Bruce Norris is joined this week by John Burns. John is the CEO of John Burns Real Estate Consulting Firm, and he has put together quite a talented team of trusted advisors. They do service for banks, lenders, builders, developers, investors, and product manufacturers. It is a very well-respected business, and Bruce has been amazed at the transformation over the last five years. As the downturn has occurred, his business has grown and expanded. John said they have diversified, and if he had continued hanging out with homebuilders he might not have done quite as well. The cheese moved, and he moved right along with it. In doing so, this has really expanded his knowledge in how things work. John considers himself very fortunate and has a couple guys who are now famous for starting the subprime situation. They taught him what was happening in the mortgage market. Now he has the products guys giving him some new issues and more private equity folks. There are a lot of smart clients looking at this from different directions, and he tries to pull it all together. Bruce is also one of the smart people he listens to for advice.
One of the things that has been delaying any normal process of getting back to a good economy is that construction has been in the doldrums. Bruce wondered how important construction’s resurgence is to fixing the unemployment. John said one of the big issues in the homebuilding industry is a labor shortage. This sounds almost idiotic given that we are 70-80% off the peak and trying to grow again. He said they are just finishing up a big research project for two of their clients on this, and the homebuilders met with Bernanke last Thursday with this big issue. We are having a labor shortage, and trade labor wages are increasing. Bernanke was ecstatic about this. The trades have said they have laid off all their best people and are paying their people far less than they used to pay them. Building a home is hard work, and they are not willing to hire until they can get their rates back up again. Their best folks and the people they have known have moved on to other industries and don’t really want to come back to housing given the way they got treated and how cyclical they know the business is. We have lost 1.46 million construction jobs nationally in residential construction, and we have only gained back 40,000.
Bruce said his granddaughter was in a summer program where she was in a small town in Texas. Even while he was there picking her up there was somebody there who asked the church to put them up for a weekend because there was no place to stay. He thought there must have been a housing boom going on, and they said there was not but rather everybody who came through there thinking they would stay in construction goes to the oil fields since they pay twice as much. They could have a building boom, but they could not put it together. John heard that especially in Texas and Arizona there have been a lot of people who left for the oil industry and are not coming back. They are getting paid $100 grand to start when they don’t know anything.
Bruce wondered when construction gets going what other categories of jobs it helps along. He wondered if manufacturing is one of those benefactors. John said they definitely are; and if you look at the publically traded product manufacturers, they are reporting their U.S. sales are up 5-7%. They are scratching their heads wondering why all the public homebuilders are up 20-30% while we are only up 5-7%. That is part of this labor lag that the builders are selling all these homes but are not ordering the materials because they don’t have anybody to put in the materials. There will probably be about a 9-month lag, but they will see a benefit. The other part of this is part of a construction recovery, but the recovery we are going through is we are going to transition to more real buyers instead of investors. The real buyers go out and spend way more money on furniture or go to Crate and Barrel, Target, or Sears. You will see a lot of ancillary businesses and see their revenue grow 1-2% per year. For retailers this is a big move once we see the housing market start to come back, which is already occurring.
Bruce wondered how commercial occupancy gets helped, to which John said this is totally job growth. Architects will start hiring again, and the lawyers have fared pretty well through all this. There are a lot of service firms to the industry that will start hiring again. John knows a lot of these guys, and when he goes to their offices they are only half-full. A lot of companies will really benefit, and it will really help the economy overall. Bruce said one of the things that is interesting to him is you will see the headlines say that construction is up 20%, but then you have to look at the chart and think it’s really off of a number that almost doesn’t exist. Riverside had one of these where it was up 30%. Bruce looked at how many homes were built and realized it was a rise of 8 houses.
One of the things in which a lot of people have difficulty is seeing where we will inevitably be in a very short period of time. We have one month’s supply of inventory in Riverside, yet our lot or subdivision creation is 95% off of its peak. To Bruce, these two don’t match. John said what it means is prices are going to increase. Bruce said he would think we are going to have a price run because you have policies that took us from 6 months to 1 month of inventory. Those policies have not changed, and now we are at 1 month of inventory. He does not know how we go back to 6 months of inventory with the policies in place. The only way we could is if we had some kind of recession and everybody pulls back. What is interesting about that is you could have a recession and end up with a lower interest rate that starts with a 2. In California, you are blessed with an abundance of former owners that would save $500 a month going from renter to owner again, and FHA will let them do it. John does not think we will see prices fall for that reason.
If you saw a recession, there would be more skittishness amongst some people more than others, even if they mess up this whole fiscal cliff and debt crisis. John has one client in particular who is very well known who invests in real estate all over the world, and he thinks in a global recession the biggest safe haven would be distressed real estate in the United States. Even if that happened, you could see more foreign capital flow in here as real estate. John deals with hedge funds, and all of a sudden single-family homes have become a target for the first time. To him, this is kind of a market-maker change. They are buying enough homes to where they are affecting the prices, inventory, and also the rental market. These guys chart everything, and the chart they love points to having to invest in distressed real estate. They love it when it is below replacement cost, but you can have all kinds of arguments about what are replacement costs.
The interesting thing is that they have clearly driven prices up, particularly amongst the distressed real estate to the point where they are not really trading below replacement cost anymore. The question is if they are going to have the discipline to stop buying, or have they created a little mini bubble? It really shouldn’t be called a bubble since the affordability is so fantastic and the question is if they will ride the wave that is going to happen in home price appreciation. When you have a 3 ¼% interest rate, you have these other dominoes that play out and start thinking about what this will cost monthly.
CAR comes out with reports, and they talked about how in the Inland Empire if you were about $550 per month going from renter to owner and extrapolate this in dollar terms; then the question is how much the prices will go up before you hit that $550. The answer is $127 grand, a large number. We are sort of looking at it as the way the comeback normally works, and we are going to be surprised. Bruce and Sean O’Toole went back to Washington D.C. for three days to do research at the Library of Congress. Two nerds were looking at microfilm for three days, and it was fun for them. One of the things they wanted to do was check since they sometimes hear that interest rates are at their lowest in the last 50 years. Bruce said he can definitely confirm that the interest rates on mortgages have never been this low any time in the 1900s. This is amazing since prices are the same that they were 11-12 years ago. This is no doubt the bargain of all times.
Regarding below replacement cost, when somebody starts to think about writing a check for a piece of land, they have to count everything. In Riverside County, one of the problems is we do not have sub-division creation because you could not make a case that would pencil tomorrow. Bruce wondered how far away we are in terms of price movement before somebody would say we need 100 lots somewhere. John said there is plenty of demand in the better submarkets, such as Chino and the Dairy lands, Rancho Cucamonga, and even Lake Elsinore. If the land prices rise, things could make sense. It is when you get up to the High Desert in areas such as Victorville that there is less demand or even in areas where the landowner is not going to sell the land for the price you could make money on it.
A big part of it is that we have far fewer distressed land sellers everybody thought we would. We thought it would be the RTC all over again, and for whatever reasons the farmers and other land sellers either did not have too much debt or saved enough cash to hold onto their investments. Bruce wondered if they had sold under an option, got the option money, then people backed out. They would have a pile of money that they never thought they would have in the first place. They are then continuing to farm the land or doing whatever else they’re doing with it. They have residual money now to pay the taxes, and they are more comfortable than ever.
When a developer takes a piece of land and he ends up with a building lot, including streets and sewers, Bruce wondered what it would cost to get to this point. John said he knows but is not going to quote it since there are too many variables as well as a lot of money. Bruce also wondered if California’s permit structure cost is higher than other states. John said it is absurd. Somebody did a study a while ago on the city of Carlsbad, and it was north of $110,000 a home just in permit fees. You could build or sell a home in Texas for this amount. That is also a another big change that is going to inhibit construction; while the cost of building the home and putting it in the streets has come down dramatically because the trades have had to lower their prices, the permitting costs and the regulatory hurdles have gone through the roof. Clients have complained all the time about the changes that the Army Corp. of Engineer had and the puddle they had on it for 30 days, and it is now protected wetland. Things are getting ridiculous. It will be much harder to play catch up if we are behind, which is where Bruce thinks we are.
We do not have a lot of available building lots, and this is the number one complaint. John spoke at an event in San Diego, and he told them he thought sales would double over the next four years. Unfortunately, we just don’t have the lots. John was talking about us getting back to 2003 volumes and 2007 volumes. If we sold four a month instead of 2 ½ a month, you are 2/3 of the way there. Everyone at the event was telling him the profitable lots just do not exist. Bruce said he would think existing lots would be very good to stock up on. Even they were talking about raw land, but there is no raw land entitled for development that he can touch given today’s home prices. What is interesting about this is normally we have a cycle that is very different where you have construction improve the job picture, and then the job picture improves once we get migration all in this sequence. This time we are going to pretend we do not have anything for sale. This is almost what it is because the idea that the shadow inventory was going to show up in such quantity was going to create another downturn. Bruce said from his seat, he looks at every policy they are deciding on, none of which ends up for sale in the MLS. They have bulk sales of property and bulk sales of notes. The hedge funds that are buying properties are sending those into rentals for years. The question is where the glut of the properties is going to show up.
John said the other people were totally wrong, and we have been wrong on a lot of things. However, they were right on this in that it would play out over 4-5 years. The only great day was in Southern California where the RERC collected good foreclosure data in the 90s that you saw play out over years. They then found a few executives in the bank servicing businesses who did not understand a thing he said and mandated that they foreclose on the people and sell the homes. This was something they could not do because they have to document everything when they cannot even keep their software up to date.
Every state is changing the rules on Bank of America, so they have to rewrite their rules for California and Nevada. There is no way they could process the paperwork. What it is doing is it is telling them to sell the loan. You can sell the portfolio of loans, and even though you will make less revenue at the end of the day, you are going to lose less because it going to take you forever to take it through REO. They then sell it at a discount to where a company like Carrington can go talk to the owners and it never becomes an REO. The bank cannot cut your principal 20% because it is morally hazardous to them and they think it is ridiculous. However, they will sell the loan at $.60 on the dollar to somebody who will then cut the principal 20% since they just now made money doing it.
B of A first did a mailer to people who were behind and had credit lines. This mailer was an offer to reduce their principle, but they received a 7% response rate on the mailer. The next mailer they sent out was 150,000 credit lines that were forgiven completely. The letter said that unless we they heard from them within 30 days, it was enacted. Therefore, they did not need a response. They should thank the bank because if they needed it in January, it would possibly be taxable income. We’re all sitting here thinking they are going to make a decision, and the worst decision would probably be no decision on a lot of these things that have come up. One of them is the ability to not pay tax on forgiven debt. This would not be a good thing for California. It would end the short sale craze, which is about the only craze occurring. John wonders if the IRS would really pursue this. One of the easier things with this is you don’t have to do a bankruptcy to get rid of this, but you can do an insolvency. This is much simpler and a process Bruce is much more familiar with since he asked his tax lady what happens in this situation. If everybody knows it is going to get past, then why would you wait until December 31 to do it?
Bruce asked John what his opinion was on the fiscal cliff. It does not seem like it is going to have an early resolution, but he wonders what the resolution will ultimately be and what impacts it would have to the benefits we have assumed will continue for real estate. John said he thinks they are going to continue to play chicken with each other right up until the deadline. They will see who gives first and then it could then be extended through all these fancy shenanigans all the way until February or March. He said it would not surprise him to see us in this period also, and they will probably also do something that looks like they at least solved the problem for twelve months and will be back at it again next year.
The problems are so huge, and they are not even really tacking the major problems here. They are just trying to tackle this year’s problems. This is one big U.S. financial crisis, and the U.S. balance sheet has to collapse at some point. With 800 years of financial history and tons of companies, for every single one of them at some point the investment community has lost confidence in the government and told them they would not buy their debt anymore. Bernanke cannot control interest rates when that happens since they could go through the roof. You cannot control long-term if people’s sentiment turns against it. You can control what the banks borrow at, but the question is who is going to buy our debt when China and everybody else stops buying it. They are then going to want a 10 or 12% return to do so.
About a year ago we had a credit downgrade, and the ten-year went from basically two and a half to one and a half. Bruce was surprised by this as he thought we now have a problem. However, we are the cleanest shirt in the dirty laundry. Everyone else has a situation that is even worse than ours. John said a lot of Europe does, although he does not think the whole world does. There was a really good article in the November 30 Wall Street Journal that laid it out nicely. Mary Meeker wrote a good report called USA, Inc. that is a solidified report on the US balance sheet. There is $62 trillion in off-balance sheet liabilities for Medicare and social security. That is not even being discussed. What we are worried about is our $16 trillion debt, but we have four times this off-balance sheet. If we do the accounting right, we have about $80+ trillion that we are already committed to pay and are not going to have. We are running a trillion dollar a year deficit. They claim we are accruing about 7 trillion a year for Medicare and Social Security liabilities. If you take all the income of all the people and businesses in the United States, it is only $7 trillion. Even if you tax us at 100%, it doesn’t cover it.
One of the reports Bruce wrote forced him to take a look at the tax structure. In one of the years, we had capital gains equal to the highest personal rate. Revenue in that segment went down and has never recovered. It has never collected the same percentage of taxes that it did prior to the law change. With some of the ideas to get money from the rich, if you don’t do it correctly the rich do not have to sell something. They just say forget it, do a 1031 exchange, hire one last person, or have people work 30 hours instead of 40. Bruce has people telling him there are stores where at one he was in a line that was 15 people long, and it was the first time he had ever seen this. What happened was the store had let go about 30% of the staff, and the rest only worked 30 hours. They don’t have any full-time employees in the store, so they don’t have to pay any medical expenses. This is one way to skin the cat.
Tune in next week as Bruce continues his discussion with John Burns on part 2 of this segment of the Norris Group real estate radio show and podcast.
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