More on Subprime

And this is what passes for analysis from Nouriel Roubini:

"This fairy tale spinned by free market supply side voodoo fundamentalism zealots will blame the otherwise appropriate current Congressional action on predatory lending for being one of the main causes of the credit crunch that will lead to a painful recession (as the WSJ editorial page recently claimed) while forgetting that predatory lending practices developed by free unregulated markets created the toxic waste that is subprime and near-prime mortgages.. This voodoo religion cabal will also incorrectly blame regulators"

I am not sure if this whole sentence qualifies as "analysis." I recognize that we as the blogging community are not all that filtered, but as an economist, we do like approach things from an objective manner. Roubini clearly does not, and lets his emotions color his analysis, which is very unfortunate. It may fire up his fans, but hardly leads to intelligent debate.


Dave Altig, over at macroblog covers this ground from a less excited perspective yesterday. The risk is two fold From a housing perspective, how long does the reduction in credit to the riskier borrowers last? And what effect does that have on housing demand? Secondly, does the default risk as Altig points out spread to commercial mortgages?


The answer remains... we shall see.


As a side note, apartments will likely benefit from the lack of liquidity in the subprime market. This will be very regional, but could spell good news for places like North Scottsdale, and other prime Class A buildings / Locations, who lost a lot of renters to conversions and for-sale housing.

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.

Demand vs Supply Side

Just a quick thought, as we were analyzing the Tucson apartment market this morning, it brought on a quick thought. Demand vs Supply. Basic economics right? Even, the non-econ will tell you economics is about supply and demand (they're not correct, but I digress) for changing definitions, see this post from Mike Mandel at Economics Unbound.

Well I think in the apartment industry, the big boys (Equity, Archstone, etc) have focused too much on the supply side of the equation. Their mantra has been "supply constrained" markets, aka high barrier-to-entry markets, places where it is hard to add additional supply. The other focus of which only one big boy (Camden) uses, is demand side. In the supply restricted areas (which incidentally aren't all that restricted, see the multifamily permit boom in SF, Oakland, and LA-all popular supply-constrained markets).

The biggest problem for the supply constrained markets, is their inherent volatility. In a study that I did, we identified the most volatile markets from a rental rate perspective and calculated a beta for them. San Francisco, San Jose, Oakland, New York, Boston were the top-5. The interesting finding from all this research is two things. Supply constrained markets are generally more volatile, and definitely more sensitive to economic conditions. This means that appropriate discount rate applied to these markets should be higher because of the greater degree of risk. Current valuation practices do not take this factor into account. In fact, over time, the high growth regions have generally outperformed (using real $2005) the so-called supply constrained areas.

In conclusion, the supply side focus is trendy, but wrong-headed and will leave certain big guys in the apartment industry with a bad hangover in a downturn. Yield management will help mitigate some of this effect, but that won't avoid the storm. It leaves companies like Camden, well placed to outperform its peers.

2007

Outlook 2007

The Economy

Although 2006 started off with strong economically, the year finished on a lower note. In the first half of the year, GDP growth surged forwarded at a 4.1% annualized rate. Third quarter GDP growth slowed down to an annualized rate of 2.0% and it is likely that fourth quarter GDP growth will be similar, though slightly higher at 2.5% due a slowdown in personal consumption expenditures and an increase in the savings rate. We expect this trend to continue into the first half of 2007. Job growth will slow to an average gain of 125,000 jobs a month, from an average of 165,000 jobs gained a month in 2006. If credit conditions continue to normalize and don’t retract, as we expect, growth should recover in the second half due to an increase in net exports, a stabilization in the residential housing sector, and inventory rebuilding, which we predict will rebound after a decline inventories. Other key indicators such as demand for office space are also showing a slowdown after strong gains in the beginning of 2006. Equipment Leasing is still growing strongly year-over-year, but has shown some leveling off, which according to past data is a leading indicator of economic activity. Both of these statistics combined paint a picture of a slowdown in growth, and not an outright recession. Anecdotal evidence has suggested that small businesses especially, are having difficulty attracting and retaining talent. This is backed up by an increase in jobs posted online compared to the labor force. Higher demand for skilled labor will increase compensation in certain areas, and raise the overall skill level in the economy, which initially will lower productivity growth as we are seeing now, but will increase overall productivity growth, and by a matter of course, raise wages. Consequently the increase in income, and low unemployment will support growth in personal consumption expenditures.

Continued below-trend growth will contribute to an easing in pricing pressures. This trend is already evident, as the annual rate of inflation as measured by CPI has tailed off towards the end of 2006, from a high of 4.1% in June 2006, down to 2.0% in November. The less volatile “core” CPI, which excludes energy and food, fell from a high of a 2.9% annual gain in September 2006, to an annual gain of 2.6% in November. The acceleration in the rate of inflation that was propelled by energy prices seems to largely have subsided, lessening the pressure on the Federal Reserve to raise rates. If this deceleration continues, the Federal Reserve will be able to lower short-term rates as most observers expect them to.

Inflationary expectations, while still elevated from over comparable periods in 2005, have started to recede back to more comfortable levels.

Job growth will continue to be concentrated in service sectors jobs, with manufacturing employment falling slightly. Metropolitan areas with strong professional business sectors, and new household formation will continue to benefit, whereas slower growth metropolitan areas with strong base employment such as the San Jose-Santa Clara MSA, will continue to have a stratified labor market with strong gains at the very top end for skilled workers, but slow overall growth in employment and median income.

The Investment Climate

Low interest rates and a continuing improvement in average NOI moderated out the effect of a severe reduction in condo conversions. Low interest rates kept cap rates at a low level and improvements in NOI held pricing steady despite the absence of the aggressive bidding of the condo conversion buyers. Average seller cap rates fell slightly from 6.4% to 6.1% in 2006, despite a rise in equivalent bond rates from a 2005 average of 6.0% to a 2006 average of 6.5%. This indicates bullish investor sentiment for the future of multifamily properties. However, we believe that, pricing will stabilize in 2007. Gross yields and average cap rates will shift slightly higher, representing a broad stabilization of pricing in the market, as NOI expectations will shift slightly. We believe that operationally, the broad market hit a cyclical peak in expected rent per unit in the third quarter of 2006. Some markets, especially in the Midwest will experience favorable investment conditions, but slow in-migration will temper any gain in pricing power by owners. Given the expected trends, we expect the average yield per unit to increase slightly reflecting a leveling off of and possible decline in some markets in price per unit.

New apartment building starts will increase over their levels last year. Some previously planned for-sale projects will shift over into rentals due to strong rental traction and a slowing for-sale market. Also, rising construction costs, which had put a heavy damper on new apartment construction in many markets and had skewed new construction toward Class A product, have eased and will allow builders to pursue a wider variety of new construction projects. In addition, many properties that were set to be converted to condos, in fast rising markets like Phoenix, Las Vegas and Florida will revert back to rental properties. All of these factors will increase the available supply of apartment units.

In the longer term, a deepening of the available finance pool via CMBS debt, market indices and other financial tools, will lower the cost of capital, and allow investors greater flexibility in taking on risk. Financial innovation has deepened capital markets in other industries and will lead to lower lending rates, and hence better pricing.

Cap rates have fallen significantly since 2000, and part of this is a reflection of capital deepening, and partly due to an overall lower cost of capital throughout the economy. Fed Chairman Ben Bernanke has described this as a global savings glut, by which he means that global capital availability has increased faster than the available projects to invest in. Lower default rates, and sustained disinflation throughout the world, have also helped lower the cost of capital. We are projecting a slight rise in cap rates in 2007.

Apartment Operations

The slowdown in job growth will manifest itself in slowing household formation, and therefore a lower rate of absorption for apartments. We are forecasting that demand will fall about 30% in the major metropolitan areas that we track, from approximately 93,000 units in 2006, to around 63,000 units in 2007, the vacancy rate will increase 10 basis points to 5.5%. Construction in the major metropolitan areas will total 70,000 units in 2007, slightly exceeding the rate of demand. Overall, the level of concessions should rise slightly because of a slackening in demand. Uncertainty in the for-sale market is currently benefiting apartment operators. In the last half of 2007, we expect that the for-sale market will firm up, contributing to a slackening in demand for apartment units as mortgage rates remain at historically low levels. A general fall in for-sale housing prices via HOA concessions, payment of closing costs, and other non-price concessions, and even in some markets outright year-over-year price declines, will help raise the level of affordability. Some of the gains in affordability will be offset by stricter lending standards, particularly in the subprime market. Overall, though capital is abundant in the mortgage markets, which means that lending rates will remain low and demand should firm up.