July 31, 2007Kyle KazanComments 3
So far, the local economy of Los Angeles / Orange County has continued to do well. We noted however that in hiring some new managers for apartments in Orange County, we received many resumes from people recently unemployed (or whose employment terms changed to 100% commission) from the mortgage banking industry. Orange County and in particular the city of Irvine has employed many people in this industry, including those employed by New Century Financial Corporation which filed Chapter 11.
In my February letter, I predicted that lenders would tighten credit standards while foreclosures increased. Both have happened and I’m expecting more foreclosures and a credit crunch which I’ll describe herein.
This letter will be filled with good news / bad news inconsistencies which belie a feeling that the real estate market and local economy are in a state of flux. According to many of my friends who also own/run local companies there is wage pressure and a difficulty in finding qualified employees. Prices for items used to maintain our properties along with the labor rates are inflating as are energy prices. That said, last night I authorized 3 – 5% rent increases in most of our apartments as our occupancy rates remain high.
At the same time, the housing market continues to weaken particularly in the outlying areas of Lancaster, Riverside and San Bernardino. Delinquencies and foreclosures are rising, prices are stagnating and lowering while financing becomes more difficult as lenders have largely phased out 0% down payment mortgages and stated income (subprime) loans. In the past few years, it was easier to acquire home financing than it was to rent one of our units as we verify income stated by those applying to occupy our rentals. It is my belief that the lack of fiscal discipline in making loans to people who were not good credit risks along with allowing little to no down payment fueled home price appreciation and thusly fed liquidity into our economy which will now come back and haunt.
In Multifamily real estate where we focus, we’ve benefited from the rise in barrier to entry for home buyers (in spite of the non-existent lending standards) as prices have inflated which allowed us to consistently run properties with very low vacancies. We’ve also been able to raise rents over the last 10 years. As liquidity has looked for returns, California apartments and more recently office properties have looked like “can’t miss investments.” In the last couple of years, I’ve heard real estate economists compare apartment investments in Los Angeles and Orange County to bonds; both in terms of security and yield.
As someone who lives and breathes the day to day operations of these “bonds,” I fail to understand the “paradigm shift by institutional investors who understand the solid economics (rising population and underdevelopment of affordable housing) and stability of these investments.” To me, this was reasoning for paying very high prices and accepting low yields on properties which are already operating at optimum capacity. When I stopped buying apartments “en masse” at the end of 2002, it was because of the cap rate compression / lowering of yields which inverted the risk/reward analysis that I run before pulling out my check book. Or quite frankly, I must not understand the paradigm shift and my belief that real estate is cyclical and not secular is wrong.
I believe the peak in this current cycle has passed (likely the top was in 2005) as there has been a slight cap rate decompression but unleveraged returns still remain lower than the cost of borrowed money which I don’t feel is sustainable. Borrowing costs are rising while the 10 year treasury is nearly the same as it was last summer, the spread has risen approximately 50 basis points (1/2%) from last year due to investor reluctance to invest in mortgage debt.
While I’m sure you must think that I’m wearing a giant bear suit while writing this forecast, I still believe strongly that commercial real estate investment in Southern California can be very smart given the demographics of the area, the good weather, the diversified economy and quite frankly it is a desirable place to live. When the yields are back at a level that rewards the buyers who assume the risk of increased vacancies / delinquencies along with the actual costs of running a property for the long-term (new roof, painting the building, plumbing and electrical repairs) then I will be acquiring more properties. Today, you can get a similar yield with no risk by putting your money in the bank.
As Warren Buffett says, “be greedy when others are fearful and fearful when others are greedy.”