Is History About to Repeat in Real Estate?

During the 1980s, major US banks made loans to Latin American countries. While the loans never made economic sense, the banks were able to charge exorbitant interest rates to countries becoming poorer by the minute. The banks booked high interest income, although they never received principal payments; the countries continued to renegotiate the loans. Eventually reality was faced and these loans defaulted. Bank of Boston, among others, lost hundred of millions of dollars. Furthermore, the loan write-offs came just as the US housing market was about to burst and the already weakened banking system had the first salvo which with twenty/ twenty hindsight was the precursor to the crash of 1987, the meltdown in the housing market and the recession that followed. Twenty years later, we are witnessing a similar situation.

As anyone who has read the newspapers, watched TV news or seen news on the internet, home sales have fallen sharply. We are perhaps witnessing the beginning of the much ballyhooed collapse in real estate as an investment. The first groups to suffer are the homebuilding companies whose average share price has declined 12% in just the last few months. Now we are seeing a surge in defaults (i.e. foreclosures) on the most vulnerable group of homeowners, the sub-prime borrowers. For the week ending February 22^nd, this entire sector dropped again when Nova Star Financial (NFI) announced that its losses were so great that it would not have any taxable income for the next four years. Even worse, the company stated it might choose to drop its real estate investment trust (REIT) status, a move that would end its tax advantages.

NFI shares dropped more than 40% on this past Wednesday, March 8^th. With losses mounting, the first company to report gives a glimpse as to what the rest of the industry might look like. In all likelihood, the share prices of the rest of the sub-prime sector will follow suit. New Century, another sub prime lender, is under investigation for its lending practices by the US Attorney General's office in California on April 2^nd, 2007. Its stock has entered the death spiral where the stock collapsed from $14.56 on Friday March 30^th to $4.56 open on Monday April 2^nd and that was before it filed for bankruptcy the same day!

We are effectively witnessing what happens when the fine print of the credit bubble finally takes effect. For years, banks have loaned money to prime and sub-prime lenders, which have in turn made loans to consumers with faulty credit.

Many of these mortgages were "no income verification" loans: loans in which the borrower simply stated how much he or she made, without providing any evidence to support the claims. In this setup, a homeless person could walk into a sub-prime lender, claim an annual income of $250,000, and receive a million-dollar loan.

Sometimes called NINA loans (no income, no asset), these borderline-fraudulent mortgages comprise an estimated 40% ($500 billion to $600 billion) of the sub-prime-lending market. In other words, nearly half of the money loaned to consumers with bad credit was based on the borrower's "word," rather than any real income or collateral. No one really cared about this practice when the banks were lending money at 1% or less. However, since 2003, the Federal Reserve has raised interest rates 17 consecutive times to 5.25%. Those mortgages and loan payments rose with each hike, and suddenly borrowers' pretend income isn't covering the monthly payments.

Last year, real estate prices first stabilized and then began to fall. Home prices declined by more than six percent last year as measured by the median price of homes that were sold. Therefore, when these sub-prime borrowers could not pay, they could not jump out of the loan with a quick sale at a profit. So, foreclosures and missed payments started to show up in the income statements of the sub-primes. And the fireworks began. All in all, twenty-three sub-prime lenders have closed shop or declared bankruptcy in 2006.

More are on the way…?

The deciding factor here is the big banks: UBS, HSBC, Barclay's, Goldman Sachs, Wachovia, etc. If the banks decide to pull the plug on sub-primes and demand their loans back, then, lights out. We experienced something similar in Massachusetts recently; newly in office Governor Deval Patrick called upon Robert Rubin at Citibank on behalf of Ameriquest Mortgage. Citibank does billions of dollars worth of financing and bond sales with the Commonwealth of Massachusetts so the phone call from the governor carried some weight. The issue was that Ameriquest Mortgage, like the other sub-primes, currently failed a liquidity test.

Most contracts between the big banks and sub-primes require that the latter maintain a certain level of liquidity. That is, the banks require a certain amount of cash to be on hand to cover whatever losses the NINA loans generate. If a sub-prime doesn't keep enough money as collateral, the bank can terminate the contracts, forcing the sub-prime to go bankrupt as it ponies up cash for the loans.

However the entire sub prime market represents a paltry 15% of all mortgages. Stated more emphatically, the headlines are ignoring that 85% of homes are not sub prime. Foreclosures in the prime (good credit market) part of the market have not been rising like the sub prime and have grown from 2.44% to 2.57%* Although foreclosures on sub prime account for a staggering 13% of all sub prime loans; the foreclosures when compared to all mortgages represents slightly more than 2% of all mortgages. So currently the combined rate is 4.95%. Unless sub primes are showing a trend that may reflect what is happening in the larger real estate market, sub prime in and of itself is only tempest in a teapot. As a matter of fact, the combined rate continues to be within historic norms per the latest report from Mortgage Bankers Association. The range has moved in a rather narrow range from a low of 4.31% to a high of 5.27% in mid 2002.

The sub prime market was hurt by the increasing increases in the Federal Reserve rates for more than one year. In general, three variables affect real estate prices: 1) interest Rates: currently they are stable, 2) employment: the more and higher wages people receive the greater the demand for real estate; conversely as employment drops, the rise of delinquencies and drop in home prices accelerates, 3) the tax laws: since mortgage interest and real estate taxes are tax deductible (in general) tax rates and laws affect valuations. The rest is simply supply and demand.

We have just experienced a year's worth of rises in interest rates along with growing employment and rising economic activity. During most of the past six years, since the Dot.com bust of 2000, real estate has buoyed the economy. We are now experiencing current real estate prices dropping by about 6.7% nationally from the record high reached in April 2006. The drop in real estate prices along with the general weakness in the entire sector has resulted in a general tightening of mortgage lending. So, now, housing is a drag on the economy rather than a prop to it. Currently it appears that housing is in for a slow slide rather than a quick crash, which is good for everyone.

Our view on housing has always been that national trends are deceiving. Certain local markets do well despite national trends. Homes in Detroit Michigan, where 80,000 high paying auto jobs are in the midst of evaporating, are selling for depressed prices while other areas are still seeing steady sales. There are several factors that affect housing demand and prices. First, population growth, the US population is growing; second, steady or improving employment, so far, US employment is still growing; third, interest rates, the lower mortgage interest rates are, the more demand for housing. Thirty year fixed rate mortgages bottomed out at about 5.25% and currently fixed rate mortgages average about 6.29% per HSH Associates Financial Publishers, web page. So, the pressure on mortgages may be less than they seem. Fourth, the echo boomers are entering the years in which they start to enter both the job and housing market.

According to the latest available data (2005), approximately one out of three homes in America is owned free and clear of any mortgage. Another 57 percent of all homes are secured by traditional, fixed-rate mortgages. Therefore as of 2005, 90% of homes had either no mortgage or a fixed mortgage. Only 10% of homes had any variable mortgage (Adjustable Rate Mortgage (ARMS). But at the time of the melt down in Sub Prime lending 40% of mortgages had no verification of income. How many of those were sub prime is not clear, but we suspect much greater than 10%.

However, since housing is such an important sector to the well being of the economy and the current economic expansion is beginning to look old, the fear is that economic activity may decline, unemployment may rise along with some shock to the stock market which may cause a correction in the current bull market and turn it into a full blown bear market which will lead to the inevitable other shoe falling in the real estate market. Then real estate will crash as it did in the 1987 to 1991 period where prices dropped in many areas by 50 percent or more. Remember that crash in real estate was largely due to the change in tax laws which meant that negative cash flow investments could not be deducted from taxes, which virtually killed the tax shelter market and made many real estate investments unaffordable for owners.

For these reasons, we, at Colman Knight, continue to view real estate as having less upside potential in the United States and more downside potential than in years past. As we have been doing for the past couple years we continue to advocate reducing REIT and other real estate related investments because their stock prices rose greater than their earnings. We continue to value the sector long term, but we have been underweighting it for the reasons we describe in this article. We are adding real estate and REIT exposure on an international basis as investments that are liquid (easy to buy or sell) come on the US market. The speculation in the international real estate is less than the US in some countries and we are adding to your portfolios in specific countries only when the economics make sense.

As for the sub-prime market has been avoided in your accounts managed by us and you will be minimally affected. Additionally, exposure to the building trade is minimal except for companies such as Home Depot and Lowes. We currently recommend the sale of Home Depot and we continue to watch Lowes. None of you directly own homebuilder stocks in your portfolios. However, there may be limited exposure in your mutual funds. Our greatest exposure is to companies with strong balance sheets paying high dividends which we believe minimizes the effect.

With our continued communication, our anticipation of this issue and strategy to journey through it, we expect you will experience confidence in your investment management as well as renewed inspiration to direct your energies to what matters most to you in your life.

* The Mortgage Bankers Association (MBA) quarterly delinquency report for the quarter ending December 31, 2006.