Real Estate Rentals and insurance thoughts from Jim on the FOOL.
He is heavily into rental property.
These are his two most recent posts.
The housing programs which got started in the late '90s, and then the steady drop in rates from the time of the market crash, had strained the rental industry, but not to the breaking point and, although vacancies had gone up, things were clearly turning around. Through the first part of 2001, the rental business improved steadily.
After 9/11, everything changed. I noticed the impact immediately - and I mean within days. The phone stopped ringing. No appointments to show apartments. No applications. No leases. It showed in a large trail-off of the business in the screening service as well; clearly the problem was at least regional.
Then the layoffs started to hit. Move outs due to loss of job, moving in with relatives. Vacancies shot up. Then more Fed rate cuts to stimulate the economy. More churn on the low end as mortgage rates fell and more people were suddenly able to qualify for a mortgage. Suddenly, the cyclical improvement we had been seeing was aborted, and we were taking another turn around the maypole as pressure on rents increased yet again.
But all of this was relatively superficial. There was a much bigger problem brewing below the surface, and this problem is just starting to surface. I first became aware of the problem less than four months ago - I would never have predicted it - and I am among the early ones affected, just because of where in the calendar my renewals fall.
Now, understand that I am starting to talk in an area where my knowledge is incomplete; much of what I have to say has been given to me by people in the industry and I am just repeating it. I am, though, seeing the effects "up close and personal."
The insurance industry is in big trouble, and this spells disaster for the real estate industry if it is not dealt with very soon. Evidently, the fall of the Twin Towers did enough damage, in aggregate, to wipe out part of the reinsurance industry.
When you purchase insurance, if the insurance carrier decides that their exposure is excessive, they will lay off part of their risk to a reinsurance firm, thereby spreading the risk. The reinsurance is relatively inexpensive since it only comes into play if the damage exceeds some relatively large threshold.
Well, the damage caused by the terrorist attacks evidently was substantial enough that - in the words of one agent I deal with - "several reinsurers were wiped out." I find this to be strange, but this is what he says.
Now, it is also true that insurance companies historically derive considerable portions of their income from their investment portfolios - which curiously enough often includes substantial positions in investment real estate (either directly or through mortgages). The stock market crash has pretty much eliminated that source of income.
Also, over the last several years, claims (mostly fires) from investment properties have been on the rise. Why this would be is out of scope for this post, but I for one am satisfied that this is probably true. The short version is that the average quality of tenant has declined over the last several years as the better tenants buy houses. Poorer quality tenants generally are less responsible in every aspect of their everyday lives, and...well...you do the math. Fire claims are going up.
Another agent I have been dealing with says "State Farm alone lost $600 million last year." Again, I have made no attempt to verify the statement; I just report what I was told.
The upshot is that insurance for investment properties is becoming extremely difficult to obtain at any price and, when it can be found, that price is unaffordable. TMFTom9 reported in his article today that I told him my insurance has gone up 100% on renewal. What he didn't report was that my old policy had $1,000 deductible, replacement cost coverage, with $2 Million liability and included coverage for my five truck, two car fleet. My new policy is up slightly more than 100%, has a five thousand deductible, $500K liability, no vehicle coverage, and coverage on properties that really doesn't meet their actual value although it does meet the mortgage values. Also, there is one property that so far I have been unable to purchase insurance for at any price.
Not only that, I am told it is going to get worse, possibly much worse.
To put it bluntly, I can't afford it. I should also point out that we have a very good risk history; we have two claims in the last twelve years (both fires) and our premiums paid have greatly exceeded the cost of the two claims combined (by a factor of about 5). Also, we have never been successfully sued, and keep good records.
The insurance industry is in trouble. They are hemhorraging money, and becoming very risk averse. Landlords are now being faced with the choice of buying insurance they can't afford and can't pass on as rent increases, or being either "force placed" by mortgage holders or foreclosed on for mortgage violation by those same mortgage holders.
You do the math. And according to all the agents I have spoken with, it is going to get "much worse before it gets better."
If this situation is not brought under control very quickly, the investment property industry will collapse. The industry has been under pressure starting in the late '90s with the new mortage programs. The pressure increased after the market crash as rates fell quickly, and then the recovery of 2001 was aborted by 9/11. And now, there is a massive cost shock just starting to work through the industry, at a time when much of the industry is short of cash and struggling with cash flow.
In my next post, I'll talk a bit about what I see as the implications of all of this.
======== Next post follows
I suppose it has been a bit over a year ago that I started thinking about deflation. I mean, look at it as it was then. Interest rates very low. No inflation. Stock market bubble popped, and effects still rippling through the system. And a recession in place. Well, deflation looked like a distinct possibility.
But, I said both to myself and to others - on this and other boards - it seems a manageable risk. If a deflationary round were to get started, it would practically have to start with the real estate market, and it was kind of hard to see how that might happen.
After all, one of the great attractions of real estate is that all markets are local. What happens in Piqua has no effect on Peoria. Heck, in the current marketplace, I have multifamily properties with 100% occupancy, while just a couple of miles away I have others that are below 50%. Occupancy is a very local phenomenon, usually.
So it might be that in Podunk the factory has closed, and as a consequence everyone has moved out of town and gone to Smallville, ten miles down the road, where a new factory has opened. Too bad for the real estate market in Podunk, but great for Smallville. And, when the average for the county is taken, there is no net effect because Smallville offset Podunk.
So, even with the recession and the vacancies that was engendering, even with these housing programs that are causing such grief, it seemed unlikely that widespread catastrophic deflation could get started. There might be some bubble busting, locally, in a lot of locales, but it would happen by fits and starts and relatively slowly as the rental market adjusted to a no-inflation low-rate environment. Consequently, the macro economic environment wouldn't be shocked and the overall impact would be moderate.
As recently as about six weeks ago, I posted on the CREOnline message board (www.creonline.com) that "I don't want to sound like a Cassandra; the risk of deflation seems to me to be greater now than it ever has been in my lifetime, but I think that risk is manageable and it doesn't seem likely that a serious round of deflation will get started." I have made similar sounding posts around TMF in the last six months or so.
Now, there have been occasions in the past where widespread real estate collapses have occurred, and usually the heavy hand of the Federal Gov't can be seen as precipitating it - such as happened when the various tax law changes led directly to the S&L collapse in '86. But it just didn't seem to me that this could happen again in '02.
But suddenly, this insurance problem has been surfacing like a submarine making a battle-surface, which is to say: very quickly and without warning. The shock wave is just starting to move through the system and, given the stress the multi-family market has been feeling, the shock will be severe. Suddenly, when I look at the risk of deflation, it seems very real and very imminent.
Again, all real estate markets are local. When I was actively purchasing, I made it a point to purchase in a geographically diverse fashion so that I was in several different markets. The idea of course was to not have all my real estate eggs in one marketplace basket. That idea has paid off; as I say, I do have 100% occupancy some places. But the overall market is weak enough that my system-wide occupancy isn't acceptable.
However, if I were to separate my system into neighborhoods and look at each one separately, I could say "this one can stand the insurance heat; this one is marginal; and this one won't make it." In fact, I am doing that - and it is driving my selling plans.
Just like that, around the country some areas will cry a bit but otherwise be unaffected, while other areas will go under. My fear is that the areas that will go under are too widespread for the economic health of the United States, since the underpinnings of the marketplace have been eroded by the Gov't housing programs as well as the usual business cycle effects.
If the collapse starts, it will snowball quickly. Weaker properties will appear on the market, and won't sell for enough to permit the owners to escape with a whole skin. Either that, or they won't sell at all, bankrupting the owners and causing banks to become landlords. This will happen in some regions quickly enough and extensively enough to collapse many regional and perhaps one or two national banks.
A national bank collapse will dry up credit overnight. The attempt to liquidate all these distressed properties will drive the prices down very quickly. Cash buyers will be able to step in for a song - if they dare - and fill the properties at very low rents, thus pressuring the local housing markets which will already be distressed by the credit crunch.
The whole thing will trigger layoffs and dislocations - hence more foreclosures, and the effects will spread nationwide very quickly. We then would most likely enter a depression.
Now, when the S&L crisis hit, Congress stepped up to the plate and funded a bailout. Key to that bailout was the health of the banking system, which made it possible to liquidate the damages with virtually no impact on the rest of the economy. But what happens if the banking system itself is what is ailing?
This insurance situation needs to be dealt with, and quickly. The shock is starting to move through the system. The system probably can't take it.
To put it in clear perspective, my insurance cost per unit per month used to be about $14. It is now $29 per unit per month, in one step, and I have a much greater exposure to risk than I used to have.
You do the math. |
