Friday, May 31, 2013

Robust Real Estate Hides Truth

cartoon image in color of a small house
How great would it be to have lots of extra cash now that houses sell for much less than during the bubble? This is certainly the wish of millions of people looking to buy a house but struggling to get a loan. And now, to complicate things further, there are no more homes for sale. Things are clearly not as simple as offer versus demand.
The Pending Home Sales Index produced by the National Association of Realtors has hovered at a recent low due to insufficient inventories of homes available for sale. The glut of homes left after the bursting of the housing bubble seems gone. The few homes left are now going up in price due to aggressive bidding. As a result, the well respected S&P/Case-Shiller Home Price Index recently reported robust increases of more than 10% in year over year home prices. The natural conclusion to all these is that historically low interest rates have created a housing bounce.  
image of graph of CME's Lumber futures showing a sharp decline in the commodity
Lumber Future - Chicago Merchantile Exchange
Unfortunately, things don't look so great just below the surface. Lumber prices, for example, have collapsed since reaching a top at the end of last year. Whenever the housing marked is healthy, lumber goes up in price. This drop is an indication that construction has not recovered. Why wouldn't builders rush to construct more homes after selling prices and demand increased while competing inventories dropped? They clearly know something that the rest of us don't.
Meanwhile, real estate agents are seeing peculiar patterns in the market. Today, it is safe to be the highest bidder for a house. Once the winning bid is selected, everybody knows that appraisers will value the property much lower than the bid, dictating the actual selling price. After finding themselves in the middle of the housing bubble mess, appraisers are no longer willing to help drive pricing higher. To their detractors, appraisers are responding by being overly conservative with their valuations. As a result, winning bidders can eliminate competing bids before renegotiating a lower price that more closely approximates what the bank will lend. The bidding process is therefore irrelevant now.
Now that sellers know how to play the game too. They prefer to take a second or third highest bid if it comes from a cash buyer. Aside from eliminating low appraisal risks, sellers also protect against last minute loan denials, which seem to happen often. This means that high bidding cash buyers have the leading edge in this environment. 
illustration of a small house atop a pile of US cash
Hard Money
But these aren't the typical local cash buyer. The residential industry has long had a core local buyer: an investor who bids low and pays with so called hard money. Bidding high works against this type of investor because hard money costs too much in interests. To be profitable, he needs to bid low. He must also flip the homes quickly. Any delays reselling a house cost too much in interests. Notice that homes sold are not coming back to the market for resale and that winning bids are going up and not down. These local investors are therefore complaining that they are losing the bids to the few homes available. So who is devouring the homes for sale?
A recent conversation with a Palm Beach real estate investor shed light on the issue. "BlackRock is buying everything" he said after I asked who was buying all the homes. "And they are bidding high", he continued. BlackRock is a leading global investment manager best known for managing a few billion dollars of the Chinese sovereign fund. 
Every Wall Street hedge fund and money manager has been looking at all possible ways to take advantage of the state of the home market. Even Warren Buffet made repeated comments about loading up on homes if he could find a way to manage them. His comments reflect the fact that serious problems arise from holding residential properties within a portfolio. The market is quite fragmented; there are homes in every city in the nation. Yet, each home is different. Just buying all those homes is a logistics nightmare. Then there are the challenges of handling maintenance and payment collection. These has kept really big money out of each local market; until now. Rather than talking, BalckRock and a few others are acting.  
On May 29, CNBC's Squawk Box anchor Andrew Ross Sorkin asked BlackRock's CEO, Larry Fink, about the state of the economy. Among other comments by Mr. Fink, he said "we can't find enough good investments"; implying that they hold more money than what they are comfortable deploying. 
But how is it possible that there's so much capital available for money managers to buy all the residential inventory but there isn't enough for families to borrow to buy a home?
The reality is that BlackRock is not alone. There are massive pools of capital struggling to find assets where to invest. With low interest rates on treasuries and a Fed that continues to be a large treasury buyer, risk-adverse capital is being crowed out of typical investment vehicles. These funds are pushing dividend-paying low-risk stocks higher, for example. They also have depleted residential inventories.
cartoon image of a red blowing bomb, labeled "RISK"
Considering such large and homogeneous market participants, it should pay to know the risks associated with their involvement. First, there is the possibility that a change in macro-economic risk may increase fund redemptions at these firms, forcing their managers to dump properties at low prices. The real estate market would relapse; pushing many home owners further underwater and adding many more to the list.
Next, there is the question of exit strategy. When will all money managers get out of their investments and what if all exit at the same time? This unknown is probably what's forcing builders to think twice before fully firing up their engines once again. A large and sudden increase of new listings from exiting money managers as they take aim at the next hottest asset class could ruin builders who are caught flat footed.  
Then, there is the uncertainty of the returns. Despite great expertise within companies like BlackRock, there is the possibility that successfully managing properties at this scale may not result in the risk-adjusted profits they expect. In money management, there is always a question about being invested in the categories that have the highest yields. At some point, real estate property management will certainly fall below other asset categories forcing them to liquidate faster than would have been the case for local investors. 
Finally, there is the risk of exhaustion. There is the possibility that all or most of low priced properties have already be taken. Money managers have pushed prices higher, reducing the potential profits from the rest of the properties still in inventory. At the same time, prices are yet to be high enough for builders to construct new homes at profitable levels; thus limiting builders ability to drive the next leg up of the real estate recovery. 
In a nutshell, the recovery that we see in the real estate market should be approached cautiously. Purchases by families are not driving the apparent improvement. Construction of new homes is not responding either. Furthermore, the properties sold could suddenly comeback to the market, making it collapse once again. Until we see families buy sufficient homes at prices high enough to help builders remain profitable, any signs of recovery could be just a mirage.

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