Housing Forecast

Stewart Title’s Chief Economist and the Denver Metro Chamber of Commerce Economist recently held a public discussion of the economy at the Jefferson County Board of realtors. They foresee the housing market in Denver as “returning to normal,” with “normal” being defined as sales volume in 2003. They project price stability to arrive in 2009.

We believe that prices will still decline as the entry of the last of the foreclosed sub-prime mortgages, combined with the continued slowdown in sales of +$500,000 homes make for a lower average sales price.

We expect unit sales volume to decline by 2.5%.

What is interesting in their presentations is the mortgage forecast. Now is the time to buy and/or refinance. Because of the deficit spending we are about to experience they are forecasting increased inflation and higher interest rates. They estimate 30-year fixed rate mortgages to be at 4.8% for 2009, 7-8%% for 2010.

Don’t worry about buying “at the bottom” of the cycle. If you want to get into market with great rates, it’s time to do it now. If prices for homes drop another 10%, but mortgage rates go up 1%, you actually end up behind.  Smart buyers will buy ASAP.

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The Foreclosure Mess: the Government, Bankers, and the Consumer

Today we have raging foreclosures, neighborhood by neighborhood. Families have lost their homes, banks are in trouble and jobs are disappearing. Our economy had a 3.8% drop in GDP in the 4^th quarter of 2008.

But how did we get here? A primary source of our problems is the changes in the financing of homes. What changed in our society that moved families from financing their home purchases with traditional 30-year fixed rate mortgages to new, riskier loan products issued to borrowers who, traditionally, would have never qualified during the “good old times?” It’s a complicated story with many players. The cast is long and diverse involving the government, mortgage lenders, and, most importantly the homebuyers.

Until 1970 banks that issued the mortgages kept them on their books. They managed their own portfolio of loans. In 1970 investment bankers created mortgage backed securities (MBS). These debt instruments were created to free up mortgage lenders’ capital by selling the mortgages in their portfolios to investors.

In 1977 the Carter Administration, in response to allegations of banks “redlining” sub-prime zip codes, asked Congress to pass the Community Reinvestment Act (CRA). The CRA encouraged banks to meet the credit needs of low- and moderate-income areas. This was the beginning of the weakening of risk management within lenders.

In 1980 Congress passed legislation that eliminated the states’ limits on interest rates. Banks began to charge interest rates that reflected the risk of the borrower. The number of denials of mortgages was greatly reduced, as banks were glad to charge more for riskier customers. Banks became more profitable; more families stretched to buy homes.

Mortgages expanded to more and more of the population. With higher rates for riskier borrowers more houses were bought. Banks understood that the monthly payment amount was the key factor for housing affordability. In 1982 mortgage rates reached 18%. Demand fell. Banks then created adjustable rate mortgages to lower the first few years’ rates and thus reached a broader swath of the population.

In 1983 Fannie Mae asked Salomon Brothers and First Boston to create Collateralized Mortgage Obligations (CMO’s). This new debt instrument allowed the GSE’s (Government Sponsored Entities) to spread the risk of prepayment¹ among several classes of instruments. This assured investors who had purchased the debt that the prepayment risk on their investments would be minimized. In effect, it broadened the liquidity of these instruments.

Ronald Reagan’s 1986 Tax Reform Act eliminated all interest deductions except for home mortgages. The same law created Real Estate Mortgage Investment Conduit (REMIC), the most common form of CMOs.² Since mortgages became the only deductible interest expense families began to take out second mortgages to finance their life style. Debt level increased.

When automated underwriting was implemented in 1990 it simplified and made more efficient the underwriting process. Recent studies have shown that automated underwriting better predicts creditworthiness of marginal buyers than does human analysis. . However, it also removed the human analytical influence on mortgage decisions. Looking the borrower in the eye as a decision-making tool was gone.

In an expansion of the use of the principals behind the 1977 CRA, in 1992 Congress created specific mortgage purchase goals for the GSEs. This initiative raised the probability of delinquency to a statistically significant level. This was reported to Congress, but they moved forward with the proposal anyway. In the next year HUD began suing banks with lower minority mortgage approval rates than for whites. In response to this pressure, lenders began to relax down payment and income requirements. At this time there were still no sub-prime mortgages.

In 1994 the lenders created what came to be known as sub-prime mortgages. Lenders responded more forcefully to Congressional and Federal regulatory pressure by making mortgages more affordable. The primary vehicle was hybrid, or teaser rate loans, in which borrowers paid a lower teaser rate during the first two-years of their mortgage and then adjusted to market rates. In addition, it was clear that these other recent developments such as automated underwriting, securitization (CMOs, REMICS), the use of pre-payment penalties and the entry of unregulated lenders into the market would make the growth of the subprime market more aggressive.  Seeing this opportunity, hedge funds entered as investors.

In 1995 Congress amended CRA to force banks into lending to riskier borrowers. Banks began to lend to non-creditworthy borrowers in response to community pressure groups such as ACORN. Credit Default Swaps (CDS) were invented to free up lending capital for banks. These were used as an insurance policy to help manage the credit risk of the borrowers. The next year HUD gave the mortgage banks a specific target of 42% of all mortgages for low-income borrowers.

In response to 9/11 the Federal Reserve began to lower interest rates to stimulate the economy. As the money supply expanded economic activity picked up. Foreign countries were flush with dollars as a result of their export success and saw the American market as the place to invest. There were huge influxes of cheap capital looking for larger and larger returns. Non-prime borrowers (subprime and ALT-A) at that time represented less than 10% of all existing mortgages. ARMS represented 20%.

The St. Louis Fed began to elucidate the risk associated with the GSE’s. Their portfolio had grown to $5 trillion. The interconnectedness of the GSE’s with the global financial players  was noted. Further, the St. Louis Fed said, “And, most importantly, there is no effective regulator.”

By 2003 there was a real negative Fed Funds rate. Most mortgages were GSE backed, thus creating an implied guaranty of the US Government. The rate of appreciation of home prices exploded to 16% per year. Real estate loan originations were growing at 10-17% rate while the growth of goods and services was at 5-7%.

This resulted in the creation of the demand bubble. This pushed up prices of existing houses and created demand for new houses on vacant land.

One-year teaser rates became significantly cheaper than 30 year fixed rate mortgages (+-2%). The subprime and ALT-A borrowers were given convincing arguments by lenders. They primarily focused on the exit strategies of refinancing at lower rates as the house value appreciated, or selling the highly appreciated asset if times got tough. “As long as prices continue to appreciate, you can refinance into a 30-year fixed rate mortgage.”

William Poole, President of St. Louis Fed warned Congress that Freddie and Fannie had insufficient capital to withstand adverse conditions. He advised Congress to explicitly remove Federal backing of their CMOs so that the GSE’s would face market discipline.

By the next year, 2004, ARMs represented 40% of all loan originations. FHA required only a 3% down payment. In 2005 HUD required that 52% of all mortgages go to families with income below the area median. HUD also placed requirements on the GSEs’ purchases. 28% of all purchases had to be from mortgages with families with income less than 60% of the area median. Investors were under the impression that the Federal government would guarantee these loans.

Subprime mortgage totals grew to $625 billion, which is a 23% annual rate of increase since 1993. 12 million new poor and minority homeowners were created. The percentage of households that owned their own homes moved from 64% to 69%. The mix of loan originators looked like this:

·      20% of subprime mortgages were made by regulated institutions

·      30% are made by affiliates of these institutions.

·      50% are made by state-chartered, but not federally regulated mortgage brokers.

·      Almost all prime loans are made by regulated banks.

By 2006 over one-half of mortgages issued did not meet conforming criteria. Subprime and ALT-A mortgages began to dominate. The traditional “20% Down” mortgage became a relic of the past.

From 2002 until 2006 home prices appreciated at an annual rate of 16%. For the previous 55 years the rate was 3%. As the values skyrocketed fewer and fewer families could afford the monthly payments associated with the traditional, conforming 30-year fixed rate mortgage. The problem moved from subprime zip codes to most price points. Builders saw their buyers combined loan to value ratio move to 95%.

By 2007 the credit default swap write-down begins. A chill moves through the spine of the financial industry as they realized no one knew the value of the CDS issued. The subprime mortgage volume had reached $1 trillion. In June, the Fed issues regulations for subprime lending. The default rate for new subprime mortgages reaches 20%; however, for all subprime mortgages the default rate was 12%. This means that 88% of the 12 million new homeowners were making their payments. The subprime products were not a total disaster.

Summary and Conclusions

During the rapid growth of the sub-prime market from 2001-to 2007 the quality of the market deteriorated dramatically. High LTV borrowers became increasingly risky. Mortgage rates became more sensitive to the LTV ratio of borrowers. Securitizers were aware of the problem. The sub-prime mark up over the prime rate should have increased over time as the riskiness of the borrowers increased. It did not. A combination of rapid market growth, loosening underwriting standards, deteriorating loan performance, and decreasing risk premiums created the crash. Rapid appreciation in house appreciation masked the problem. When house prices stopped appreciating the problem became apparent.

This chart separates non-distress and distress unit sales volume over time.

Note how until recently the two graphs have had distinct characteristics, or patterns.

Non-distress sales have followed the same seasonality pattern over the years but at different levels. The different levels are a result of the average number of units falling, year-on-year.

The distress volume trends have been steadily increasing without seasonaity.

In September non-distress sales volume demonstrated a break in the pattern with an uptick, followed by the same thing in October. In November the sales volume of non-distress properties tanked. Beginning in September we had:

Distress properties sales volume growth, which had been steady for years, stopped in April and has remained flat, although with considerable variation.  In July the volumes began to look like the non-distress property cycle.

Conclusions:

Normal, stable processes have been changed by special causes that came from outside the processes. We have a pretty good idea of what happened. What we don’t know is if the volume of bank listings on MLS has dropped. We also do not know what is causing the distress properties graph to look like the non-distress properties graph. Understanding what is going on here may help investors make the right decisions.

Are banks holding inventory while they wait to see what will happen with the TARP funds? Perhaps the Fed and the FDIC will force the issue on inventory since they do not like for banks to hold houses as inventory on their balance sheets. Their assets need to be loans and their liabilities deposits. I doubt that these regulators will allow the banks to accumulate house inventory for long.

Stay tuned. I believe this is a volatile situation and that rapid dramatic changes will soon be upon us.

My prediction? There will be a huge influx of new inventory for investors to buy in the Denver metropolitan market by March 1st.�

Denver’s Mayfair Neighborhood Market Analysis

We recently completed an analysis for a client in the Mayfair neighborhood of Denver, Colorado to help them understand what price they might achieve and how long it might take to sell their property.

All cities are complex, living organisms that are constantly changing.  The real estate market is just one of many that is driven by local conditions. Local, in this context, means neighborhood and perhaps even sub-neighborhoods, or segments within neighborhoods.

In any neighborhood there are sales dynamics that help buyers and sellers understand when to sell, buy, and at what price. These dynamics, or drivers, are based upon the historical sales data. Often these data are not easy to interpret and require slicing and dicing to get at the truth and the real story.

In doing a comparison, it is important to understand the differences within a neighborhood and compare the most similar in age, architectural style and size.

We selected similar houses in Mayfair within a 6-block radius of our client’s property.

In this segment in the Mayfair neighborhood over the last 6 months there were 31 sales, or 5 per month. There were 17 new listings during that period. 31 houses went out of inventory and only 17 came in which, in effect, is an inventory reduction of 14 houses.

The days-on-market (DOM) have been steadily increasing with greater variation in the time it takes to sell a home. Days-on-market have increased 22% since July, traditionally the hottest month of sales. This is a leading indicator of a reduction in prices to come. Smart buyers will recognize this trend and will offer prices that reflect the future price.

Since July inventory has dropped 17% to only 5 months of inventory,  This is a good sign for sellers. The existing inventory has been absorbed by sales occurring at a faster pace than new inventory entering the market. For sellers, this is exactly what is needed. Lower supply means higher prices. However, it also reflects the sellers’ uncertainty about the market. If they don’t have to sell they are holding off.

The basic driver behind price, Price Per Square Foot (PSF) has also declined since July (by 17%). In addition, the active listings are showing a 14% average PSF reduction from the prior 6-months.

Diminishing inventory, increasing DOM, decreasing prices: what do they mean?

Both buy and sell activity have diminished significantly in Mayfair. Increasing DOM is producing lower prices. Fewer buyers are looking. Mr. Seller, hold your property until the DOM begins to drop and the inventory levels drop even further. Then sell.

The real estate industry in the Denver market might be a case study through which interested folks might learn about the opportunity presented by the real estate crisis.

 Perhaps the government should just let the private sector move us out of this crisis. It seems to be proceeding nicely and with great aplomb in Denver.  Despite the positive impact investors are having in the revitalization of neighborhoods with a high percentage of foreclosures, the Federal Government, through HUD’s Neighborhood Revitalization Program, has offered the City and County of Denver $6 million to do exactly what the private sector is doing.

 Your Castle Real Estate has used GIS software to map real estate transactions by the ~450 neighborhoods in the Denver Metropolitan area. We have then used some analytics to determine where there is a high foreclosure rate, whether it is increasing or decreasing, what prices are doing, the correlation among those factors and with days-on-market, which our analysis shows is a leading indicator of price changes.

 We then looked at all transactions over the last 36 months and filtered them by those homes that had sold twice within any 12-month period. We filtered further by those with a difference between the first and second sale of greater than $25,000, the gross margin. There were roughly 3600 transactions that met our criteria. Our thesis was that those houses would be fix and flips. To test the theory, we took a random sample of 100 and checked the descriptions for both transactions. What we found for 99 out of the 100 were descriptions of the first transactions that typically looked like this: “Bank sale. Sold as is. Bring your tool belt. Needs TLC.” For the second transaction we typically found descriptions that described the house as “A complete remodel. Slab granite, travertine tile, cherry kitchen cabinets. Bring your pickiest buyers.”

 Our conclusions?

·      The low-end neighborhoods that historically have had high foreclosure rates today have a significantly lower percentage of bank sales and more remodeled sales.

·      It is becoming more and more difficult to buy properties in these neighborhoods at bargain prices.

·      Really good deals attract multiple offers and contracts are written within days of the listing, with premiums being paid over the asking prices.

·      The gross margins for fix and flips (the difference between the first sales price and the second sales price) are steadily increasing and for all of Denver now average more than $80,000.

·      Using our data analyses it is possible to identify which neighborhoods have considerable price decline still to pass through, which ones are at the bottom, and which ones are on the rise.

·      Below sales price of $325,000 is a seller’s market, above it is a buyer’s market.

 The City and County of Denver’s Office of Economic Development that is charged with developing a plan to use the $6 million mentioned earlier.

 The neighborhoods where they had planned to spend the monies were some of the neighborhoods with the greatest fix and flip activity, where the bottom had been reached and where prices were on the rise. Their plan was to compete with the private sector. In effect, they would take the private sector’s money to do a chore not needed and in so doing, compete with the private sector, driving up prices further and making housing more unaffordable for those who need affordable housing the most.

 Further conclusions:

·      Not all low-end homebuyers have bad credit. There is significant pent up demand that can be met by competent fix and flip activity.

·      Real estate investors are not all ravenous heartless pigs. There are many who are providing a needed service to their communities: making nice, ready-to-move-in properties available to the first-time homebuyer.

·      The Office of Economic Development of the City and County of Denver has a $6 million pile of cash burning a hole in its pocket and it does not know where to invest it. Can they give it back?

 Our point is this. The private sector can fix this problem. Keep the government out of it. If there is an opportunity to buy low (first year of business school) and to sell high (second year) the private sector will find it.

 Your mission, dear reader, if you chose to accept it, is to inform the world that there are opportunities in the real estate market that we have not seen since the great depression. If you have moved cash into your 401K, move to investing in real estate.