Bruce Norris is joined this week by David Goldberg. David is an executive director at UBS, covering the building and building product sector. Before assuming coverage, David was an associate analyst who focused on the home-building companies within the sector. Prior to this and before business school, he worked at the Convergent Wealth Advisors, a wealth management firm in Rockville, Maryland that focuses on providing independent financial advice to high net worth families.
Before going on air, Bruce and David reminisced about a meeting they had in 2009. Because of David, Bruce was placed with ten of the world’s largest hedge funds for dinner. Bruce wondered why there were there and why there were interested in talking to him. Before they sat down, Bill Richards told Bruce he was probably going to be talking to a quarter of a trillion dollars. Bruce was not even sure how to say what this number is. He cannot be worried if someone tells him he is going to be in fifty feet of water or 50,000 fathoms since he is not touching the bottom either way. Bruce was not worried, but he did wonder why they were there listening to him. David said at the time in 2009, what they saw play out in a lot of ways was a lot of institutional capital as well as an understanding that there was a dislocation and disintermediation in the market. There were a lot of people who needed a place to live and a lot of foreclosures coming through the system. Therefore, it was difficult to get mortgage loans, and therefore the buy-for-rent business was going to be a very massive new asset class.
David said he had seen a lot of companies in the business of buying distressed properties and renting them out. There was a very clear sign from the hedge fund and Wall Street community. Generally if there was an opportunity to break the disintermediation with capital and profit by it, many have. Bruce and David talked about how this worked out and how it started to morph into other things. They went from buying single-family homes to loaning on them to investors. There are hybrids of both.
Bruce asked David if he got the sense that one day the majority of them would exit their holdings, or are they creating scattered REITs that will just be REITs for a long time. David said this was a good question but it is difficult to know the exit strategy. He thinks there are some who clearly see this as a new asset class and trying to find ways to improve the efficiency of the business. It was always a big concern that instead of having a multifamily high rise building or low rise building with multi-family rentals and where there was a natural efficiency geographically, a single-family detached rental business would always be an issue because the locations were scattered and it was hard to try it from a maintenance perspective. People are trying to come up and fix these issues to build infrastructure and run REITs for an extended period of time, whether it is 7-10 years or infinitely. Some see this as a new asset class, while there are others where it is left clear what the exit strategy is. Some of them would like to sell the positions using some of the funds that got raised and have definite timelines and return the capital to shareholders at some point. The exit strategy in this case is a lot less clear when it comes to flipping the house.
Bruce said the fear is that they become market-makers in the sense that they are going to drive the market. In a way there were a lot of REITs available for 2013 being the up-year that it was. It was not that they bought 80% of the property, they just made an offer on 80% of the properties. There is the fear that there are all these properties being held by investors that are being held as rentals. You have this situation where some time in the future they have to liquidate the homes because they have to get cash back to investors and close the funds down. These are rational investors, and they are not going to dump 100,000 properties on the market tomorrow. They are going to be very careful in the way they go about executing any transactions because they do have a full portfolio behind them. Their view is that you will see a very rational and orderly liquidation of supplies for what gets liquidated.
When we think about this relative to the larger housing market and towards the public builders, we are transitioning to the next stage of the housing recovery. If the first stage was very concentrated in the best locations and very supply-driven, which drove much of the price appreciation, the next stage will start moving the periphery of REOs being brought back from the market and investment properties being brought back. You have foreclosures that are still in process out there and people who want to sell. You have a lot of vacant land in these more peripheral locations, and you have less of the supply constraints. It is more volume-driven and less price-driven. The big driver, especially in California, was you could buy an existing home way below replacement cost. Those days have probably gone in most areas.
When Wall Street came in, they came in later than they were invited. When Bruce was there in 2009, he mentioned to them how it would be a good idea to finance other investors. Bruce did not know if they would ever think that this investment would be for them. A couple years later they showed up at a different price level, and it still made sense. Now they have moved onto other places. The next phase is that builders can finally make a spread again in the states that were dominated by REOs. This is something we are slowly progressing towards. You see the builders try to build product that will be competitive, even if it is at a higher price than they thought were in the existing home markets. When we talk about the next stage of the recovery, we think about the spread geographically, less California specific. In areas like Phoenix, it is going away from the areas where people want to be. The entry-level buyers is the next big part of the market. As we get into any of the CD locations, this is where what was REO at one point are primarily rental properties now. This helps takes the supply constrain away a little bit.
David said when he looks at what happened in 2013, he saw builders building in massively supply-constrained areas with very low rates, which drove demand above supply. Demand was high-quality, so there was not much price sensitivity. Bruce asked about when David mentioned the entry-level buyer and if you also have to deal with entry-level financing. In 2008, 60% of FHA’s business was to a FICO score that was under 680. In 2013, it was 10%. The credit quality of that first-time buyer has changed drastically to where half of the size of the volume they were for California during most of the cycles where we are coming off a bottom and building momentum on price, the first-time buyer crowd is normally 45-50% of the California market. The builder is going to look at that demographic and say that we may have somebody who wants one but will not get a yes answer from a lender.
The question is what is happening in terms of margin liquidity. David would say as he talks to most builders across the country that we are seeing marginal easing. It is really at the margin and just starting to ease. You are seeing more non-QM prime loan availability as well as more jumbo prime availability. You are seeing the banks want to be in the business where they have not been in years prior. You are seeing this in the National Association of Home Builders, Credit Availability Index, and other surveys. You are seeing a little bit of easing-up margin right now. It is not that significant or enough to drive enough entry-level demand. However, it is getting incrementally better and will continue to get better. They have QM in place right now to buffet mortgage standards.
The non-bank lenders are going through their audits with the CFPB and getting their back offices and quality control correct and in place. The market is slowly starting to loosen, and this is a process we are going to see continue for the next few years because we will be in a stable to moderately growing home price environment. You will also see loosening since there are a lot of opportunities. Capital is getting there, but it is a very slow process to match the capital with the borrowing needs out there. This is true especially with the trepidation given the political landscape that is behind subprime lending or anything outside of non-traditional lending. It is a very slow process, but he thinks it is starting and we are going to continue to see more of it in 2015-2017.
Bruce asked David where the source of this capital is originating if it is not the government. David said you are going to see it from a number of sources. It is not going to be banks primarily because of capital rule. It is not so much quick back risk at some point in the future, but rather the way banks securitize loans and deal with QRM and first-loss risks that banks will need to take for non-QRM lending. This is something that will look a lot like QM. From a regulatory standpoint, he does not think it will be driven by the banks. David said if he had to guess, it would probably be a combination of non-bank lenders, many of whom have been formed or significantly grown in size, since this upturn in housing has essentially built machines to put a lot of volume through in terms of mortgage loans. They have been out there, and even as they have moved to the upturn they have done a little more than the bank in terms of the overlays they have been doing on FHA loans. The next extension of this is going into the non-FHA, non-conventional, and non-QM line of originations.
You can add on top of this non-traditional lenders being increasingly in the game. You hear more and more about non-traditional, private equity, and traditional money getting into the non-QM prime area right now. These include self-employed borrowers who cannot meet the 43% back-end debt-to-income ratio, as an example, where you can find some great borrowers who cannot get fancy because of the fairly rigid box that is being accepted now in the QM world. If add on top of this the mortgage rates, they will be a more important part of the business. They do not have any issues in terms of having a risk of loss since they will portfolio the loans. They also will not have put-back issues from trying to securitize the loan. You will see a combination of different sources, but it will not be traditional banks.
Bruce did not understand the way we were funding loans from 2004-2006. He really did not know what a mortgage-backed security was or a credit default swap. It was almost after the fact in 2008 when he finally realized. Bruce asked if this world has a chance to re-emerge, or will it mostly be portfolio. David said this is a tough question since it really speaks to the heart of if we should forget what happened. We often forget history; but this has been a serious downturn not just in housing and the average homeowner and wealth impact, but also the banks who have taken massive write-offs and losses. Many banks have gone away because of this. Where people’s history and company history may be short, the regulatory environment is changing in such a way that will keep us from remembering what happened. A lasting piece of this may be where even if banks want to do it, it may get tougher to go out and do it. There will no doubt be securitizations as we are already seeing QM prime loan securitizations come through. We are seeing mortgage REITs get formed and raising capital if we ever get to the extent of where we were in terms of looseness at the peak.
It seems the banks are now getting penalties that have been dished out in the last year of $5-$10 billion. This is exactly the point. There have been some pretty harsh ramifications, not just in the losses we have taken but also from the subsequent panel of bank space. Some of the banks have changed their attitude toward mortgage lending because of this. As we look forward, there will be a different attitude from a lot of banks. It will not go back to where it was back in 2005 and 2006 any time in the next decade.
Bruce asked about the builders’ outlook as far as what they see coming up in the next few years. David said moderate growth is probably the best way to describe the public builders for sure. They look out and see a macroeconomic environment. If you look at the individual pieces, from a demand perspective we have seasoned job growth, not robust but okay. We have not had enough wage inflation, which is a concern. The question is if new households can eventually afford housing. Down payments seem to be the biggest impediment to the financial level buyer. We do see job growth and wages flatten, growing only slightly. They see the mortgage market loosening potentially on the margin right now. They look at the demand picture, and demographics seem to be in their favor to some extent with the echo boomers and millennial. In the prime homebuilding and home buying years we see an increase, so the demand seems to be okay. It is not robustly positive, but it is still positive.
On the supply side, it is not like you are sitting out here with a lot of supply in the market, especially with the CD locations to give you a nice volume recovery but not a lot of price. It is not like you are inundated with volume like you were in the past when we went through a lot of the foreclosure and REO properties. David said he thinks the builders see a moderate growth recovery ahead of them with a slow march toward normalization. However, it will take them years to get there. The builders are very cognitive of this.
When Bruce hears of CD locations, to him this usually means distance and away from work centers. Almost the same mentality that drives prices way up drives the thought that it is okay to drive that far to work. Bruce and other finished a project in 2005 where they built 93 houses. 90 of those buyers drove to Los Angeles each way at least 90 minutes to 2 hours each way. They made this decision because prices had been exploding. The CD locations get affected by how exciting it is to own a home and how much people buy into the fact that it will keep increasing. David thinks there is a psychological aspect to it. When you look at the markets like D.C. where people were buying homes in West Virginia to commute to D.C., David does not think we are going back to those peripheral locations any time soon.
We are building about 24,000 new homes, which is actually not that many as in the past. We are seeing about 1 million starts, but single-family starts have not moved that much off the bottom. David believes when you look at the prime locations where people really want to live, there is not a lot of supplied housing. Prices had gone up significantly in 2013 for sure, not as much in 2014. Here it was more stagnant after a huge movement in 2013. Rates have gone up and will probably go up a little bit more as we look forward to housing starts begin to recover. You start to price people out of homeownership in those locations, and it will start in C before it gets to D. It will eventually be the pricing in C that drives people to go to D since you cannot afford C anymore. However, he thinks the next stage of the recovery is more volume-oriented and will be in more peripheral locations.
Bruce asked if the builders are building a very different product than they were in the last run. David said this is an interesting question and there are a lot of ways to tackle it. From a location perspective, thus far in the cycle the builders have been much more focused on the AB locations where they view the land underneath as lower risk. It started off with buying finished lots, then they ran out of finished lots in those better locations. Now the purchasing they are doing is more development oriented. They have to entitle and develop more land and it is further out in terms of their timeframe for the land itself. In terms of the homes, David would say that the builders work pretty hard to try to refuse so many insufficiencies to price the house more efficiently. This includes more options, more upgrades. Before they were putting granite in homes, and now granite is more of an option and is an upgrade for somebody. They worked hard on the value engineering and are not certainly done with the process. However, they have gotten better and supplied their businesses.
In terms of the homes themselves, design may be a little bit different or there may be less features in the house. It is a more option upgrade kind of model. It also includes some simplifications in order to keep the cost down, although nothing radically different. Bruce also asked if the level of unsold homes is pretty safe everywhere. David said it does feel that way and that most builders are not building much spec. There are a couple exceptions of builders who tend to focus more on specs in their construction, but generally speaking the builders are being very cautious right now.
Bruce asked David how sensitive he thinks the builders industry is to interest rate changes. David said this is a question they get a lot from investors. For example, what if the ten-year is up 75 days or yield starts to move up? David said he does not think this is the case for the entry-level buyer, although he does not want to underestimate affordability. He does not think it is an affordability issue from most entry-level buyers today. He thinks it is much more of a down payment issue. If you were to talk to builders, and there are some builders where 0% financing is only available in certain parts of the country, it is kind of a rare product. When you go to a 0% model, demand spikes quite a bit in the entry level. When you get to an FHA model, where you are putting 3 ½% down, there clearly is not as much demand. David does not think it is an affordability payment issue, but rather it is more of a down payment issue. This is probably true for another 75-100 basis points in rates. If we keep going up from there, it gets tougher. But for now, rates should be okay.
Builders can always change products, and this is something we tend to think about a lot. If a buyer can afford less payments, the builder can change quite a few payments. It is always going to require flexibility. Around 2010, we were really hurting for sales and did a tax credit of $8,000. Bruce wondered how this pile of loans worked out since this was basically a nothing down loan program. Bruce had a feeling it performed really well. David said he would imagine this was true. From what he has seen, it looks like the most problematic loans originated post upturn when the down payment assistance programs involved the seller donating money to a third party that was a non-profit, which was then being donated for the down payment. These seemed to be problematic loans, but it seems the loans that originated under the government tax credit seems to perform fairly well. The flip side of this is when you talked to the builders, it felt like the tax credit was much more of a pull-forward of demand than anything else. It really didn’t have a net impact on demand in the end. They buyer still had to come up with a down payment, they just had it refunded later. The net effective would be 0, but it still required a cash outlay out front and a refund later.
If you talk to the builders, once that went into effect, the clamoring among the public builders went down pretty quickly. One of the things that has been true over the last five years is there is no volatility to interests that is anything big. When Bruce went into the business in 1981, the Fed changed the fed fund rate 21 times that year. He does not know how quickly interest rates might change, but we are certainly used to a very casual market that does not change at all. What is interesting is that most of the time when affordability goes down, volume goes up. For everyone who is concerned about affordability becoming less and less, there is a psychological driver to where this coincides with price increases that drives demand. If you take a look at the affordability chart and you take a price chart, the price goes up and affordability goes down. However, if you look at the volume at the same time, this also increases. The assumption is that this cannot mathematically. There is a human element to it, and this equation seems to play out. This pits two different thought processes in a way.
When you think about typical end-of-cycle behavior, prices would continue to follow through and affordability would decrease. Because you are in an up-cycle for the macro economy, then you are seeing something different instead of affordability going down and volume going up. The Feds are likely raising rates because you are approaching the end of a cycle, you have been running too hot, and the Fed is trying to slow down the economy. We are in a very different market this time around. Rates are really low, and the Fed is going to have to raise. However, they are also so below what is normal. We have a 4 ½% 30-year fixed rate mortgage that the Fed raising is getting us back to a normalcy. He wonders if we will see a similar pattern as we move through this cycle since the starting point is so vastly different from where we normally start.
A lot of people say once the Fed starts raising, this will be the latter ending of the cycle. The fat lady is not singing yet, but we can hear her coming from a distance. Historically, you see the trend where the Fed raises at the end of the upcycle to slow down the economy. Now, since we have not had much of an upcycle in reality, especially from a volume perspective, it may not have the same signal to the rest of the economy that this is the end of the housing cycle. Bruce thinks it will, in fact, drive demand.
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