Bruce Norris is joined this week by John Burns. John is the CEO of John Burns real estate consulting firm, located in Irvine. They are a national source of independent housing research, advice, and consulting. Their mission is to help executives make informed housing industry decisions. His firm provides builders, developers, banks, lenders, investors, and building product manufacturers with timely analysis they need in order to make smart decisions quickly and cost effectively. Research is backed by detailed data as well as proprietary tools and experienced professionals around the country.
Bruce thanked John for providing valuable service to an industry. He thinks John has had product expansion because originally when he first heard of him he thought his client was strictly builders and developers. Bruce asked how this morphed into other clients. John said he thought builders and developers needed it most, so he started there. They are not passionate about monitoring the market, but it is usually what either makes them filthy rich or bankrupt. He saw a role here that he could play. He actually cut his teeth during a housing market downturn in the early 1990s. When he saw another one this time around, he was ready for it and picked up a lot of building product companies and hedge funds that could take advantage of the distress. He also worked on a lot of bankruptcy deals. Overall he likes having a diverse business.
As it turns out, John not only survived the downturn but has also made locations in several different places. Right now they are in ten offices and pretty spread out. Bruce was thinking how John has very knowledgeable staff. Bruce asked about when they do research and how they present something new they have discovered. Bruce asked John how this gets added to the mix of things he has discovered. John said the heart of his business and where he stands is on the ongoing research and subscription business. 2/3 of their revenue comes from market consulting. They have a Monday morning call where he encourages everybody to give them a quote about what they learned the prior week. This is how they disseminate what to pick up and what is the most interesting. They also have regularly scheduled calls throughout the month to make sure they are not missing anything. They survey a lot of their clients, both formally and informally. John loses sleep about what he does not know, so this is why he is constantly trying to figure out what they are missing.
Bruce said this is a much safer business model for his clients. The last thing you want is a consultant that knows it all. Bruce respects people who have the ability to say both sides of the equation. There is usually somebody who will be on the downside of everything, so you could always read the doom and gloom side of it. John is in a business where if you are a developer there are times you make a fortune, and to get out is to keep it. This is a very difficult thing to do because usually, just as their decisions to create a fortune have to be in advance of the opportunity being obvious to everyone, exiting is even more important. They have to make that decision in the teeth of almost euphoria. The hardest part of all of this is actually the tax laws. The 1031 exchange rule says that no matter what you do and sell a lot of money, everyone seems to roll it right back into a vortex.
What would be advantageous is if every once in a while there is a location advantage. You could have one area boom and another place to where you could exchange it to a safe haven if not another boom. This is what John sees happening today. We have really changed from being a national housing market to a super high local one. You have a lot of dynamics that are not really connected to real estate and which sometimes is law-dictated. For example, in Florida you have a foreclosure process that if you look at how long it has taken to foreclose on something, it is approaching four years. This changes the dynamics of what is in the market. Texas has oil, so this is a dynamic that is not always prevalent in real estate. When you look at oil prices today dip below $56, Bruce wondered how this affects somebody in the real estate industry in Texas. John said generally it is a huge positive for the industry. This includes putting a lot of extra money into the homebuyers’ pocket. They have been making commuting a lot more affordable. Land is in the outlying areas, while you are trying to sell homes to commuters. This has been lost in the press, and there are some real positives that this should help with all the construction increases. In Houston, they are still trying to figure out what the impact is going to be. There is no doubt in his mind they will be laying people off, and one person even said it would be bigger and quicker than anybody realizes.
Houston is not 100% about oil. If you look at all the industry sectors, it is only 2 ½% of the employment in Houston. There are a lot of other sectors in there that benefit from oil. A lawyer, for example, is in a different sector and may specialize in the oil industry. The big question is what kind of job losses we are going to see in Houston since right now they can only guess. When oil prices go down this fast, Bruce wondered if this was something analysts were able to tell them in advance or if this was due to usage declining. John said what they did not expect was a decline in demand. There has been a huge increase in supplies, primarily through fracking. They have been staffing up crazy for that, and there are a lot of areas that are $80-$90 a barrel where you can make a lot of money. However, at $55 a barrel you cannot. They have to stop since they borrowed a lot of money to do those activities and there will be a lot of distress associated with it. This oil has fluctuated a lot in the past, and in the 90s some of the declines did not result in a lot of economic distress in Houston. This was because they did not have fracking technology and were not staffing up like crazy. They were simply benefiting from it.
Bruce asked about the years of declines in the 90s. He remembers the 80s since he got involved in buying real estate in Grand Junction. Later in the 90s we saw price declines which he tried to relate to other real estate prices. Another thing John had mentioned that Bruce had also read an article about was bonds and their connection to oil. This is where they think there could be some risk and where there has been a lot of risky leverage associated with it. With the price decline, this is something that could be a problem. A lot of this is lost to private companies, so there is no way you could get access to this data.
Some of John’s clients are hedge funds. Bruce asked when he watches them move around the country if it gives him an idea, or is their opinion what he has told them about some places being priced out and others are yet to increase. Regarding private equity companies investing directly in the business and owning rental properties, Bruce wondered if they have exited as far as being the main purchaser and going somewhere else. The hedge funds are more the people who trade security, while the private equity are the ones that were playing that game. The great trade of this cycle was to buy homes at a huge discount for replacement costs knowing full well that there would eventually be an upside or there would be no new home construction. That game played out pretty quickly in California and Arizona since so many people wanted to play the game. The disclosure laws here allowed those homes to come out of the system.
Those who got in early made a lot of money, while those who came in late did not. Now the game is more in the judicial foreclosure states, but it has gotten more competitive here. For this reason he does not think they are being bought at discounts anymore. What is happening in this business is they are recapitalizing it. They went out and raised a lot of entrepreneurial capital. Now they see it as more of a stable operating business. They have thousands of homes and have figured out how to run it and make money. The capital they raised wants a 20% plus IRR, which is no longer this business since it is now a steady cash flow business. They are cashing out the 20% IRR people and selling bonds on Wall Street at low single-digit interest rates to people who want some bond income backed by a hard asset.
Bruce wondered how these bonds are doing and if there is high demand for them. John said there has been very high demand for them. When there is a structure like this, it is one of the concerns for this new player that is capable of owning several thousand homes. Bruce wondered if they were market makers at moving price while they were participating as buyers. John said there is no doubt about this and that prices rose so much in 2012 and the first half of 2013 because of this. One of the reasons they turned extremely optimistic in 2012 is because they picked these people up with clients, and they knew that even if they had another downturn they would just buy everything. He knew there was a floor in the market, and he does not think this floor is here in the West Coast anymore.
One of the things that also happened was it was not just what they bought, but that they offered on everything they did not buy. No matter whether they bought it or not, they have put pressure on the price for somebody else to buy it at a different level. One of the things people do not understand due to the auction process being so unsophisticated is how sophisticated these people really are. If you saw the computer systems and the data, there is no way they could have done this 15 years ago. You can get somebody an address now with the level of information you can pull up and see the rental comps in the area over the last time it was sold. They were able to do their due diligence amazingly quick and get the information to someone out in the field as they were bidding.
Bruce said we have had to compete with this model and literally turn into this. He and his son Greg have spent the money to create this same type of process where he even knows who is bidding against him. He could pull up who is bidding against him and where they own all their properties. All this goes on seamlessly while the bidding process is occurring. It is a game changer of an industry where before it was very few players since access to the information was tedious. Now it has changed a lot. Bruce asked if he views them as market makers as far as rental values being either contained or increasing. John said not really. They are not monopolies by any means, so he does not think they can control this since it is a competitive market. One company in particular targeted cities, and in that particular city they make the market on a single-family rental complex. This is the same way a landlord would make the market on an apartment complex.
One of the main concerns is you have multiple groups with this particular buying power that has gone from city to city and done their thing. The big concern is whether they will make the market when they exit. Bruce wondered whether or not the exit is selling and what John’s take on this is. He said the exit strategy for them is ideal because they have multiple exit strategies. They could have gone the route to hold the properties forever, or they could dump them on the market. This is the easiest thing to do. If you own 10,000 homes, you can call 10,000 real estate agents and put them on the market. What has played out for the big institutions is that most of them are now committed to some securitization where they have an outstanding loan on these assets, investors expecting cash flow, and 2-year long leases. It is pretty hard to sell a home when there is a tenant in it. It is not the big guys we should be worrying about dumping homes on the market. They are only a small percentage of the market; and John thinks it is the mom and pop investors and those who own 10-100 of them who don’t have the structure he mentioned. They can just as easily wake up tomorrow and say it is a great time to sell all their homes. During the next downturn when everybody is convinced we are in one, it will exacerbate the downturn.
Bruce asked about foreign investor participation and if it is different in percentage this time. John said it is and has been significant enough that they wrote a 57-page paper on it. He figured it out, but could not predict what they were going to do. It all really boils down to one thing, which is safety in the United States. There was distress here and an opportunity there, but what he learned was there were so many millionaires created around the world as all these other economies grew much faster than they did. They wanted to get their money into a safer currency, and in a lot of countries the title laws are not clear. You cannot pass real estate on to your heirs, and everything we take for granted here in the United States cannot be done in these other countries. It was a tremendous creation of affluence around the world that drove them here. Whether or not the creation will continue is not known.
Bruce asked how the dynamic would be different for the current buyer, whether they are Chinese or Canadian versus the Japanese buyer of the late ‘80s. This is a good example because the Japanese economy has not grown at all. We saw them disappear and pull out. For the most part they have not dumped their assets, but instead have held onto them. They stopped investing, and this was when we saw a slowdown. If we saw something similar happen in China or Russia, would they start selling their assets in the United States? This is also not known at this point. The answer would depend on whether or not they have debt on it or leverage.
Bruce spoke in front of a group of Chinese investors in Northern California, and one of them made an interesting statement. He said he bought a home in San Jose for $1 million that two years later was now worth $2 million. He was going to hold it until it was worth $7 million. Bruce thought this was pretty optimistic for one house, yet when he inquired further he realized he was from Beijing, which had gone up 1,000%. It is human nature to think that you are part of that success. If somebody had 1,000% gain in China’s investment in real estate and bring it here, they are likely looking for the same return. In their head they are thinking they are good at this and will do it again.
Bruce asked John when he was looking at the end of 2013 into 2014, how has it turned out differently than he projected? He wondered if it is different or if it has played out the way he thought it would. John said 2014 was definitely not as strong a year as we thought. This made perfect sense to Bruce and a very rational conclusion. John said there is definitely something big going on out there beyond his comprehension. However, as they modeled and estimated what was going to happen during this recovery, they have looked to Houston’s recovery in the mid-80s and Southern California’s in the mid-90s. There were some bumps along the way with volumes growing at 10-15% and home prices returning to normal, and it took about ten years. What we saw happen nationally was the market overcorrected a little further and investors came in and drove things up faster.
Tune in next week as Bruce continues his discussion with John Burns on the Norris Group real estate radio show.
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