Seeking Alpha
Long/short equity, contrarian, newsletter provider, research analyst
Profile| Send Message|
( followers)  

The headlines read that real estate prices increased dramatically in 2013, but behind the curtains, something interesting is also obvious. Usually, I keep my eye on three main markets: La Jolla, Rancho Santa Fe and the Bay Area, but these markets all have a similar characteristic - they are all dominated by affluent buyers. I consider this a niche, but one that can also help define the next leg of the cycle.

The facts are quite clear:

Investors bought homes of all sizes and shapes in 2009, 2010 and 2011. The biggest hedge funds gobbled up tens of thousands of homes all at the same time as Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) cleaned up their balance sheets, and for the most part, these investors received great deals from their all-cash lump-sum purchases, but those became commonplace in the open market too. This is exactly what has driven prices higher in the markets I focus on, and the same is true in other affluent communities as well.

However, very recently, something interesting has begun to happen. The all-cash offers are drying up and institutional selling has become obvious. These investors bought properties at what were rock-bottom prices, and then many restored those properties but did not turn around and sell. Instead, they rented most of the properties, which produced income, and the combination of the capital gains they could record as their assets increased and the income they received as rents came in made the managers of those hedge funds very happy people.

Hedge funds typically get paid when assets increase, and their performance fees kick in. The typical model is 2 x 20, where a hedge fund manager received a 2% flat fee + 20% of the growth (beyond 2%). Since December 2011, typical real estate assets increased by approximately 20%, and in some cases, more than that. Those hedge funds were able to realize substantial gains and potentially significant bonuses, but when it comes to realizing bonuses, something else is important to understand.

If gains are not recognized, the hedge fund managers do not get bonuses, and therefore, those large funds tend to dissolve or hedge underperforming assets. If, for example, those hedge funds perceived property values to be poised to decline, they would seriously consider selling those assets.

In many cases, that is exactly what I have become witness to lately. It has begun on the fringes of these more affluent communities, and soon I expect it will work its way through all segments of the real estate market. Institutional investors are beginning to sell, and this is the first time I have really started to see this since they began to buy assets from those banks.

There is no panic in the market - they are not dropping prices and trying to get out as fast as they can by any means - but many do appear eager to sell. They all seem to believe that real estate prices may come under pressure, especially if interest rates continue to increase, which many of them believe will happen as tapering continues. Of course they want to get the best prices possible, but in many cases, a few percent lower will not adversely affect their bonuses.

On the fringes, I am starting to see investors list properties under the comps in that area because they want to sell rather quickly, but again, they are not panicking. They are locking in gains, no one seems afraid, but that can change.

The interesting part of this conversation comes in the "what-if scenario that would occur if real estate prices indeed began to come under pressure. How fast would the hedge funds get out, and how much wiggle room do they really have before selling below the peak in the market would adversely affect their bonuses? In my estimation, the real estate market may have actually peaked at the end of 2013, and because the end of the calendar year defines bonus schedules for most hedge funds, it is also reasonable that any price-based decline from the end of 2013 could adversely affect bonuses.

Therefore, the pressure may already have begun, and if it continues, hedge funds will likely be first to the door. They gladly bought the assets that the banks could no longer hold. They did this at rock-bottom prices. They realized huge gains from those positions. But now certainly seems to be the time those funds are starting to look to sell. They may not have all started to act yet, but they all have similar opinions about both interest rates and the fabricated growth induced by the FOMC stimulus dollars.

As a result, if selling momentum starts on the institutional side, not only will those all-cash buyers dry up, but selling below market value may become a regular occurrence.

With that risk, coupled with interest rate risk and economic risk, with additional pressure from the transition of FOMC influence from positive to negative liquidity (when coupled with US Treasury Operations), I believe that this is a very bad time to buy real estate.

I am sure that interest rate risk will surface. I am also almost sure that the economy will become very ugly again soon, given what the investment rate (macroeconomic analysis) says about the next few years, but I cannot be sure if those hedge funds will start to sell aggressively. If they do, though, one thing I can be sure of is that they can drive prices down just as fast as they drove prices up, and if they perceive that pricing pressure will persist, they may also position themselves to take advantage of it.

I will end with this interesting addition.

What if institutional investors knew they could begin a wave of selling in real estate by liquidating inventory? Those institutions could hedge their real estate positions (that's what they do, after all), and start to sell aggressively. If they did this as a group, if this was the trade du-jour, for example, like the carry-trade was for part of last year, home prices may not only have peaked, but they may get slammed. This could happen without hurting a hedge fund that hedges its position, and could even make some of them considerable money. They were certainly first to buy, and they now seem poised to sell.

Idea: Short the iShares U.S. Real Estate ETF (NYSEARCA:IYR) at some point soon.

Source: Real Estate: A Bad Time To Buy