Coldwell Banker Premier Realty

The Shadow Inventory Debate Continues


Can homes come out of the shadows enough to hurt prices?
Posted: March 12, 2013 by John McClelland

Recently there has been a lot of talk regarding shadow inventory, negative equity and Nevada Assembly Bill 284. AB 284 requires an affadavit of authority which states that the signatory has personal knowledge of the documents required for a proper foreclosure. This has lead to a sharp drop in notices of default, the first step in the foreclosure process. However, I don’t think that AB284 should get all of the blame. Certainly it has had a major impact but we shouldn’t look at it in isolation. Lack of inventory is a national problem and while a lot of this dark pool is concentrated in judicial foreclosure states, inventory has fallen in states where foreclosure completion times are much shorter, like Arizona. Time to foreclose in Maricopa county is about 213 days shorter than Nevada and the time to market is 57 days shorter. The National Foreclosure settlement is more likely a culprit in reducing inventories in these areas. Further, there is a ton of demand side interest in those areas.

 
On the demand side, we can question what will happen in the long-run and whether or not we are getting ahead of ourselves. The Fed has institutional capital awash in cheap money so there is likely to be malinvestment, chasing of yields in ever riskier assets. Cap rates on quality multifamily in southern California is closer to 4% now. 10-year government bond yields are at 2.05% and prime lending is 3.25%. Junk bonds are closer to 6%. Returns north of that look pretty attractive and a lot of single family rental falls in that domain. Some operators are likely to get hosed at some point, especially if they don’t get scale in their operations. However, many of these firms are organizing themselves as long-term businesses, not just holders of real estate assets. The wave of IPO’s we will see following Silver Bay necessitates that these firms take a long view with little notion to dispossess themselves of assets because they would then cease to be businesses. Few multifamily or Industrial REITs dissolved even during the epic blow-ups in those sectors. Institutional operators may actually be the heroes. The risky ones are the weakly capitalized mom and pops but may also be positive for us as they are more likely to dribble out the inventory in the next few years. So what happens when interest rates go up? One nice feature for institutions is that if they lock in fixed debt just of 3%, they can withstand some buffeting if prices get sawtooth. Most buy with equity so it is less of a problem now, although if organized as a REIT most will try to get about 50% leverage.
 
Investors are using equity and we have seen total mortgage debt outstanding in Nevada drop by about 7% year-over-year, that is from about $112 billion to about $104 Billion. The level of negative equity has dropped about $2 billion. This should add stability.
 
I certainly sympethize with the troubles owner-occupants are having finding homes as I have close freinds in that same situation. However, renters are people too and for every renter there must be a landlord. I am hesitant to choose which one should have the most standing.
 
Finally, I hesitate to characterize recent price trajectories as a bubble. While some may define a bubble as merely rapid expansion in prices followed by a contraction, I share Robert Shiller’s view that it is more of a speculative mania. The best example is the housing bubble we were just in, or internet stocks, or excited parents on Ebay bidding on Tickle Me Elmo from a few years ago. This doesn’t seem like a mania, rather low-interest rates worldwide have made it hard to find places to park money. We see it in equities and bonds. Where do you put money? Many of the institutional buyers we work with simply zoom out on the time series of prices and note below trend values. Further, many properties cash flow. Where do you find assets that appear to be below trend that produce cash?
 
There are a lot of big ifs on the horizon. The government and the Fed owns the mortgage business. We may be complacent towards future risks. What happens to Fannie and Freddie. What happens to China. Yet we are at an interesting point where there are about as many positive signals as negative ones. Therefore….hedge the tail risks if you can, and its hard not to take a net long position in housing when vacancy rates actually appear to be falling and mild improvements on the job market are in place. But I always like a hedge. Our notions regarding future outcomes should really be thought in terms of risk management . One of the best ways to do that is to keep leverage low and luckily we have seen a fair amount of deleveraging in Nevada. Also, since it is very attractive to take long positions in real estate, we look for either strong cash flow or very good asset qualtity. As a hedge, one may consider short ETF's on RE related business or more directly with CBOE RPX or Case-Shiller CME contracts (not investment advice, just a notation for other research you might want to do).
 
On a final note, Genting, a large Malaysian firm purchased Boyd's Echelon property on the strip. They expect to bring a project to market in about three years, which means some work is likely to begin shortly. The Linq project continues and Howard Hughes has been signing pre-leases on Summerlin Centre. There are also some positive signals in the Valley's labor market so there are certainly some favorable charcteristics that we are observing as of recent.

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