners will escape taxation on the sale of personal residences under the new law, investors that decided to wait for the fiscal cliff dust to settle may find the tax implications of real estate deals play a larger role in evaluating short and long term returns.  Deferring taxes should be part of the overall strategy and should be good news to the qualified 1031 intermediaries.

2013 may also bring new opportunities for investors in the bulk sales arena. The FHA, reeling from losses of vintage pre-2009 loan guarantees, has embraced distressed note sales as one of its strategies to remain solvent. Bank of America is shedding billions in mortgage servicing rights and through auctions of toxic assets acquired from its ill-fated Countrywide acquisition. Investors have found a new asset class in bulk purchases to fuel the newest REO-to-rentals market. While housing inventory at the consumer level is still constrained and driving up home values, bulk sales available to the investor class is developing as a new sector for 2013. This was being handled internally with a very limited number of qualified investment funds and not really open to a large class of smaller investors. Perhaps this year, they will open it up. 

While stopgap measures signed into law on January 1st extended consumer relief without a major disruption in investor activities, the jury is still out on the long-term consequences changes in taxation will have on the industry’s momentum achieved in 2012. The tougher decisions on debt ceiling and program cuts still lie ahead that now may have greater implications for the economy. Now that we’ve taken a few steps away from the edge of the cliff, the real estate industry can take a breather --- for now.