Not so fast:
Modigliani-Miller applied to the housing market:
seekingalpha.com
Faux Demand for Foreclosed Homes
The Wall Street Journal’s “Investors Pounce on Distressed Homes” implies that when 38% of April single family home sales in Phoenix were all cash, as was 67% in Punta Gorda, FL and 39% in Las Vegas, investors must be controlling the market. At the same time Barclays Capital estimates that foreclosed inventory won’t peak until mid to late 2010 at roughly 1.3M units, investors are currently outbidding end users on the approximately 765.5K foreclosures currently in inventory. When this investor owned inventory returns to the market, end user demand will truly be tested.
The Journal cites Hudson-Cross Financial, Gorilla Capital and smaller funds with $6M to $30M to invest in single family homes at prices difficult to resist. These big time speculators are managed by alumni from major firms such as Deutsche Bank (DB), Morgan Stanley (MS) and D.R. Horton (DHI). Banks find them attractive REO customers because they make all cash offers for homes in bulk (10 to 200 units). After the purchases, the funds then hope to finance up to 50% of their purchases to keep the ball rolling.
The speculators expect a small positive rental return until the housing market improves and they can sell their inventory at a profit. This story sounds similar to the "Big Time Buying in Foreclosed Single Family Homes" article I wrote about Silver Portal’s ventures in the San Diego area. I did not think that a large fund could find the profit in single family home rentals the way experienced mom and pop operators have.
The numbers did not seem to add up, but Silver Portal’s Managing Principal Burland East emailed me to vigorously disagree with my assumptions on occupancy rates, taxes, maintenance and operating expenses. East claimed rents of $1900 per month were factual, a 98.5% lease rate in the San Diego area single home market, an estimated net yield on rentals of 8.8%, and a projected IRR at sale in 5 years of 25% to 30% with 50% leverage. East expects “that prices will not recover in 5 years, they will get back about half the loss since 2005.”
To be fair, The Wall Street Journal’s “Plying the Foreclosure Market” reported that East was looking for moderately priced homes in desirable neighborhoods, so he had a reasonable chance at achieving appreciation success. But in a second email to me East said I should not base my modeling assumptions simply on a newspaper report.
I do not dispute East’s corrections to my previous article for his market, but in general I still do not see how a financial firm can efficiently manage discrete single family rentals. I believe most of these funds will be operating cash flow negative without even considering the value of the money. In order to hope to break even on rentals, their purchases would have to be in the neighborhoods least likely to appreciate quickly.
In property selection, the criterion for a profitable rental is far different than the criteria for strong appreciation. California’s overbuilt far east bay communities are not the equivalent of the San Francisco peninsula or the Silicon Valley. Some neighborhoods are unlikely to ever appreciate back to boom levels.
Now all the TV pontiffs, including CNBC’s financial comic Jim Cramer are citing the bottom of the housing market. They claim the increase in foreclosures and other distressed transactions is leading to price discovery and great opportunities for first time home buyers. I disagree. The anecdotal evidence that I see in southeast Florida is that any properties in stronger hands are holding out, and distress sales reflect marginal or less desirable neighborhoods.
The press likes to talk about the two extremes, multimillion dollar mansions dropping 30% or more and way out xburbs like California’s central valley homes losing more than half their value. But the stable middle class suburbs have yet to capitulate.
With the Fed flooding the mortgage market with liquidity, artificially low interest rates are creating artificial affordability. But what the Journal is telling us is that this affordability is stuck in refinancing, not contributing to the end user purchases of homes.
The efforts of these single family home investment funds are equivalent to rearranging the deck chairs on the Titanic.
Price discovery won’t be achieved until the majority of single home buyers actually plan to live in the purchases. |
