From a small northwestern observatory…

Finance and economics generally focused on real estate

Archive for November 2011

Musings about the real estate market — part 1

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When we say the “real estate market” we’re really talking about four distinct but somewhat inter-related components:  housing sales (and values), housing finance, commercial real estate (starts, occupancy, etc.), and commercial finance.  Each of these components has plenty of sub-groupings.  For example, commercial apartment development is going well, although commercial apartment finance still has some problems.  Housing development finance is on life support.  Many aspects of commercial development (e.g. – hotels) are moribund.

I’ll start today with the most significant problem in the housing sector — the one which may take the longest to fix — and that’s housing starts.  The market is worse than it’s been since we’ve been tracking data (40+ years) and certainly the worst in my experience.  The attached graphic comes from the National Association of Homebuilders, and shows their tracking of both housing starts as well as the NAHB/Wells Fargo Housing Market Index (HMI).

The HMI is based on a survey of current new home sales, prospective sales in the next six months, and “traffic” of prospective buyers (seasonally adjusted).  While the two graphs seem to track one another, as you can see, the HMI is a bit of a leading indicator of the direction of housing starts.  On a historic basis, this makes sense, since homebuilders will “start” houses they think will be sold six months from now, and they will heuristically base that on traffic from prospective buyers.  (Back when I was in the game, we talked about a “qualified buying unit” being a prospective buyer or housing unit — such as a family — who actually had the capacity to buy a home and were actively in the market for a new home.)

As you can see, back during a period of relative housing stability (1985 – 2005), housing starts generally cycled between 1 million and 1.4 millin per year.  With the bubble in home ownership rates, starts got up to 1.8 million for a short period then collapsed.  More interestingly is the period between 1989 and 1993, when home starts dipped to about 600,000 per year, then rapidly bounced back to a healthy level.  That was a period marked by real problems with acquisition, development and construction (ADC) loans, but the underlying demand and value equations still held firm.  Thus, when the market cleared (when demand sapped up any supply overhang), the homebuilding community was ready to go back to work.

Today, it’s VERY different.  ADC lending is still nearly non-existent (compared to a half-decade ago).  The decline in values means that in many markets, it’s difficult to build a home for less than the selling prices.  Further, the permanent lending market is also problematic.  A big chunk of homebuilding is the “move-up” market, with a secondary chunk in the vacation or second-home market.  Down payments for “move-ups” and second-homes traditionally come from equity in existing homes.  However, a substantial proportion of homes in America have no net-equity.  Reports talk about the high percentage of homes which are “under water” (that is, the value is less than the mortgage.  However, for a home to have positive “net equity”, the value needs to exceed both the mortgage as well as anticipated selling costs.  A handy rule-of-thumb in many markets is that a home needs to be valued around 110% of the mortgage for a seller just to break even on a sale.  Worse, for there to be sufficient equity to “move up”, the home needs to be valued more like 120% to 130% of the mortgage.  That simply doesn’t exist in most of America right now — trillions of dollars in paper equity disappeared over the past few years.

Additionally, there is a huge overhang in shadow inventory.  As I noted in a recent blog post, Americans are currently buying under 5 million homes per year (new plus re-sale) and in a healthy market, the inventory for sale is about a six-month supply.  However, the shadow inventory alone is close to 6 million right now (and that doesn’t include “regular” homes on the market).  Thus, we’re looking at a couple of years of absorption just to get the market back to some level of stability.  Even THAT presumes that the home ownership rate will stabilize right where it is (it’s been falling precipitously for several years).  Bottom line, I wouldn’t be betting on home construction any time in the near future.

This is important for several reasons.  First, home construction is a very big chunk of the economy.  When homes aren’t getting built, lots of carpenters, plumbers, electricians, materials suppliers, real estate agents, bulldozer operators, bricklayers, and such don’t have work.  Second, these are skills which are being lost to the economy.  Further, if America is going to get the employment picture fixed, these people have to get back to work.

Good news — such as it is — is that the HMI is trending upward, ever so slightly.  It’s currently standing at 20, up from a bottom below 10 about 3 years ago (and a near-term bottom of about 15 earlier this year).  It needs to bounce all the way back up in the 50 range if the leading-indicator relationship holds true for it to point toward a healthy housing market.  It actually went that far in the 1991 – 1993, range, when it bounced from 20 to 70 in about 3 years.  However, that was a market with pent-up demand, good values, and a healthier lending climate.

Written by johnkilpatrick

November 30, 2011 at 3:30 pm

S&P Case Shiller Report

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The latest Case-Shiller analysis hit my desk today, looking at housing prices through the 3rd quarter of 2011.  Their headline says it all:  Home Prices Weaken as the Third Quarter 2011 Ends.

Chart Courtesy S&P - Case Shiller

Their overall national index was declining at a 3.9% annual rate as of the end of the 3rd quarter.  Looking for faint hope in the data, this is actually an improvement over the 5.8% decline rate measured at the end of the 2nd quarter.  Home prices continue to cycle around (and mainly slightly below) their 2003 levels, which they’ve been doing for quite some time.  For more information, visit the Standard and Poors web site.

Written by johnkilpatrick

November 29, 2011 at 9:53 am

GDP, Housing, and post-Thanksgiving musings

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First, the good news.  My good friend, Dr. Bill Conerly, in his Businomics blog of 11/17, brought to my attention Dr. Mark Perry’s Carpe Diem post of that same date.  Dr. Perry brings up two great points, both good news for the U.S.  First, the global GDP is poised to hit $50 Trillion for the first time this year, up 2.7% from last year.  Second, and a bit unfortunately, this good news isn’t evenly distributed.  Somewhat surprisingly, the U.S. share of Real GDP has held fairly constant for the past four decades, hovering between 25% and 30% of the world’s total.  While the U.S. share is down slightly from its peak a decade ago, it’s actually higher today than it was in the early 1980’s.

Courtesy Dr. Mark Perry, Carpe Diem

The most interesting — and obvious — observation is that growth in the Asian share has come at the expense of the Europeans.  For more, I’d refer you to Dr. Perry’s exellent commentary on this.

In addition, this week’s Economist magazine just hit my mailbox.  I cannot speak to highly of this weekly — anyone who really wants to be informed on the complexity of the world needs to read it cover-to-cover the moment it’s printed.  It comes with a decidedly British feel and a slightly right-of-center focus, but with those caveats aside, it’s simply the best news magazine in the world.   And no, I have to pay for my subscription just like everyone else.

This week’s issue has an intriguing piece on the softness of global housing market.  I’ve long held that corrections in the U.S. bubble were triggered by the inablity of the secondary financing market to accomodate slight changes in underlying default rates.  In short, the secondary market is basically made up of derivatives of derivatives of derivatives.  Each layer of “securities” (a more ironic name for these instruments could not be found) assumes away a certain level of risk, applying a totally falatious reading of Markowitz.  However, the pain in the U.S. market may be close to ending, as the bubble in home ownership rates nears a nadir.

The more global problem, however, is that other markets have not fallen in the same way as the American market.  In the U.S., house-price-to-income ratio now stands below 80 (1977 to 2011 average = 100).  On the other hand, Britain and France — two economies with some pent-up troubles ahead of them — both stand at between 120 and 140, and indeed France is near its peak for the past three decades.  (Britain is slightly down, but not by much).  By their measure, most of Europe (except Germany and Switzerland) is in trouble, as well as Canada and Australia.     Japan has now declined even more than the U.S., but Japan’s market was widely considered to be terrifically overvalued before (maybe even worse than America’s).

While this is new territory for most countries, Britain’s housing market got out-of-whack back in the late 1980s, and fell about as far, relatively, as the U.S. market has fallen in the past few years (and over about the same time frame).  If Britain’s experience provides any indication for the U.S., it’s market stayed relatively low for several years before rebounding.

Not all economists agree with this perspective, and many feel that systemic low interest rates make this particular measure of housing prices invalid.  The problem with this perspective is that European interest rates are rising, and may continue to do so in the wake of the various debt problems in the Eurozone.

Written by johnkilpatrick

November 27, 2011 at 1:18 pm

Predicting recessions

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The onset of a recession is much like the onset of a bad cold, or perhaps the flu.  You THINK you know you have it, and then the next morning you wake up feeling like you’ve been hit by a truck.

What if we had a tool that could actually PREDICT a recession a year or so in the future?  Wouldn’t that be handy?  In fact, two researchers at the New York Federal Reserve Bank actually developed something a few years ago (early 2006, to be precise) that seems to have some promise.  They noted that the spread between 10-year Treasuries and 3-month Treasuries was a leading indicators of economic activity (which makes intuitive sense).  Using historical data, they craft a formula which calculates the probability of a recession occurring in the coming 12 months:

…where “spread” is the difference, in percentage points, between the 10-year yield and the 3-month yield and F is the standard normal distribution (mean of 0, standard deviation of 1).  Plotting their data over time, and comparing to the onset of a recession, they get Chart 2.  While no model is 100% predictive, this one clearly indicates that a recession is highly probable whenever the spread-indicated probability gets much above 30%.

Of course, the statistical math can get a bit hairy, but there is a handy rule-of-thumb.  As you can see from Chart 1, whenever the spread turns negative, a recession is fairly likely in the coming months.  Why?  Because a negative spread suggests two things:  first, that borrowers have little demand for long-term money, and second that investors are looking for a safe place to tuck money away that they don’t think they’ll need for a while, and aren’t afraid of inflation.  In short, the yield spread constitutes a fairly accurate survey of investor expectations about the economy.

Unfortunately, Estrella and Trubin end their research with July, 2006, which at the time was giving off a 27% recession signal for July, 2007.  A great test of their model would be to see if it would have predicted the onset of the December, 2007, through March, 2009, recession.   We used the same H.15 data from the Federal Reserve Board, and came up with the following:

 

 

Ironically, our analysis shows that the probability of a recession crossed the 30% barrier on July 31, 2006 — a month after the cut-off of their study, and 16 months before the official “onset” of the recession.

 

By the way, if you’re worried, the current probability is at 1.8%.  We’ll keep you posted.

 

 

Written by johnkilpatrick

November 23, 2011 at 10:13 am

Mueller’s Market Cycle Monitor

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Dr. Glenn Muller of Dividend Capital Research has one of the more intuitive “takes” on the commercial real estate market.  His Market Cycle Monitor  is based on a piece he wrote for the journal Real Estate Finance back in 1995.  It notes that a given type of real estate (office, industrial, etc.) in a particular geographic market (New York, Seattle, etc.) moves through a cycle which can be broken down into four phases:  expansion, hypersupply, recession, and recovery.  The driving force through these cycles is property occupancy — when occupancy levels rise, developers are encouraged to build new product, which leads into a hypersupply situation where occupancies fall and properties go into recession.  For a more detailed look at his model, click on the link above, which will take you to the Dividend Capital website where you can view the 3rd Quarter report.

In short, he finds that as of the 3rd quarter, 2011, most property types in most markets are in the early stages of recovery.  The office market nationally, as well as in about a third of the cities he follows, is still in the late stages of recession (except Sacramento, which is in the early recession stage).  Austin and Salt Lake seem poised to break out into expansion.

In the industrial market, every region is in recovery, with Pittsburgh, Riverside, and San Jose the furthest along.  However, none of these markets evidence being close to expansion at this time.  As for apartments, every market is in some stage of recovery, with Austin close to breaking out into expansion.  Lagging the recovery are New Orleans, Norfolk, and Richmond.  Nationally, the apartment market is right in the middle of recovery, with expansion still a few steps in the future.  The retail market is in about the same position as apartments, but with Long Island, San Diego, and San Francisco furthest along.  Nationally, we’re still close to the beginning of a retail recovery and not very far along.  Hotels seem to be slightly further along than regail, with Honolulu, New York, and San Francisco leading the pack (and poised to break out into expansion).

Written by johnkilpatrick

November 22, 2011 at 10:35 am

Bottom, bottom, who can find the bottom?

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In the owner-occupied housing sector, a “bottom” seems to be like the weather — everyone talks about it, but no one seems to be able to do anything. I’ve been positing that a “bottom” (or at least “stabilization”) won’t be a reality until we get some sort of stability in the home ownershps rate, which has been creeping downward for about 5 years. If that stabilizes (and my own projection is somewhere between where it is — about 66% — and 64%), then prices will have the necessary demand stabilization to perk up.

Money Magazine, on the other hand, says “lo, the bottom is nigh”. Specifically, they say that in the coming year, 95% of home-ownership markets that they track will begin to rise. Caveats about, of course — “The median expectation among more than 100 economists and real estate pros surveyed by MacroMarkets is that home values will inch ahead by a mere 0.25%, compared to their 2011 median forecast decline of 2.8%. They also foresee annualized gains through 2015 of just 1.1%, as the real estate market slowly works its way through a mountain of foreclosures.”

Why the continued sluggishness? The folks at CoreLogic tell us that the “shadow market” is 5.4 million homes, including bank-owned properties, homes in the foreclosure pipeline that haven’t hit the market yet, or properties where owners are seriously behind on payments. Now, compare that forecasts from FreddieMac that the entire market for homes in this coming year will be 4.8 million, and that a 6-month inventory of available properties is generally thought to be healthy, and you can see the supply-demand imbalance.

Mark Fleming, chief economist over at CoreLogic, uses the analogy of a flood. “The water is very deep in the living room, but it’s no longer getting deeper and is starting to recede.”

Written by johnkilpatrick

November 21, 2011 at 9:24 am

Hard to feel sorry for Bank of America…

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….but let’s try, just this once. As pretty much everyone knows, over the past few years, they’ve repeatedly shot themselves in the foot, then reloaded, then opened fire again. Public displays of embarassment like the $5 debit card fee are just the tip of the iceberg (and, indeed, helped them shed a lot of low-return or even negative-return depositors who could and should be better handled by credit unions).

More interesting has been their acquisition of Countrywide a few years ago, which everyone agrees was a debacle, and their subsequent messy handling of CW’s meltdown. However, now that they’re in such a fiscal and regulatory mess, BofA is having to shed itself of assets — at firesale prices — that in good years they’d want to keep. The latest example is BofA’s interest in Archstone Residential, one of the biggest apartment owners in the U.S. with 78,000 units. Recall that apartments are doing VERY well today, and are the one sector of the real estate industry which weathered the recession storm nicely. Indeed, given the trend in apartment valuation, BofA would be well advised to hang onto this asset for dear life.

BofA and Barclays acquired a 53% interest in Archstone Residential via a Lehman Brothers-led acquisition. The original purchase price in 2007 was $22 Billion. That works out to about $282,000 per apartment, which is pretty darned high, admittedly. Let’s suggest that a reasonable value would be in the range of $200,000 per apartment, or about $15 Billion. Of course, REITs often sell for a premium over net asset value, so the $22 Billion acquisition price probably wasn’t terribly off the mark at the time. Thus, the total net asset value $15 to $16 Billion, which indeed is close to Dow Jones’ current estimate of $18 Billion.

However, who has $15 to $16 Billion laying around? (Or, to be specific, 53% of $15 to $16 Billion, or about $8 Billion?) Up to the plate steps Sam Zell — yes the same guy who gave us Equity Office Properties. He now owns Equity Residential, which is making a bid for the 53% at….. (drum roll, please)….. $2.5 Billion in cash and stock. In general, this works out to about $64,000 per apartment, which is painfully low. Note also, that Zell is the winning bidder, having out-bid AvalonBay, Blackstone, and Brookfield.

Why is BofA letting this go so cheap? For one thing, they don’t have much choice. The regulators are making them dump whatver they can at Craigslist prices to generate cash and cash-equivilents. For another, the nasty market we’re in makes cash king — no one is financing this sort of deal, not even at these firesale prices.

In some ways, Sam Zell is a lot like Warren Buffett. Often it’s said — mistakenly — that you could do worse than simply buying stock in whatever Buffett buys. That’s true, but only if you pay the prices (usually deeply discounted) that Buffett pays. Now, the same appears to be true with Zell.

Written by johnkilpatrick

November 18, 2011 at 10:36 am