Reactions to a Bubble

Ray Alcorn, a regular writer on Commercial Real Estate Online" (http://www.real-estate-online.com/commercial-real-estate/wwwboard5/index.html) has some interesting reactions to the real estate bubble many talk about.

I’m reminded of a quote; “We tend to over-estimate the effects of change in the short run and under-estimate the effects of change in the long run.”. I see you must have read Mr. Mauldin’s latest “Out of the Box” memo with a highlighter at the ready.

Many of your comments also echo the thoughts from Barry Ritholtz’s blog piece, (“Real Estate Begins to Cool” at http://bigpicture.typepad.com/,) linked from the OotB article. While I agree with the thinking in a broad sense, in my view the conclusions you’ve drawn are beyond the limits of the data offered as support.

First, the stats he uses to support the assertion of the coming RE bust are based on one residential MLS database in one New York market, plus some anecdotal comments from residential brokers in a NYT article. If I understood the context of the blog post correctly, Ritholtz is a market strategist for an investment house, and views the housing slowdown as an indicator of the coming macro economic slowdown and posits some possible effects in the context of what to stay away from in the investment universe. In re, stay away from Home Depot, Lowes and homebuilder stocks, because they are directly in the line of fire. I have very little knowledge about stocks, but that makes perfect sense. However, I can’t agree on the conclusions and would point out that anytime outsiders begin analyzing my field of expertise I fairly jump at the chance to prove them wrong.

What I know is real estate, and a basic fact of that business is that commercial real estate is driven by different dynamics than single family residential real estate. Extrapolating data from one sector to the other creates major blind spots for both. More on that in a moment, but first, let’s remember that we’ve been here before, and quite recently.

I wrote an article in 2000 that predicted “the highest appreciation gains in real estate ever seen will occur in the next eight to ten years”.

Boy, I nailed that one. However, in full disclosure, I that same article I badly missed the prediction on manufactured housing. But I wrote those thoughts in the face of the media stories of the day expounding on the rapid rise in home prices and that real estate was headed for a crash. Yes, it started way back in the nineties, lest we forget. The point of that article was, contrary to the prevailing wisdom of the time, real estate was positioned perfectly to gain value like never before. My reasoning then was that commercial real estate value was being driven by what was then a very strange concept... stability in the RE capital markets.

And that, my prognosticating friend, is what makes the RE world go round. Nothing has changed in that reasoning except that what was then theory is now history, and the results speak for themselves.

In a nutshell, when capital isn’t happy, no one in RE is happy. The volatile periods in the real estate markets were all caused by major disruptions in the capital flow. We are so far from that scenario that I can’t even see it from here. This is not a matter of believing “something is different this time” is the death rattle of investors blinded by the light. There has been a sea change in the CRE sector that is not going to just disappear at the first hiccup in GDP.

What has changed is the very capital structure underpinning the majority of real estate assets in the country. CMBS financing, with strict underwriting procedures in return for low cost capital, revolutionized commercial RE investment across the board. CMBS loans now account for almost a quarter of all CRE lending, and over 75% of residential lending. The effect of these CMBS pools of loans is that the risk is now spread evenly with pricing. That takes a huge chunk of uncertainty out of the picture.

Next, the concurrent rise of the REITs changed the face of the equity side of the equation. Over 25% of all CRE is now owned by REITs capitalized with very low leverage and relatively low return expectations. They now own almost 75% of the class A and B assets nationally, and they are well poised to weather a downturn in occupancies, an increase in rates, and as in every business cycle there will be winners and losers.

Those factors, combined with a global surfeit of capital in a desperate search for yield, have been responsible for the “re-pricing” of commercial real estate I mentioned when we talked in June. But to gauge the effects of rising rates on real estate in toto is a fallacy from the start. Not only is there no national real estate market, neither is there no one “real estate” market. The major blind spot for most “investment managers” and economists is that they lump all dirt into one category, and attempt to make predictions for the whole sector, just as they do with industry segments from utilities to semiconductors. I’m sorry, but it ain’t that simple.

There are distinct differences in the types of real estate that must be accounted for when trying to measure effects. The first and simplest division is between residential real estate (e.g. single-family homes) and commercial real estate (income properties).

Is there a housing bubble? Yes, in some places. Are people going to get hurt? Yes again, but it will not be on the scale of a national meltdown. My belief is that the correction is already happening, but more along the lines of the market wringing out the excesses of a drunken binge on cheap money. And just like any addictive behavior, the severity of withdrawal pains will be in direct proportion to the amount consumed.

The speculators are getting their comeuppance already. Anyone riding empty houses and condos with floating rate debt and betting on 20%-30% overnight appreciation is getting burned as we speak. No surprise there. At Ed Garcia’s latest workshop, there was an investor in just that position. The real shame of his predicament was that both Ed and I had warned him several months earlier that he was playing a dangerous game. He didn’t listen, bought more condos, and is now faced with some very unpleasant consequences.

Will higher long-term rates cool the housing market? You bet. But the effect is going to be felt on the supply side first, and the caveat above for homebuilder stocks is dead on. Starts are projected at a very healthy (and non-boom like) 1.374mm this year. History as recent as 2001 indicates that 7% mortgage rates (an increase of 150 bps from today’s 30-year fixed rate) will support 1.3mm starts, hardly a decrease of crash proportions.

But before you jump to the conclusion that home values will move inversely in lockstep with increasing rates, examine the existing homeowner’s options. If they wake up one morning and their house is worth 20% less, what are they going to do? My bet is they will stay put, ride it out, and hope for better days. Will some pay the price of foreclosure for using adjustable and interest-only mortgages? Yes again, but assuming they have a job and can still afford the payment they signed up for, they will live with those decisions. Some will most certainly be caught short, and blazoned all over the media as “victims” of ruthless realtors and bloodsucking bankers (I love alliteration!) “forcing” them to reach for more than they should have.

But the real nub of the issue is that it is assumed that a slowing housing market will cascade into reduced spending, hence lower production, hence less jobs, and tailspin into a full-blown recessionary nightmare.

I strongly agree that there is a recession coming sooner than later, and last year I said (in a lengthy post here, which I can’t find the link to right now) it would begin in the latter half of ’05. As you mentioned, the leading indicators are all negative or trending that way even though the summer numbers look fairly strong at the moment. So I’m right so far, but that’s a minor point. How severe, how long, and the long-term effects of a recession are questions we can’t answer with any accuracy until we are closer to it.

My view, just as I wrote in 2000, is that money can be made in real estate with deals that make sense. I’ve made more money in the last five years than any other period of my career, and I did it by staying ahead of the trends. I wrote a post in 2004 about the same topic, and countered the doom talk with my own strategy of niche plays, developing when acquisitions are impossible, and sorting through the myriad of deals to find the ones that make sense.