Sean O’Toole with PropertyRadar #391

Norris Bruce

Bruce Norris is an active investor, hard money lender, and real estate educator with over 30 years experience. Bruce has been involved in over 2,000 real estate transactions as a buyer, seller, builder and money partner.

Norris Bruce
July 18, 2014

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Bruce Norris is joined again this week by Sean O’Toole. Sean is the founder of PropertyRadar.com. He began his very successful career as an entrepreneur in Silicon Valley working with people and starting up companies. He is a personal friend, and he and Bruce have gone on trips together down to Washington D.C. to do research. PropertyRadar.com is a big advantage to any investor or realtor who has access to it since it helps them navigate the real estate market and find things easier than you would have any other way.

One of the things that is a little disappointing this is year are sales. CAR projected we would be in the mid-450s, maybe even higher as far 450,000 sales in California. For much of the first 3-4 months we bounced around 360 and have had one month where it panned out at about 390. It’s also pretty disappointing with retail sales, so Bruce wondered what was going on here as well. Sean said the basic problem is that his prediction last year was right in terms of price growth. We had a big jump in prices last year as well as a change in interest rates, which also impacts affordability. As rates go up, the person with the given income can afford less. That further took a bite out of affordability, and with these two things combined we saw a real decline in sales, more than the seasonal decline, at the end of last year. It has continued into this year and will continue because we are back at a point where prices exceed what people can afford.

Bruce said this drives him nuts because historically when affordability goes down, volume goes up. This is consistent in the 80s and 90s and 2000-2005. Even though mathematically what you are saying absolutely feels like it has to be true, in the case where the less people can afford the less participation they will have, it has never been this way. This time it is true we have less volume of sales, but Bruce said he does not know how to peg it to affordability because it has never been this way. Sean actually thinks it has been this way, and the problem is how others measure affordability. If you look at CAR’s or NAR’s calculation for affordability, it is pretty static. It only takes into account interest rates. Credit term, debt-to-income ratios and the rest are a lot more important. Where we have low affordability in the past from a CAR metric standpoint, we actually had high affordability from the standpoint of a pay-option teaser ARM. You have to use a different pay-option teaser ARM as your affordability metric, not CAR’s 30-year 20% down payment calculations.

What is fundamentally different this time is that credit terms are not loosening. Bruce said it is too simplistic to say that because people can afford less, volume naturally decreased. This is not what happened. What Sean described is the reason. People who used to get a yes answer are getting no answers. Sean said he still fundamentally calls this affordability, just not affordability that can be tracked on an affordability index based on 30-year financing, 20% down. It does not take into account these other factors that are really what drives the market. You have to consider all the metrics and go back to see the implementation of all the other programs that made it more affordable as prices went up because it required less of the borrowers and qualifications. You then have to recalculate where a likely stopping point for affordability is this time.

Bruce looks at 17%, and he sees this being pretty consistent. Now, if the rules of financing have changed and it is permanent, there is no way it is going to get there. Bruce said he has not really bought into this yet because he sees areas like a San Jose and San Francisco after flying by their former price point, and he knows the human being is still the same. San Jose is a good example here. If you take a look at this city as well as San Francisco and the whole Silicon Valley, and you look at affordability versus the census income data for the median household income for that area. From that standpoint, we are blowing out affordability. How we are blowing out affordability is by displacing those median income families for new families coming in for higher opportunities that pay significantly more than the median income has traditionally been. What you have here is a gentrification issue blowing through affordability rather than credit terms.

What is fun about this subject is you are never done looking at the new twists you didn’t know you would ever have to study. Bruce said he never thinks he is done. This time it is different, even in the participants. We have a huge buying going on with hedge funds because real estate became the asset of choice for a short period of time in California. When prices accelerated, then it is possible they have gone to other states such as Nevada and Arizona. Bruce asked if they are still finding areas in which they are active. Sean said the Phoenix market especially is over on that front as well, even before California. He said the LLCP purchases have really declined here; and what is left is primarily not the institutional buy and hold guys, who are certainly not doing much in California at this point.

One of the things they have now brought billions of dollars to is financing for investors. As they learn about this whole market and the rest, they saw an opportunity to still make really good returns while offering their services. They had learned a lot about these markets, so it opened up new opportunities about which they previously did not know. When Bruce and Sean went to Washington D.C, there was a room full of these guys. He and Sean spoke in front of Fannie and FHA to talk about financing for investors. This was back in 2010, and Bruce’s first comment was that he appreciated being invited but did not understand why he didn’t show up before this since this was really the place where the lowest risk existed. They are four years late, and Bruce thinks it is going to run its course almost like the buying of properties. They are going to find the niche of one person owning forty properties and someone helping them refi them. However, are they really going to get down to the level to find enough volume to place their billions of dollars?

The reason he thinks this answer is important is because they are not going to find enough business here, and that big pile of money will land in the occupant borrower’s lap with creative programs eventually. This would be interesting. Even though it is a big pile of money, it would be a pin drop in the owner-occupant market. Bruce mentioned to the an audience about how we have shown up four years late and think you will go through your $3 billion and be primarily done. If you really went after the owner-occupant with a low-down payment or stated income in a market that is not priced out yet, that would be a very safe loan. There would be tens of billions if not hundreds of billions of dollars they could put in bonds and have a successful outcome. Sean said the problem here is that the regulatory pendulum has swung so far against owner-occupant loans that it is really hard for him to see smart money wanting to take that back.

Bruce said he is already seeing programs out there for lower and lower FICO scores and stated income. He does not know the down payment requirements, but somebody will go after and capture a big chunk of business. Their competitors will look at this and respond negatively. They are actually getting paid by 99.9% of their borrowers, so they want to participate in this niche. It has not happened in any quantity yet, so this is what is next. If this does not happen, it will be really interesting to see what volume continues to be possible in California. He does not think everybody is going to be too excited about California’s 380,000 sales in 2014 and 2015. Sean said there are three possible ways to solve this. One is to lose your credit, which is the point Bruce is making. Two is some sort of major economic growth that leads to higher wages. We are seeing this in Silicon Valley and San Francisco but not much throughout the rest of the state. Long-term incomes have been declining since the ‘70s on an inflationary adjusted basis. Three is a price decline. What could also happen is we see prices come back down and affordability approved. What he does not see right now is any three of these things happening. Sellers are not fighting back to get where they are right now and are not anxious to start dropping prices. He does not see incomes rising substantially, and he does not see credit loosening up when we are still talking about how to shut down Fannie and Freddie. There is so much fear over loss and the belief that regulatory rules are how you contain laws. Sean thinks we are stuck with poor sales for a while.

Unfortunately this exacerbates the employment issue because if you are builder you are not going to start developing houses. Land is pretty expensive now, so you have to say that by the time we get done with the lots prices will substantiate all this work we just did. There is enough uncertainty where you still have lot construction in Riverside County, which is really where a lot of construction is usually done at about 85% down from a normal number. Developers are not just going crazy creating lots. If you only have 380,000 sales in 2014, he cannot imagine the builder being a bigger and bigger percentage unless they just throw caution to the wind. If they don’t do that, then employment is really going to still have a problem. Sean is fairly convinced we have an issue of having some of the wrong inventory in California. Especially in the boom, we built too many mansions in the suburbs and especially areas where it is 100 degrees and costs $600 a month to air condition, especially for a 4,000 square foot house.

There are opportunities for builders to construct the right products in the right areas. We have seen things even in areas such as Las Vegas, which was super hard hit, and it is now one of the best subdivisions in the nation according to John Burns. They really built the right product in the right area at the right time. It was built before the crash and did not suffer like all the areas around it to nearly the same degree. It came back quickly and is one of the hottest markets in Las Vegas today. There are lots of opportunities for smart builders to construct the right product in the right place. Since there are only 380,000 units being sold, they have to stop looking at these big macro designs and ask why. Is it because there are a bunch of units that are the wrong unit at the wrong price and in the wrong place?

Bruce asked Sean about the impact of the foreign investor in California. Their volume has been growing, so Bruce wondered if they pick and choose very specific areas that mostly affect this specific area. Sean said this is somewhat true and is usually a place where they have family or somebody else to keep an eye on the property. He runs into a lot of folks at the real estate investment club who are buying up real estate. It is clear that they are part of a larger family, and they are the ones who moved out to America to put some of the money to work. They have even seen this in the foreclosure investing family fund. If you are going to fund the people here who are based in the U.S. and have some family wealth willing to put it someplace with a good inflation hedge. Real estate is a good inflation hedge. If you are in China and worried about a bubble there and want something more likely to perform well over the long-term and real estate still looks good.

If you look at Japan, the so-called lost decade has now extended well beyond that where 2% returns on money is still pretty good. To come here and get 5-7% return on money is double-triple what you are doing at home. There are really compelling reasons for it. He does not think we have very good data on it, and like many things including investor purchases, every house is going to invest. At the peak it was 6 ½% when sales were going to investors. Sean thinks this story is similar and is certainly a portion of the market. However, it is not as big a deal as everybody makes it out to be.

Bruce said when he speaks he always gets the question about what the effect is going to be of the hedge funds selling off all their properties at the same time. Sean said the example he likes to give is China owning trillions of dollars of U.S. treasuries. They probably love to dump some of this just to mess with us. However, if they do the value of the rest of the money will suddenly go down. If they were to dump $100 billion worth of treasuries, the other $700 billion would probably drop dramatically. They are cutting their own throats here. Sean said his big picture is unless there is some kind of major market panic, the chances that the hedge funds will cut their own throats is zero. They are like the banks to where they are smart enough to know they have enough assets to unload them and can’t just put them all in the market in one day.

Back in 2004, there was a gentleman in Sacramento who bought up 300 rentals back in the 90s. He decided he was ready to sell all of his rentals totaling around 300 properties in a state of 12 million properties. He said there were eviction notices to all 300 properties, and the governor intervened. It is just not going to happen. A lot of the business models are different too. With the hedge funds, not all of them have the intention of selling the inventory. Some of them formed REITs, and those are like scattered apartments they will hold. The hedge funds had their exit. They took their initial investment dollars and put it into a REIT, which means they have been paid. They are done, so you have managers in place now who will be out of work if they sell off the property. What’s their incentive?

Bruce asked Sean if there is anything that concerns him in the immediate horizon that might affect the value of real estate. Sean said in his mind there is no question to him that the stock market is in an unhealthy place. We have a fundamental issue he does not know whether it will correct any time soon. The Fed is propping up and continues to fight their announcement that they will continue tapering out those purchases. In 2008, things fundamentally changed. If you look at the long-term GDP growth and draw a line through it, we have a lot of new debt and a fundamental output gap. We are growing again, so we are not technically in recession. However, if you look at the long-term line it zigs and does not recover. Even from the Great Depression, that line recovered back to trend. It is not recovering at all this time, and this is fundamentally different. He does not think the markets, Fed, interest rates, are really helping. We have a lot of artificial stimulation going on in this market; and he thinks at some point, whether it is six months or twenty years from now, it could unfold but he is just not sure how.

Bruce asked what the ramifications are of being below trend and if GDP growth is under what it should be and not even playing catch up to the demographic shift. You now have more and more people wanting to collect social security and be on Medicare. This is big bill in which people will have a hard time paying as well as interest payments on debt that we continue to accumulate. With interest rates as they are, this is not a big deal. We have put ourselves in this trap where we have to have low interest rates. We have created a world where we are stealing from savers to make profits for banks and prop up welfare and social programs. All of this is coming on the backs of savers, and all of this puts us economically at a pretty long-term lost decades disadvantage that is not healthy. Japan has the debt and interest situation to where if they had a fluctuation of an interest rate, even half a percent, that could be a very big problem for the debt level they have. It will be interesting to see how this plays out.

Bruce asked Sean if he feels real estate is still a good hedge against inflation. Sean said regardless of how everything works out, even if it ends up completely blowing up, at the end of the day as long as you pick real estate that is uninhabitable and undesirable people still need a place to live. If they are going to pay you in chickens, then at least you can pay. Bruce said he has not thought about collecting rent in such a fashion as this.

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