This week Bruce is joined once again 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.
In today’s topic, Bruce started by asking what the common theme has been for a builder to survive between 2007 and now. In response, John states that first, regarding the privately held ones, the ones that were managing their balance sheets very carefully, trying to not become too overextended in debt, diversified into other businesses, and sold land at the top of the market were the ones who made it through. Some of the public builders, even after the market corrected, carried out some large bulk land sales, some being almost $.34 on the dollar while others were $.16 on the dollar. Not only did this get them some cash in the bank, but they were able to recognize some tax losses and get back millions of dollars that they had paid the IRS in prior years. The other thing that happened to the public builders was that the debt markets were wide open the last couple of years, so they have gone out to the debt markets and stuck out their debt maturities until 2016 or later. They have not had to make principle payments. So the two things previously mentioned have really helped them significantly.
As Bruce says, from a lender’s perspective this is a straight note. In 2016, they have a lot of bonds due, and at the time that they come due they either have to write another check or obtain another bond. They don’t have one big bond due in 2016; they have little chunks due in various years, which was really smart. However, at some point you will have to either refinance or pay off the debt. Most likely nothing spectacular will happen before 2016, but the bondholders who buy that are managing Bruce’s and John’s retirement funds, and right now a 10-year treasury is 3% while a lot of the debt trade is anywhere from 6-11%. Therefore, there is an appetite for the high-yield portion of the funds where they will take some risk. If things get really bad, they may have to refinance from an 8% interest rate into a 10 or 11% rate, but the person who owns 8% rate still gets paid off that way. The real risk is if the bondholder can’t refinance because someone thinks the bonds are not going to make it.
If you’re a public builder, the biggest advantage is the access to the capital markets. If you’re a private builder, you don’t have this kind of access, and all the debt is non-recourse. The public builder CEOs sleep better than private builders because they don’t have recourse debt. The ones with the best balance sheets have bought quite a bit of land, some of it with a really long-term perspective because none of them are worried about any cash crunch. Most of the builders have been buying enough land to assure that they have good revenue in 2012 and 2013. Much of the land they own is in tough areas where they can’t make money, so they’re trying to buy land in better locations. They will come back to the tougher land some day in the future when it makes sense again, usually in about 6-8 years. In the meantime, the twelve largest publicly trade builders are sitting on $13 billion in cash. So what do you do with that cash? Most of redeploying it into their own business, but also, if you look at their income you see that they’re breaking even and covering their overhead to stay alive for another day. Some of the more creative ones are now thinking about new businesses to get into. Toll Brothers is buying nonperforming loans from the FDIC and starting a golf course management business. Lennar is buying nonperforming loans, and Beazer is buying REO in Phoenix and renting it out. There have been local builders that have been involved in the trust deed sale business to buy, resell, and have houses to fix. Bruce does not think they’re used to the margins, and how big the margins are is usually a common misconception. For example, in the business The Norris Group does the margins shrunk. Beazer, for example, is hoping to make a 6-8% return on their REO purchases and are not looking for anything bigger than that. They’re keeping them as rentals and not reselling it until some point in the future. If you’re buying and reselling it the return is quite a bit better, but it’s also risky.
They went on to discuss shadow inventory. John’s definition of shadow inventory is a distressed sale that is not yet on the market. If somebody is 90 days delinquent or more, research has shown that very few of those delinquencies become current and the borrower gets saved. There are about 4.5 million of these in the country today, and our best estimate is about 1-2 million of them are on the market. Therefore, there is about 3.5 million shadow inventory with more coming. The report Bruce saw had 91,000 resolutions in the month the report came out, so being in the buying and selling business, The Norris Group is feeling pretty comfortable right now. In Riverside when you look at what’s for sale, you have a few REOs, some in disrepair, and a lot of short sales. However, this is not too exciting if you are an owner-occupant buyer because it may take 4 months to get a yes or a no answer. You don’t really have a lot of real inventory to sell against, but if you look at what is behind you at the churning shadow inventory, a lot of times the thought that lenders have already taken back the property and are not presenting it on the market just shows that what John Burns believes about shadow inventory is true. Shadow inventory is the properties they refuse foreclose on, and this is one of the things they talked about when they met with Fannie and Freddie. About 30% of all the foreclosures are over two years behind. Bruce wonders if next year they will be three years behind. At some point, we need to cut to the chase.
There is a website called housingwire.com, which was founded by a man from the mortgage servicing business who is very well connected to the industry. They had a conference in North Carolina two weeks ago that John attended along with all the top foreclosure attorneys and the CEOs of Fannie and Freddie. Here, John became very convinced that virtually every judge in America hates the banks, does not trust them, and is going to make it very difficult for them to move and act and foreclose the way they want to. The Norris Group had interviewed the president of MERS right after he had testified in Congress, and simultaneously almost the same week Bruce interviewed the president of the Title Insurance industry. Bruce’s concern was that they’re buying REOs trying to resell them, and all of a sudden in the industry people are getting sued because somebody said they were foreclosed on wrongfully. The idea that you’re being hung out to dry is one of the reasons Bruce interviewed the president from title insurance. He’s asking himself, “Do we have title insurance?”, which is true if you have an REO. But if he buys at trustee sales, it’s not necessarily true. You’re stepping into lender liability issues and a whole bunch of other things. Sometimes he gets title insurance the day he wins the bid, and another time they were sued because there was not a reason to foreclose. Recently, there have been courts that have upheld that, when a commitment has been made verbally to a client that the lender is in fact going to pursue a loan modification and they foreclose on them anyway, the client does have recourse and rights to sue.
Another interesting twist with how the lenders conduct the sales is that the only way there is a deal, in Riverside for example, is if the lender lowers the bid. If they are owed $500 and start opening bids at $200, then Bruce said he will be interested at that point and will pursue checking out title and who is in the house. What he does not understand is when lenders let Bruce know at 8 a.m. about a 10 a.m. sale. He does have the infrastructure to be able to cope with this and get to a knowledgeable answer very quickly, so he might end up with some deals that he wouldn’t normally have. However, from a lender’s side it is absolutely ridiculous because you end up with far less qualified people being able to bid up the price. It’s rare that The Norris Group would do much interviewing of the person at the door because a lot of times they’re either not there or don’t answer or they will tell you stories. So it’s hard, but this is the business model. In the courts and politics there is definitely a leaning away from housing, and this is going to be so different than the 30 years we have just experienced for most of our careers.
Bruce stated that as we see the prices of homes go down in Riverside to where they are below replacement cost, then it’s a safe bet that we’re going to build a another house in Riverside. From the peak of housing construction to today, building costs are down about 30-35%. However, a portion of this reduced cost is that builders are putting fewer bells and whistles in the house. They have cut down on the amenities, and most of the savings have come from labor as well as all the materials. There are some cost increases with the commodity increases, but none on the labor side. They preferred not to go into depth on inflation and deflation; but Bruce said he reads everything he can on it and the practical side of him looks at the ability for labor to ask for more per hour, which he does not see happening anytime soon. Normally, printing more money causes inflation, but for some reason Japan has printed a lot of money and they don’t have inflation, so deflation and inflation are kind of a confusing situation. However, it does at the same time make it difficult as an investor to go forward and make the correct decisions, so you really have to be conservative, which most of the companies who have survived have done. As an interesting twist on costs, John has been receiving some early feedback from clients who think the cost of entitling lots is going to get more expensive. There are going to be environmental regulations along with storm water mitigation efforts moving about that could significantly increase the cost of new construction. The army corp. of engineers is making some changes. After Hurricane Katrina, they changed the definition of what a 100-year plane flood was and made an entire area of Sacramento that was under development just stop development in the middle because the workers had to go fix the levies in New Orleans before they could build any more. The environmental movement that is now taking a foot in the country is going to make construction more expensive. On the same note, when you’re fixing properties there are areas even in California where you now have to have a permit for every rental that you have. They will also most likely mandate more energy efficient homes, which will also be more expensive to build. There is one city that mandates repairs of the property to specific standards. It’s pretty scary. There is financing available for this type of work, and somehow it is equal to a tax lean, a superior lean to the first. So you can buy a property, borrow money to do the green rehab, and it becomes superior to the first trust deed in the case of a foreclosure and non-payment. On a related matter regarding CFD bonds and mello roos bonds, a lot of John’s construction lending clients suddenly woke up and realized that they didn’t make the first loan, but instead the second one. The mello roos one was superior, and now they’re the equity in the project instead of the debt.
In general, the construction business is down as well as commercial real estate. It’s unknown what the percentage of employment or GDP this represents, but it is possible that we are in the early stages of seeing a lot of apartment construction. This will be good for the economy, but only time will tell whether the apartment market will be overbuilt. If in the future the housing declines then about 4.5 million people won’t live in the apartments anymore, but at the same time it will create 4.5 million vacant residences. There could be a case for them building apartments that are more attractive if they have the amenities that people want, something about which builders ask a lot. They would not build an apartment complex that is bare bones, but instead they would build ones where people would rather be in the apartment than a house. They also would not build it in the Inland Empire, but rather San Diego, Orange County, and L.A in areas where people would traditionally rent anyway. The thought is that as we come out of this and create millions of jobs, for all the reasons discussed in this radio show people are going to be forced to rent. If you look at all the pro-government policies toward home ownership over the last twenty years reversing themselves, it’s going to create an opportunity to build some apartment complexes, even though there have not been a lot built over the last twenty years. Probably more importantly than anything else is that it’s not the fundamentals that matter, it’s the demand and supply of capital. The money is flowing in to build apartments.
When asked whether California’s employment situation has even been solved without construction being a major contributor, John responded that he has not sure it’s ever been solved. One interesting statistic is that there are 350,000 fewer documented employees in L.A. today than 1990. In Japan, it took them till about the year 2000 to get back to their 1990 levels of employment, while we have fallen since then.
The Pure Affordability Index, which looks at housing costs in relation to income on John’s website, holds an A+ right now. However, when you look at some of the other factors that John and his company group into the Affordability Index, things are horrible. This is why affordability holds a D+ on his scale even though it’s at the highest it has been. If you’re a renter, today is the most affordable time to get into the market. If you’re a homeowner, it’s an F. This is because you lack equity. The strongest F is the loan to value on existing loans, which holds an 85%, which is a lot higher than it was earlier. They also look at income growth, which is also not very strong right now. Also, the debt-to-equity ratio does not include properties that are free and clear, but only the ones that have debt.
In regards to California’s commercial market, it is a lot like what the residential market was like 4-5 years ago where people are staring at a lot of maturities coming due. The interesting conundrum here is if interest rates stay low, you are most likely going to see a lot of extend and pretend. This is because the loan to values won’t come in, but the properties can cash flow given the interest rate being so low. If interest rates go up, then there is no hope of extending and pretending and therefore you will see a lot of distress including the properties that have a lot of vacancy.
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