On October 19, 2012, The Norris Group proudly presented I Survived Real Estate 2012. An expert line-up of industry experts joined Bruce Norris to discuss perplexing industry trends, head-scratching legislation, and the outlook for real estate in the coming year. Over $77,000 was raised to benefit Make a Wish and St. Jude Children’s Research Hospital. This event would not have been possible without the generous help of the following platinum partners: ForeclosureRadar, the San Diego Creative Real Estate Investors Association, the Investors Workshops, Invest Club for Women, San Jose Real Estate Investors Association, Frye Wyles, MVT Productions, and White House Catering. Lean more about the panel and how to attend at isurvivedrealestate.com.
Bruce continued his discussion with Chapter 9 bankruptcy. It is a serious problem to have a big deficit, and from what Bruce has seen Chapter 9 bankruptcy does not solve the biggest problem since the retirement dollars of CalPERS is kind of an untouchable item.
Despite not being an expert, Sean said in areas such as Vallejo that have gone through this already where some of the debt has been cleared, it has not cleared up the unfunded pension liabilities. There is still this huge problem that has not yet been faced. This is clearly going to continue to be an issue for cities in California. We have a lot of cities on the brink. What it has changed is they very often do not show up first to their fires, and they have other companies from other cities beat them to it because they have so few. They may be busy with one thing, and they cannot get to another. Sean said one of the things that really bothers him is when he hears that foreclosures cause price declines. In his little hometown of Discovery Bay, they closed down the local fire department that has been there since the place started 30 years ago. They said they had to close it down because they had lost so much revenue. However, the only problem with that is they have more revenue today than they had before the bubble. Revenue has increased it better than rates of inflation.
What happened during the bubble were our cities, counties, and states went out and spent the revenue as if it was going to continue coming forever instead of taking it as a big one-time windfall that it was. This largely happened in pensions, benefits, and public sector pay. It is really hard to put that genie back in the hat, but we are now losing fire departments when there is more revenue than they had before because there is not enough revenue. There is a structural problem where we let some of these things advance costs and advance faster than they should have. At some point we are going to have to recognize it and deal with it. In the meantime, it is going to get worse before it gets better. Rick jokingly said on the high speed rail line we could get the fire department from Orange County up to Discovery Bay, so we’re all covered. Just it going by so fast will put out the fire.
Bruce mentioned all the task forces where the Democrats and Republicans worked for months and came up with a document that he took the time to read. He said this was a meaningless document; none of this will even get contemplated and it was just a perfunctory. Eric said in regards to government growing over the last 30 years, Federal government in terms of employment has been shrinking and has been relatively flat. It has gone from about 33% to 13% of total government employment since the 1970s. The huge area of growth has been in the local government. We have all become accustomed to a high level of service, and it is expensive. They have all these people to pay and all their pensions to pay. The other thing that happened was all these towns got talked into taking out all these bonds. There is a reason municipal bonds have such a lower default rate than corporate bonds. Towns can always go find the money to pay the bonds even if they cannot find the money to pay the fire department. Mark Palim said one thing to look at when you are trying to judge these things is to take a look at whether there is a local state police retirement system and see what their assumptions are about their rates of return that they are using to discount those future liabilities.
There are two things to look at. The first is how underfunded the plan is, but do not just stop looking at this. The second thing to look at is their assumptions, which is usually about an 8 or 9% growth rate in investments under pension accounting rules for corporate entities. We have a little bit of the old dynamic that some remember from the 80s where there are different accounting rules in some cases, so some of the decisions some of the states and municipalities are making about returns are another place where you are going to see problems.
When Bruce spoke to E.J. Burke on the radio, he mentioned how it is good for us to have borrowed money against real estate; but it is really on the other side of the coin where the person who saved everything was trying to get a yield on it. Now you have a 12-month return for CalPERS that was projected to be 7-8% in order to make it but ended up being 1%. This is a problem. E.J. said this is the flip side of the low interest environment. We’re taking money out of the savers and putting it over into somebody else’s pocket. It is making this pension issue, which is huge, not only for state and local government but also for certain corporations and other organizations that have legacy pension plans. They can’t earn enough to pay their participants who are living longer than they assumed even in the beginning.
Bruce said it is a mathematical certainty we are not paying the people to whom we made promises. It would be good if we told them early. Who is going to go for the plan where the people will not be told until the end when they have no chance to make the money up and will be homeless? Bruce doesn’t really understand the plan, and this frustrates him. Bruce thought we were going to have something happen after the election where Democrats and Republicans would go in and say, “Let’s knock this off for the next 60 days and do something that is right.” Rick Sharga jokingly checked to see if he was feeling okay.
Bruce continued the discussion with commercial real estate. Bruce said he didn’t really know the answer, but he knew there was a ton of debt coming due. He mentioned $1½ trillion in the next four years where the maturity date happens being the worst of the worst loan that was made at the peak of the market and probably has the least teeth originally. Bruce wanted to know if this is going to cause a lot of losses in the equivalent to the mortgage-backed security world for residential. He wanted to know if it is going do this because people have collateralized debt obligations while other people have credit default swap bets against that. He wondered if that is arranged the same way. E.J. said first of all, just because a loan matures it does not cause a loss. If you look at the commercial equivalent of the residential mortgage-backed market, it is about $700 billion. This has actually been shrinking at the rate of about $100 billion a year over the last couple of years through a combination of refinancing and paying off and people taking losses. The big maturity bubble is actually about two years out.
E.J. said the number itself is pretty manageable. When you talk about trillions of dollars in maturities, the bulk of that is actually sitting in the banks. In that area, the banks are actually in pretty good shape. Roughly 85% of the banking assets in the United States are held by the top 25 banks. Those top 25 banks have shrunk their real estate at a pretty rapid pace. E.J. said his bank is a little different from most, but since 2007 their commercial real estate has dropped from $16 ½ billion to $11 billion. E.J. personally believed it was not at the kind of Armageddon that you read about in the press. Bruce said he is watching Auction.com auction off the notes at a discount, and he figured they are in business because some lender cannot get what they are owed. There is a listing next door of a building that was bought for $950+ that he bought at $319. The lender just took back the $3.6 million loan that they had not been paid on for a while that they had originally listed at one and a half. Bruce is seeing that this will put a dent in your balance sheet. However, E.J. said you do not know when that debt was incurred since it does not necessarily occur the day that they put the note out.
In 2008-2010, banks built enormous reserves, and this is part of the reason we had TARP and the stress test. After we had the stress test we had to go out and raise a whole lot of equity. A lot of the accounting for that is you build the reserve up, sell the note, and charge it down. A lot of the losses were actually recognized in the years 2008 through 2010. Sean mentioned all the negative equity shown in the chart and in all the reports from CoreLogic, and one thing that is very important to understand is that negative equity sits on homeowners’ balance sheets. However, a lot of it has been written down on the banks’ balance sheets. When the bank writes that loan down, the homeowner does not get that reduction. This translates into our day to day life.
You see a neighbor that gets principal balance modification, and it cuts their principal in half. When you talk to them, it turns out they had a pay-option ARM worst of the worst loan. However, it makes sense because that loan traded for pennies on the dollars years ago, and the person recognized a large gain because they actually reduced it to an amount more than what they bought it for. It is now performing again, so that big negative equity number sits on homeowners still and hurts the economy which is consumer driven. However, it is not necessarily a problem at the banks to the same degree.
Bruce continued by asking each panelist if they were a pessimist or optimist regarding the industry over the next year. Gary said he is extremely optimistic, although this may just be his nature. He thinks we have seen the worst of the times for us unless we fall off of the fiscal cliff, which he does not see happening. We are poised for good growth, not extreme growth, but good.
Sean O’Toole also said he is overall optimistic about real estate, especially with the decent return on investment. This matters a lot more to him than comps. He does believe in the theory of a black swan, or unexpected events. Sean said he thinks we have real structural problems, and the likelihood of something coming that is bad is still a real possibility. However, he is not that optimistic overall in terms of the economy in that we likely have some rough days ahead of us. However, if he thinks about where he wants his money to actually be, he wants it to be in real assets on which he thinks he can get a real return.
Rick Sharga said he is more optimistic than pessimistic, but within a certain context. He thinks we are in for what he would call a saw tooth recovery. We are probably a year away from having inventory levels for properties that feel like we are not in a period of oversupply. However, between foreclosures starting up again in a lot of parts of the country and new homebuilders starting up again, at some point we are going to see enough supply that prices go back down a little bit. It will take us a couple years to work through the backlog of distressed inventory that we have. To Sean’s point, the economy is still relatively weak. Rick said what he has been able to determine historically is that until you see unemployment rates getting down somewhere between 6-6 ½%, you are not going to see a huge upswing in terms of home purchasing. It will probably take us a couple years to work our way through that until unemployment rates come back down. Someone said the housing market is in recovery, but it is much like a patient who has been in intensive care for the last few years. They are feeling better, but not quite ready to run a triathlon.
(Sara’s statements reflect her thoughts prior to the election)
Sara Stephens also said she is optimistic. She thinks that we are seeing returns finally on investment in real estate. Moving forward, the months following the election are going to be extremely critical in terms of investor attitude and how people will choose to move forward. She thinks that, depending on the person who is elected, her optimism may shrink a bit, but she would hope that moving forward we could see more growth. She thinks that the maturation of the baby boomers is certainly something out there that is going to have an extreme effect on the housing market as we see people looking for a different kind of lifestyle and place and being able to afford that kind of style. This also applies to the kind of investment they need to make in the economy and the kind of investment they need to make to keep them moving and viable as well as keeping the economy viable.
Eric Janszen said we just went through a pretty traumatic experience where we had an epic bubble in residential real estate, a core aspect of our economy. This has been very important for our economy for well over 30 years. It became the epicenter of this gigantic pricing credit distortion. It has only been recovering now for about six years. Whether they are expecting it to recover in only six years is a lot to expect. The Federal Government and Federal Reserve are throwing everything in the kitchen sink at it. If they continue to do that then we will probably see the same rate of recovery that we are seeing, which is starting to feel a lot better than it has in the past. The fundamental question is if we can afford to continue to maintain this level of support for the industry. We have an economy that is like an economy running close to stall speed and very vulnerable to a shock. These are challenges we have to maintain this level of support and to even continue the level of recovery that we are getting. We are vulnerable to shocks and a fiscal cliff as well as a number of other things. Eric said he would like to be optimistic, but he thinks we have put ourselves in a very vulnerable spot.
Mark Palim said optimism is relative. Given what we have all gotten used to, he said he is guardedly optimistic. We have a long list of things that could go wrong. We do see unemployment very slowly and gradually improving, and to him this is a key thing. What worries him the most is that he does not know if we will be able to sustain one of the things that has worked well recently, which has been a big improvement in exports. Europe is now in a recession, and in Asia it is hard to tell exactly what is going on; although some say it is slowing down considerably. It was still a big commodity, agricultural export and energy producer. He worries about when you are trying to grow an economy using productivity improvement rather than adding leverage, it strikes him as a much slower rate of growth. Managerial and technical innovation has to drive the growth rather than just leverage. Mark thinks we are going to grow and not go into another recession, but it is not going to be any great, fantastic growth rate. Ultimately, we need employment to hold up real estate prices.
E.J. Burke said he is also optimistic because he has very low expectations. If you have charged off as much as he has since 2007 and then see how little he is charging off today, you can see why he is very happy. He is cautiously optimistic, although he said it is a slow recovery and we need to expect that we are going to have a few more years of slow growth.
Thank you so much for everyone who supported I Survived Real Estate and for listening. Tune in next week as Bruce interviews John Burns of John Burns Real Estate Consulting. The Norris Group would like to thank their gold sponsors for supporting the event: Adrenaline Athletics, California Property Solvers, Coldwell Banker Pioneer Real Estate, Elite Auctions, For Investors By Investors, In a Day Development, Inland Empire Investors Forum, Inland Valley Association of Realtors, Investor Experts, Inc., Keller Williams of Corona, Keystone CPA, Las Brisas Escrow, Leivas Associates, Mike Cantu, Northern California Real Estate Investors Association, Northern San Diego Real Estate Investors Association, Personal Real Estate Magazine, Pilot Limo, Realty 411 Magazine, Real Wealth Network, Rick and LeaAnne Rossiter, Southwest Riverside County Association of Realtors, Jon Risinger Photography, Sonoca Corporation, Spinnaker Loans, uDirect IRA, Wilson Investment Properties, Tony Alvarez, Westin South Coast Plaza, and Winning in Tough Times, LLC. See isurvivedrealestate.com for the video from the live event.
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