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.

No Disclosures.

Comments

[Fedora:]

It would be outta my league, but I inquired with my brother who lives in southeast fla,about the all new homes in a new development east of Ft. Myers with the 'highest foreclosure rate in the nation'-thinking well that looks like 'opportunity' doesn't it? Until he explained the staggering crime rate, vacant homes vandalized, lived in by squatters, reefer growing operations, and other stash waehousing operations going on in that 'upscale neighborhood'. Incidentally, one of his cassic cars was cleverly stolen by a 'prospect' who test drove it, only to have made a key, and returned in the wee hours to purloin said Mercedes. Bro' asked the investigating officer about the likelihood of recovery of the vehicle, to which the officer stifled a guffaw, and explained that 10 cars a day are stolen in Ft Myers....that's 3,600 cars a year. Does the term "sweep back the tide with a broom' mean anything to "ya'll'?

May 25 09:38 AM

[Buckoux:]

Wall St. is not alone in the sub-prime crime. The dispersed American version of "Fleet Street" is just as guilty of cooking the numbers for their own profits. The Los Angeles Times, in the heyday of the real estate bubble, had thick and separate sections on "Real Estate" and "Business". The ad revenue must have been glorious. Now, the two sections are combined and the classifieds are four times thicker. "Bubbles" need a willing messenger to carry the bubble mania to the masses and for this the nations print and electronic media were more than willing to do. Banks aren't the only whores responsible for the spread or our current economic disease. The newspapers now have the economic clap, and they didn't get it from the Internet.

May 25 10:53 AM

[Tim Plaehn:]

Please explain to me how you can be cash flow negative on a rental home without a mortgage? Even a home with a 50% loan to current value mortgage should cash flow positive in the California rental market. I think these funds will make out like bandits over the next 3 to 5 years. The median selling price in the San Diego area has already increased $10k this year.

May 26 08:35 AM

[Jimmy K:]

Tim,
if you'd ever dealt with a typical renter... you'd realize the problem... they don't care about the house. They move on average every 12 months. The amount of wear and tear they can inflict on a home in the space of a year is amazing...

May 26 08:41 AM

[Fred W:]

I will make this easy to grasp, since you are obviously are "slow".
Annual taxes and "upkeep" cost more than the annual rent...was that really difficult to figure out?


On May 26 08:35 AM Tim Plaehn wrote:

> Please explain to me how you can be cash flow negative on a rental
> home without a mortgage? Even a home with a 50% loan to current value
> mortgage should cash flow positive in the California rental market.
> I think these funds will make out like bandits over the next 3 to
> 5 years. The median selling price in the San Diego area has already
> increased $10k this year.

May 26 12:55 PM

[henarl:]

Tim: Of course you can achieve "positive cash flow" on residential rental property if you buy for 100% cash, have perfect tenants, and do the maintenance yourself. But what else could you have done with that cash and your labor that might have made you even more "profit"?
I have been in the residential rental business ( I now just have mini-storage) and I have realized positive cash flow but mostly because I was also a contractor and built my own multiple residential units. Positive cash flow is very hard to acheive with single family residences.

May 26 03:27 PM

[joof:]

yes it is difficult to figure out...because you are wrong

In CA taxes are about 1.1-1.3% of purchase price - or about 200-400/month on a median house. Upkeep and insurance could be generously 500/month. So if you rent at 1900-2500 and pay out under a 1000, how do you lose money?






On May 26 12:55 PM Fred W wrote:

> I will make this easy to grasp, since you are obviously are "slow".
>
> Annual taxes and "upkeep" cost more than the annual rent...was that
> really difficult to figure out?

May 26 06:16 PM

[Sean in CA:]

Amen to that! See the Modesto Bee for a (sub) prime example of printing whatever the R.E. agencies want.


On May 25 10:53 AM Buckoux wrote:

> Wall St. is not alone in the sub-prime crime. The dispersed American
> version of "Fleet Street" is just as guilty of cooking the numbers
> for their own profits. The Los Angeles Times, in the heyday of the
> real estate bubble, had thick and separate sections on "Real Estate"
> and "Business". The ad revenue must have been glorious. Now, the
> two sections are combined and the classifieds are four times thicker.
> "Bubbles" need a willing messenger to carry the bubble mania to the
> masses and for this the nations print and electronic media were more
> than willing to do. Banks aren't the only whores responsible for
> the spread or our current economic disease. The newspapers now have
> the economic clap, and they didn't get it from the Internet.

May 26 07:22 PM

[henarl:]

joof: How much did you pay for that house that you are renting out for $1900-2500/month? If you have a big mortgage on that house, how much are your mortgage payments? If you paid cash for it, what else could you have done with that money that would probably give you a better return? The cost of money is the largest consideration when investing in residential income property and the payoff is not in monthly positive cash flow but in selling the house for much more than you paid for it. That worked for a long time but don't count on it happening any more in the foreseeable future. "How you lose money" is when the house goes down in value, instead of up, while you are holding it. Duh!

May 26 09:39 PM

[MarkitWacha:]

Like Alan Greenspan said, even before his famous 'irrational exuberance' speech, the value of real estate is measured by the rents the property can charge.

THAT is excellent advice for people buying a home in this market, because if you can at least charge rent to mostly cover the mortgage, the purchase is safer.

Full disclosure: I'm a landlord, and I might purchase shares of SRS soon as a hedge against future loss.

May 27 12:54 AM

[TPA:]

IMHO, as a property investor with some experience, the appreciation (or depreciation) of the property has the largest impact on your overall return in SFHs. A modest drop of 5% in the price of the property can easily wipe out a year's worth of rental income.

Therefore, I would think that the real question (if you are buying to invest and make money) is not whether you're cash flow positive or not, but rather if there is room for modest appreciation. Asking whether you would buy the same property if you had to pay cash for the property is the right attitude. This is a lesson that many of the would-be investors have yet to learn based on what I'm reading of Pheonix, Las Vegas and other foreclosure towns. They may be able to cover their 80% mortgage payments with cash flow from a temporary 8-10% rental yield, but in the end, it's still dead money.


On May 26 09:39 PM henarl wrote:

> joof: How much did you pay for that house that you are renting out
> for $1900-2500/month? If you have a big mortgage on that house, how
> much are your mortgage payments? If you paid cash for it, what else
> could you have done with that money that would probably give you
> a better return? The cost of money is the largest consideration when
> investing in residential income property and the payoff is not in
> monthly positive cash flow but in selling the house for much more
> than you paid for it. That worked for a long time but don't count
> on it happening any more in the foreseeable future. "How you lose
> money" is when the house goes down in value, instead of up, while
> you are holding it. Duh!

May 27 01:41 AM