Large private-equity hedge funds will begin tapering their purchases of houses shortly. Prices have simply gotten to high, and with the flood of rentals from their previous purchases, rents are softening in many of the markets where these funds have been most active. Rising costs and declining income doesn’t make for a good combination. However, despite the apparent worsening of conditions for this investment class, some housing analysts are worried that investors will remain too active and possibly overheat prices.
Investor Momentum In The Housing Market May Have Swung Too Far
John Burns, John Burns Real Estate Consulting Jul. 25, 2013, 6:51 PM
During the downturn and early stages of recovery, we were huge proponents of investors taking advantage of overcorrected home prices to make great investments while also helping the housing market recover. Mission accomplished.
I laid out the case for investing in these properties in the post Buy Las Vegas real estateback on August 5, 2010. I knew that the activity of investors like me would help the market bottom. What I didn’t know at the time was that Wall Street would also figure out what a good deal these homes were and enter the market in force. Between the infusion of hedge fund cash and the change in policies at the banks favoring can-kicking over foreclosure, the inventory dried up just as demand hit the market. The result was a premature bottom and a rapid rise in price since.
We are now concerned that investor momentum has swung too far in the other direction. Recent developments include:
Highest investor activity ever. We now have an all-time high level of investor activity, reaching 30% of all resales in the markets we track and 45% in markets such as Orlando and Florida. We believe that thousands of organizations and individuals now have the capital and infrastructure to invest quickly, and we don’t know what will shut it off.
I nearly got funded by a large private equity group from Chicago who wanted to get into this business. I know how private equity works. They will fund anything where they see a return, and they will defund anything that doesn’t provide returns just as quickly. The idea that this money can’t or won’t be shut off quickly is rather silly.
In the hedge fund agreement I was party to, the fund was going to provide increments of $5M up to a max of $200M. After we spent $3.5M of the $5M, we were supposed to provide the fund with an analysis of market conditions and a recommendation for future funding. If I had told them prices were up significantly and rents were falling, the spigot would have been turned off immediately. The funding conditions of these private equity deals mostly have similar terms.
No more bargains. Price appreciation at the lower end of the market now exceeds 30% YOY in markets such as Atlanta, Phoenix, Minneapolis, and Las Vegas (Case-Shiller data). The bargains are gone.
The real bargains are certainly gone. Overall prices are still well below historic norms, but raise the price of anything 30% and lower it’s income potential, and the deal won’t be as compelling.
Above replacement cost. We are hearing many stories of investors buying new homes, both in bulk and by pretending to be a real buyer in the new home sales office. The great investment thesis of buying below replacement cost is now gone.
Every home I purchased in Las Vegas I purchased at below replacement costs. The sticks and bricks cost more than the house did. I honestly don’t know what he is talking about with people buying new homes under replacement costs. What builder would do this? Would anyone build a house for $100/SF and sell it for $80/SF? If they did, they wouldn’t be in business very long.
Flippers. House flipping is up 19% YOY according to Realtytrac, and we are hearing radio ads again for companies who will teach you how to flip a home. Never underestimate the American allure of making a quick buck!
Debt availability. The big institutions have raised debt from banks, and Blackstone recently announced B2R, a platform to lend to medium-sized investment groups. We suspect that small investors are finding or will find debt soon. All of this will allow investors to double their platforms without raising any more equity.
John Burns Real Estate Consulting
It isn’t surprising that the percentage of investor purchases is so high. Potential owner-occupant buyers have too much debt, many have poor credit, and few have the necessary down payments. With owner occupants absent from the market, the share of investors is bound to rise.
While the permabears or big name economists (who are lucky to have a staff of one focused on housing) went on TV claiming that rising mortgage rates would cause another downturn, and Wall Street responded by selling all things housing,
Was that a dig at Mark Hanson?
we went public on June 3 and June 26 saying that rising rates were necessary to prevent another bubble.
I imagine the homebuilders were happy for his assistance in talking up the market.
Since investors remain as optimistic as ever, rising rates do not appear to be cooling the market much at all.
Oh, really? Not according to the Wall Street Journal: As Rates Rise, New-Home Orders Slow for Home Builders. And as Mike noted over the weekend: Buried in the June housing report, New Home prices down 11.5% from April. I postulated that Future housing markets will be very interest rate sensitive. This will be particularly true for homebuilders. The resale market is still undervalued in most areas, but that isn’t true for homebuilders. They usually charge such a stiff premium that they quickly raised their prices to the limit of affordability nearly everywhere. For example, when I was still actively acquiring properties in Las Vegas, I noted homebuilders were obtaining a 30% premium for new homes over the same floorplans from just a few years earlier. In one neighborhood, I was bidding on properties with a $160,000 resale value built in 2005 and 2006, and the builder was selling houses the same size a few blocks away for $210,000. Since Las Vegas was so drastically undervalued, the builder premium grew very large. Since builders are already selling at the limit of affordability, sudden interest rate jolts like we had in May pummels their business. Homebuilder stocks sold off because investors recognize that builders face problems when interest rates go up.
At this pace, the Fed will soon accomplish their unstated goal of eliminating negative equity, which will allow for refinancing that will be great for the economy.
Actually, it will provide collateral banking for bank bad loans. Will it provide those few buyers at the bottom and those who didn’t borrow themselves into oblivion with a chance for free HELOC money? Perhaps, but the existing homeowners who didn’t tap their equity before the bubble aren’t likely to go Ponzi now.
However, I don’t know what will shut off the investors other than another crisis or recession.
Rising prices will shut off the funding — quickly. This notion doesn’t even rise to the level of a tempest in a teapot. It’s a big nothingburger.
… As for now, the fundamentals still look strong.
Oh, really? Which fundamentals are those? It isn’t stellar wage growth (See: With stagnant wages, what will cause rents and home prices to rise?). It isn’t robust economic growth (See: Economy skids dangerously close to contraction, and Leading Economic Indicators Flat in June). It isn’t falling interest rates or improving affordability (See: Mortgage rates move higher, housing less affordable). It isn’t a commitment to endless quantitative easing (See: Can the fed taper housing market stimulus with no ill effects?). I guess you just have to take his word for it. The fundamentals are great.
What will happen as investors slow their buying activity?
The hedge funds pumping money into real estate are about to turn off the spigot. My estimation is that over the remainder of 2013, investor activity will decline sharply. The fantasy has always been that owner occupants would step up and take the place of investors as they pulled back. But how likely is that really? I never believed this inevitable transition would be orderly. Owner occupants are less active in the market for the reasons I pointed out above, they have too much debt, bad credit, and too little savings. These conditions won’t change quickly, certainly not as quickly as the investors will curtail their buying. Owner-occupant buying is still in its four-year holding pattern at 1990s levels. Now consider that since March of 2012 — a time of low owner-occupant activity — prices have risen 20% to 30% in most markets, and interest rates have removed 10% to 15% of the purchasing power of potential buyers. How is the number of owner occupants supposed to increase when houses just got 40% more expensive? The restricted inventory conditions will not change, and nobody expects any must-sell inventory to come to market any time soon. Given those facts, it isn’t likely prices will fall. If there is a “fundamental” supporting the market, that’s it. What’s far more likely is that as investors stop buying, sales volumes will decline. Low inventory and low sales volumes is what we have to look forward to through next spring.
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