[davelj]

I agree with most here… keep thinking about it but don’t act yet. Prices are trending lower. Open up a small deposit account with a credit union here in San Diego (there’s a boatload of them) and you’ll probably get the best borrowing rate when the time comes. I bet if you wait another 2-3 years you’ll be looking at a 5% fixed-rate mortgage and prices that are 20% lower than they are today. Just my opinion.

[davelj]

Poll results support Outcome A; therefore Outcome A must be the eventual outcome.

Interesting. I don’t recall the Polling Corollary from my logic class back in college. Well, anyhow, I’m sure David Pressly is right. I mean, he has no vested interest in the outcome after all…

[davelj]

Are you sure these were originally going to be marketed as condos? It appears that they were built with the intention of being apartments, but I could be wrong.

[davelj]

This series of posts reminds me of something my father told me a long time ago: “Don’t get into a fight with a pig, son. You both end up getting dirty but the pig enjoys it.”

[davelj]

CRE is in a mini-bubble, but not nearly the bubble that residential real estate, and more specifically single-family residences, is in. Recall that when appraisers appraise a SFR they basically just use comparable sales to value the property – this is a recipe for bubblicious behavior as there’s no mooring to value based on cashflows. Where most CRE is concerned there is an interest coverage ratio – typically 1.10x to 1.20x – that the lender generally requires that puts a ceiling on the valuation (and, conversely, puts a floor under the cap rate) assigned to the property. REITs are currently assiging cap rates of about 5%-5.5% on big class A properties here in SoCal (too low by about 1.5% in my opinion) and smaller properties that are being funded by banks are being assigned cap rates of about 6%-7% these days (again, probably too low by about 100 – 150 bps). But, despite the fact that these cap rates are probably lower than they should be, they’re cashflowing well and vacancies are very low (here in SoCal that is), so while there’s reason for caution, CRE isn’t in nearly as bad a shape as SFRs.

[davelj]

zeropoint, people who aren’t forced to resort to this sort of thing probably won’t – remember, this still ruins your credit score. Most people value their credit score and their reputation more than $100K or whatever number it is. For those that don’t, this is one way to work things out if it’s available to them, which it will probably be on a very limited basis for the reasons I presented.

sdrealtor, I basically agree. People are amazingly resilient when backed up against the wall. Sure, lots still implode, but most figure a way out of their mess without blowing everything up around them. I still think things are going to get very ugly, but I discount the views of the armageddoners here pretty heavily. There are too many moving parts of which we are unaware and they tend to make the doom mongerers look silly in hindsight.

I’ll share but one example to make a point: I know of a friend of a friend who’s in trouble financially (he has a bad mortgage that’s resetting). Well, guess what, his parents are helping to bail him out. They’re not super rich but have the resources to stage a small rescue. There are a lot of people in houses they can’t afford who can tap parental/family resources if they MUST. I’m sure they don’t want to go down that road, but it’s available in a pinch to a lot more people than we probably are aware. But it’s something people here rarely put into their calculations…

[davelj]

Perry, the banks absolutely can do this if they so choose. It’s no violation of underwriting standards or banking regulations. BUT, they have to charge off that $125K immediately and that’s a direct hit to the bank’s equity (depending on the size of the bank’s reserve). Essentially the bank is saying, “We made a mistake on the first loan and are charging off the size of our ‘mistake’ and now the homeowner’s debt/income, etc. makes sense so we have a new, properly underwritten loan.” Enough of these ‘mistakes,’ however, and the bank has no equity left. Recall that the average bank balance sheet is leveraged 12.5-to-1, so if the assets are worth 1% less than initially believed, equity takes an 8% hit. The problem in the larger context is that most home loans aren’t on bank or thrift balance sheets – they’re securitized into pools owned by investors (in the form of MBS) and serviced by Wall Street-affiliated firms. The question is whether the owners of these MBS will allow the servicers of these MBS to engage in the same kind of loss mitigating behavior. Possible, but I doubt it. When a bank (or thrift) owns a loan there’s just two parties involved, the bank and the borrower. So, it’s pretty easy to work out a deal if there’s one to be made. Once a loan is part of a securitized pool, however, it gets very complicated to efficiently fix a problem because there are more parties involved. What’s best for the servicer might be in conflict with what’s best for the MBS holder which might be in conflict with what’s best for the owner, etc.

[davelj]

I don’t think the “quality” of the cashflow is the main issue. True, you’re theoretically dealing with a better quality renter, but that actually may not be the case. The biggest issue is how much the cashflow is expected to grow over time. Rents in affluent, high growth areas are expected to grow more rapidly over time than less affluent, lower growth areas. Show me a high growth, less affluent area and I’ll show you higher price-to-rent multiples than low growth, more affluent areas. It’s like discounting the dividends of a stock. If V=CF/(D-G) where , V=Value, CF=Cashflow (rent less expenses), D=Discount Rate, and G=Growth, D may be a little lower for the higher quality properties (less risk), all else being equal, but the real differential in the denominator will be determined by G (growth). The higher the expected growth, the higher the value and thus the price-to-rent ratio.

[davelj]

PS, I don’t think the KaPoom theory is completely crazy in general, but you have to remember that the inflation he talks about doesn’t even begin to get underway until 2012 and then takes a few more years just to get back to current levels before accelerating upward. That’s 10 years out… I don’t know about you, but my crystal ball gets pretty hazy that far out. I consider myself a pretty long-term oriented investor but even I have my limits. And I don’t think rates will go as high as he’s predicting although we could see some jump in long-term rates at some point several years out. I have a word for economic predictions made more than a few years out: “guesswork.” In my view, the fact that this guy made millions in venture capital has absolutely zero impact on his credibility as a forecaster. But if you want to invest based on this kind of stuff, that’s certainly your prerogative.

[davelj]

Recent academic research has shown that a person’s lifetime income (a very rough measure of professional success) is more highly correlated with the best college that person COULD have gotten into than with the college s/he ACTUALLY attended. For example, two students with 1500 SATs and a 4.0 GPA who both got accepted at Harvard and San Diego State – with one choosing to go to one school and the other choosing the other – on average don’t show statistically different lifetime incomes. Again, this is on average. Kids from Harvard don’t do well because they go to Harvard; they do well because they’re the type of kids that can get into Harvard in the first place. That is, most of them are smart, disciplined and driven. The fact that they choose one college over the other doesn’t change these personal characteristics.

Personally, I wouldn’t spend money on Bishop’s or Harvard or any other highly tauted private school unless the amount I was spending was so small relative to my income as to be meaningless. But that’s just me.

[davelj]

While I’m on the topic, here’s another:

I’m very familiar with a particular condo complex up in Carlsbad. All of the units have the same square footage, albeit varying views and renovations. Last summer two middling units changed hands at just north of $400K. Despite a handful of units on the market since that time there were no sales until last month – one sold for $345K and the other for $338K. There is now a unit for sale at $299K. I don’t have to tell anyone that that’s an enormous year-over-year change.

[davelj]

If there’s ever been a case of shutting the barn door after the horse has already galloped down the road, this is it.

[davelj]

Contentrenter, like Josh, I’m curious about the general area you live in as well. It’s extremely unusual to see anything less than $1.75/sq.ft. downtown and some are as high as $2.75/sq.ft. You’re in at under $1.10/sq.ft. – that’s quite a deal.

[davelj]

The typical value-to-rent for small multi-family properties these days is around 10x-12x here in SD, implying a 6%-7% cap rate using traditional financing. The comparable price-to-rent for similar condos is, as the chart above suggests, around 18x-20x, albeit falling slowly.

The main reason that multi-family properties will always trade at a discount to similar single-family dwellings from the standpoint of price-to-rent ratios is the tax advantage the latter has over the former, although the cheaper financing also plays a role. The buyer of multi-family properties gets to use depreciation and writes off the interest expense (that is, it’s a pre-tax expense), but s/he isn’t living in the property and getting that direct tax benefit that an occupied dwelling gives its owner. Consequently, someone who’s purchasing a condo to live in, for example, should be willing to pay more for that unit than someone that’s merely buying it for its cashflow. The tax benefits are more direct to the former. But, that difference isn’t enormous. Perhaps the combination of the tax benefits and cheaper financing justifies a 15%-20% premium, but not the 35%+ premium evidenced in today’s market.

Now, having said all that (and acknowledging that I’m bearish on RE), here’s why I think the price-to-rent ratio will NOT decline to the 8x-10x range during this cycle. While it’s true that “this time it’s different” are the four most expensive words in investing, the fact remains that each “this time” is in fact a little bit different from the previous “this time.” So, here are a few differences between today and the late-80s/early-90s:

1. SD, whether you like it or not, is now a “glamour city” (to use Robert Shiller’s term), much like LA, NYC, SF, Miami and Chicago. It wasn’t mentioned in the same breath as these cities back in the early-90s. Back then it was a sleepy tourist destination with great weather and a big military presence. Today, it’s a much larger city, with a more diversified employment base (too much real estate, I know) and a “real” downtown. Rancho Santa Fe and La Jolla are known internationally as enclaves for the rich and famous. Again, this wasn’t the case 15 years ago. SD is, rightly or wrongly, now considered in the big leagues of american cities. Its biggest “problem” is, of course, the cost of housing. That’s probably the only thing that keeps the population from doubling. Bottom line: A boatload of people want to live here, despite the traffic and other negative issues. As housing prices come down, the area will become more attractive relative to other areas that are also facing falling prices. So, this relatively new “glamour city” status means that there’s a premium that may stay in SD housing prices for quite some time. Manhattan was probably the first “glamour location” and the price-to-rent ratios there have simply continued to climb over time, with temporary minor blips in downturns. I’m not saying those prices won’t fall, but they’ll probably always seem “high” to us normal folks.

2. The employment base is better in SD today than it was back in the early-90s. Yeah I know – here come the shouts – SD has an over-reliance on real estate. No doubt about it. But even factoring that in, the employment base is far more stable than it was during the early-90s. Even if real estate industry employment mean reverts, the employment picture isn’t going to look like it did 15 years ago. Consequently, another small boost to long-term real estate premiums in SD.

3. Back in the dog days of the early-90s, interest rates were 200 bps higher than they are today. And if things really do slow down, mortgage rates are more likely to fall than rise from current levels. Consequently, values to some extent will have another plank of flooring beneath them relative to the early-90s.

That’s three pretty big issues. My guess is that we get back to 11x-13x price-to-rent ratios at some point during this cycle, but those waiting for 8x-10x are going to waiting a loooooooooong time.

Recall that for most of the period between 1930 and the late-1950s, the dividend yield on the Dow Jones Industrial Average was greater than the yield available on 10-year treasuries. Many investors thought this was a necessary risk-premium to require in order to induce them to invest in stocks. Those who followed this approach sold in the late-50s and haven’t seen comparable dividend yields since. Things were indeed different that time.

[davelj]

Stock prices reflect the constant struggle between expected interest rates, expected earnings and expected changes in risk premiums. It’s that simple. Most bulls know that the economy is slowing but they’re buying stocks because they believe that we’ll have a soft landing – thus their bet is that earnings will hold up o.k., but interest rates will decline and therefore that valuations will increase. The bears, on the other hand, believe that even if interest rates decline (as they will in a slowdown), that the decline in earnings will more than offset the decline in interest rates and thus valuations will fall.

To use an overly simplistic example, let’s say the market is represented by a single Stock A. EPS for Stock A will be $1.00 this year and are discounted at 7.5% (which reflects current long-term interest rates, earnings growth and a risk premium). The value of Stock A today is $13.33 ($1.00/7.5%).

The bulls believe that next year’s EPS for Stock A will be $1.06, long-term interest rates will decline by 50 bps and the risk-premium will remain steady, yielding a discount rate of 7%. So, they believe Stock A will be worth $15.14 next year.

The bears believe that next year’s EPS for Stock A will be $0.85, long-term interest rates will fall by 75 bps and the risk-premium will remain steady, yielding a discount rate of 6.75%. So, they believe Stock A will be worth $12.59 next year.

Again, this is an overly simplistic example, but my point is that the challenge for the bears (and I’m one) is that EVEN IF earnings stay flat or decline, the decline in interest rates may overwhelm the impact of reduced earnings from a present value standpoint – not even considering the issue of the risk premium – and stocks could go up. Interest rates and earnings are like a seesaw with the risk premium sliding around in the middle. You have to get at least two of the three right and even then sometimes the third overwhelms the other two. It ain’t easy.

I made a long post a while back regarding efficient markets that I thought explained the theories fairly succinctly. I guess I was wrong. I’m too lazy to go over it again, but the key issue is not to focus on “right” and “wrong” but rather “biased” and “unbiased.”

[Author]

Posts