Distressed Residential Investing Using Quantitative Measures to Maximize Returns and Minimize Risk

Metrostudy successfully predicted changes in home prices and sales just before the downturn in the housing market. Bradley Hunter explains how robust indicators can be used by hedge funds to quantify the current status of local housing markets, helping them to make informed decisions.

By Bradley Hunter
Chief Economist/National Director of Consulting

While the media often refers to national statistics when referring to the current downturn in the housing industry, those with investment portfolios particularly sensitive to the housing cycle know there is no “U.S. Housing Market.” Rather, hundreds (or thousands) of housing markets are rolled into national totals for purposes of recognizing trends or quantifying an upswing or a downturn. These totals, however, can obscure vital differences among markets. For example, San Francisco’s housing cycle has been radically different from Raleigh-Durham’s, and its current trajectory and outlook are also distinct.

Common to local housing markets, even in markets where there was no “boom,” like Raleigh, is a universal theme — a dearth of home buying, but there are some early signs that the market is turning the corner now that homes are affordable again.

Even consumers who still have a good job and good income are being deterred from buying a home. I attribute this to what I call the four “Fs”– fear, financing, falling home prices, and failure to sell an existing home.

Governmental entities have failed to arrest the decline in home prices and foreclosures because they have not been able to change consumer psychology nor overcome the problem of negative equity. Lowering interest rates, offering tax credits to people buying homes and raising conforming loan limits were measures taken to encourage people to buy, but they have not been powerful enough to overcome the four Fs.

Sales of existing homes are way up, but that can be largely attributed to the addition of many more deeply-discounted foreclosure homes and short sales to the market, which means that the improvement is actually an indicator of market weakness rather than strength. That said, I have heard from many homebuilders that their sales are increasing. The flow of traffic through their models is still excruciatingly slow, but those people who do turn up are more likely to buy. Sales are up and cancellation rates are down in most of the bubble markets, particularly in the last month or two.

So, hedge funds and private equity funds are lining up like never before, preparing to buy residential property – bulk lots, broken subdivisions, or homebuilding companies. Our phone has started to ring noticeably more often just in the last two weeks, as more of the investment firms need rigorous market due diligence!

Hedge funds want to know: what are the “tea leaves” that predict turns in local housing markets? As an inventory indicator, many analysts refer to the number of resale listings on the local Multiple Listing Service. The problem is most of those so-called inventory homes are not inventory because they have people living in them. The more pertinent question is “how many homes have builders built that have never been occupied?” That number provides a clearer measure of excess housing inventory than resale listings. It is a more difficult number to obtain, but is more meaningful.

The amount of finished, vacant new inventory is a much better predictor of downward price pressure than resale listings. It was easy for Metrostudy analysts to predict a downturn in prices in Las Vegas and Miami in late 2004 and early 2005 by looking at finished, vacant new housing inventory. Inventory levels became excessive in those markets several months before prices started to come down. Those two markets were the first to show serious oversupply problems.

The most reliable benchmark to use in determining if a local market has an excess of finished, vacant homes is months of supply, determined by dividing the number of finished, vacant new homes on the market by the number of resident or user move-ins per month. If the months of supply, which normally ranges from 1.5 to 2.5 months in most markets, goes above three months, price concessions by builders almost always follow. (The exception is Atlanta, which is normally a speculative market where the equilibrium of months of supply of finished, vacant inventory is higher than in other markets.)

So where are we today? The first graph shows the total count of finished, vacant new housing. It also shows the months of supply. The order is based on months of supply; therefore, markets on the right are the most balanced, with 2.5 to three months of inventory in San Antonio, Charlotte, Indianapolis, Austin and Houston. The most overbuilt markets have six to seven months of supply and include several Florida and California markets. These data were gathered in the course of Metrostudy’s quarterly 100 percent count of starts, inventories and move-ins. Move-ins are counted according to visible signs of occupancy.

The markets listed on the left side of the graph will continue to suffer downward pressure on home prices through the end of 2009 and most likely well into 2010. The foreclosure pace in most of those markets is high. Along with finished inventory, the foreclosure pace must also be monitored.

In most of these markets, the finished, vacant inventory is owned by individuals, not builders. Many would-be speculators who bought homes near the peak of pricing, in late 2005 or early 2006, have not managed to find buyers or renters. Builders have purged a lot of their standing inventory, but they are still competing against their own supply, now in the hands of speculators or banks that are taking keys back from speculators.

All markets listed in the first graph have an excess of finished, vacant inventory, but the surplus amount in Texas and in the Carolinas is manageable and will be quickly absorbed when consumers start buying again. A revival of absorption in those areas will immediately move the months of supply back under two months as the denominator (move-ins) increases.

The markets listed on the left side of the graph will continue to suffer downward pressure on home prices through the end of 2008 and most likely well into 2009. The foreclosure pace in most of those markets is high. Along with finished, vacant inventory, the foreclosure pace must also be monitored.

Lot Supplies

The supply of developed lots is another market indicator to watch carefully. Delivery of lots to the market continues at a faster pace than demand nationwide. Again, certain markets have a greater oversupply than others (readings over 120 months are shown at 120 on the graph).

Depending upon the specific market, a normal level of months-of-supply for lots is 24 to 30 months. As seen in the second graph, some markets have in excess of 100 months of supply, indicating not only an oversupply of lots, and a potential for an extended oversupply of homes, but also a high level of acquisition and development (A&D) loans that are going to go bad.

Recent Developments in Specific Markets

  • Southern California’s pace of existing home sales has improved recently, but more than half of the sales are of REO (bank-foreclosed) homes. Demand for those REO units is strong: sometimes 15 or 20 bidders compete for each foreclosed unit; therefore, discounting has not been as drastic as predicted. Builders are selling some homes for 50 percent of their original (peak) prices. San Diego’s conversion rates (traffic converting into sales) have shot up in recent weeks to the highest levels in years, and cancellation rates are at the lowest levels (10%) since the slowdown began.
  • Developed lot supplies are excessive in many markets — extremely so in Chicago (some outlying areas have a 72-month supply of lots), Minneapolis, and the Inland Empire. Certain parts of Metro Atlanta have an eight-year supply based on current absorption rates.
  • In most parts of the country, housing starts have fallen below the level of demand, but California’s Bay Area was slow to reduce starts to below the move-in pace. Despite this, land constraints and continued in-migration make the San Francisco area very interesting from an REO investment standpoint.
  • Even in strong markets that never experienced a serious boom, (Austin, Raleigh, Salt Lake City), weakness is intensifying. Now the soft housing sector is affecting economic growth in general. In Austin, Dell, AMD, and Applied Materials announced moderate layoffs last year, the first layoffs of note in many years.
  • Denver’s housing starts are off significantly. Despite layoffs at John Laing Homes and the closure of Neumann Homes, however, Metrostudy expects starts to pick up earlier in Denver than in most other markets, but that market didn’t fall far, so the upswing will not be dramatic.
  • Phoenix’s housing market continues to suffer, with the number of foreclosure filings in Maricopa County topping 9,000 per month and still rising. Homebuilders in Phoenix have seen some positive signs lately, as the conversion rate for traffic into their models has improved markedly in the past four weeks. Also encouraging, cancellation rates are at running at only 20%, compared with 30% a year ago and 40% in 2007.
  • Resale activity in Las Vegas has finally started to show signs of life, but the economy is soft, and buyers are still looking for deep discounts. Conversion rates improved dramatically from the dismal rates of early 2009, now higher than any time since the slowdown began. Similarly, cancellation rates are lower than they had been for the same period of time in 2008 or 2007.
  • The Washington, D.C. area has remained surprisingly resilient, even seeing some stablization in the resale market in Northern Virginia, but suburban Maryland remains soft.
  • Home sales in South Florida remain stagnant, and high levels of foreclosures (more than 7,000 filings per month in Miami-Dade and 1,000 REO per month) keep downward pressure on prices. Some builders are selling at 50% of their peak pricing. Central Florida caught the speculator boom nine months after South Florida did, and its walk-aways (borrowers who give the keys back to their lenders) are increasing. This market did not dive as deep as South Florida, and probably won’t rebound as fast, at least in the remote suburbs. Naples/Fort Myers statistics are troubling, but the worst problems are concentrated in the Lehigh Acres and Cape Coral areas of northern Lee County. Lee County foreclosures are running high, with 6,250 new cases filed during the first quarter, and the unemployment rate is now over 12%.

Most institutional investors are exposed to the housing cycle, and to banks and other businesses that depend on the homebuilding sector, and many investors seek to capitalize on the downturn. Aggressive investors are looking for “excess,” returns, and superior information will be the key to success in that search. All investors are advised to seek out local information in order to understand the risks and the potential rewards relating to this historic cycle. This article mentions only a few local indicators. A wide variety of information is called for, and local insights will be vital.

The housing boom years were forgiving of those who had incomplete or shallow information; the next few years will not be so kind. Every geographic market is on its own course. Some repercussions of the current housing cycle are being experienced in all regions, but the nuances between markets and submarkets will determine which investments will earn a superior return and which will suffer a loss.

Bradley Hunter can be reached at 561.835.9235 or bhunter@metrostudy.com. Follow his observations on the housing data minutes after they get released, on Twitter.

About Bradley Hunter

Bradley Hunter is a leading national housing market analyst with 24 years of experience in real estate analysis and local economic forecasting. He spearheads the consulting practice at Metrostudy, a national housing market consulting firm. Previously, he was president and principal of Powers-Hunter Group, a real estate consulting firm, and he was Chief Economist/VP for Goodkin Research and a Research Economist at DRI/McGraw-Hill before that. As an expert on housing industry trends, he is regularly cited in the news media, is a sought-after speaker and advises regulatory agencies of the U.S. government.

About Metrostudy

Established in 1975, Metrostudy is the leading provider of primary and secondary market information relating to the housing industry and related industries nationwide. The company is recognized for its consulting expertise in investment due-diligence, repositioning of residential projects, fundamental valuation of REO and loan pools backed by residential.

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