Gary Watts with Impact Real Estate #385

Bruce Norris is joined again this week by Gary Watts. Gary is the broker and owner of Impact Real Estate. This is a private real estate company that provides consulting services to not only buyers, sellers, and investors, but also to companies affiliated with the real estate industry in California. Gary is a well-known real estate economist who began his career in 1971. Today, he and his company are called upon to advise the home industry of economic trends that will affect and effect their future impact on real estate. He also manages investment properties that they acquire for their investors.

Bruce asked Gary if he considers the trend for a large number of properties going into the rental pool by large buyers a first and dangerous in any way. Gary said when it first started back in late 2011/early 2012 it was a welcome relief to take those properties off the market. Demographically, we are moving more towards a rental society and there are some implications with this. The hedge funds might have been smart, but the big question is if they took a lot of inventory off the market. If they decide they have made their returns and start putting it back on the market, then that might have an impact on the reverse side.

It was not so much the quantity of properties they bought, but that they offered everything that moved in a certain price range. Even if they did not buy it, they had a finger in where the price ended up. They may have a similar effect in rental values to where they own enough of them in a tight area to where they will in fact dictate the number. The rents in the Orange County marketplace were up 4.3% in the last 12 months. They had some big pools come in and acquire some properties. This was probably the beginning signal that when the portfolio investors started moving into a residential real estate and the media picked up on it, the small investors who were disenchanted with the spill of the stock market back then were bailing out. Once those started entering and you saw increased sales, then those who had been sitting there 4-5 years waiting for the bottoms saw it had reached the bottom. Around late 2011-2012 they saw anybody who had an open house only had to hold it open for about 35-40 minutes to get 50 people through and multiple offers. You could have held an auction on the front yard and done very well.

For hedge funds, this asset class of single-family real estate rentals is not a permanent interest to them. There are some who have created reits, but for a lot of these types of funds they are a passing fancy. Maybe they have a vehicle where they can offload the investment to Wall Street via bonds. He is not sure the houses have to sell in order for them to get what they want. There are all types of entities looking for stable income. One of the biggest entities is insurance companies. Gary could see where they would just package it off and sell it to a variety of insurance companies since this way they have a steady cash flow for projecting out their annuity.

Gary mentioned that demographically we were headed towards a rental society. You almost have to look at the history of the world, and we are the youngest of the homebuilding nation. If you have traveled abroad, you know there are two classes: those who own homes and those who rent. If you go to these countries, you can see that it is almost 30% ownership and 70% rental. What is interesting is that at our peak we had 69% homeownership, and the latest number for the first quarter of this year we were down to 62%. We are moving closer to where we will be almost half renters and half owners. Part of this is demographics as there is a large cycle coming in.
You have the young people today who have a couple problems. One is that they are saddled with some debt from college and the job market is not fluid for them. If they are employed, they see a lot of changes in the job market industry and are not confident. The other factor is they saw their parents settle with a home they could not unload and were losing money on it. This new generation is coming into the marketplace and saying they do not need all this. Gary said he wants to be flexible; and even these young start-up companies where they sell out making billions of dollars are renting. He wants to have his money where it counts, be fluid, and be able to leave. These trends are building.

A good example of this is an Irvine company that owns 48,000 rental units in Orange County. They were told by another manager to take all their land and fill it with rentals. He wanted to double the number over the next four years to 98,000 rental units. He sees the global trends and how it goes with nations, and he is jumping in early. Bruce asked Gary if this is a statement he believes will happen and that the asset will go up. Gary said yes and we have just seen the monthly rental rates rising on a year-over-year basis. He is referring to the cash flow going up and how he is going to keep 90,000 rentals instead of at some point saying they have gone up a fortune and he does not need to do anything else with them other than create a cash flow. It is a tremendous cash flow for the company.

Bruce said he knows this is where the trend is, and this is why he likes interviewing. When you put a great recession terminology on what we just went through, you do not lend credence to the damage that it has caused to families. If you were a 20 year old in 2006 and watch for the next ten years what real estate has done, then maybe you can go and take this seriously. He is not buying that this is the final decision, but he can see how this would create hesitancy. The report came out for the first quarter this year, and for the first-time homebuyer age group it is the lowest percentage ever in the history of the United States. If you want an easy answer, you can just say it is affordability. However, the answers he has given are better than that one answer by far.

In 2013, you came out with a $200,000 property in Riverside. There was one that had been in the MLS for 9 days. Bruce happened to be on a trip, and when he came back it did not look visibly pending. He called the broker and asked them why it was not pending. The broker answered that they had over 100 offers, 99% of which were all cash. However, they did not have time to come to a final decision on the best and final counter. Bruce really thought if you are an FHA buyer, good luck. You are not going to get one. There is a big pile of people who were underserved, who wanted one but never got a chance. Finally, you have to have stability and settle. Bruce said he is not sure this is somebody who has made a decision not to own, but that we at least have to have some stability.

Starting in 2012 and up through the last quarter, we saw that the first-time homebuyer barely stood a chance of acquiring the property because of investors or people with 20% down. He was shocked because last year he handled a 16-unit conversion in Orange County, and of the 16 units only two of the people came in with 10% down. The others were putting down 25-30%, and these were priced at $425. Four people paid all cash. The other thing is you have all the foreclosures that occurred that have re-emerged credit capable again. They are only able to get an FHA loan as far as credit goes. If you had a foreclosure, you are not getting a Fannie Mae loan for 7 years. Your loan is an FHA loan, and they just reduced the loan amount you can get. He still thinks this group still has to play out a longer time before they can get back into the game. Bruce said if they are willing to get back in they probably will, but only time will tell.

A lot of times in the last five years we have been concerned about shadow inventory. Bruce thinks there are shadow buyers. Bruce said you normally do not have a rise in inventory with rise in price; it just does not happen. Gary paid attention to inventory levels really carefully during the last cycle. Between 2000 and 2005 when prices escalated and affordability went down, inventory did not grow. It got less and less, and this happens all the time. Now, we have stable inventory and lower sales volume. We have close to a record interest rate, and what we are having is a different outcome than we have ever had. It is really important that the people look at this and say this is really different. The easy answer that it is less affordable is not correct because the chart will disprove it.

This generation looks at houses and says “I don’t think so.” This could be a very valid outcome, although he does not know if we are so far into it where we can say this is it. He does not know if it will turn the next time. This could mean their college buddy gets into a condo and goes up $100 grand. This could be the turning point. Bruce asked Gary when he was at the end of 2012 looking into 2013, what did he see as far as price progression or inventory changes? Gary said most of the time when he addresses an audience it is in Orange County. It is reflective of the whole nation. At that time he told the association that for 2013 they are going to look at a low of 13-15% appreciation. This was probably four times as high as the CAR projection. The reason for this goes back to what Bruce said earlier about us having low inventory.

Normally in Orange County we carry around a historical average of about 8500 homes on the market. We were below 3,000. Bruce said what is also significant about that number is the mix. You did not have 3,000 REOs anymore, you had 3,000 properties comprised of short sales and REOs. The bulk of them were people who were going to sell and rebuy something. For the first time the equity buyer was moving in. By the middle of 2013, the equity buyer had greatly surpassed the distressed property seller. When you start looking at where inventory will go, the question is how it grows when 85-90% of your sellers want to buy another one. It is hard to grow. This is why when you look at a price chart and an inventory chart, you see that inventory does not go up when prices increase, it goes down instead.

Bruce said when he is standing at the end of 2013 and looking at inventory and the charts, he would not have assumed we would have less sales and that the CAR projection of 440+ has turned into 350+. Bruce does not see a reason for this and does not know why we are down. Gary looked at this and said we are going to have slower sales, so Bruce wondered what chart said this was going to happen. Gary said the bigger chart is the cycle of real estate. Any time after a recession, anywhere from 18-24 months, you have booming sales. This is what was alluded to earlier. You had the hedge funds, and you have the investors come in and this really drove the pricing.

Unfortunately, it hurt the first-time homebuyer because he could not compete against those all-cash offers. At the end of 2013, the last quarter was the first time we had not had quarter-over-quarter sales gains. This tied right in with the real estate cycle of 18-24 months. In Orange County they ran 22 months. It ended after this. Since now a lot of the investors and institutional people are gone, it made sense that we would be having fewer buyers. When we started at the beginning of the year, our inventory was less than 5,000. Now we are up to 7,000. Gary told the audience that for 2014, he sees an appreciation rate around 7-10. We stayed right around 6,000, and if our inventory goes up to 7,500 then we may be on the lower side of the 7%. Bruce asked how many months of supply 7,000 homes equates, to which Gary said it is about 2 ½. This is not a threatening number and the reason why we will still have appreciation.

The second cycle only lasts about 12 months, so 2014 will be pretty good. You then get into the third cycle, and that only lasts about a year. You then get back into nominal appreciation where you are looking at 3-5%. Bruce said he definitely lands on a different set of charts, but he is fascinated by the process. Bruce asked Gary what year we are mimicking if you go back to anything between 2000 and 2006. He asked what year 2014 would be, to which Gary said it would probably be close to late 2006, early 2007. Bruce did not expect this and asked if we have used up this much price in 2014 since he is bumping his head on a top number with a certain 10-20% for sure.

Bruce asked about the affordability in Orange County and what year it is mimicking. Gary said in Orange County, as the first quarter came to an end, only 19% of homes were affordable. When you go back in history, you are going to have that same chart and go up the next year. 32% is where California is, and that is almost as high as it ever got in the ‘80s. We got to 36% in the 90s, then we went down to 17% almost regularly. When Bruce looks at where we see California in general, he sees a very earlier year and it mimicking 2001 and 2002. This is why he looks at it and says he feels we have some price aggression in different markets. The Inland Empire is a different animal in a sense. There were quite a few new home products in Orange County.

What is interesting about Riverside is out employment needs that to kick off in order for it to get better. However, even last year in an area where normally create 350 sub-divisions a year we created 40 in 2013, even after the price run we had. We then created 20 five years in a row prior to that. We do not have a whole lot of building lots waiting in the wings, we just have building lots that were already created, bought, and being built upon. There is going to be a round where we will need a lot of new houses and there will be nothing. Orange County is not in the same boat since the construction, even if it is higher in number, really did not even get high in 2005 and 2006. There were not enough lots available.

The thing with Orange County versus the Inland Empire was they were always the first to turn around and the last to go in. Their cycle would be different for Orange County than it would be for the Inland Empire since they would be the first going in and the last coming out. The time lag in terms of years is understandable. There is actually a color chart one of the companies put together that was fascinating to watch. If you put your mouse over it and scroll, you can see the Inland Empire turning green later.

Bruce asked Gary what chart he considers to be the Holy Grail. For Bruce, he looks at affordability and feels like this is a domino chart. Once we hit a certain number on the low side, he can say with certainty there will be other charts reacting in a negative way. Gary said there are two things he considers key. He agrees with Bruce on the affordability because that affects everything. If you don’t get the entry-level buyers in, you are shutting down the food chain near the top. The wealthy can buy and don’t care about the economy. Another thing is the job market and the income growth that is occurring. If this is really small and the job market is not creating the jobs it needs, we have an issue. Housing and jobs is joined at the hip. This made 2013 a really difficult projection. We said that we would have a good price increase, but it was based on Bruce’s experience as a seller knowing every time he has something for sale it flies off the shelf. However, he could not look at a job chart and say we are back. This chart did not say this.

Once again, you are looking at something and seeing a different result. Normally construction improves, and that drives the job market, occupancy of commercial, and migration back to California. All those charts domino the way they are supposed to, and we get price increases. Here we are having price increases, and we have not fixed any of the normal charts. This is what is fun about projecting charts. It is a never-ending study as you are looking at it trying to see what you were thinking about or have not figured out yet. There is always something new and so many variables. We have the job market, demographics, and what the financial market did over the last three years. There are a number of people who refinanced to take their 30-year mortgage and take it down to a 10 or 15.

He just read that 19.8% of homeowners are accelerating their loan payment. This is a very astute comment since ultimately you end up with people who have a lot of free and clear real estate. This is a very stable person. 25% of the homes in Orange County are free and clear, and this may be the other effect of experiencing something very negative. There will be a certain percentage of people who will say they want to get rid of a home payment. They may in fact be headed in this direction.

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