Real Estate in the Time of Pandemic

Photo by CDC

With our country beginning to find its way to a new normal at the end of months of quarantine, we in the real estate market are all left with one nagging question—What should we expect from here? 

Like most people, I do not have definitive answer. If you are over the age of thirteen, however, this pandemic is certainly not the first market disruption that you have experienced and with each such occurrence, we all learn some valuable lessons about the real estate industry. With that said, here are a couple of lessons that we can learn from this particular time of change: 

Social Justice Real Estate

I try my best on this blog to focus on the issues effecting the real estate market and offer a perspective uninfluenced by political factors. To the extent that social factors effect the real estate market, I am happy to address them, but I work diligently to ensure that this blog does not serve the dual purpose of promoting any particular political ideology. With that said, we are all contextual creatures and I, as an African-American male, cannot ignore the current outcry regarding police brutality against my fellow brothers and sisters.

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.

In the Weeds: How a Multidisciplinary Approach to Real Estate Can Lead to Increased Success

I once had a conversation with a coworker in which I expressed my frustration regarding the siloed view of real estate that many real estate professionals seem to employ as a matter of course. I complained that so few real estate professionals truly attempted to view real estate as a multifaceted asset and instead cared only to focus on their specialization within the industry. I wondered out loud how productive the industry could truly be if, in addition to their own professional perspectives, appraisers attempted to see the industry a little more like attorneys and attorneys tried to orient themselves to view the market like investors and investors like Relators, etc. 

My coworker listened politely until I was finished and wisely stated that the reason such cross-pollination of perspectives was not present in the real estate industry was that everyone was too “in the weeds” in their various roles and on their various projects to even attempt to take such a view. It was at that moment that I realized that I realized that my coworker had accurately described a condition that plagues much of the real estate industry—myopia. Indeed, many real estate professionals become so great at their specialization that cannot see the forest for trees or better yet, the weeds. 

My How Local Lending Has Changed!

Today's banks are unabashedly international businesses which thrive on providing services and taking advantage of opportunities throughout the world. Long gone are the days of the local Savings and Loan as the provider of the community's mortgage needs. Instead, behemoths of consolidations dominate today's lending scene, thriving off of large economies of scale that make any potentially smaller competitors shutter. This change in the role of banking in the community, although the largely the product of intentional moves by the banking industry and Congress, is not without its effects on the real estate industry, particularly the residential market.

In order to explain the effect of big banks on the residential real estate market, one must understand the role of local banks prior to the expansion and consolidation of banks that led to the current situation. Until the 1980's, US mortgage lending was dominated by small local banks and Savings and Loan Associations (S&L's), local banking entities that engaged in lending and offering savings deposit accounts. Initially, S&L's were heavily regulated and restricted from offering consumer loans and investing deposits in most of the investment vehicles available in the market. The Savings and Loan model relied on a favorable treatment by the Federal Reserve to allow for an increased spread between the rate charged on mortgage lending and the rate offered on deposit accounts. S&L's also frequently managed underwriting risk with local market knowledge.

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.

Same Mechanism, Different Crisis

I recently read William Seidman's book Full Faith and Credit, which contains a detailed explanation of the S&L crash of the early 1990's that was spurred on by a crash of the US commercial real estate market. William Seidman was head of the FDIC at the time of the crash. A day after I finished the book, I walked by my bookshelf and noticed the book Bull By Its Horns, by Shelia Bair, the chairman of the FDIC during the 2007/2008 financial crisis, when it hit me--both publications are the same book written nearly 20 years apart. Although each of the authors have their individual differences, they are both similar in that they were Republican chairmen (or is the term chairpeople?), serving during Republican presidencies, who presided over the fallout of a banking crisis that resulted in the largescale nationalization of private assets and companies.

The political affiliation of both former heads of the FDIC is tangential to my point, however, I mention it to make two observations. The first observation is that both Mr. Seidman and Ms. Bair are linked by political party. The second is that the economic climate forced them to participate in the goverment takeover of private companies and their assets, an idea that is antithetical to most Republican ideology.

Although one of the chief duties of the FDIC is to close failing institutions and liquidate their assets, under most normal economic circumstances, this duty of the FDIC is either carried out infrequently or confined to a certain sector of the market. Both the S&L crisis of early 1990's and the Great Recession of the late first decade 2000's, however, forced the FDIC and other government agencies to either take ownership an stake or fully national financial institutions in a large, systemic manner.

Residential Mortgage Backed Securities: How They're Supposed To Work

Residential Mortgage Backed Securities (RMBS) are the fuel that powers our country's mortgage market. Their role in mortgage lending is not complicated, despite the fact that accurately pricing them requires in-depth knowledge of stochastic processes, matrix math, as well as a solid understanding of partial differential equations. I recently found a great article on-line by American University's Peter Chinloy that explains the how RMBS functions and the many of the assumptions that undergird them.

The long and short of it is that RMBS expands the lending capacity of financial institutions by allowing them to sell the home loans that they originate to purchasers on the secondary market to other institutions, exchanging the cash flow from the loans for cash for their balance sheets. The purchasers of these loans then package them and create investment vehicles or conduits. Investors are then offered an opportunity to participate in the cash flows that comes from the payment of these loans through the purchase of bonds issued on behalf of a conduit. These bonds are categorized as RMBS. They offer the investor exposure to the returns and activity of the housing market without the idiosyncrasies of property ownership or the capital  and labor requirements of lending. Moreover, a great deal of investment grade RMBS is guaranteed and can be insured. Add in the historically low home loan default rates with the lower capital reserve requirements of for insurance companies holding RMBS and it seems like a solid investment.

By now, the story of RMBS and its function has been told in many different places since the beginning of the economic downturn, so I harbor no delusion that what I have written thus far is not already widely understood. Chinloy's article, though written 16 years ago, offers a refreshing explanation of the purpose of each component of the mortgage lending system. It also illustrates the mathematical assumptions of lending behavior, important variables and basic RMBS pricing that can be easily used in Excel.

Chinloy describes the differences in private and agency RMBS that were once key to residential loan securitization. Originally, GNMA or agency RMBS was the outlet for borrowers that had less capital or lower credit scores than was required of conventional loans. Loans that fell under the purview of GNMA, known as FHA, VA or FmHA loans, were not only insured by FHA, VA or FmHA, but they also had default premiums priced into the mortgage payment. GNMA assumed  that the lower access to credit and/or capital typical of the borrowers of these loans would sever to lessen the frequency of prepayment through early payoff or refinance. Prepayment is generally undesirable to the bond holders of RMBS products, because it lowers the interest rate carry of each prepaid mortgage, reducing the amount of cash flow from that note and thus reducing the cash flow to the bond holder. The insurance premiums built into the loans covered prepayment due to default and the entire system was guaranteed with government credit. The added risk of the borrowers of an agency loan was therefore offset by the government's guarantee and the bond holder was generally assured that loan prepayment would be low.

Conventional mortgages, on the other hand required higher down-payments and were typically given by borrowers that had more access to capital (let's remember the borrowers give mortgages and banks give loans). Prepayment risk is generally higher via early payoffs or refinances, especially as interest rates tended downward. Fannie Mae and Freddie Mac, the largest purchasers of conventional mortgages, insured all mortgage collateral and the payments on their RMBS issues, in order to reduce this risk. The money from this insurance was both built into the price of the RMBS, but was also guaranteed by both organizations' access to a $2.5 billion credit line from the government. Principal Mortgage Insurance (PMI) was also employed in cases where the borrower's loan-to-value, LTV, exceeded 80%, making the loan more of a risk for default. PMI, however, only covered the difference between market value and mortgage value.

One of the most ironic aspects of the article is its discussion of private RMBS securitization, which it describes as a highly risky and generally below investment grade for a number of reasons. We know that this view of private securitization was largely ignored during the real estate bubble and that not only did private RMBS overtake the RMBS market, but also the resultant demand for mortgage notes led to the replacement of PMI. This practice traded insurance for increased exposure to risk from the same asset. Understanding the function of PMI, default rates and down payment requirements from the perspective of RMBS issuances, allows one to see why the once widespread practice of "piggyback loans" and "no money down" financing was a recipe for disaster. Not only did such lending practices dilute the relationship of the borrower to the property, making default much more likely, but they also eroded many of the insurance fail-safes of the private home mortgage lending system that insured the private RMBS payments to the investors in case of default. Additionally, piggyback loans, created two instances of default for a property instead of one, doubling the effect of default of each similarly financed property on the secondary market and on the related securities markets.

I could write a book about my reaction to Chinloy's article. I particularly like his analysis of mortgage payments and defaults as options, which lends borrowing behavior to derivative analysis. I also appreciate his in-depth explanation of forward and backward solving models for pricing RMBS. I am not sure which one I prefer, but I must say that I am somewhat partial to the type of analysis that the backward solving model employs. Though both types of models are useful tools, forward solving models are inherently more optimistic.  There is also a key point made on page 19 of the article regarding Fannie Mae's finding that properties with more than 10% negative equity have a high likelihood of default. Chinloy's mention of the lack of accounting for borrower liquidity in most RMBS pricing models is also noteworthy.

I do want to point out that some of the references in this article are dated. Due to mortgage acceleration clauses, new FHA, VA and FmHA mortgages are no longer assumable, therefore all of the sections about the assumablity of mortgages and selling the mortgage with the house are no longer relevant. It is also clear that Chinloy had no indication of the explosion of private and conventional loan and RMBS origination that would begin to take place just 3 or 4 years after the writing of his article and thus some of his predictions seem disconnected with what actually transpired in the real estate and securities markets. Chinloy, however, offers a cogent overview of the system of RMBS issuance that existed up until the late 1990's. It is clear that had this system been more clearly understood and followed by lenders, investment banks, investors and RMBS originators much of the calamity that recently befell our financial system could have either been predicted or avoided.

Capitalization Rates: Prespective on Their True Meaning

Cap rates are one of the most referenced metrics in all of commercial real estate. Unfortunately, they are also one of the most misunderstood metrics in our industry. I genuinely believe that this misunderstanding comes from the diversity of significant players in commercial real estate. Unlike the equities and debt markets, commercial real estate does not require the presence of a financial institution to mitigate the flow of information and to establish standard practices. Moreover, the equities markets are heavily regulated to insure honesty, transparency and equality of information. The debt markets, though not transparent, however, are generally restricted to institutional investors and high net worth individuals. Commercial real estate sales and acquisitions have no such regulations or restrictions and therefore do not require knowledge of the real estate metrics and their related mathematics to effectively transact. Many commercial property owners purchase properties based on simplified formulas, local knowledge of the property, purchasing rituals or merely "gut feelings." The presence of such transaction activity lends to frequent misuse of real estate metrics.

Despite the misunderstanding of real estate mathematics amongst a certain sector of the real estate market, savvy real estate purchasers, appraisers, institutional buyers and real estate analyst are typically comfortable with the metrics used to describe property performance. The Capitalization Rate or cap rate of a property is one such metric that can offer a wealth of information about the performance of a property and the market assumptions of the seller.

The cap rate expresses the annual rate of return of a property's net operating income given its market value or purchase price. Since debt service, income and expense escalations, and tax considerations, it is not the most reliable method of determining annual return. If properly calculated, however, the cap rate can be compared with a metric of opportunity costs, such as the Weighted Average Cost of Capital from the world of equities to determine the desirability of the property given alternative investments.

I recently found a paper written for the Journal of Real Estate Research that explains the components of cap rate. It explains that cap rates are significantly influenced by the debt and equities markets, but contain significant time lags, given the illiquidity of real estate. The paper asserts that there are 4 components to a cap rate: the risk free rate (here measured by 3 month treasuries, usually measured by the rate of 30 yr. treasuries); a component composed of the market cost of debt divided by the property value (let's call it the property's market LTV) and the spread of a BAA rated bond (lowest possible investment grade); a component comprised of the 1 minus the property's market LTV, the equity spread (as measured by the performance of the S&P 500) and a volatility coefficient beta for stocks (measured by the covariance between real estate equity returns and market returns, divided by the variance of market returns); finally, the negative of the growth rate.

Cap rates are also typically expressed as the discount rate less the property growth rate. Following this logic, one can collapse all of the above components of the cap rate, except for the growth rate negative, into the cap rate's given discount rate. Therefore, given a cap rate, one can look up the risk free rate, the market cost of debt, the BAA bond spread, the equity spread and the equity volatility beta and find the growth rate of the property assumed. All of the aforementioned components are regularly published.

Knowing the assumed growth rate of a property allows for a deeper understanding of how that property is priced and how it is expected to perform. It also explains the inverse relationship between cap rate and price, as a larger cap rate assumes more negative growth or appreciation, as it is called in real estate.

One caveat to both this discussion and the paper referenced is that I am not convinced that cap rates are significantly influenced by the changes in the equities market, although equities are an appropriate asset by which opportunity costs can be measured. The influence of both property REIT's and mortgage REIT's as well as the proximity of the stock market's historical returns (hovering around 8.5%) to historical cap rates (around 7.6%) all make the case that the equities market has some influence on cap rates. Given real estate's local nature and the idiosyncrasies of each property type, however, it is difficult to believe that the link between cap rates and equities can remain significant in the face of more influential determinants of the property's value. I prefer to think of the equities portion of the equation as open to be replaced by whatever alternative investment is feasible to the purchaser at the time the cap rate is figured, accompanied by its related volatility beta.