Change Is A Coming: How Current Economic Conditions Should Affect Real Estate Investment

Many economist and market pundits are predicting a market downturn, beginning some time in 2019 or 2020. All of the indicators of an overheated boom seem to be present--increasing margin debt, decreasing dividends, stock market price inflation and increased levels of corporate debt. Essentially, low interest rates have made credit more accessible. As a result, businesses are using credit to buy back some of their outstanding stock. In response to the relative decrease in availability of stock, stock market prices are rising, increasing household wealth across the nation. Spurred on in part by technological development, the economy seems to be booming at present, but it is important to note that mechanism that is fueling this increase in wealth is debt.

Property Maintenance Laws and Lending

The fight against property blight is a battle that has been waged for many decades. Some areas of the nation, have struggled with abandoned properties and even abandoned neighborhoods since the shrinking of the nation’s industrial sector beginning in the 1970’s. Other areas became intimately acquainted with blight as a result of the wave of foreclosures that took place at the end of the first decade of the century. However it may have arrived, the real estate finance market is certainly now affected by the palpable concern of property blight and has had to adjust to attempts to mitigate its damaging effects. 

Why Worry About Blight?

To be clear, blight is a real issue that can lead to a number of undesirable effects. Abandoned properties that are poorly maintained cause safety issues. Poorly maintained building systems and structure will eventually fail at some point, causing unsafe buildings. Overgrown landscaping leads to health concerns. These health and safety concerns become a problem for neighboring properties, as neighbors must then focus on how to curb the spread of these issues onto their properties. More generally, well-maintained properties inspire a pride of ownership that carries over to neighboring property owners. The opposite is also true—abandoned and poorly maintained properties drain the neighborhood of pride of ownership and lead to less diligent maintenance throughout the neighborhood.

Monte Carlo Mortgages

In his book Mortgage Wars, former CFO of Fannie Mae, Timothy Howard explains how Fannie's realization that mortgages behave like bonds with embedded call options revolutionized its ability to value its portfolio and manage risk. Prior to this change in thinking, Fannie Mae's methods for reserving capital were consistently shown to be inadequate. Today, the valuation of mortgages and mortgage-related securities as bonds with embedded calls is nothing new.

A call option is a type of derivative, which conveys the right (but not the obligation) to purchase another financial instrument (the underlying asset) for a specified price (the strike price) at a specified time (the expiration date). Purchasing a call option offers the right to purchase the underlying asset and selling a call options impose the obligation of delivering the underlying asset at the strike price on the execution date.

Mortgages are freely refinanceable at any point. In this way, they function as bonds in which the payments from the homeowner serve as the coupon payment and the ability to refinance serves as a call option sold to the homeowner by the mortgage holder. Typically the refinance rates increase as interest rates decrease. Although mortgage prepayment penalties are included in mortgages to discourage refinancing, a large enough drop in interest rates can make refinancing worthwhile to a property owner in spite of the prepayment penalty. For mortgage and MBS investors, prepayments are undesirable. Given that most mortgage investors look to invest anywhere between 5 and 30 years, an early decline in interest rates can leave many investors with cash from prepayments that must be invested in a market offering lower interests rates. This undesirable situation is the double-edged sword of prepayment risk for mortgages.

Why Historical Beta Does Not Always Work For Real Estate

Real estate investment is typically viewed as an essential part of any balanced portfolio. Its immutable characteristics, such as its relatively long pricing cycles and its above average returns, cause real estate to be seen as a stable asset. On the other hand, due to its sensitivity to interest rates, its lack of liquidity at the property level and its longer periods appreciation, exposure to the real estate can also serve as an inflationary hedge. Although real estate exposure may be purchased for any number of reasons, the risk profile of real estate assets is of interest to most, if not all, real estate investors.

The ways in which the risk profile of real estate has been expressed vary from the informal to the highly computational. On the most informal end of the spectrum, owner-operators of property frequently concern themselves with the tax consequences and appreciation of the property, content to face changes in the market or externalities, as they come. On the opposite end of the spectrum are portfolio managers and fixed-income investors, who seek quantifiable means to express the volatility of real estate securities. One such attempt at quantifying the volatility of real estate and its related securities is through the use of real estate's historical beta.

From Property to Liens and Back

In light of my previous post on timing the market, I thought that I would follow up with a post on one type of investment strategy that takes advantage of the cyclical nature of real estate.

There are a number of ways to invest in real estate. From property acquisition to shorting housing starts to buying equity in a REIT, each type of investment in the real estate market comes with its own idiosyncrasies, which must be understood in order to ensure maximum profitability. Specialization in one category or subcategory is often expected and praised among real estate practitioners and investors. The various entry points into real estate, however, allow for diversification. Purchasing property, notes or securitized bonds provide direct access to the real estate market, while liens, nonperforming notes and real estate derivatives can serve to counteract real estate defaults, if properly purchased. Although, given the change in the regulatory climate for derivatives, real estate derivatives have become more theoretical than piratical.

Since the real estate market has some many points of entry, one can balance a real estate portfolio by investing in different asset classes, depending on the performance of the market at any given time. In this way, an investor can capitalize on the cyclical nature of real estate. One such way to diversify is to purchase property for appreciation and purchase liens and nonperforming notes as the market declines.

Buy Low, Sell High

I am always amazed at how the real estate market seems to demonstrate a certain level of fervor during the upswings and panic during the downturns. Although the magnitude and length of each particular cycle may vary, the cyclical nature of real estate is one of its fundamental traits.  Given the illiquidity of property, however, real estate cycles typically take place over a number of years. It has been my experience that an entire real estate cycle can last 5-10 years. Given this timeframe, there is usually sufficient opportunity to prepare to take advantage of the idiosyncrasies of each section of the real estate curve.

 The old stock market adage: "buy low, sell high" can serve as a strong guiding principal when creating a real estate strategy that will yield success throughout the real estate cycle. Almost contrite in its simplicity as it applies to equities, "buy low, sell high" is a great way to describe the recommended counter-cyclical behavior of a real estate investor. Buying low essentially means that purchases should be made in a down market and sales should be made in an up market. The challenge with counter-cyclical investment however, is that it goes against market conditions. Buying in a down market can be challenging, as that is when lenders tend to be wary of additional exposure to declining price and credit becomes scarce. It is, therefore, important to have capital available for purchases in down markets. Solid valuation is also key in a down market, as purchasing too early can result in acquiring an asset at a price point at which the asset will take a substantial amount of time to recover through appreciation. The fear of overpaying, however, should not paralyze investors into inaction, but should be seen as requiring a higher level of diligence and discipline. Opportunities are generally present in the down market, but must be scrutinized.