Downsize to save Detroit?

We've spoken of this option often in our rants - there is an oversupply of housing, oftentimes concentrated in specific areas, that needs to be absorbed. Only 2 options: increase demand or decrease supply.Viewing the remainder of this article requires a Subscription

Connecting the dots 2-25-2010

Or at least trying to keep track of everything... I want to first give you an insight into what I've been reading this morning, then we'll see where it leads us. As many of you know, I'm a believer that excess profits flow through to the real estate sector and have referred to Fred Harrison's book on the subject often (http://www.amazon.com/Boom-Bust-Prices-Banking-Depression/dp/0856832545/ref=sr_1_1?ie=UTF8&s=books&qid=1267115867&sr=8-1 - it's a must read).Viewing the remainder of this article requires a Subscription

Watch the 10-Year

Everyone is talking about Plosser discussing selling off the Fed's MBS hoard. It's obviously necessary, but completely unfeasible given a still shaky housing market and no lending. Additionally, it would fly in the face of the Fed's QE campaign.Viewing the remainder of this article requires a Subscription

Commercial real estate – not new, but people are coming to grips with it

From the Financial Times:

“The most serious wave of commercial real estate difficulties is just now beginning”

Posted by Tracy Alloway on Feb 11 15:46.Here’s one of the scariest sentences you will (in all likelihood) read today: That’s from the latest Congressional Oversight Panel (COP) report, and it is all about — you guessed it — commercial real estate in the US.

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Anticipation and why we’re not writing about the Euro

I’m seeing stories left and right about Greece…and Portugal…and Spain…and the EURO. I’m not surprised, but I feel like this is by now an old story for our readers. Europe is facing an unsustainable situation and it was only a question of timing for when would the “Union” come under fire. So now, everyone is talking about the PIIGS, or Greek spreads (not taramosalata), etc. but I feel like they should have been discussing these issues months ago. Instead, just a few months back, everyone was talking about the death of the dollar and shifting to the Euro to diversify reserves. I just couldn’t believe that Russian central bankers would get that right. For investors (as opposed to traders), you had to be set up months ago, and had to wait a while. Traders can now try to jump on the bandwagon, but the investor who was looking at the valuations and positioning of the major player could sit back and look at it unfold. So for us, there’s nothing to write about the Euro here. It’s still in trouble. We’re maintaining our short position versus the dollar (not adding, not taking anything off), and we continue to wait.

So now the question is how do we position ourselves for the future. Looking forward, the bond market seems to be the area that needs the attention. Why? Because it is the most heavily manipulated market right now. Let’s try to describe the real estate market to an outsider (in it’s current form): well, homeowners can’t afford the houses on the market, so the government taxes them so that they can give them a credit, then it provides them with cheaper financing than they deserve, thereby taking on risk, which it (the government) doesn’t know how to value and keeps off its balance sheet. Does that sound like a market you’d want to invest in? Probably not. Taking that description to the Treasury market, the government provides 0% financing (look how well that worked out for GM) to banks so that they can in turn lend it out, which they do. They lend it out to the government by buying longer dated bonds, which in turn is given right back to the banks for more cheap financing. If this sounds like an Enron type scheme, where there’s no economic value to the transaction, only the middle man gets a cut, or a large Ponzi scheme that is bound to fail as soon as one party runs out of suckers, then you understand our contention that the Treasury market is unsustainable. We are probably off on the timing, but we usually are early as we try to build positions in anticipation.

The inflation/deflation debate will be meaningless for the bond market. We can have deflation and declining bonds (just like we can have inflation with no growth, which was assumed to never happen prior to the 1970’s). Rates have to go up to reflect how expensive it is to lock up money and provide financing in an uncertain environment. The government can manage short term rates, but it’s the long-term rates that will tell the story. Bonds might stage safe-haven rallies, but the support will ultimately fail, as investors shy away from providing the US government with cheap financing. How many times can the Senate increase the debt ceiling? See related story: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=as..HY4pCfZc.

If you haven’t seen it, please read Reinhart and Rogoff’s piece This Time Is Different piece, highlighting the tipping points for debt to GDP levels (happens to be 90%, the US is currently at 84% if you don’t use accrual methodology and don’t count Fannie and Freddie as government liabilities).

So now, we wait in anticipation. And once everyone realizes what’s happening, we’ll already have to start searching for the next place to wait. Investing is all about the waiting.

Is deflation winning out?

In the ongoing debate between inflation and deflation, we’ve heard both sides, tried to look to the historical record for guidance, sought comfort from statistics and experts, yet in the end have come up with strong arguments on all sides. We’re not even sure all the information is conflicting anymore, but in the end, we have to define and quantify a bias, a world view, a story that binds the different pieces together. We find ourselves continually biased towards deflation. It’s colored our decisions, and impacted our investments, and still we find ourselves now with seemingly conflicting investing ideas: short bonds and long metals sounds like it might be inflationary trades, underweight equity and long cash sound like they are deflationary trades. Underweight real estate, overweight India and zero weight to China – how do those all fit in? Are they hedges against each other? Compounding each other?

Let’s start with some basics. Deflation happens when an organization loses pricing power. It happens when organizations need to find lower market clearing prices. It can happen in positive ways (for example, by paying $500 for a laptop with the computing power that cost $5,000 a few short years ago) or negative ways (for example, when you’re house sells for 15% less than it did 3 years ago). It is initially painful to the seller, and especially painful to the levered seller. For the buyer, it feels great – initially. Until it doesn’t. At some point, the buyer decides that it’s worthwhile to wait longer for an even better deal. At some point after that, the buyer realizes that whatever product of service he/she is selling will probably also need to be discounted in order to clear, at which point a bit of fear sets in. And there’s the danger. On a more macro level – organizations that lose pricing power face a squeeze on margins. Those that are levered then face a squeeze on financing. On a more macro level – trade goes down, protectionism looks like a good idea, and then it’s over. At some point market clearing prices are reached, companies that survive with strong balance sheets regain pricing power, etc.

Why go through this exercise? Let’s think through the organizations we have to analyze: people, households, companies, governments. As we go through each organization, we find deflationary forces:

1. People – labor is not in control these days. Wages are stagnant, at best. Unemployment is at 10% and if you’re using good statistics, closer to 18%. If anything, wages will be put under pressure in the near future.
2. Households – continue to be indebted, even though many are trying to lower it. Residential real estate has been nationalized, with 95% of new mortgage originations occurring through GSE’s. Real estate has not stabilized, and commercial real estate is about to roll over.
3. Companies – retails has actually held up better than expected, but credit card defaults are rising and the consumer will require more and more sales (deflation) to purchase. Internal demand from Asia hasn’t materialize (yet). Most importantly, margins have risen to such high levels off the back of squeezing costs. Margins going forward will be tough without an increase in revenues, which hasn’t come.
4. Governments – governments can lose pricing power as well. Japan has been a startling anomaly, but I wouldn’t depend on it continuing or working for others. With debt to GDP starting to hit important levels, government bonds will lose their appeal, and with it, their pricing power. So, prices will have to go on sale. We’re seeing it already in the municipal bond market. We’re seeing it with sovereigns like Greece. We’ll see it with Treasuries as well. If the US government loses pricing power, won’t the dollar fall as well? Actually, it might not. The dollar will still be needed for trade, for a safe haven, and as a relative trade against the worse government situations in Japan and Europe, so we can have a situation where the dollar is up and the Treasuries are down.

All of these organizations seem to me to point to a contraction of margins on all fronts, loss of pricing power, consolidation, retrenchment, and balance sheet rewinds to the pre-”stock option/insanely low interest rate/agency-moral hazard games of manager vs. owner/etc.” times.

We continue to mistrust rallies at these valuations, and are wary of people screaming to buy the dips.

John Mauldin’s “Outside the Box” – Commercial Real Estate

John Mauldin distributed the following piece yesterday and I thought it was worthwhile to post it in full. While the information shouldn’t be new nor surprising to regular readers of our letter, I think it’s always important to hear it in different ways. One of the pillars of a sustainable turnaround will be the stabilization of the real estate market, which we do not believe has materialized, contrary to the popular press. In this piece, Andy Miller (who’s being interviewed) goes through his impression of the commercial real estate market and comes out with a similar conclusion. Of particular note is Andy’s mention of the bond market hitting a wall. We agree! When the bond market no longer absorbs the government auctions, reality will set in across asset classes.

Volume 6 – Issue 7
January 25, 2010

An Insider’s View of the
Real Estate Train Wreck
By David Galland

I have been writing for a very long time about the coming debacle that the commercial real estate problem is going to be. This week’s Outside the Box is an interview that my good friend David Galland did with Andy Miller, a man on the inside of the coming commercial real estate crisis. I thought it was very revealing, as there are so many nuances to the problem. For instance, in some cases, if you default and walk away from the loan you may trigger huge taxes as the loan loss to the bank is now considered income to you. Ouch! So many strings to unravel as you figure this one out.

I asked David if I could use this as an Outside the Box, and he agreed. This was from Casey Research, a very good source for non-mainstream investment ideas. You can learn more or subscribe at a discount here.

I really think you will find this a very easy and informative read. Have a great week.

Your writing from Monaco on my way to Zurich analyst,

John Mauldin, Editor
Outside the Box

An Insider’s View of the Real Estate Train Wreck
By David Galland, The Casey Report

The first time I spoke with real estate entrepreneur Andy Miller was in late 2007, when I asked him to serve on the faculty of a Casey Research Summit. As John Mauldin, a former faculty member himself, knows, we’re very selective with our speakers. And there was no one in the nation I wanted more than Andy to address the critical topic of real estate.

My interest in Andy was due to the fact that he has been singularly successful in pretty much all aspects of the real estate market, including financing and developing large projects – such as shopping centers, apartment communities, office buildings, and warehouses – from one end of the country to the other. His expertise has also allowed him to build an impressive business providing assistance to large financial institutions that need help in dealing with problem commercial real estate loans. As you might suspect, business is booming.

Back in 2007, however, what most intrigued me about Andy was that he had been almost alone among his peer group in foreseeing the coming end of the real estate bubble, and in liquidating essentially all of his considerable portfolio of projects near the top. There are people that think they know what’s going on, and those who actually know – Andy very much belongs in the latter category.

In fact, he initially refused to speak at our event, only agreeing very reluctantly after I had hounded him for several months. The reason for his refusal, I later found out, was that he had spoken at several industry events before the real estate collapse and had been all but booed off the stage for his dire outlook.

The happy ending of this story is that Andy’s speech at our Summit was a rousing success, and he enjoyed it so much that he has now spoken at several, and has kindly agreed to sit for periodic interviews to keep our readers up to date on the latest developments in this critical sector. So far, Andy’s real estate forecasts continue to come true.

As you’ll read in the following excerpt from my latest interview with Andy, who now spends considerable time each day helping the nation’s biggest banks cope with growing stacks of problem loans, he remains deeply concerned about the outlook for real estate.

David Galland

No one has been more right on the housing market in recent years. So, what’s coming next? Some of the housing numbers in the last few months look a little less ugly. Could housing be getting ready to get well?

MILLER: I don’t think so.

For all intents and purposes, the United States home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the U.S. were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA.

If it’s true that most of the financing in the single-family home market is being facilitated by government guarantees, that should make everybody very, very concerned. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe, because private lenders for single-family homes are nervous. Lenders that are still lending are reverting to 75% to 80% loan to value. But that doesn’t help a homeowner whose property is worth less than the mortgage. So when the supply of government-facilitated loans dries up, it’s going to put the home market in a very, very bad place.

Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper.

The public doesn’t have any idea of the scale of the guarantees the government is taking on through Fannie, Freddie, and FHA. It’s huge. If people understood what the federal government has done and subjected the taxpayers to, there would be a public outrage. But you can’t get people to focus on it, and it’s very esoteric, it’s very hard to understand. But it’s not something the bond market won’t notice. The government can’t keep doing what it has been doing to support mortgage lending without pushing interest rates way up.

Refinancings of single-family homes are very interest-rate sensitive. Consumers have their backs against the wall. They have too much debt. Refinancing their maturing mortgages or their adjustable-rate mortgages is very problematic if rates go up, but that’s exactly where they’re headed. So anyone who’s comforted by current statistics on single-family homes should look beyond the data and into the dynamics of the market. What they’ll find is very alarming.

On that topic, recent data I saw was that something like 24% of the loans FHA backed in 2007 are now in default, and for those generated in 2008, 20% are in default, and the FHA is out of money.

MILLER: Fannie Mae had a $19 billion loss for the third quarter of 2009, and they are now drawing on their facility with the U.S. Treasury. We have all forgotten that Fannie and Freddie are still being operated under a federal conservatorship. On Christmas Eve, the agency announced that they were going to remove all the caps on the agencies.

So what about commercial real estate?

MILLER: When I saw what was happening in the housing market, I liquidated all my multifamily apartments, shopping centers, and office buildings. I liquidated all my loan portfolios, and I’m happy I did.

Then it occurred to me in 2005 and 2006 that the commercial world had to follow suit. Why? Because it’s a normal progression. Obviously, when single-family homes decline in value, multifamily apartments decline in value. And when consumers hit the wall with spending and debt, that’s going to have an impact on retailers that pay for commercial space.

Furthermore, the financing for retail properties had gotten ludicrous. The conduits were making loans that they advertised as 80% of property value when they originated them, but in reality the loan-to-value ratios were well over 100%. And I say that to you with absolute, categorical certainty, because I was a seller and nobody knew the value of the properties that I was selling better than I did. I had operated some of them for 20 years, so I knew exactly what they were bringing in. I knew what the operating expenses were, and I knew what the cap rates were. And, you know, the underwriting on the loan side and the purchasing side of these assets was completely insane. It was ludicrous. It did not reflect at all what the conduits thought they were doing. They were valuing the properties way too aggressively.

I became very bearish about the commercial business starting in late ‘05. In fact, I think I was in Argentina with Doug Casey, sitting on a veranda at one of the estancias, and he and I were lamenting what was going on in the real estate business, and I said there was going to be a huge adjustment in the commercial market.

Beyond the obvious, that the real estate market has taken pretty significant hits and some banks have been dragged under by their bad loans, what has really changed in real estate since the crash?

MILLER: I think the first thing that changed was that people learned that prices don’t go up forever. Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of their properties had been financed too aggressively, but still, I don’t think even at the fall of Lehman, anybody was predicting a wholesale collapse in commercial real estate.

But they did see they should be more circumspect with loan underwritings. In fact, after the fall of Lehman, they completely stopped lending. I think they realized we had been living in fantasy land for 10 years. And that was the first change – a mental adjustment from Alice in Wonderland to reality.

Today it’s clear that commercial properties are not performing and that values have gone down, although I’ve got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios. People still do not understand how grave this is.

Right now there are an awful lot of banks that do an awful lot of commercial real estate lending, and for about a year now you’ve been telling me that you saw the first and second quarter of 2010 as being particularly risky for commercial real estate. Why this year, and what do you see happening with these loans and the banks holding them?

MILLER: It’s an educated guess, and it hasn’t changed. I still think that it’s second quarter 2010.

The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point, which I believe will come sometime in 2010. When you hit that breaking point, unless there’s some alternative in place, it’s going to be a very hideous picture for the bond market and the banking system.

The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe. I will get to that in a minute. But they can influence the speed with which it all unfolds, and I’ll give you an example.

In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined. One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn’t have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital.

That’s very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they’ll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them. Now, that’s horribly destructive.

Just to be clear on this, let’s say I own an apartment building and I’ve been making my payments, but I’m having trouble and the value of the property has fallen by half. I go to the bank and say, “Look, I’ve got a problem,” and the bank says, “Okay, let’s work something out, and instead of you paying $10,000 a month, you pay us $5,000 a month and we’ll shake hands and smile.” Then, even though the property’s value has dropped, as long as we keep smiling and I’m still making payments, then the bank won’t have to reserve anything against the risk that I’ll give the building back and it will be worth a whole lot less than the mortgage.

MILLER: I think what you just described is accurate. And it’s exactly a Japanese-style solution. This is what Japan did in ‘89 and ‘90 because they didn’t want their banking system to implode, so they made it easier for their banks to sit on bad assets without owning up to the losses.

And what’s the result? Well, it leaves the status quo in place. The real problem with this is twofold. One is that it prolongs the problem – if a bank is allowed to sit on bad assets for three to five years, it’s not going to sell them.

Why is that bad? Well, the money tied up in the loans the bank is sitting on is idle. It is not being used for anything productive.

Wouldn’t banks know that ultimately the piper must be paid, and so they’d be trying to build cash – trying to build capital to deal with the problem when it comes home to roost?

MILLER: The more intelligent banks are doing exactly that, hoping they can weather the storm by building enough reserves, so when they do ultimately have to take the loss, it’s digestible. But in commercial real estate generally, the longer you delay realizing a loss, the more severe it’s going to be. I can tell you that because I’m out there servicing real estate all day long. Not facing the problems, and not writing down the values, and not allowing purchasers to come in and take these assets at discounted prices – all the foot-dragging allows the fundamental problem to get worse.

In the apartment business, people are under water, particularly if they got their loan through a conduit. When maintenance is required, a borrower with a property worth less than the loan is very reluctant to reach into his pocket. If you have a $10 million loan on a property now worth $5 million, you’re clearly not making any cash flow. So what do you do when you need new roofs? Are you going to dig into your pocket and spend $600,000 on roofing? Not likely. Why would you do that?

Or a borrower who is sitting on a suburban office property – he’s got two years left on the loan. He knows he has a loan-to-value problem. Well, a new tenant wants to lease from him, but it would cost $30 a square foot to put the tenant in. Is the borrower going to put the tenant in? I don’t think so. So the problems get bigger.

Why would the owner bother going through a workout with the bank if he knows he’s so deep underwater he’s below snorkel depth?

MILLER: It’s always in your interest to delay an inevitable default. For example, the minute you give the property back to the bank, you trigger a huge taxable gain. All of a sudden the forgiveness of debt on your loan becomes taxable income to you. Another reason is that many of these loans are either full recourse or part recourse. If you’re a borrower who’s guaranteed a loan, why would you want to hasten the call on your guarantee? You want to delay as long as possible because there’s always a little hope that values will turn around. So there is no reason to hurry into a default. None.

So that’s from the borrower’s standpoint. But wouldn’t the banks want to clear these loans off their balance sheets?

MILLER: No. The banks have a lot of incentive to delay the realization of the problem because if they liquidate the asset and the loss is realized, then they have to reserve the loss against their capital immediately. If they keep extending the loan under the rules present today, then they can delay a write-down and hope for better days. Remember, you suffer if the bank succumbs and turns around and liquidates that asset, then you really do have to take a write-down because then your capital is gone.

So here we are, we’ve got the federal government again, through its agencies and the FDIC, ready to support the commercial real estate market. They’ve taken one step, in allowing banks to use a very loose standard for loss reserves. What else can they do?

MILLER: Well, obviously nobody knows, but I can guess at what’s coming by extrapolating from what the federal government has already done. I believe that the Treasury and the Federal Reserve now see that commercial real estate is a huge problem.

I think they’re going to contrive something to help assist commercial real estate so that it doesn’t hurt the banks that lent on commercial real estate. It’ll resemble what they did with housing.

They created a nearly perfect political formula in dealing with housing, and they are going to follow that formula. The entire U.S. residential mortgage market has in effect been nationalized, but there wasn’t any act of Congress, no screaming and shouting, no headlines in the Wall Street Journal or the New York Times about “Should we nationalize the home loan market in America.” No. It happened right under our noses and with no hue and cry. That’s a template for what they could do with the commercial loan market.

And how can they do that? By using federal guarantees much in the way they used federal guarantees for the FHA. FHA issues Ginnie Mae securities, which are sold to the public. Those proceeds are used to make the loans.

But it won’t really be a solution. In fact, it will make the problems much more intense.

Don’t these properties have to be allowed to go to their intrinsic value before the market can start working again?

MILLER: Yes. Of course, very few people agree with that, because if you let it all go today, there would be enormous losses and a tremendous amount of pain. We’re going to have some really terrible, terrible years ahead of us because letting it all go is the only way to be done with the problem.

Do you think the U.S. will come out of this crisis? I mean, do you think the country, the institutions, the government, or the banking sector are going to look anything like they do today when this thing is over?

MILLER: I know this is going to make you laugh, but I’m actually an optimist about this. I’m not optimistic about the short run, and I’m not optimistic about the severity of the problem, but I’m totally optimistic as it relates to the United States of America.

This is a very resilient place. We have very resilient people. There is nothing like the American spirit. There is nothing like American ingenuity anywhere on Planet Earth, and while I certainly believe that we are headed for a catastrophe and a crisis, I also believe that ultimately we are going to come out better.

________________________________________

Andy Miller is the co-founder of the Miller Frishman Group (www.millerfrishman.com), which includes three companies serving different sectors of the real estate market – from mortgage brokerage and banking, to the building, management, and marketing of commercial real estate across the United States. His firm is currently deeply involved in the distressed real estate business, assisting lenders across the nation with their growing portfolios of non-performing loans.

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Note: John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Plexus Asset Management; Fynn Capital; and Nicola Wealth Management. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

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Update on Detroit

Forget about the political message in this video, the pictures are graphic and scary for any investor – exactly why I’m researching it.

In the video, you’ll see tracts of land in the middle of the city that are uninhabitable, housing being used as drug labs, etc. This is the proverbial “blood in the streets” that makes for an opportunity. I’m not buying anything, and I don’t recommend buying anything in Detroit: I just think it’s worth researching at this point:

Detroit in Ruins

More on Detroit

It seems like everyone is a contrarian these days, with article titles supporting the thesis that “Being a Contrarian Is Difficult”. So let’s talk about a difficult play right now – Detroit. The American automakers failed (it only took 30+ years for some to recognize it). The unions failed, as Detroit, a city with one of the highest union participation rates is also ranked as #1 in people living under the poverty line. American industry is facing tough times on all fronts. And the list goes on. Detroit faced urban flight for years, as the wealthy left the city for the suburbs. And so, it should come as no surprise that the real estate in Detroit is in dismal shape. The average house in Detroit sells for $12K, with many selling for $50 (yes, just $50), just so that people can stop paying taxes and carrying costs. Banks don’t want it on their books. Rental prices…well, you should feel lucky if you could find good renters. Also, I took an informal poll of investors and colleagues, and not one of them was interested in Detroit real estate.

What does it point to? Well, maybe I’m crazy, but it’s starting to look like an opportunity I like. I don’t particularly like speculative real estate, since I’m a value investor at heart, which means you need cashflows to discount, P/E’s to compare, rental yields, etc. So in the next few weeks, I’ll be looking at some ways to implement this idea. It will be a difficult investment, since financing is limited, and investors don’t want to hear about Detroit, but that’s exactly the kind of investment arena I like best.

I’ll be posting some links as I get them, but here are a few to get you started:

• From Mark Perry, some facts about Detroit: http://mjperry.blogspot.com/2009/12/facts-of-day-about-detroit.html
• From cnn.com: http://www.cnn.com/2009/US/03/17/rtr.detroit.opportunity/index.html

For the record, I have no stake in anything mentioned above at the time of the writing, nor anything mentioned in the articles. This is in no way a recommendation to buy any security or real estate.

Real estate – the high end is not holding up

Contrary to what you might hear in the popular press, the numbers we are seeing do not point to a stabilization (yet) of the real estate market.

I want to highlight one paragraph from a recent Bloomberg article:

Payments on about 12 percent of mortgages exceeding $1 million were 90 days or more overdue in September, compared with 6.3 percent on loans less than $250,000 and 7.4 percent on all U.S. mortgages, according to data from First American CoreLogic Inc., a Santa Ana, California-based research firm. The rate for mortgages above $1 million was 4.7 percent a year earlier.

12%? That’s crazy. Up from 4.7%? Yikes. I think a lot of places haven’t faced up to the fact that the high end properties are going to end up being the more damaging – at least at this stage – to balance sheets than the low end.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aQED_96QBBkk

Walking away from a mortgage

Defaulting on a mortgage has become more acceptable, and strategic defaults are on the rise. What does it mean?

Real estate is one of the greatest reversion to the mean trades out there. As real estate receives the benefits of excess profits, as corporate profits and personal income increase, so does real estate. We can use GDP as a proxy for measuring the rate of increase, with some factoring of increased productivity, population growth, etc. In the end, we get that real estate, on an unlevered basis, is not such a great investment. What has made it such a powerful wealth creator in the past are a few factors:

• Tax benefits: here, we have government policies distorting the market to promote home ownership.
• Interest rate benefits: with Fannie and Freddie and the accomodative interest rate policies, we have government finding additional ways to distort the market and drive it higher than it should have been.
• Leverage: Ask your broker to lend you on margin and he’ll give you 50%. Maybe if you’re a big guy he’ll give you 2-1. For individual investors, receiving 4-1 (20% down) leverage or more is unheard of. Suddenly that 4% return on your real estate investment looks really really good.

Suddenly people are realizing that they have better things to do with their money than sink it into real estate. So what’s the solution? Walk away from your mortgage, send the keys to the bank, and start renting. It used to have a bad stigma associated with it and your credit is ruined. But as more and more people are doing it, defaulting on a mortgage isn’t what it used to be. I expect that new government policies will be enacted to limit the impact on your credit score (again, distorting the market).

The Wall Street Journal estimates today that if all the people with negative equity walk away from their house, the impact will be a $400 billion hit. I think they are underestimating the second level impact from banks’ balance sheets, impact on credit card companies’ (including credit card companies that look like retail companies), auto financing, etc. The irony, of course, is that by writing these articles, defaulting just becomes more accepted. http://online.wsj.com/article/SB126040517376983621.html?mod=WSJ_hps_MIDDLEThirdNews

For a general discussion of strategic defaults, check out this white paper, recently published by the Loan Value Group.

Andy Xie on China and USD

China bubble, USD, Chinese real estate, speculation, hot money… except not in the direction you’d expect. Xie outlines how China might go bust if the USD bottoms, and how the Chinese government has no choice but to continue inflating their own bubble – a very scary prospect. he believes it won’t happen for a few years; I’m not as confident.

http://www.businessinsider.com/andy-xie-china-is-trying-to-prolong-the-bubble-2009-12

Apartment Rents Fall 4.9% in SoCal

We are still not experiencing the stabilization of real estate, partially because there is no stabilization in rents. With owners equivalent rent (OER) the largest component of the CPI, there will not be significant upward pressure on CPI (at least headline CPI) until we see rents bottoming out. http://www.calculatedriskblog.com/2009/11/apartment-rents-fall-49-in-socal.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+CalculatedRisk+%28Calculated+Risk%29&utm_content=Google+Reader

Recession Finally Hits Down on the Farm

The Agriculture Department said it expects net farm income — a widely followed measure of profitability — to drop to $54 billion in 2009, down $33.2 billion from last year’s estimated net farm income of $87.2 billion, which was nearly a record high. The drop in farm prices is likely to lead to a slower increase in food costs for American consumers, economists say.

The slump isn’t affecting all farmers equally: Many are still reaping big profits while others are having a hard year. Farmers are accustomed to seeing their incomes swing widely, due to the vagaries of such things as Mother Nature and the oil market’s impact on the price of corn-derived ethanol fuel.

http://online.wsj.com/article/SB125138431827963711.html

Cities Tolerate Homeless Camps

I think this is one of those stories that makes one think about the real vs stock market economy.

NASHVILLE, Tenn. — Last summer, police responding to complaints about campfires under a highway overpass found dozens of homeless people living on public land along the Cumberland River.

Eviction notices went up — and then were suspended by Nashville Mayor Karl Dean, a Democrat, who said housing for the homeless should be found first.

A year later, little has been found — and Nashville, with help from local nonprofits, is now servicing a tent city, arranging for portable toilets, trash pickup, a mobile medical van and visits from social workers. Volunteers bring in firewood for the camp’s 60 or so dwellers.

http://online.wsj.com/article/SB124994409537920819.html