Seeking Alpha
Research analyst, dividend investing, ETF investing, long/short equity
Profile| Send Message|
( followers)  

By Ramsey Su

The first piece of income property I owned was a junky duplex in a so-so neighborhood of San Diego. That was in 1975. While I can say that I have never lost a dime in any of my real estate investments since I bought that duplex, that is not exactly an exceptional achievement. In hindsight, any unsophisticated investor could have accomplished the same, just as long as he was not over-leveraged and had the ability to hang tight for a few years.

The sub-prime bubble put an end to that lucky streak for investors. Real estate is now no longer a risk free investment. It is not uncommon to find investors and homeowners who were not even aware that they were actually speculators. Some have already taken their losses and have moved on. Some are so fortunate as to be living in free housing courtesy of government intervention.

Then there is a large number of people that policy makers has not paid much attention to. These are the investors who are stuck with an asset that they really do not want. They may have negative cash flow and/or they may be underwater. They cannot refinance because most of the government's give-away programs are limited to owner-occupants. They cannot walk away, not only because it would ruin their credit, but also because they would have to pay taxes on debt forgiveness, as only one's principal residence enjoys an exemption.

The important question is: What is normal? Now that EBR (Everyone But Ramsey) has declared that the bottom is in, is real estate once again the no risk investment that we once enjoyed, or has it forever been transformed into something far riskier? I would opine that the latter is the case.

Interventionism Is the 'New Normal'

Ever since the bursting of the sub-prime bubble in 2006, there has been a flood of politically motivated intervention in the real estate market. It has become so commonplace that it is now widely taken for granted. Every little market move that is not to the liking of policy makers will trigger some type of policy reaction, with each new round of intervention more disturbing than the last. In theory this should be very bullish, because we have the full force of the government and the Federal Reserve backstopping the downside, but let us think about the potential upside for a moment.

To get upside, we would need another bubble. It would take too long for any snail pace type appreciation to dig us out of the sub-prime hole. In other words, we would need another 'jobless recovery'. We would need assets that not only appreciate rapidly, but are accessible to all who have no money for a downpayment, no income, no credit and no qualifications. We would need the 'wealth effect' to kick in. We would need the return of mortgage equity withdrawal. In short, we would need what amounts to pipe dreams.

A prudent investor may want to look at what our government has put in place for us if the market doesn't recover fast enough or even turns sour again.

Starting off with Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA), it has been almost exactly four years since they went into receivership. We are still not any closer to a resolution. There is no exit plan. If conditions should worsen, the final nail in the free market coffin will likely be principal reduction. Once we go down that path, there is no chance that any private label mortgage-backed securities can hope to compete with government mortgages.

The biggest uncertainty to real estate investors today is posed by the Consumer Financial Protection Bureau (CFPB). The system is in need of clear regulations and enforcement. Unfortunately the CFPB is not the answer. It is headed by Rich Cordray, and I do not see anything in his background that suggests he has the experience required to get us out of the current fiasco. So far, his actions have confirmed my worst nightmares. The market is going to hear from this monstrous bureaucracy for years to come.

I have previously written about this 1,099 page proposal, dealing with Reg X and Reg Z. It is not my intent to bore everyone to tears so I can only say, "trust me, these regulations have little to do with the sub-prime fiasco, nor do they really need fixing." The proposal did read like a freshman book report, written by someone who lacks even a basic understanding of mortgage finance practices.

There was recently a scandal that was not widely reported in the media and that sheds some light on the Bureau:

Judicial Watch Obtains Records Detailing Questionable Expenditures at the Consumer Financial Protection Bureau

CFPB Spent $479,354 to Hire Sign Language Translation Services for Two Entry Level Employees and Sent High-Paid Agency Attorneys to "Banking Law Fundamentals" Class

Reading through some of the other CFPB proposals such as "Agencies issue proposed rule on appraisals for higher-risk mortgages" and "Consumer Financial Protection Bureau Proposes Rules to Protect Mortgage Borrowers", it leaves you wondering what the hell they are trying to do. Frankly, I have no idea what exactly they are trying to correct, improve or protect.

It is frightening that this Bureau has a budget of $356 million for 2012 and a budget of $447.7 million for 2013. I wonder how much it is going to extort from the industry for every minute infraction of some obscure regulation to justify its existence. I am not defending the issuers of credit, many of whom are indeed scum, but the cost of having to deal with the CFPB will be enormous and will no doubt be passed on to consumers.

Regarding my home State of California, here are two recent articles that have appeared in Housing Wire:

San Bernardino to consider next step on eminent domain plan, and California AG says mortgage servicers slow to adopt settlement changes

The Supreme Court of the State of Washington just ruled that MERS cannot foreclose without the actual copy of the deed. Washington is a title state, meaning the foreclosure process is usually non-judicial. With this ruling, who knows how many foreclosures will have to become lawsuits henceforth.

There are numerous examples of how the system has been hijacked by state and local politicians. Their actions are unpredictable and unless you are intimately familiar with every single one of the local markets, the impact is not really measurable. In the failed State of California, any mention of rent control or mention of a repeal of Prop 13 may shut down the market overnight.

Interest Rate Risk and a Different Approach to Real Estate Investment

Finally, the biggest risk to the market remains the future course of interest rates. We are in a no-win trap. Current market conditions are supported by Bernanke's monumental easing effort, which has driven mortgage rates from the 6% range to sub-4%. What can Bernanke do to drive rates even lower without setting off all kinds of ugly unintended consequences? If the U.S. dollar loses its hegemonic power, rates may escape the control of the Fed anyway. That is why I think the effects of the 'QE' operations are exhausted and Bernanke is powerless to provide any further stimulus.

In conclusion, physical real estate is a far riskier investment today that it once was and this risk is not priced in.

I am not advocating anything, I'm merely thinking out loud: What if instead of investing in an illiquid asset that requires intensive hands-on management, an investor simply buys a basket of builder stocks? Would that accomplish the same objectives? If for some reason policy makers are successful in re-inflating the bubble, the builders may generate far bigger returns, but more importantly, it would be much easier to exit if the bet turns out to be wrong. In addition, a bearish investor can short a basket of builder stocks, while it is impossible to short an apartment building.


(click to enlarge)

The S&P Homebuilder Index XHB since 2007, via BigCharts

Source: A New Aspect Of Real Estate Investing: Risk