Tuesday, February 20, 2007

The Great Big Shadow

The great real estate boom, created some interesting situations in a variety of markets like Las Vegas, Phoenix, S. Florida, etc.... The massive wave of condo-conversions in these markets, appealed to investors for a variety of reasons, and somewhat like the dot-com boom and subsequent collapse, the chickens are coming home to roost. For the most part, industry commentators have focused on the effect on the banking system. Given, the dispersion of risk associated with MBS (mortgage backed securities), I believe that the risk to the banking system is fairly limited. Share prices of a few institutions such as HSBC, have fallen, and also New Century (NCEN) due to their exposure to the sub-prime mortgage market, but there does not seem to be any real risk of systemic collapse for a variety of reasons. Individual banks or lending institutions may run into some trouble, but for the most part, the big guys have hedged their exposure through MBS debt, and are much larger than in previous banking crises, such as the Latin American crisis of the 1980s and the S&L debacle. The end result, may be some hurt on the share price, and a reduction in capital availability to lower-end (ie. riskier) borrowers.

The real guys to be hurt, will be the speculators, as the slowdown in home sales volume has prevented them from liquidating their investments. The vultures and speculators have turned to a suddenly strong rental market as a solution to this problem. Hence, the title of this post, the Great Big Shadow.

The Great Big Shadow refers to the fact these units (both multi and single-family) are not easily tabulated by researchers. Little signs start to point to their impact. The first check is anecdotal. Look at hot areas for condo-conversions, and note the slow-down in sales volume for all types of residential real estate. It is an implied estimator of demand. Secondly, Craigs List and other internet sources indicate a significant amount of units for rent. Thirdly, driving around my hometown, I have seen a big change in the number of signs, and indications of concessions on many apartment buildings, especially ones that the big boys (public REITS) own.

All in all these are signs that indicate something is wrong. I'm not a huge believe in anecdotes, because they often obscure the forest for the trees. Lets take a look at Phoenix in particular, because I live here, and there's good data for it. Its a large, fairly liquid market, and saw a good amount of speculation, particularly in 2005, and on into 2006. Job growth is strong, and so is net domestic migration. These are all good indicators for a strong apartment market. And, to top it off, home prices skyrocketed, creating quite the spread between rent and mortgage payments.

For instance, according to the Census Bureau, the median home price was $127,900 in the second quarter of 2000. Extrapolating (and with a little estimating) using the OFHEO repeat sales index, we determine that by the end of 2006, the nominal median home price in the Phoenix-Mesa-Scottsdale MSA was $281,100. The mortgage to rent ratio rose from 1.3 to 2.1, meaning that the premium for owning a home was 130% of rent in 4th quarter of 2000, and by the end of 2006, this measured 210% of average market rent.

The sum of all this evidence, there was a huge pool of renters for apartments. The evidence backs it up, measured absorption rose every year coincident with the recovery in the employment market and the domestic migration number. Then in 2006, funny things start to happen, measured absorption, adjusted for conversions fell significantly, dropping from about 9,000 units in 2005 to 2,300 in 2006. All other signs pointed to a significant increase in net apartment demand (also called absorption). It didn't happen. The results....The big guys began to see this, and began to offer concessions to maintain occupancy levels. Other research I've done indicates that yields for apartment units also peaked in the third quarter of 2006, and have been trending upward, as opposed to their previous compression trend. The hard data isn't there yet, indicating rising vacancies, and falling rents... but, given building in excess of demand, an abundance of conversion activity, anecdotal evidence, of a lot of rental inventory, and knowing that certain buildings are being recalled from conversion and put back into rental inventory, it seems the shadow is beginning to loom large. Look for this story to become more apparent in 2007 as the year unfolds.

It is a great reminder that past performance does not equate to future results. Looking back, things look great, but 2007 will illustrate the dangers of looking backwards to forecast the future.

Las Vegas, S. Florida, Orange County and other markets with heavy building or conversions are facing a similar issue. Until, the for-sale market is able to absorb the available inventory, rent growth for apartments will be subdued, and the shadow of uncounted inventory will continue to affect the real estate market.

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