Bruce Norris is joined again 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.
In the last segment, Bruce and John covered what they thought was going to happen in 2014. John had mentioned he thought it would turn out better than it did, and Bruce thought this was a reasonable assumption. They are both in a little bit of the same business where they try to look forward and tell themselves where they think things are going. They have a group of people who listen, and John has a clientele that listens. All you can really hope to do is, looking back a year later at the same charts, you would have made the same exact projection. This gives Bruce comfort in seeing what he is looking at, he can know what he would have said and would repeat it. The difference now is looking at it with one more year experience and see what did not occur and figure out what the wild car was they had not taken into account.
Bruce wondered if John had come up with any of this, to which he said he was still looking. He knew the clients would be pulling out. However, what he does not have a lot of visibility into is a lot of the smaller professional investors. He thought they would continue to fill the void. He picked up a couple hard money lenders as clients, and he knew they were lending to a particular group. He thought there is now debt for these people that have bought twenty homes, can finance them at 50%, and go buy another twenty. John does not understand why this did not happen. Bruce thinks part of the reason for this is the ease of inventory changed. If you have a list of REOs, it is a lot easier to buy. If you have to find them one at a time, this is a much more difficult proposition. You really had to have an experienced group of investors and be able to understand that this was a game they were going to have to change on their own. This depletion of REOs ended some people’s ability to buy since this was the only way they knew.
When you get into a market similar to 2013/2014 when we are funding hard money loans, half of them are now coming directly from a seller via mailer from somebody who took the time to say they buy houses in the form of a mailer or sign. You really had to have somebody know that transition was necessary. This helps being around it for thirty years and to know this in advance. Part of what they do is they teach their clients to do it in advance, and this is why they still have a loan business. However, this is only part of it. The other part is prices rose in some areas where there was no cash flow.
As far as the construction numbers in California, single-family construction is still at a Depression-level and has been for six years. Bruce remembers adding up the last six years of construction on single-family homes, and it is less than one year in 1962. This was the earliest year he had, so this is pretty bad. What is also interesting is if you look at subdivision creation going forward, we are still down in Riverside County by about 85% from a normal year. This speaks to somebody’s confidence going forward. Bruce asked John about what the other companies see going forward that really concerns them. John said there are a couple things.
One thing that did not change during the downturn was the cost to develop. Some of the horizontal costs may have fallen, but the entitlement fees increased. What is keeping subdivision construction down is financial feasibility. The builders would be creating more lots and building more homes, and this way they could make money. Unfortunately, they have not been able to do this. During the downturn there is no money devoted to entitlement, so this was also part of the problem. There were also a lot of environmental restrictions added during this time. This includes new fees that were brought on and made it very difficult to build a home.
If you look at subdivision creation in Riverside County in 2005 and 2006, it keeps increasing. Bruce asked about a developer in 2005 and 2006 who develops subdivisions at a record pace and if they were counting on future price increases to make this work. John said they were in the middle of a great market and the end game was to sell a $500,000 house. Now that house is $300 grand, which does not make any financial sense.
Bruce asked how FHA’s reduction of loan balance affected the builders. John said it hurt them pretty hard, but they just pulled some data that stunned him a little bit. The FHA reduction cut right across the area where new homes were priced. In Riverside, for example, it went from about $500,000 down to about $350,000. Most of them were priced at this much. It took the low-down payment buyers out of the equation all together. What surprised him was when he went back and bought the data for year through October, there has been as many transactions between $350 and $500 this year as there was last year. What has caused some things to fall below $350 is a lack of supply and lower priced homes. Builders had a tough year in all price points, and they are pointing to this as one of the reasons.
Bruce asked John if they do any research on the amount of unsold inventory going into a year versus sales. This has to be the lowest ever as far as inventory unsold going into a year. It seems there is no overhang of new homes. There is also not a bigger ring of resale homes. Going forward, there was always some concern that there was going to be a big flood of inventory. Bruce wondered how this would happen when you now have 91% of equity sellers to buy something. It is very hard to go up in inventory, which goes back to one of the things that you could point to in 2014 and say it could be a very strong year. Part of the reason for this was these 91% of sellers would buy something and there would be less and less available. The fact that volume of sales was down on existing homes surprised Bruce a lot.
Regarding the lending world, Bruce asked John what he feels the impact would be of not just the FHA changing a loan balance but also the people they are incapable of saying yes to where they would in a normal market. Bruce asked if this is where the problem really lies. Bruce is referring to the reps and warranties. The documentation the mortgage people described was they had to build the perfect loan file. What they learned this time was if you went into default, somebody would go through the loan file and say they forgot to dot an I or cross a T and force a whole lot of banks fines and to force back the principle to the underwriter.
The banks have said that if they are going to do this they need to build the perfect credit file. They may come up with somebody who can clearly pay the loan but has an outstanding medical bill that is pretty explicable or their income was lowered two years ago because their wives stopped working when they had a child and is now back in the workforce. There are several reasonable reasons, but the banks are concerned that if the loan goes into default the government will put it back to them and say they should not have loaned to someone since they did not have three years’ worth of income. It is an automated underwriting that goes into these reps and warranties, and there has not been much clarity made. The question is what is reasonable underwriting and what is not in that regard. The banks have gotten very conservative, and some of the nonbanks tend to be a little bit more aggressive and can see the forest through the trees. They are charging more of a premium interest rate for this.
John is referring to overlays where Fannie and Freddie say they will buy a certain loan, but then the person who actually writes it says there is no way they will do it or will only do it if the person has six months of reserves in the bank. This is a sample overlay. The banks say they will take this put back risk, but they need something else that makes them feel good that they will not have a bad loan.
Bruce asked about the impact of the 3% Fannie and Freddie new loan, 3% down program. It will take some market share from FHA and add some sales. However, everything they have looked at and been told is it will not be monumental. What it is doing is shifting some risk from FHA, which turns a pretty hefty insurance premium, to the GSEs who charge less of a premium. However, it is not made for the same borrower. Fannie’s credit requirement would be higher than Freddie. John said this is symptomatic of a shift in Wall Street. First they wanted to protect the consumer from themselves and making ridiculous rules to avoid making loans to people who cannot afford them. Now things are starting to loosen up, and several years from now we may get back to some pretty loose lending again. This would make perfect sense because this seems to be human nature, which Bruce relies on when he looks at charts. It is also the practical direction from where we are.
Politicians want to grow homeownership in this country. He does not underestimate the power of real estate lobbyists since he has been told they are the most powerful group in Washington, D.C. If this is the right thing for them, then there is a pretty good chance it will get done. Bruce also asked about the group that were former owners. John had done his own research on the record number of foreclosures and loan mods in California. If you added up all the people in Riverside County who were foreclosed on, they literally were more than a year’s worth of volume of sales. Bruce thought their re-emergence would be on top of normal demand and drive it through the roof, but this did not happen.
Bruce asked if the inclination of the person who was foreclosed on five years ago would be that they want a chance to own but have not gotten a yes answer. John said there is some of both. They did a paper on this projecting the recovery of the boomerang buyer, and in 2012 and 2013 they were pretty close. However, in 2014 they disappeared. What happened was the ones who really wanted to get back in did, and now we are sitting here with everybody else. John got to hear the top man from ASU speak in Phoenix, and he figured that all the homes in Phoenix had gone through foreclosure. He was also at a real estate conference where a man said he knew 90% of the people in the room, and half of them went through foreclosure. This left a bad taste in everybody’s mouth, and they still had bad credit. What he also learned from talking to the mortgage people was when you lose your job, it creates a lot of other issues. It is not only that you went through foreclosure, but you have outstanding liens, medical bills, credit cards, and all kinds of things you ended up defaulting on that make you really hard to underwrite.
One other thing that he really clued into was that there is a replacement product out there for them called single-family rental homes. Everyone talks about them as comparing them to apartments. The tenant profile is really your homeowner profile, which is somebody with two kids and a dog. They have a home, can afford the payment, have the flexibility, and are in the school district they want to be in, so what is the hurry? Bruce said this is a good question because usually the hurry would be that it is very economically profitable to own one, but their recent experience was that it was devastating. John also thinks there has been a change amongst the younger people who were not in this last time around and are saying they should not leverage themselves to the eyeballs. They are not going to take on a mortgage until they have at least six months of reserves. It takes a lot of time to save this kind of money.
Bruce has studied this, and what is interesting about this particular group is that a lot of them do not have full-time jobs yet. There is no way they are going to qualify for buying a house until then. They are an unusual generation in that they are making households much later or a different type of household. John said what was unusual was the baby boomers. If you look around the rest of the world and the United States before the baby boomers, you lived with your parents until you were married or had a kid. This is what was common at the time. In a lot of countries it is considered insulting to move out until you get married. Baby boomers look at the millennials and say this is really unusual, but it is actually more usual. You ask the baby boomers if they raised the kids to get along with them and keep them in the house into their twenties, and the answer is usually yes. John said he would change the paradigm from people being slackers and won’t to get out of the house to them living with them because it is financially smart.
Doug Duncan said some of it is at the request of the parents since it is helpful to the household. There are some really exciting things going on in the homebuilding industry that are more opportunistic. Lennar’s next generation models are generational homes with a brand new home design with separate entries and living spaces for an adult kid or your parents where they can be part of the house but really go peel off and do something separate. These types of homes do not exist in the resale market. They have done very well with these, which makes sense.
They had talked earlier about judicial foreclosure states lagging. When you get foreclosed on in California, they take the house and that is it. However, when you lose a house in a judicial state there is a judgment. Bruce asked if the recovery in these types of markets will be much slower or very different. You have no chance of a judgment in California that is recorded, whereas in a judicial state that process allows for that. This may be worth looking at since those people may have a judgment against them when they lost $100 grand on their house. They might just become renters for a long time. If you refi here in California you could also have a judgment against you, but they would have to do a judicial foreclosure. There are very few people pursuing this money because they do not have the money in the first place. In Florida it is part and parcel with the process that they will have one, so we will see what happens. Some companies will even buy that judgment from the bank for pennies on the dollar.
Bruce asked what percentage of the time baby boomers retire and move out of the area and if it is uncommon. John said it is very uncommon, although much more common on the East Coast because of the weather. You see a lot of people getting out of the North East and Mid West and going to Florida or the Carolinas. However, it is less common in the Western U.S. The number one amenity for baby boomers and retirement is their grandchildren. Bruce wondered if they generally want to downsize, or do they mind staying where they are? John said most people prefer to stay where they are at because they were comfortable there. There are no transaction costs. By far the mobility rate keeps decreasing as people get older. Those who moved, however, are looking for a floor plan that is more livable. If they are currently in a house with a lot of stairs or a big yard to mow, they would have to be looking for single-story home with rocks in the backyard as landscape.
Bruce asked John what charts he looks at to say what is positive and what would concern him. John said he puts out a huge macro report every month, and most of them look fine. There were about 7 or 8 that showed we have still not fully recovered yet to capacity and plans are still not at a normal level. Job growth is also part-time instead of full-time. This was such a nasty downturn that we still have not completely recovered. The one that puzzles John a little is consumer confidence since this has really not come back. It is back to its historical averages according to most of the confidence measures at which they usually take a look. Income growth is not occurring, but they are starting to tear this one up quite a bit and John thinks there is more positive news here than people think.
Bruce has heard about prices becoming frothy. Bruce asked if there are markets that are currently pushing their limits to where they are in danger of anything negative. John said San Francisco seems really frothy to him. He did a big event up there with Pacific Union Homes, which was fascinating. They broadcast it to a couple places in China, which was scary enough in itself. This tells you what is going on that we are broadcasting local housing markets back to China. What he struggles with here is that by historical standards, even by San Francisco’s expensive historical standards, this is too expensive. Then you talk to investor groups and ask why San Francisco is cheaper than London, Paris, New York, Hong Kong, and Shanghai. You would think it would be equally as expensive. What concerns John is he does not think San Francisco’s local incomes are the part that is occurring. They are not your replacement buyer for what is occurring. This is something you could have said about Manhattan for the last forty years.
Bruce ended by asking if there were any tax law changes that might hurt real estate, such as Proposition 13. John said he does not, and neither does Bruce. The only one John really saw already occurred. The income tax increase in the state of California clearly drove some affluent people to Nevada. He has seen people do work in Nevada as well as seen million dollar transacting in Las Vegas to people from California.
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