in the wake of the subprime debacle, investors rethink the ways they are investing in real estate.
The subprime mortgage meltdown was long in coming but sudden in its impact, sending shivers through the global financial markets and causing fears of a possible U.S. recession. In the midst of an unprecedented boom in the global economy, the domestic housing market could potentially experience its biggest bust in 70 years.
In an August report, Standard & Poor's chief economist David Wyss said that losses and foreclosures aren't likely to peak till early 2009. During the housing recession of 1991-92, home prices fell 6.5% from peak to trough, according to the Standard & Poor's/Case-Shiller index. Wyss expects the current cycle to be even worse because of the 106% run-up in home prices from 2000 through mid-2006. Economists at Goldman Sachs & Co. predict housing prices will decline 7% both this year and in 2008.
It's clear that the subprime meltdown won't be confined to just the subprime market, as many, including Federal Reserve Board Chairman Ben Bernanke, predicted last spring. Now the question is where and when the roller-coaster stops. Housing default rates are climbing as home prices are falling; bad loans have spooked the credit markets and forced the Federal Reserve and central bankers elsewhere to intervene in order to keep the credit spigot flowing; and the equity and bond markets have taken investors on a loop-the-loop ride that has tested their mettle.
By September the credit market showed signs of stabilizing, and hope reigned that the Fed and the Bush Administration would take action to bolster the housing market and the economy as a whole. By some measures, the U.S. economy-and certainly the global economy-remains sound. But many forecasters don't see the housing market rebounding anytime soon. "I think people who expect housing to turn around in the next two or three quarters will be really disappointed," says Stephen Wood, portfolio strategist at Russell Investment Group.
Trouble signs were evident in 2006 as subprime mortgage foreclosures rose and the value of the underlying loans came into question. Lax lending standards that enabled borrowers with less-than-stellar finances to buy homes came back to haunt the industry when rising interest rates and falling property values caused a spike in defaults among these homeowners. Scores of lenders closed shop, filed for bankruptcy or ceased making home loans.
The subsequent spillover from the subprime meltdown caused a crisis of confidence throughout the credit market. "The current volatility is due to uncertainty caused by the securitization of subprime debt that's been chopped into little pieces, repackaged and distributed throughout the world, says Wood. "From a global financial perspective, subprime is the contagion theory, and what's happening in commercial paper, or the money market, is that people are wondering who's got what. Since nobody knows to what degree or how leveraged they are, banks are holding on to cash as a reserve to cover potential problems down the road."
The uncertainty has taken the stock and bond markets on a wild ride since mid-July. For equities in particular, the volatility has been far more dramatic than the peak-to-trough decline-at least so far. "These swings mean that the market doesn't have a good feel or understanding of the situation," says Wood. In addition, given their superior liquidity, stock market corrections tend to be much sharper and quicker than real estate contractions.
The notion promulgated by everyone from Ben Bernanke to Ben Stein that the subprime debacle would be a localized event is turning out to be a huge miscalculation. While many expected subprime problems to spill over into the broader real estate market, practically no one expected it to roil financial markets from Germany to Australia to Brazil.
"The key point that people have to understand is that housing touches a wide range of industries," says Joel Naroff, chief economist at New Jersey-based Commerce Bank and president of his own economic advisory firm. "In a macro sense, the housing market has tentacles into a large chunk of the economy."
Housing slowdowns impact not only home builders and construction materials companies, but also plumbers, electricians, painters and others involved with new home construction. They also crimp sales of appliances, furniture and carpeting.
Most importantly, they influence consumer psychology, which affects consumer spending that accounts for 70% of the economy. "It doesn't stop there, because a lot of people borrow off of their homes," says Naroff. "People who are selling and have borrowed a lot of money from their home might not get the price to match their outstanding mortgage." In some cases, people who refinanced homes with declining value have borrowed the entire value and owe more on it than it's really worth.
Furthermore, city governments reap permit fees from new construction, and state and local governments rake in more money from appreciating real estate, so governments can suffer revenue shortfalls when housing tanks. "It's a gloomy picture," says Naroff, who wonders if his forecast for a housing turnaround by next summer is too optimistic.
The sharp rise in home prices was a worldwide phenomenon spurred by low interest rates, wrote Wyss, and the large inventory of unsold homes is likely to delay any recovery in building activity. On the bright side, Wyss wrote that higher hotel and office occupancy rates have led to a surge in construction in those two sectors.
S&P, along with fellow credit-ratings companies Moody's Investors Service and Fitch Ratings, are under fire for giving overly favorable ratings to mortgage-backed financial instruments and for being slow to downgrade them.
The Roof Is Falling
The National Association of Realtors reported that the median price of a home sold in July slumped to $230,200, a drop of 0.6% from the prior July, marking a record 12 straight months of declining home prices. July also marked the fifth consecutive month of declining home sales, with sales down 9% from the year before. The association has revised its sales forecast downward seven times this year, and it expects that tighter credit for mortgages will postpone an expected recovery in existing-home sales until 2008.
.S. home prices, as tracked by the S&P/Case-Shiller quarterly index, sank 3.2% in the second quarter, the worst decline since Standard & Poor's began its nationwide housing index in 1987.
And RealtyTrac reported that foreclosure filings leaped 9% in July from the prior month and zoomed 93% from July of last year. Forty-three states had year-over-year increases, with Georgia, Michigan, California, Florida and Ohio making up more than half of the national foreclosure total. The Mortgage Bankers Association reports that non-owner occupied homes are a major driver in rising default rates.
Things got so bad during the summer that a survey conducted by the National Association for Business Economics (NABE) found that subprime and other credit problems topped the list of the most important near-term risks to the U.S. economy. These issues never even appeared in the four prior semiannual surveys of NABE members, where terrorism and energy prices were usually the top two concerns.
But not everyone is caught up in the negative hype. Bedda D'Angelo, president of Fiduciary Solutions in Durham, N.C., says that during the heat of the subprime-related crisis this summer she had clients who had no trouble selling homes or refinancing. She adds that none of her clients own hedge funds that own mortgage derivatives nor do they have exposure to domestic or international real estate investment trusts (REITs) that have taken a hit.
"Subprime mortgages represent only about 13% of the total mortgage market," she says. "And [only] $67 billion of the $1.3 trillion [amount of subprime mortgages] is in foreclosure. Basically, this is a non-event for the average consumer, except for the fact of irrational volatility in the capital markets worldwide, which affects 401(k) holdings."
Try telling that to advisor Chris Zehnder, whose client base is chock full of realtors or people in real estate-related fields such as mortgage and title companies. "It's a bloodbath down here right now," says Zehnder, a CFP in St. Cloud, Fla. "Some of my clients are suffering badly."
After doing midyear tax planning with his clients, Zehnder projected that a lot of his real estate industry people will make 40% to 50% less than last year, which wasn't a great year to begin with. Zehnder, based near Orlando, says it's a buyers' market in Central Florida, with lenders short-selling properties by taking less than what they have on the mortgages just to get them off their books.
That's a big change from the boom times. "In our practice we tell people to focus risk on the things they know," he says. "For real estate people, there is a nice marriage between real estate and investments because they can leverage what they know."
Zehnder's asset allocation model calls for most clients to have roughly one-third of their net worth in real estate. He'll bump that up to 40% to 60% for clients in the real estate industry; the highest range applies to those with sufficient reserves to pay the mortgage if a property doesn't sell. But some of his clients got way out there. "It's our job as advisors to tell them when they're pushing the envelope," he says. "But it's hard when you're in a hot market where people are turning over properties and making large profits because they adopt a gambler's mentality."
After everything hit the fan, some of Zehnder's clients are stuck with properties they can't sell. And the current surplus of rentals means they can't get as much by renting them. Zehnder advises realtors to save about 20% of commissions-depending on their tax bracket-as a reserve. But some realtor clients haven't sold a property in months and are depleting reserves and whittling away their savings.
Zehnder says he's now in phase two for some of them, which means looking at other revenue sources and possibly dipping into their Roths for emergency funds. "I get a call a week from someone who needs to take money out of their retirement plans to survive," he says. "It's kind of a scary time for some of them."
Clients Sniff Bargains
During the boom days on the Florida Panhandle coast, it wasn't uncommon to put down $10,000 on a condo or piece of land and flip it at closing for $100,000 or more in a short amount of time, says Buz Livingston, a certified financial planner in Santa Rosa Beach, Fla. "We'll probably never see that type of frenzy again in our lifetime, or at least for a very long time."
Livingston recalls meeting with one prospective client who was making a killing in the real estate market along the Gulf Coast by flipping properties like they were burgers. Livingston imparted words of caution to the man, such as the notion that real estate is traditionally an illiquid asset. "The prospect said, 'You don't understand, things are different,' and he walked out and I never saw him again," he says.
Some of Livingston's clients earned nice profits playing Florida's real estate market, but many now are stuck with properties that are worth less than what they paid. "I ask them do they want to continue to make the payments or do they want to sell at a loss," he says. "That's a difficult conversation."
Livingston is a member of the Garrett Planning Network. Most of his clients are middle-market folks, and many have the bulk of their wealth tied up in land. He says most have enough income to service the debt on the properties they bought, but he's concerned that some might be spending their retirement income to pay for the real estate. He shows them how much it costs them to hold onto the property, and that they can invest that money in other things rather than just giving it to the bank.
"It's a matter of walking them through the process," says Livingston. "Prices were greatly inflated, but the current price might just be the real price and it might be the price to sell it. Some can afford to hold on longer depending on their purchase price. Depending where they bought it, some will come out ahead while others won't get back what they put into it."
John D. Smith, a CFP licensee with Balasa Dinverno & Foltz in Itasca, Ill., says that with the possible exception of people who plan to sell a property in the near future, most of his clients aren't overly worried about the current real estate market. In fact, some of them see current conditions as a buying opportunity. "We're not advising them to do that," he says.
Smith says it's not uncommon for some of his high-net-worth clients to have 30% to 50% of their wealth tied up in real estate. He questions the need for them to go bargain house hunting when they already have sizable real estate assets, and he asks them if they want to take on the risk that comes with trying to hit a home run on a real estate deal. "The answer typically is no," he says, "because the risk/reward trade-off isn't there. There's no guarantee that real estate will rebound."
Bobbie Munroe is more bullish about real estate investing. "I made a lot of money on real estate in Atlanta and on the Florida Panhandle coast," says Munroe, a CFP designee and owner of Fraser Financial in Atlanta. And she believes there are still pockets of opportunity in real estate for people willing to do their homework and not overpay.
"It depends on the person and their circumstances as to whether or not real estate makes sense," says Munroe, "but you have to buy in an area and at a time when no one wants it." Munroe says that some of her clients have done well with property in northern Georgia, and she says that it's possible to buy 40 acres in central Alabama for roughly $80,000. She believes that the southeast will continue to attract retiring baby boomers because of the inexpensive cost of living.
Back Up The Truck?
The recent turmoil in the stock and bond markets created seeming buying opportunities among distressed securities, but some people aren't ready to rush in.
Diane Pearson, a CFP at Legend Financial Advisors in Pittsburgh, says the firm's in-house stock portfolio is sitting on a lot of cash and that they're in no hurry to buy until they see quality opportunities. "We're not ready to jump back yet into the U.S. market because we think that subprime issues will continue, at minimum, for the next 24 months," says Pearson.
She says that current mortgage-related troubles are tied to the conversion of three-year adjustable-rate mortgages from their lower, three-year fixed-rate period into their adjustable phase at higher rates, and that there's still another two years to deal with the potential fallout from the equally popular five-year ARMs as they convert into higher fixed rates.
Legend has positions in long-short funds, and Pearson says the firm's investment in the Van Eck Global Hard Assets commodities-related fund has held up well. She says Legend dumped all of its U.S. REIT funds earlier this year after a significant run-up and shifted its REIT exposure to the Cohen & Steers International Realty fund.
Smith at Balasa Dinverno & Foltz says he was never a big REIT fan but that he has recently put some client money into international REITs because several countries have changed their tax laws to allow for the REIT structure. "We think there's a lot of emerging opportunities overseas where they haven't experienced a big run-up in real estate prices," says Smith. He uses the Dimensional Fund Advisors International Real Estate Securities fund in tax-qualified accounts and the SPDR DJ Wilshire International Real Estate ETF from State Street Global Advisors in taxable accounts.
The REIT structure has existed for a while in North America, Australia and Belgium, but it has proliferated in recent years to include Japan, Hong Kong, Singapore, South Korea, Taiwan and France. Newcomers this year include Italy, Germany and Great Britain.
REITs are taking it on the chin in 2007 after a seven-year bull run led to profit taking in the face of excessive valuations and lower yields. The Dow Jones U.S. REIT index was down 10.23% through Aug. 31 (including dividends, the total return loss was 8.23%). The Dow Jones Global REIT index was negative 6.41% on a price basis, minus 4.00% on a total return basis. The iShares FTSE NAREIT Mortgage REIT ETF sank nearly 40% from its May launch through August 31.
The U.S. housing turmoil hasn't aided the REITs' cause, either. But there's a distinction between residential and commercial REITs. The former doesn't invest in homebuilders; rather, they invest in companies that manage properties such as apartments. The latter invest in office properties, shopping malls and the like that have nothing to do with the housing market.
"The subprime issue affects the cost of capital for every asset class," says Scott Crowe, a global research strategist and portfolio manager for Cohen & Steers' international REIT portfolios. "It affects commercial real estate perhaps disproportionately more than other types of assets because it's a fairly credit-intensive asset class. Interest payments are normally the biggest cost of owning commercial real estate, so there's an indirect market linkage" with the subprime mess.
But Crowe says the link is overstated, and that the recent downturn in commercial REITs creates some compelling valuations. He says the international commercial market trades at about a 10% discount to underlying net asset value; the U.S. commercial REIT market trades at a 20% discount. "That's excessively pessimistic," says Crowe. "The U.S. now looks relatively cheap."
Crowe's favorite international plays right now are Great Britain and Hong Kong. Britain has solid fundamentals and trades at a 20% discount to NAV. Hong Kong's discount is smaller, but Crowe says it's at a much earlier stage in the real estate cycle and has solid growth and accelerating fundamentals. And he's increasing the U.S. weighting in his portfolios to scoop up some unfairly punished shares. "The inefficiencies are good news because that's where you can make some money," says Crowe.
On the fixed-income side, the ripple effects from the subprime meltdown-and the ensuing credit crunch that has slowed down the private equity buyout binge-has created potentially good buying opportunities among BBB-rated corporate bonds, says Dan Shackelford, portfolio manager at the T. Rowe Price New Income fund. He shied away from this space during the leveraged buyout craze because LBOs are generally bad for the bondholders of the acquired companies; instead, he opted for Treasuries or higher-quality AA-rated banks and financials less likely to experience an LBO. The latter plays are on shakier ground after the subprime sector imploded, so he thinks the lower-quality names now might be better bets.
"These are consistent BBB- or low A-rated companies versus the AA-rated companies that are exposed to the uncertainties of the financial sector," says Shackelford. His favorite sectors include general industrial companies, as well as utilities and the media, cable and wireless industries.
Stephen Wood, the Russell portfolio strategist, says now isn't the time to make radical changes in one's portfolio. "History is very unkind to people who make portfolio changes in times of stress," he says. "People should've known ahead of time what they'd do in a market like this because this is a conversation they should've had with their advisor one to three years ago."
On the whole, Wood advises against investing in financials because of too many unknowns in that sector related to possible exposure to bad subprime loans. But he is overweight in oil services, slightly overweight in tech, and he likes certain luxury brand names such as Tiffany & Co. and Coach. He still believes in the global growth story in Asia and emerging markets, as well as in globally diversified U.S. companies such as Caterpillar, Deere & Co. and Boeing.
In the end, subprime mortgages and the use of leverage as a financing tool have helped thousands of people become homeowners even as these trends accelerated greed and poor decision-making among many lenders and borrowers. The overall housing market is chastened-for now.
Buz Livingston, the Florida-based CFP, believes the old-fashioned approach to real estate works best for most of his clients. "Grandma and granddaddy had the right idea," he says. "Put down 20% and try to get a 30-year mortgage. If you move, take the profit and pay down on the house so that you don't have a mortgage when you retire."
He wonders how all of these new products and refinancing deals out there will impact people's ability to retire. "My clients who can count on a solid retirement have paid off their home," he continues. "Some consider that wasted equity that could be invested elsewhere, and that's probably true for those with enough income to keep all of their balls in the air. But I think that having something paid for creates a better mindset for retirement."
By Even Simonoff
Just how powerful-or how flimsy-is the vast network of economic interconnections traversing between Wall Street and Main Street? If the answer to that vexing question were clear, market volatility would revert from its recent extremes to some semblance of normalcy.
The next few months should provide sufficient economic information to gauge that question. So far, the recent unpleasantness has disturbed Wall Street, where most folks are bracing for their own recession, far more than anyplace except the subprime corner of Main Street.
Dare it be said, but many things seem very different this time. Asset bubble cycles, extended by innovations in leverage, are displacing inventory reversals as the leading cause of recessions. Right now, non-housing inventory levels are much lower than they were in either 1990 or 2000, when excess supplies of technology were bursting out of warehouses. Both these recessions were mild by historical standards.
And if the only clear indication of a change in economic direction that has surfaced since July19 was the August unemployment figures, it's worth remembering that one month's number is often a statistical blip and that prior to July 19, conventional global market wisdom was increasingly convinced of a Fed rate hike in reaction to the accelerating global boom. Since then, the speedy transition from expansionary, euphoric credit market conditions to the recent state of catatonic paralysis has been jolting and virtually unprecedented.
Contradictions are ubiquitous, whether it's between the convulsions in the credit markets and the modest decline in equities, or the hysteria on Wall Street and the normalcy elsewhere, or the juxtaposition between America's position in past financial crises as a problem solver and its new, uncomfortable position as the source of contagion. Kurt Wolfgruber, president and chief investment officer at OppenheimerFunds, wonders to what degree the strength in Asia and other developing nations will help pull us through this.
Since July 19, only four of the 35 markets tracked by economist Ed Yardeni are up, including China, Hong Kong and India. "How much does the U.S. matter to the world economy?" asks Yardeni, in a recent briefing. "Fortunately, it matters less. Fortunately for the U.S. economy, the global economy matters more. In other words, the U.S. housing recession and credit market woes are less likely to derail the global economic boom than in the past."
America's declining economic power also goes a long way toward explaining the game of chicken that Fed Chairman Ben Bernanke is playing with the bawling hedge fund pooh-bahs howling for lower interest rates and longing for a return to the days when Bernanke's predecessor, Alan Greenspan, would bail them out. Unfortunately, the weak U.S. dollar gives Bernanke-who is wary of bailing banks, speculators and homebuyers out of mistakes that displayed reckless and collective stupidity-much less flexibility than Greenspan had. Nor is it clear that lower interest rates will solve liquidity crunch issues or ease problems in other critical areas like commercial paper and LIBOR (the London interbank-offered rate), which have taken on lives of their own.
As of this writing on September 12, the odds of a recession are rising, and if falling housing prices cause consumer spending to roll over, those odds could climb above the current 30%-to-40% betting line that most bookies (oops, economists) are proffering. So a recalcitrant Bernanke probably has little choice but to cut rates, even though his Bank Of England counterpart, Mervyn King, has issued a warning that such moves will only encourage future reckless behavior. "The August unemployment report gave Bernanke the cover to lower rates," says Michael Cuggina, manager of Permanent Portfolio, explaining that the Fed can now justify a rate cut as a soft-landing precaution, not a Greenspanesque Wall Street bailout.
Whether the lower rates can help ease the unwinding of excess leverage in the financial system isn't clear, but it can't hurt. And even after two months of deleveraging, speculative debt remains higher than in past financial crises. David Albrycht, senior managing director at Phoenix Investment Partners, estimates the amount of leverage in all investment vehicles has fallen from 28% to the 22%-to-23% area since mid-July. That's still much higher than 8% during the Orange County bankruptcy in 1995 or the 12% level when Long Term Capital Management went bust in 1998.
In so many past financial crises, the equity market has led the other markets down the waterfall. This time stocks have been followers, and pretty tepid ones at that. A few major indexes experienced 10% declines, but only for an intraday nanosecond.
It ain't over until it's over, but so far equities don't want to go down. If commercial paper and other debt markets respond well to lower interest rates, some like Yardeni, who still believes the greatest global economic boom in history hasn't ended, postulate that "a positive wealth effect from stocks" could partially offset the negative wealth effect from housing.
Some even go so far as to say equities entered September at their cheapest levels in 12 years. Defining what earnings are in today's accounting world is a random process, though Wolfgruber at OppenheimerFunds, says a market multiple of 14.5 times earnings, albeit peak-cycle earnings, may not be far off the mark. "I'm not a bear, but I do think we've changed the dynamic of the market through the shift to absolute-return investing," he says, referring to a strategy embraced by many hedge funds.
On many days this year, three hedge funds or hedge fund-like institutions-AQR Capital Management, Renaissance Capital and Goldman Sachs-have accounted for half the daily trading volume, Wolfgruber estimates. "They are looking for small attractive returns that they can leverage into much higher but still predictable returns," he adds.
Many folks are wishfully predicting the death of most hedge funds, yet they keep springing up faster than they keep crapping out. Market neutral quant strategies, 120/20 blew up almost as badly as credit derivatives arbitrage, but they're not going away. Wolfgruber estimates that, in addition to the $1.7 trillion in 9,300 hedge funds extant, the proprietary desks at the giant Wall Street firms have another $4 trillion to $5 trillion committed to hedge fund-style trading strategies.
"They are seeking short-term profits using very robust models that ignore long-term fundamentals," he explains. "No one talks about long-term growth rates any more."
Before recent events roiled the markets, overall volatility was very low but volatility for individual equities was often very high, thanks to hedge funds, and that's not likely to change. So traditional long-term investors like Wolfgruber are asking whether they have to "play like hedge funds," since the market has become their sandbox.
In the end, long-term growth rates should determine long-term investment performance. In times like this, it's very hard to see beyond the next Fed meeting or quarter. So if it turns out equities have limited downside, the same may apply to their upside, an ideal environment for hedge funds.
So the more things change, the more they stay the same. The U.S. economy has survived much greater threats to its health than this subprime debacle, but the way its resolution is shaping up-providing reckless hedge funds, mortgage lenders and individual borrowers with some variant of a bailout-virtually guarantees that many of the same mistakes will be repeated a few years down the road.
No less of an authority than Alan Greenspan is now voicing deep concerns about long-term prospects for America, but if he is wondering how we came to this sorry position of nanny state capitalism, he might start by looking in the mirror.