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October 22, 2009

The 2010 Real Estate Trifecta
by J.D. Rosendahl

On 8-11-2009 I wrote an article for www.safehaven.com, "Mustard Seeds for Deflation: The Deflationary Cycle Full Monty", and in that article I discussed 8 potential risks that could happen over the next 1-5 years that will cause a deflationary cycle/spiral.

And now that we have entered the 4th quarter of 2009, we need to start looking at the issues for 2010. Well, two of those risks I wrote about plus something else occurring now could all come to a head creating the real estate trifecta of problematic issues beginning next year.

1) The Current Issue: The current issue at hand in residential real estate is the sharp increase in foreclosure notices, which are currently going to mostly prime mortgage holders. The mortgage/foreclosure problem of the past was mostly sub-prime and related to those with a marginal ability to qualify for lending. Then there was a moratorium on filing foreclosures that ended a few months ago, and since then, we've experienced a sharp increase in foreclosure notices and this time it's in large part on prime mortgages.

This change from sub-prime to prime mortgage foreclosures reflects a broadening of the mortgage affordability issue from lower qualified borrowers to mainstream Americans. It reflects those who could conventionally quality for standard loans with down payments are facing issues and can no longer afford their home payment. This is what happens when the unemployment rate gets as high as it is today, and blows even qualified borrowers/people out of their homes.

The foreclosure process takes months to actually turn into homes owned by the banks, so a sharp increase in foreclosure notices should translate into more bank owned real estate in 2010, which should equal more bank supply of homes for sale on the market. It's something that has not been good for home prices in the past, and shouldn't be good for home prices in the future.

2) The Commercial Real Estate Market: The commercial real estate market has rolled over in 2009. We are witnessing much greater vacancies levels than recent years, and significant pressure on lease rates for commercial buildings. Higher vacancies cause pressure on lease rates to come down. And, existing businesses are demanding lower lease rates to maintain business operations. That coupled with higher vacancies are driving down lease rates and net income from commercial buildings.

I recently spoke with a commercial leasing broker about lease rates in my area of California, and he said the best shopping centers are seeing about a 5-10% drop in rates, and lower demand properties are off 35-40% in lease rates. And, building owners have to offer more incentives like paying for tenant improvements and free rent for short periods to get new tenants. And, when you add in vacancies to lower lease rates commercial buildings might have lower net income by 15-50%.

Commercial property owners are facing significant downside pressure on net income from buildings. This reduced gross rental income and corresponding lower net operating income ultimately reduces a building's value, and since the pressure on income is large we are seeing a re-valuation of commercial real estate that is significant.

And while the typical financing of commercial buildings forces owners to put 20-35% down and have some real skin in the deal, we are going to see corrections in commercial real estate that exhaust the equity in many commercial buildings and turn buildings upside down with values below what's owed to the bank. And we all know what happens eventually after that, it becomes bank owned at some point in time.

One area that might be an intense problem is the owner user building financed through the governmental SBA financing program, which you can finance a building with only a 10% down payment. These loans are often similar to sub-prime mortgages as they usually represent weaker borrowers. As lease rates fall, and an owner user sees their business struggle, this particular sub segment could see relatively intense foreclosures as businesses fail and a minimal down payment was used to get financing.

A second area of problem might be the owner user building sub-segment in a larger sense than just the SBA financed part. The mortgage payment of that building is being paid for from rent which is ultimately supported by the business operations of the business using that property. So, as that property owner's corresponding business struggles or fails the source of cash flow for rent diminishes or goes away completely, and the ability to continue making that mortgage payment is impaired.

As the commercial real estate market continues to roll over, we should expect at some point in 2010 to see an increase in bank owned commercial buildings for sale, and if the residential market is any guild, prices will be forced much lower as more properties are bank owned, so we should expect a continuation of lower valued commercial property into 2010.

This should create an intense problem for the regional and community type banks because they usually focus a lot of their lending on this type of financing. An increase in bank owned commercial buildings could intensify the closing of regional and community banks by the FDIC in 2010.

3) Options Arm and Alt A. Loan Programs: The third leg of the trifecta issues gaining momentum is something I wrote about concerning the conversion of payment structures on Option ARMs and Alt. A. loan programs. Below is a chart of when they begin to convert and by home much.

Beginning in the 4th quarter of 2009 and going well into 2011, we'll see a sharp increase in the number of homes receiving adjustments on mortgage payments, and by a wide margin (40-80% increases). Many of those mortgages where written as a way for someone to buy a house they couldn't afford on traditional home financing terms, and when the payment adjusts they will not be able to afford that home.

If you can't afford the mortgage payment, and the house is worth less than what's owed, it's not rocket science, it's just a matter of when the bank gets to own it. The re-pricing of mortgages should cause another wave of bank owned homes and more financially distressed real estate. This sub-segment problem might take until the end of 2010 to actually hit bank balance sheets (as real estate owned by the bank) given the timing of the payment change and foreclosing process of properties.

One of the more interesting notes about these exotic mortgages is it seems like they were highly concentrated in the higher end real estate markets. As a commercial banker, I see a lot of people who have these types of mortgages on higher end homes. In California I see these types of mortgages on loans typically $700,000 or higher. So, as the mortgage re-pricing occurs we might see this problem concentrated in the higher end real estate markets, as those assets flow into bank owned and then back onto the market as distressed real estate, we should expect compression in real estate values from the top down.

Another unique note is that slightly more than 50% of these types of mortgages were underwritten in California, so the intensity of the problem should be felt in California, "The Bubble State". If so, it should negatively impact CA real estate values and those banks specializing in this lending product in California. Hmmm, I can't remember, but who bought Wachovia?

4) The Bonus Issue: If there is one more real estate issue worthy of discussing for 2010 its multifamily real estate. I know several owners of this property type, and all have said rentals rates are coming down. I just spoke to my own land lord and he cut my rent by 9% by simply asking for a reduction, and I probably could have pressed him for more.

The problem for multifamily is that is was bid up to high during the bubble days to peak values that weren't justified based on gross rental incomes. So, a correction should be expected as a reversion to a more standard gross income multiplier levels, and if rental rates are coming down, then we should expect an even larger correction in multifamily. Based on cap rates at peak levels during the bubble days, a 50% decline seems like a bare bones minimum from those bubble pricing peaks.

We are already starting to see this happen in some markets. In reviewing real estate for sale in Arizona, California, and other parts of the Western U.S., some pricing reflects sharp declines but it's really just beginning. We are also starting to see some bank owned multifamily properties, but this trend is also just beginning.

It wouldn't surprise me at all if this segment witnessed lower valuation trends in 2010, and possibly created more bank issues.

Summary:

The above issues should gain momentum in 2010, and probably intensify heading into the end of 2010.

Yes, residential real estate has bounced recently in some markets albeit minimally, based on diminished inventories, a moratorium on foreclosures, and government stimulation and tax credits to purchase, especially in the starter market. But the sad truth for most real estate is that the fundamentals just aren't there, and it's still over priced in most markets when compared to personal income levels or rental income levels. It's still not a buy and hold and since it lacks the liquidity of the stock market it's far more difficult to trade than stocks.

A recent study reflected 40% of corporate executives plan on more layoffs in the near future. And those finding work after being laid off are finding lesser jobs at lesser pay. We should continue to see wage deflation like I expect over the coming years, and in that environment real estate of most types and locations is very over priced.

If we've learned anything in 2008, it's that real cash is King, and real cash flow is Queen, so:

1. It baffles me why anyone would continue to own investment real estate in today's world that has negative cash flow. I still see a lot of investors with rental properties with negative or break even cash flow. It makes absolutely no sense when the trends still call for lower values and lower rental rates. Those real estate assets that have negative cash flow should be sold. If you're lucky to have equity in a particular property and you can sell it and get rid of negative cash flow and raise cash balances at the same time, that's an immensely smart strategy in my view and should be considered.
2. B. When I was in banking in the early 1990s the standard was you spent 28-32% of your gross income on your housing payment. In today's world we've seen that leveraged too much higher ratios. So, anyone paying more than 45-50% of their gross income on their housing payment should evaluate the true affordability of their home. I would imagine it's still cheaper to rent versus own for most, even after the tax benefits of owning. There are some areas where the price declines have been so devastating it's become cheaper to own, but far too many have become slaves to their mortgage payment, and re-consideration of this approach is a smart and prudent strategy.

The above issues should ultimately force another wave of bank owned real estate. Bank owned real estate is not good for the valuation model of real estate, nor is it good for the banking industry. We should expect a broadening of real estate issues to all types of real estate and expect lower real estate values. We should also expect more bank closures by the FDIC if the real estate trifecta gains momentum in 2010, as I expect.

An interesting side note is there are a lot of banks currently not releasing bank owned real estate for sale to the market place, which is part of the shadow inventory problem in the real estate market. If the banks begin to take significantly more real estate assets back on their books, it just might force them to unload their positions in a more grand style.

The most important consideration for all is the notion that at the core of deflation or a deflationary cycle has to be a correction in real estate in both time and price that is greater than what most could ever imagine. We've already seen one large wave of real estate declines, and another one could be on the way in 2010 maybe 2011. Another wave of wealth destruction equals poor consumer spending and probably more lay offs and lower tax collections, which continue the very same problems we have today in many parts of America.

For the record, I'm still running a deflationary investment strategy for my parents. If you're managing the risks of the day or near future, they call for a deflationary strategy. Protecting what you have is integral to financial success.

Hope all is well

J.D. Rosendahl

J.D. Rosendahl is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

Copyright © 2008-2009 J.D. Rosendahl

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