The “F” in FDIC…98 and counting

As you probably know, the FDIC is proposing that large banks pay the FDIC guarantee fee in advance for 3 years worth of insurance (through 2012).  This is not that surprising given the looming hole in the FDIC’s insurance reserve fund.  The agency is preparing for significantly more bank failures in the future and needs to replenish funding.  Here are some eye-opening stats from a report releases by Institutional Risk Analytics, a firm which specializes in providing research and analytics covering the banking sector to governments and institutional investors.

• IRA gives 2,254 banks an “F” rating based on their modeling of FDIC provided data on their banks
• These 2,254 “F” rated banks represent a 54% increase over the number of “F” rated banks a year ago and represent 27% of the banks that they cover in their analysis.
• Insured assets of these “F” rated banks total $4.46 trillion (yes, that’s a “t”)

Without going through their assumptions, the implications are that if only ½ of only the “F” rated banks fail, given the loss rates experienced during this cycle, the cost to the FDIC insurance fund to cover these failures could total $400-500 billion! How much is the FDIC’s reserve today?  About $10 billion.  This is a staggering hole to fill, but the FDIC does have the ability to draw upon their $100 billion line of credit with the Treasury and through 2010 will have access to funding totally $500 billion.  Still, the borrowing does have to be paid back, and depositors are, or will be, picking up the tab.  Whether “F” is for Failure or “F” stands for Funding, the FDIC will have plenty of both on their hands for the foreseeable future.  As of this past Friday, we’re up to 98 failures this year.  There’s a lot more to come.

Housing Realities: The long climb out of a deep hole

The closely followed Case-Shiller Index reports improving sales for the 3rd straight month, with national home prices improving 1.6% for from June to July for the 20 city index. For Chicago the improvement was 2.7%.  All this is positive news, but everything is relative. Prices on a national basis are down over 18% from a year ago. The price level puts us back to 2003 pricing levels. The biggest concern is whether these improvements have any sustainability, especially if the $8,000 first-time home buyer credit is not extended.

Unfortunately, housing has a tough road ahead. The reality is that there is a huge and growing shadow supply of available housing that is bound to flood the market. Adding these homes brings the stock of for sale housing to nearly 7 million units, which is about 2 years worth of stock. Here are some figures that should be considered before thinking that housing is out of the woods (courtesy of the WSJ)

• In July 1.2 million homes had just entered the foreclosure process
• This is in addition to 1.5 million homes that are in some stage of foreclosure with their lender
• There are another 217,000 homes for which the owners are over 1 year behind on mortgage payments, but the lender has yet to file a foreclosure suit

At some point this stock will hit the market.  This is why many well-respected economist see further home price deflation in the future.  Projections are anywhere from 10-20% decreases in value as real possibilities.

All this bodes rather poorly for multi-family rental owners as well, at least in the near term.  We learn from urban economics that rents and prices respond to vacancy rates.  In cities like Chicago which are burdened by a large and growing supply of condos that are waiting to get sold, landlords now realize that they are competing against all forms of available housing unit, whether or not they are listed for sale or for rent (the denial stage is over).  Until vacancy rates reach equilibrium, rents and housing prices will feel downward pressure across all housing assets.  Of course each submarket has nuances and different levels of new or vacant supply, but the numbers don’t paint a very pretty picture.  So while housing shows some positive signs of improvement which are certainly welcome, trying to now climb out of the housing hole will be a challenging task for both rental properties and the for sale market.  It’s as if we’ve stopped digging down and want desperately to climb out, only now the problem is that some of the dirt, comprised of overextended leverage, over zealous building, and inflated values, is starting to slide back into the hole and bury us.  Let’s hope that employment starts improving and that the first-time home buyer tax credit gets extended to help us out of this hole.

The last bidder always pays the most (stating the obvious)

I’ve started looking at foreclosure sales of single family and 2-4 unit rentals to see where the opportunities are.  It didn’t take long to realize that the auctions are bringing out the amateur investors in droves.  I think auctions are a great way to buy a home for yourself, but after touring my first pre-auction property and talking to some agents, it’s clear that people are over-paying for real estate as an investment when it gets to auction.  Most of the best properties get sold pre-auction, and you can expect to be outbid at auction by someone who doesn’t think about risk premiums the way you and I might.  The auctions are exciting and actually fun to just people watch, but I think a lot of bidders are underwriting hope rather than reality.  I’ve concluded that the best way to really buy an investment property right in the year ahead will be by focusing on knowing your market dead-on, working faster and harder at diligence than your competitors, and actively engaging the brokerage community which is dealing with these assets well ahead of them ever getting to an auction.  You’re still going to lose way more deals than you’ll win, but you won’t be bidding against a buyer who doesn’t understand what a cap rate is.  If you are a “friends and family” member of a bank, that’s another way to get a first look, but for the rest of us, call your broker.

Grasping for Green Shoots – One data point has never made a trend

I’d like to hear good news as much as anyone else, but I’m starting to hit the “delete” button much more often on the e-mails I’ve been receiving that suggest that commercial real estate has turned the corner, or that it soon will because of economic stabilization from “better than expected” unemployment figures or the anticipated effects of government stimulus programs like TALF and P-PIP.  No one wants to hear more bad news, but misleading propaganda insults my intelligence.  Yes, losing 216,000 jobs in August was the lowest monthly figure in a year.  But let’s but this in perspective.  18 months ago, this number would have been eye-popping and today the Labor Department reported job openings hit a record low in July, signaling employers are in no rush to hire workers again.  The unemployment rate is now up to 9.7% after dipping 0.1% to 9.4% in July.  Most economists expect this figure to breach 10% early next year.  And although the stock market has rebounded at record pace, the sustainability of earnings improvement are highly uncertain as inventory reduction, artificial stimuli from the government, and massive cost cutting by employers created inevitable statistical improvements over analysts’ projections, which by now have turned to an underestimation bias.

With respect to real estate, residential sales have been improving, but this too is far from a sustainable trend.  A backlog of over 1 million foreclosed homes have yet to hit the market and the slower selling season is approaching.  Banking expert Meredith Whitney today suggested that home prices could fall another 25% as unemployment continues to dampen demand for homes.  As she astutely suggests: “no banks underwrote home loans based on 10% unemployment projections”.  By extension, demand for commercial space and apartment rental demand has rarely been set upon a backdrop of this magnitude of unemployment.  While I believe we are approaching the peak of unemployment (10.5% is where I think it’s going to end), let’s not gloss over the fact that the lack of job creation, and hence consumer confidence and consumption will make this recovery a relatively long and challenging one for our industry.

Prepare for more opportunities in the year ahead

The bad news is that it’s tough out there for real estate investors of all types.  If you’re an apartment owner, you’re probably  happy you’re not facing the rent declines in the office or industrial sector.  If you’re in office/industrial, you can be glad you’re not invested in retail.  If you’re retail focused, be happy you’re not a hotel owner.  And if you’re in hotels, well, someone has to be on the bottom.  Virtually every investor I speak to is working harder than ever to keep their heads above water and to survive this tough environment.  Most investors expect conditions to worsen somewhat as higher than expected unemployment trickles through the economy and as the slow winter months set in.

The good news is that many investors are also looking for new opportunities to invest in real estate, and investment brokers in the non-institutional space are telling me that they are pretty busy.  Investors continue to cite the price gap that sellers (often banks) are willing to accept as the biggest barrier to getting deals done.  I’ve never met a real estate owner that didn’t think his/her property was worth more than it really is, so in a declining market this doesn’t surprise me at all.  But the mere fact that there are deals that are getting done is positive news.  Although the volume is a trickle, this is far better than the feedback earlier in the year when the market had zero direction at all.  My view is that this is just the beginning of a growing wave of deal opportunities that will find their way into the market in the months (probably years) ahead.  These deals will find a way to get done.  Delinquency statistics have been, and are continuing to rise for all investment property classes, and without job creation, space market fundamentals are having a very difficult time finding stability.  Consumers aren’t spending, renters are doubling up or living with their parents, companies need less space, global trade is still way down.  Simply put, there is too much pain and distress in the markets for opportunities not to avail themselves in the year ahead.  To say that it’s a challenging time to be a real estate investor is obvious.  But at the same time, continuing stress will force banks to make decisions about their distressed assets: either sell the note, modify the note, or force a sale of the property.  That there will be significant deal opportunities ahead is not a question of “if”, it’s simply a matter of when.

Welcome to my Blog

Welcome to Real Estate Interest.  This is my first blog, so it’s going to be learn as I go for a little while.  I hope you will feel free to comment on my posts and ask questions about topics within the focus of my blog: commercial real estate and the real estate lending world, that interest you.  I am by no means an expert on all things real estate or even the real estate debt markets, but I’ve been in the commercial real estate industry as an investment broker and as a mortgage broker and lender for the past 17 years.  I currently work in a real estate banking division for a major U.S. financial institution, and I speak with real estate investors, brokers, attorneys, appraisers and consultants on a daily basis.  I’m always gaining insights and hearing perspectives that I think are worth sharing.  Most of all, I also hope that this blog will enable me to connect with and gain feedback from people like you, who share my interest in real estate as an investment vehicle.  Enjoy and welcome again to Real Estate Interest.  This is an interesting time for real estate and I hope we can enjoy the ride together.