Saturday, February 12, 2011

The Future For Apartments

Yesterday, I discussed The Future For Housing, which focused on why home prices would decline due to coming changes in the cost to finance property.  This is also known as leverage.

Today I want to focus on apartments using the same theme.  I called a commercial mortgage broker yesterday and spoke with him in length regarding the current state of financing for multi-family property.

The following is the summary of the discussion:

There are currently 3 avenues of financing for investors looking to put together a deal in today's multi-family real estate landscape:

1.  Fannie/Freddie

The government, just as they do with residential real estate, is currently actively involved in providing mortgages for investors in apartment buildings.

-Fannie Mae specializes in mortgages for $4 million and under.
-Freddie Mac specializes in mortgages for $4 to $10 million.
-They require 20% down (80% LTV) and the asset needs to be 90% occupied for the previous 3 months.
-They do not offer secondary or seller financing. (Must provide 20% down in cash)

2. Life Insurance Companies

-They require 25 - 30% down (70-75% LTV).  The asset does not have occupancy or performance requirements.
-Secondary or seller financing is possible. 

3. Securitised Financing

This financing was the main source of funding for commercial real estate during the real estate boom.  Loans were made by local banks then sold to Wall Street who packaged the loans and sold them to large investors.

Securitization essentially disappeared from the end of 2008 through 2010, but the market has begun to re-emerge at the start of this year.

The loan requirements are essentially the same as Life Insurance companies.

Interest Rates:

Rates for all 3 financing sources above are determined using the 10 year treasury bond rate plus a spread. 

The spread is currently at 250 basis points (2.5%)

The 10 year treasury bond is currently trading at 3.65%.

An investor today would pay 3.65% + 2.5% = 6.15% per year

This is why the government treasury bond rates are so important to the commercial real estate market. 

Looking forward:

I would make the same argument for Fannie and Freddie as I did yesterday in The Future For Housing.  This financing is going to disappear from the market.

The second two forms of financing, Life Insurarance companies (also include pension funds in this category) and Securitisation will continue in the future, but they will require stricter lending requirements, and there is an ominous threat of interest rates rising off their historical lows. 

This tightening of lending restrictions will be a tremendous downward pressure on apartment prices as we move forward.  This will come at a time when an enormous volume of real estate loans will need to be refinanced. (2012-2014)

Investors that have been patient during this false rally will finally get the opportunity to view true real estate bargains as they begin to flood the market sending cap rates soaring.

The Black Oil Swan

I remember back in 2008 during the month of February gas was hitting all time highs approaching $100 a barrel.  It was all over the news.  The talk about gas prices surging was on everyone's mind.

Prices ended up climbing to $147 a barrel during the summer of 2008 before collapsing, along with every other asset in the world, back to $33 just a few months later due to the financial system meltdown.

Since then people have assumed that it was all just a bad dream.  But here we are today, 3 years later, and oil prices are back in the low $90's, creeping toward $100 a barrel.

There are two key differences between where we are today and three years ago:

1.  Unemployment today is close to 10%.  Back in 2008 is was close to 5%.

2.  Our country has run up $5 trillion on the national debt to try and backstop the economy

Our country is far more vulnerable to an oil shock today than it was 3 years ago.  I write this not as a prediction for oil prices in the short term. They could easily reverse course and correct hard downward. (This would provide a tremendous buying opportunity)

I look at an oil price shock as a "black swan" type event that analysts do not have factored into their risk models.

With the continued unrest in the middle east, it will a very important commodity to follow.

Friday, February 11, 2011

The Future For Housing

The chart below shows the difference in interest rates between a 30 year government bond and a 30 year mortgage. 

An investor purchasing a 30 year government bond this morning receives an interest payment every year of 4.76%.

An investor purchasing a 30 year mortgage this morning receives an interest payment every year of 5.08%.

The spread, or difference, is about .36%.

How could this be?  A government bond is considered risk free, where as I do not need to tell you the risk involved in purchasing a mortgage.  You can just drive around and look at the foreclosure signs to see the investors who did not get their money back.

The reason is because both bonds are essentially the same in the world we live in today.

Our government guarantees, back-stops, or insures 99.5% of all new mortgages created today through the FHA, Fannie Mae, and Freddie Mac.

Mortgage loans = government loans.  Your local bank can issue mortgages with the comfort of knowing that if the government does not buy the loan immediately, they will insure against any losses with taxpayer money.

Most view this as bullish for the housing market, their reasoning being that investors can lock in very low rates.  That is a positive way to look at it.

Readers of this site know that I believe the United States is moving toward a sovereign debt crisis.  Our balance sheet is essentially a larger version of Greece, and in some ways it is actually worse.

What has allowed us to postpone the pain has been our ability to finance the deficit with a printing press, which Greece was unable to do because they are a part of the European Union.

I believe that some time in the next few years our government is going to have to decide what they can spend money on, and what they cannot.  The reason is as our deficits continued to be monetised with printed money the cost of living will begin to surge.  Interest rates on our government bonds will rise.

The four largest pillars that encompass our deficit are as follows:

-Social Security/Food Stamps
-Fannie, Freddie, FHA

If you believe we will have to cut spending, you need to decide which one you believe the government will take away from of these four.

My bet is on the last one.  I think the voters will choose to have food, medicine, and protection over living in an artificially high priced home that forces them to pay higher taxes and insurance every month on the artificially high paper price.

If that outcome occurs, then mortgage rates will skyrocket.  (If the government no longer guarantees the losses, banks will have to ask for higher down payments and higher interest rates to take on the risk)  As rates rocket higher, home prices will have to fall in order for Americans to afford the mortgage payments and higher down payments.

At this point real estate will be a tremendous investment opportunity.  Patient investors can sell their precious metals and have a healthy down payment for performing rental property.

Wednesday, February 9, 2011

US Dollar Record Lows

The dollar index is a measure of six of the largest world currencies against the US dollar.  It weighs the euro as 57% of the total index, with the other five currencies (Canadian dollar, Swiss franc, British pound, Japanese yen, and Swedish krona composing the other 43%)

This makes the dollar index heavily influenced by the value of the euro, which as you know is currently crumbling under a sovereign debt crisis.

A far better tool to value our currency against the others around the world is the trade weighted dollar index which is composed of a much larger basket of currencies. (26 total)

This index has just hit a new all time record low, as can be seen by the graph below, and will be an important indicator to watch as our currency moves toward the coming crisis where it will enter free fall.

2011 Outlook Update

News this week provides an update on my Outlook for 2011:

Sovereign Debt:

Portugal bonds hit an all time record high today bringing the country one step closer to our first Euro bail out of 2011.

Municipal Bonds:

Obama announced the first step today in what will ultimately be the bail out of municipal (local government) debt.  He is pushing back payments for the money states have borrowed over the past two years to pay unemployment benefits.

Stage 2 will come later this year in the form of a direct government bail out or the Federal Reserve buying municipal debt in Quantitative Easing Part 3.  (Their $600 billion QE2 program ends in June)


Zillow reported this morning that home prices fell 2.6% during the last 3 months of the year.  This has pushed the number of mortgages under water (owe more than home is worth) to 27%.

Mortgage rates rose this week from 4.81% to 5.13%.

As home prices accelerate downward and mortgage rates continue to rise look for a new housing "stimulus" program later this year or additional mortgage purchases by the Federal Reserve in their attempt to keep home prices artificially high and unaffordable.

Stock Market:

The stock market continues to be the darling story of the year, hitting new highs daily and clocking in new multi-year sentiment level highs in optimism.  People across the board believe the market is going higher at a time when economic fundamentals are crumbling under the surface.

Big Picture:

We are in a secular bear market in stocks, a cyclical bear market in housing, and the peak of an enormous bubble in bonds.  All three are dangerous investments.

We are currently in the heart of a secular bull market in commodities.  The chart below shows the 20 year bear market in commodities from 1980 to 2000, and the bull market which began in 2000 and continues today.  Pull backs in prices should be welcomed and viewed as opportunities to add to positions.

Blue Line = CRB Commodity Index
Red Line = Gold

Bernanke On Debt

From Ben Bernanke's testimony before Congress today:

"By definition, the unsustainable trajectories of deficits and debt that the CBO outlines cannot actually happen, because creditors would never be willing to lend to a government with debt, relative to national income, that is rising without limit. One way or the other, fiscal adjustments sufficient to stabilize the federal budget must occur at some point. The question is whether these adjustments will take place through a careful and deliberative process that weighs priorities and gives people adequate time to adjust to changes in government programs or tax policies, or whether the needed fiscal adjustments will come as a rapid and painful response to a looming or actual fiscal crisis."

Tremendous honesty from the Federal Reserve chairman.

It is obvious by now that the adjustment will come in the form of door number 2, a fiscal crisis, as no serious cuts to the trillion dollar annual deficits have been announced or even discussed.

Tuesday, February 8, 2011

Core Logic Home Prices

Core Logic's home price index was released this morning and showed a month over month drop of 1.8% for the month of December.

This is the fifth straight month of declines and the index has now reached post bubble peak lows. 

Look out below for the housing market.

Silver Perspective

The chart below provides some perspective on where silver stands today in relation to its record high of $50 set back in 1980.  The above ground silver inventory today is currently 90% below where it stood in 1980, yet the price is currently 50% less than the 1980 high. 

The supply of silver is one component of price.  A second is the money supply, which has grown from $1.5 trillion in 1980 to just under $9 trillion today.  The chart below, produced by the Federal Reserve, shows the money supply growth (m2) from 1980 to present.

Once again to summarize:

*The above ground silver is currently 90% below the level available in 1980

*The money supply has grown 600% between 1980 and today

*The silver price is currently about 50% below its 1980 peak price

*There is currently about 50% less silver available than gold above ground to purchase

*Gold is currently 46 times more expensive than silver. (46 to1)  The historical ratio is 15 to 1.

When this bull market meets the mania stage it will stagger the imagination at the price levels reached.

As a word of caution, based on technical analysis, the market is due for a correction and possibly a large one.  Look for this as a tremendous purchasing opportunity.

Ratigan On Food Riots

Dylan Ratigan explains Ben Bernanke's direct link to the food riots and starvation around the world in his attempt to raise stock prices and protect bank bonuses.

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