The New And Improved Real Estate Investment Model

 |  Includes: ITB, PKB, REZ, XHB
by: Acting Man

By Ramsey Su

Direct ownership of single family dwellings and small apartments has never whetted the appetite of Wall Street. In fact, they were not even of interest to big investors and were mainly left to local small potatoes. The primary reason is the lack of a convenient package large enough for them to make enough money off and far too cumbersome to manage. Furthermore, there was no mechanism for these properties to be leveraged, hypothecated or somehow be engineered into derivatives, the kind that serves no purpose except to fatten Wall Street's coffers.

Now things have changed.

The new and improved model is simple. Just like a subprime pool of loans, buy up as many properties as possible, put some lipstick on the pig (i.e., print glossy brochures) and let Wall Street sell them as REITs. They can also securitize the income and voilà, a new batch of derivatives is born. Once the fees are made and the syndicators collect their share of the profits, Wall Street can prosper off the derivatives with no regard to the underlying properties.

In every major city, hundreds of bird dogs (a.k.a. real estate agents) are writing thousands of offers, hoping that some will stick. Most of these offers are robo-signed by designated officers who have never seen the property.

Initial decisions are based purely on inserting numbers in boxes on a spread sheet (a.k.a. proprietary computer models), followed by some due diligence upon acceptance. No one knows exactly how many of these groups are active and how many properties have been accumulated so far. My guess is the pace is shockingly fast with many groups already holding thousands of properties. In the aggregate, there may be more than enough funds to gobble up every piece of property on the market, including all upcoming REOs and distressed loans.

In the next few months, there should be some news about how many properties these groups have assembled. Within the year, REITs and other forms of securitized products should be hitting the market with regularity. Just like the early years of subprime, once these products gain acceptance by the same suckers who bought subprime MBSs, Wall Street will be able to crank out these products month after month until the next bubble bursts.

This is a completely new phenomenon. It will take a little time to see how the dust settles. Upcoming data points may be confusing. For example, a significant number of sales are not going through the MLS [multiple listing service, ed.] today. NAR compiles a survey of realtors. The existing homes sales release next week is likely to grossly understate the actual number of sales. Furthermore, sales prices may increase, but they will not include all the cash deals done directly between lenders and bulk buyers. The records based services such as Corelogic, DataQuick or LPS are likely to have far better data. It is highly probable that their numbers will be in sharp contrast against the NARs.

There are many other mixed signals. Personally, I have never invested when the market is in a feeding frenzy, with unlimited investor interests supported by so much funding. And yet, prices are not going up at the rate that I would have expected. As available inventory is being absorbed, there seems to be an endless amount of supply in the pipeline.

Real estate investors need to understand prices cannot go up without the support of household balance sheets. Interest rates have become more and more accommodating, while the effects are diminishing. Many renters are renting because of their debt to income ratios, in spite of financial analysis that may justify buying versus renting. Instead of debt to income, investors should pay attention to rent to income ratios. That limits not only the ability to raise rents in the future, but to keep existing tenants during the upcoming periods of hardship. The Fed had a timely release on this subject:

Fed Says U.S. Wealth Fell 38.8% in 2007-2010 on Housing.

The most confusing signal remains the unpredictable interventions at all levels of government. Personally, I never expected the level of foreclosure prevention and other forms of disrespect of property rights as have been implemented in our supposedly free market economy. At the moment, there is little doubt that when renters start to default on their rental agreements, landlords won't be prevented from evicting tenants. Who would be a better target than a bunch of evil Wall Street landlords who "stole" these properties at rock bottom prices in the first place, and are now "gouging" poor tenants with usurious rents?

In summary, I believe the real estate market is once again sowing the seeds for mass confusion in the near future. The faltering global economy is driving down the standard of living in developed nations. It is highly possible that our society is simply living in "too much house". Is there real demand for these rental houses?