This week Bruce is joined by John Burns. John is president of John Burns Real Estate Consulting Inc, which helps real estate industry executives by analyzing and summarizing the information they need to make decisions with more confidence. Mr. Burns is on retainer with a number of companies, both in the housing industry and Wall Street to monitor housing conditions and help them refine their strategies in an ever-changing environment.
Since John last spoke with Bruce, he has expanded his consulting services to new groups of people. His two largest clients back in 2006 were John Laing Homes and Centex Homes, which no longer exist. His company monitors the housing cycle and does a lot of research; so when he saw the downturn coming, he pulled out his rolodex from the early 90’s and asked himself who they worked for during the last downturn. He thought he would end up doing a lot of work for the banks, which he has gotten a fair amount of work from even though it wasn’t what he thought it would be. A whole new world of distressed investors has come in, and they have been Mr. Burns’ primary clientele. As a consultant, when you mention something negative to a client, especially something like a downturn, how well it is received by the clientele is really in the way you say it. If you say “Now is the time to take some chips off the table,” or time to sell some land, generally people would agree with this. The publicly traded companies don’t want to hear this because by nature of their ownership they’re being forced to grow. However, at least most of John’s clients had been through a downturn earlier. During the time period of the downturn, John Laing Homes ran quarterly meetings called “Preparing for the Downturn,” and they were able to get out of the downturn, but they were definitely thinking about and prepared for it. After the market corrected in 2007, somebody from Dubai came in and offered them a large sum of money for their company, which they sold. The company the person from Dubai bought is now gone. With Centex Homes, the CEO who had been there 40 years and seen a lot of cycles said he was dropping prices in February 2006. From that time on, he was saying things were always worse than you think they are and always last longer. He made a lot of smart maneuvers and ended up selling his company to Poulty and received a 38% premium on his stock.
As a consultant, when someone asks John Burns’ opinion and he tells them what he thinks will happen based on the data, there are times he has to make sure he says his opinion in an acceptable language. His goal as a consultant is to get them to act, so you have to know your clients. No one forecasted the economy was going to be as bad as it is now. You would have really had to understand how financing was done. So in early ’07 John talked to John Paulson and another man from Front Point, and they explained things such as CDOs and mortgage backed securities to him. John still thought they were making some smart bets. When you really realize what was going on at the time, it’s shocking that we got to the point where lending was so carefree that we really didn’t care who ended up with what. This is how you ended up having the price go up so much because the lending rules really just didn’t apply as we might have assumed they still did. Still to this day, there is no good data on underwriting. You don’t know averages or even stratification on debt-to-income ratios, loan-to-value ratios, and people’s net worth. John was asking people questions about these terms back in ’05 and ’06, and they had no idea. The data was probably not collected. At this point, it may have not mattered because they were inventing whatever was necessary to get a yes answer. Nowadays, you won’t find data such as FICO scores or debt to income ratios published. You can feel the impact when you try to sell a house, but it’s really all random. On a one-to-one basis, you pick up the anecdotes, but if you had some data collection that showed the number of people who were not putting down any payment and had no means of paying it while home prices were flat, somebody would have raised a red flag.
We were very generous with financing in 2005 and 2006 when prices were ten times our median income. Now the prices have been demolished. The mood now is to take goods away from real estate. This has happened every time in the past, and it is happening again. John Burns and his team just had a meeting last week where they invited all of their clients into a room, held to about 60 people, and debated various issues. The two people who knew the most about what was happening in D.C. said that Washington D.C. was not interested in helping housing at all and, if anything, to solve the budget issues they wanted to penalize housing and the banking industry. They felt like they gave them a handout, which they did, and now it’s time to take some of it back. The people in D.C. don’t realize prices could take a big tumble because 90% of the mortgages in this country are still supported by the government. If we’re trying to sell a home today it’s going to be financed though some kind of government arm. John Burns was at a conference a couple weeks ago where the CEOs of both Fannie Mae and Freddie Mac spoke, and it was very clear to John that they were all about saving their charter right now. The way they intend to do this is only to be extremely conservative and to show that they are making money now, which they are doing. The CEO of Freddie Mac said that their average FICO score in the first quarter was 758. In addition, the payment that is emerging is much different in the ratio of people’s income than it has ever been. They’re only supporting great loans now. It’s interesting that the sentiment starts dictating policy, and politics sometimes really get in the way of what would be a very common sense decision. Fannie, for example, has been around for about 80 years, and for 4 years they made some egregious mistakes. The management who made those mistakes is gone, so why are we going to “blow up” these organizations that worked for 75 years. So overall, there are statements being made that seem perfectly logical, but if you were to see a chart you would see that charts defy what you thought was logically true.
One of the charts Bruce has is a historical foreclosure rate for Fannie, Freddie, FHA, and VA. Shelia Bair suggests that if you require a 20% minimum down payment, with the rationale of somebody putting down 20%, they’re going to make that payment for sure. If you look at the historic foreclosure rate on all the different loan types from VA nothing down to 20%, they’re all within a quarter of a percentage over four decades. This is a very important chart because they’re going the other way. They’re going to say that they will have a 20% down program, but people aren’t netting $200 grand from the sale of their houses anymore. Cars are showing a net of 35%. If you want a $150 grand median price, you have to make the rule that 20% is necessary. What’s really disturbing is when they make policies on erroneous data. Usually, the different factors are compared to earnings and price, but right now we have the lowest interest rates ever. Therefore, if you have historical numbers on comparing earnings to payment, they show how significantly inexpensive this process is if lenders are aggressively financing. We are most likely headed toward a slow 60% ownership, possibly less than that. John Burns forecast is about 62.5%. He thought the forecast should go lower, but his guys convinced him that the positive demographics and affordability would not make it go lower.
There are a lot of people that will be going from ownership to non-ownership. If the policies start going along with that trend, then you start making down payments bigger, qualifying harder, and reducing loan amounts. Orange County is probably one area that will be affected quite a bit if you start having Fannie and Freddie go from the 7’s to the 6’s and someday to the 4’s. You are looking at a very different financing world. All of the homes would become jumbo mortgages, so it would be about 50 basis points higher. Usually, it is possible to have the money readily available, thus making it possible to take the volume that’s going to be necessary. John has a number of clients that run huge bond portfolios, and the appetite for a decent pool of loans that pays a 5-6% interest rate is pretty strong.
If John was managing Fannie, Freddie, and HUD, for example, and he looked at how much REO and non-performing loans he controls, the last thing he would want to do is drive down home prices because that is where it would hurt him the most. Therefore, the more distressed sales we have in the market, the more likely home prices are going to decline. In his example, John pitched to the three organizations and didn’t get to the highest level when he did, but would tell them to create a restructure where you put REO homes into a pool that you rent out for five years. You offer a deal to the current occupant, for example, charge them $900 a month for rent, and if they can’t pay it you rent it to somebody else. This is no different than what a lot of Bruce’s investor clients are doing. The only difference is Bruce’s clients are on an individual basis and therefore it’s harder to manage; but if you give somebody 300 properties in an MSA, they can be pretty efficient in it. The model the FDIC uses is they take an ownership interest and they sell the property to somebody who manages it rather than the government managing it and the managing person gets paid for it. Their upside is limited because the FDIC would participate in any kind of upside. This was Bruce’s suggestion when he met with Fannie that they would sell to investors with a partnership arrangement where they shared in the upside. They had just done this with their multi-family portfolio with a company called Related. Bruce is not sure he would want the government as his partner because he wouldn’t be sure who would be making the decisions at the time he says it’s time to sell, and the government might disagree and think it’s not the best time to sell. If you look at the FDIC, there were different partners who formed their own divisions. Lennar formed a division called Rialto; Toll and Oaktree formed a group called Gibraltar. There is also a contract that guarantees that they are going to make a small return, and if they perform they will do quite well as will the government. Unfortunately, the reaction to John’s suggestion was ridiculous bureaucracy. People were asking if the house needed to be fixed up and if they needed to hire a union. People feel like the government is their landlord while they write the check to the U.S. government. You hear things like this, and you just think that we’re not going to get anywhere. This would be very frustrating, especially since John is surrounded by very smart people in his clientele, and he therefore would know a lot about the market and how to solve the problems if people would just listen. It’s like the political process gets in the way of practical methods. If you’re Fannie and Freddie, you’re very political right now because it’s the politicians who determine whether or not your organization is going to get blown up or saved. You don’t want to do anything to rock the boat. When they gave away the $8,000 tax rebate, in an area like the Inland Empire that was not only equivalent to nothing down, it was equivalent to cash back. It was saying that you’re buying an $80,000 property and getting $8 grand, and your down payment for that would probably be $3 grand. It would seem the loan portfolio then would have performed quite well because the payment that emerged was quite reasonable. The CEO of Freddie said that their 09-2010 loan vintages had performed very well.
In 1981 and ’82, interest rates were crazy, along the lines of 17-18%. 60% of California sales did not require a new loan. What they did require was that you had access to financing that already existed. The 70’s before that had inexpensive interest rates, so they were allowed to buy and sell houses with the financing in place. Bruce’s suggestion therefore is that they create a loan for only 3 years, and you sell the properties with qualifying. Somebody has to qualify, such as by FHA standard or VA standard, but they don’t need a down payment. This expands the demographics under 30 a tremendous amount, so you would get a lot of young adults to own a house. The criterion with that loan program is that if you fail to make the payment, the ownership can get transferred to a new owner without them having to qualify except for when it closes escrow. Then it has to be current. If skin in the game is important, we need to make it come from the second person. On just this program, if you go to a trustee sale where everyone failed to make the payment, the opening bid at the trustee sale would not be the principle, but only the back payment. Therefore, instead of having sales for hundreds of thousands of dollars, they would be ten thousand or twenty thousand dollars. This would finance new buyers, give financing availability to people who already lost homes that had become non-owners, and it would finance investors who went to trustee sales and took over existing loans subject to closing. They would pay the back payment and take over the existing loan.
Back in 2004, E-trade came up with a portable mortgage, which essentially let people take their mortgage with them when they moved, similar to taking their credit card debt with them when they moved. This was called assumable debt. Interest rates were low at the time, so who wouldn’t want to take on a 5% loan that they could then take with them when interest rates increased. Securities in the securities market traded about 50 basis points higher because they traded it as premium over 30-year treasuries rather than 10-year treasuries, which would not be repaid quickly. What E-trade found was that consumers didn’t want the extra 50 basis points. It was huge news, on the front page of the Wall Street Journal, and hardly anyone took advantage of it. It was likely a very different environment at the time. Right now, if you give somebody a chance to go from a $1500 rent to a PITI payment of $1100 with nothing down, there isn’t much risk. All of the mortgages at the end of the day get pushed off into some security, so the required interest rate on the mortgages would probably be 50 basis points higher than a traditional mortgage and would find a great deal of acceptance. One of the niches that investors use right now is they’re not afraid of a lender calling a loan due that is current. Bruce can’t imagine getting a call from a lender saying that he has reached the due-on-sale clause, so they’re going to foreclose on a current loan. Therefore, you wrap it and you sell a property to somebody for 7 or 8% that doesn’t have a chance to own. This kind of market does exist. Rather than trying to figure out how to move another few million homes reasonably, they should instead go to owner occupants. Our country should remain thinking that owning and occupying a home is a priority as opposed to protecting lenders or protecting politically what is appropriate.
There is a big chance of policy changes taking place in the future that will start taking away some of the deductions or other things that we take for granted in real estate. Ken Mueller, a lobbyist/policy analyst who John Burns has spoken to a lot and believes to be the most right, believes there is a 75% chance that the mortgage interest deduction is going to get dropped to $500,000. This will be tied into the debt reduction plan that is due August 2nd, which is coming up pretty soon. You’re also going to see all the government guarantees at best get more expensive or, at worst, go away or become available on fewer loans.
You can find out more about John Burns and John Burns Real Estate Consulting at www.realestateconsulting.com. At this site you can find a wealth of information and blogs that discuss things pertinent in our market.
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