Bruce Norris welcomes back Rick Sharga. Rick is Executive Vice President for Auction.com. He is their chief spokesman on topics related to the U.S housing market, mortgage market, commercial real estate, and international real estate.
In the first segment they talked in depth about Auction.com, its growth and what it does. In this segment they will touch on where they are in the real estate market. Bruce asked if there were any surprises looking backwards at what he thought would happen last year in January 2013. Rick said on the pricing side of things he was a little surprised by how high some prices came back in various markets. He did not think anybody could have forecast how rapidly the low end of the market was going to come back, especially distressed properties. You can really see a stark difference in home price appreciation if you strip out the distressed segment. There is a very different read on the housing market if it had not been for how rapidly that market segment came back.
Bruce asked what the driver for this was, to which Rick said it had to be investors. Bruce asked if these investors were institutional investors more than the local people. Rick said this has been a big change over the last couple of years. Institutional investors have tried to do in scale what individual investors have done for years. They have adopted the buy, fix, and rent strategy that individual investors have been doing for a long time. However, they have been trying to do it on a national scale. Because of their business models, they are a little less price-sensitive. They were probably a little overheated in some markets in terms of what they were paying. However, if they look at it over a longer-term holding period in terms of what they can get back if they file an IPO and have a publically traded REIT, then a few dollars more of purchase time is probably not that big a deal for them.
If, for example, they bought 3% of the California market, they offered on 30% of it. You always had to compete with the Fed offer. If you were a private buyer, your price probably changed because there was an investor willing to write a check who had a $20 million bank statement. Whether you were an individual investor or a traditional owner-occupant competing for that property, you had a bit of a disadvantage. This was a really weird market in terms of cash purchases, not just because the percentage was so high. Typically a cash purchase is offered at a little bit less than a financed offer. The advantage to the seller is that there are no contingencies to close right away, get your cash, and move on.
In this particular market, they actually saw cash purchases coming in higher than what a borrower was able to finance. They were willing to pay above appraisal, and this was partly because they are not as price-sensitive. Rick believes prices have continued to be stubbornly low compared to what the market is willing to bare right now. Bruce completely agrees with where a lot of the volume went and why the pricing wen there, but is also sets up a pretty good 2014. Bruce looks at this and sees there was a lot of occupant demand that did not get satisfied that still exists and is still capable. Bruce asked Rick if he thinks we will have a decent 2014, to which Rick says he hopes he is right. His fears and hesitancy in jumping right on board are in areas of economics and financing.
Rick said on the financing side, he does believe credit will tighten further before it begins to relax later this year. This will happen as the lenders really begin to implement the new qualified mortgage rules and ability-to-repay rules that come from the Consumer Financial Protection Bureau. He believes the large banks are going to focus exclusively on those loans with the possible exception of jumbo loans they will offer to ultra-qualified, high net worth individuals who are good banking customers for other services. Later this year we may see the non-bank lenders come on board with loans that are a little easier to get for the average borrower. However, they are going to be a little more expensive, and this is where the economic part comes in to play. Interest rates are due to go up, and some of the loans will be available at higher interest rates. The economy has just not generated enough full-time good paying jobs to really facilitate a robust growth in housing demand.
The first-time homebuyer segment, which really should be the 25-35 year olds is made up of a lot of people who are trying desperately to get rid of student loan debt they have accumulated over their time in college. They simply have too much debt to qualify for new loans. There is a reason Junior is still playing X-Box in his mom’s basement since he cannot afford that down payment. Bruce said one thing that is concerning about finances is the FHA lowering their loan limits. For California, especially Riverside, this was a pretty health percentage of the market that was foreclosed on. If you were to get a property in the $4-$500 grand range, you cannot get this now. It is not just FHFA, but Fannie and Freddie are talking about this as well. This throws a lot of California homes into the jumbo category; and right now to get a jumbo you need an 800 FICO score, 20% down payment, and a year’s worth of cash reserves. It is going to push a lot of borrowers who are on the march out of the market.
Having said this, there are a lot of loans that could be made to people with stated income. If you had a portfolio of $10 billion, you would not have enough losses in that portfolio to worry about it. Bruce asked if there is some giant pool of money on the sidelines that may show up in an open niche. Rick said ultimately yes, and this is why he believes we will see this from non-bank lenders and companies like the one he used to work for over at Carrington Mortgage Holdings. In order to do this, they first have to raise capital. Their capital providers are going to only issue that capital if they think there is a secondary market into which those loans can be sold. Right now the secondary market is Fannie and Freddie. Eventually between the private capital and the lenders, they will figure out how to succeed with new risk-based lending products. However, it will take a while to get this in order. Rick thinks the latter part of this year is when we will start to see this come through again.
We are risk-averse because of how badly things went with subprime back in 2003-2007. Realistically, prior to this and before everybody lost their mind and was infected by that Wall Street flu bug, most subprime loans were performing loans. If you were good at underwriting and loan servicing, your portfolio really behaved pretty well. We need to get back to this fundamentally solid underwriting and loan servicing. The market will then take care of itself. It is pretty easy to be current when you can have 20% of appreciation every year. You can then get a loan or refi. Bruce thinks there is a case for a lot of loan programs that are safe.
Bruce mentioned the B2R program, which involves private funds. Bruce asked what company is doing this program. Rick said Serberus and Blackstone is doing this kind of program as well as other companies. Even Rick’s company, Auction.com, does bridge loans in which you can get $500,000 to $5 million to buy and resell properties on a short-term basis. There are lots of options, but the B2R funds are really aimed at investors, not at the general public. For the average owner-occupant there is still not a lot of free flowing credit. When you tally up all the money that Blackstone and Serberus put together, you are not talking about $10 billion. In the residential market, you are talking about $150 billion a year. Nationally you are looking more at a trillion dollar market.
Rick thinks we are at a point now where the lending industry needs to be creative about how it funds real estate acquisitions if it wants to see the market come back. Having said all this, we are still going to see a market this year that is marginally better than it was a year ago. It just won’t see the rapid growth in terms of price appreciation that we saw or with the volume we would like to see in terms of owner-occupant purchases. Bruce is big on charts; so when he looks at them he thinks about which one he is afraid of this year versus last year. Rick said the one he is most afraid of is labor participation rates.
He believes the unemployment numbers are a mirage, and the only improvement is the people who just disappeared. If everyone votes themselves off the island because your jobless rate looks good all of a sudden, then that could be the issue. The other problem with the unemployment report is that it indicates that a lot of people are employed when what they are really doing is working part-time or several part-time jobs and not making a lot. This is the one that bothers him, and he thinks that as soon as we see labor force participation increase, it is hard to foresee any situation where we will have a boom in home purchases.
Bruce said one thing that happens when lenders get conservative is if you find a job after 18 months being out of work, then you may be closer to qualifying for a home loan. Bruce wondered how much closer you are to being qualified. Rick said it is around two years, although there are variables. If you happen to maintain a really high credit score during that period of time and can put down a decent down payment, it is always work history, credit record, and down payment. This all gets mixed together in the black box, then they all come up with the right formula for you as a borrower. There just aren’t as many potential solutions as there were a few years ago. The formulas change, especially if you are looking at a FICO score. There is an annual report FHA puts together.
Back in 2008 just after the bad things started to happen, they were loaning 60% to a FICO score that was under 679. Now it is 9%. Last year the average was about 700 as the FICO score for an FHA loan. Back in 2008 and 2009 when FHA came into the market, this was the time the subprime lenders came in and FHA was uninvited. They really came back largely and were picking up refis of these subprime loans that were about to reset. They were picking up a lot of relatively risky loans. Had FHA not been there, the fallout from the housing market would have been significantly worse. FHA probably took on more risky loans than they should have at the time, but they provided a bit of a buffer for the rest of us.
If you look over the last three years, Fannie and Freddie and FHA have probably created the safest group of loans in history. These loans are performing twice as well as loans have historically performed. Historically only 1% of loans go into default; so short of somebody getting hit by a meteorite on the way home from work, nobody is missing their payments these days. This brings up the point that maybe for Fannie and Freddie it is not a bad idea since they created the most profitable scenario ever, so should they let it keep going. Rick said this would be a logical assumption if we were not dealing with politicians during an election year. Now they are seeing a lot more noise than they have seen in the last couple years regarding Fannie and Freddie reform. This is just mind-boggling because they are now wildly profitable and have become an ATM for the Federal government. They are also protecting consumers from having rates spike because they have been keeping the lending rates lower than where the market would be if they were not the dominant players that they are.
Whatever they wind up ultimately doing to unwind Fannie and Freddie as the dominant players, they have to be very careful how they do it and what leverage they throw. You are talking about a trillion dollar already-established market where paper can freely flow in and out and replace it with no model that can handle anything close to that. Rick said he is of the school that does not believe we should go to a fully privatized system. He does think having a Fannie and Freddie in their current configuration is probably redundant. He does not think ideally we should be reliant on the government to fund 96-97% of all loans. However, he does think there should be some sort of government involvement, even if it is just the emergency backstop for when we inevitably hit another down cycle.
Bruce asked if at the very core there will still be an emphasis that U.S. people will want to own a home or encouraged by policy to want to own one. Rick said he does see this happening and that the notion of homeownership is fairly and deeply engrained in America culturally. For all the hew and cry we have had about the home ownership rate going down, historically it is usually 64% and right now is 65%. There are some benefits in terms of economic stability and community stability they have seen over the years because of homeownership. What they learned is you cannot push people into a position of homeownership when they are not ready, whether emotionally or financially. It turns out trying to make everybody a homeowner is a bad idea.
Bruce asked about immigration and if the reason people come here is because they get to own a home. Rick said he thinks this is part of the American dream, and Fannie Mae research he has seen still indicates that a lot of non-home owners ultimately aspire to be homeowners. These percentages have not flipped much. Rick thinks Bruce touched on one of the reasons homeownership rates and household formation have not gone up is immigration rates have not gone up over the last few years because the opportunities for jobs have not been there. Until we see household formation increase, we are not going to see a lot more in terms of homeownership. Until we have a bit of an economic recovery beyond what we have seen so far and immigration laws the people understand, we are not going to see that inflow of potential homeowners coming from offshore.
If we do have a passage of an immigration bill, Bruce asked Rick if he sees any effect on housing. Rick said yes, but it will have an uneven impact and not an immediate one. The question is where the immigration will come from since right now we are deporting people who are receiving doctorates at our best universities since their visas are expiring. You look up and wonder when you landed in bizarre world. The question is if we have immigration policy that makes it easier for those people to stay. Rick said his guess is you move most of these people immediately into homeownership situations. If all the immigration does is allow us to get easier access for people at the lower end of the socio-economic spectrum into the country, then that will take a little longer in terms of feeding the ecosystem for homeownership. These folks will not be able to afford to buy homes in many of the markets into which they move.
Bruce said when you look at the number of new homes being built in a country, Bruce wondered what this tells you trend wise. Rick said we are at a 40-year low in terms of new inventory that is available for sale. Even if you look at construction, it is probably running at about 60% peak right now. This tells Rick that the homebuilders believe it is about time to get restarted and they are being very selective about how they do it. Rick said they are also foreseeing that a high percentage of construction is still multifamily. Interestingly, where they are seeing a lot of growth is in 55+ communities, whether detached homes or townhouses. This segment seems to be picking up a lot of steam right now.
One thing that is unusual in Riverside, a construction county, is that last year prices increased and you could have sold anything you could build. But then Bruce looked at a chart that showed building sub-division creation for 6-7 years running averaged 350 subdivisions between 2000 and 2008. In 2013 they averaged 23, so even though last year was a good boom year they did not have any more confidence about creating a sub-division. There is also still a lot of vacant inventory out there from the last boom, and Riverside had more than its fair share of properties that were just a few years old that became foreclosure casualties. The builders had been fighting with their own inventory from a few years ago, and it really did not make any sense to build until that inventory began to get soaked up. Rick thinks we will see a gradual return, but not a boom right away.
Regarding inventory levels in general, in California we started in 2013 with three months and are starting 2014 with three months. This is not a lot of inventory. We found ourselves in an unusual position last year when all three categories of potential housing stock were unusually low. You had new homes, especially in Riverside at the lowest levels in decades. With existing homes we still had about 20% of homeowners who were upside down on their loans and would have had to do a short sale if they could to get out of their property. A lot more were just barely above negative equity, so they might not have had enough money coming out of the sale of a house to buy their next property. Therefore, existing home inventory was low. They also had delays in terms foreclosure processing so distressed inventory was low. All three levels of inventory were low, and it will candidly take a while for any of those to percolate back up again.
Regarding shadow inventory, Bruce said in his mind this is not happening since we do not have big pile that will show up. Rick has believed for many years that the whole shadow inventory concept is overblown. He never really thought there would be a tsunami of distressed properties with which the banks would flood the market. This is even less the case today. According to CoreLogic, we are looking at numbers in the vicinity of 1.7-1.8 million properties that are either unlisted REO assets, unlisted properties in foreclosure, or properties where the borrower is 60 or more days past due. We are absorbing about 1 million distressed properties a year, so it is really not a huge overhang that would really create a big problem on the market in the future. If anything, when we transition away from REO sales and short sales, when you start selling from 90% of equity sellers they buy property. Rick said we are getting closer and closer to this. In late 2015-2016 we will probably finally turn this corner.
For more information about The Norris Group’s California hard money loans or our California Trust Deed investments, visit the website or call our office at 951-780-5856 for more information. For upcoming California real estate investor training and events, visit The Norris Group website and our California investor calendar. You’ll also find our award-winning real estate radio show on KTIE 590am at 6pm on Saturdays or you can listen to over 500 podcasts in our free investor radio archive.