Seven Notes on Real Estate

All the furor over subprime. The furor is deserved, but is getting adequately covered elsewhere. The bigger stories are over residential real estate generally, and Alt-A lending, where the problems are as big, but not as well publicized.

I would write about subprime, but I feel that I would be adding to the din at this point. I’ll write about a few other real estate issues this evening.

  1. Last November on RealMoney, I wrote a timely piece that described securitization, and the subprime market, and the credit default swaps that traded around it. It was an ambitious piece, and my editor told me it must be good, because she was able to understand the complexity of the market after reading the piece. Well, a picture is worth a thousand words. The Wall Street Journal has done me one better by giving a visual description of securitization. Here it is.
  2. Housing prices are falling nationally. Barry Ritholtz has a good summary of it. I would only add that the situation is not getting better. We have had falling prices during a peak sales time, and…
  3. More homes being built even as vacancy rates increase. In the short run, it seems optimal to a homebuilder to finish the projects he has begun. Sunk costs are sunk, and he wants to maintain good relations with those whom he worked with during the good times, so many will still build if it covers their variable costs, even if they take a loss in the process. The alternative would be to sell the land at a discount, and destroy useful subcontracting relationships that will be useful once the market turns. The trouble is, if all builders act in a way that is short-term rational, it can worsen the situation in the intermediate term.
  4. Is it time to speculate on the Homebuilders yet? I don’t think so. At residential real estate market bottoms, homebuilders trade for 50-80% of their fully written down book value. There are more writedowns to come, and many still trade over 80% of book, so I don’t think we are done yet. People are still too willing to speculate here. Perhaps the time to move will be when the vacancy rate begins a decline from the record levels that it is at now.
  5. What are Alt-A loans? Loans where the borrower is alleged to be prime, but for one reason or another, declines to prove it as comprehensively as one receiving a prime loan would. Loans that are “alternative prime” should be doing okay, right?  Well, no.  The trouble with Alt-A, is that even though the credit score is higher, the level of information that the lender is getting is a lot lower.  Good lending has safeguards in place, rejecting unworthy borrowers, and then charges an adequate rate.  Yes, it’s a lot more sexy to charge a high rate to whomever walks in the door with a high FICO score, but risk control is a key to all of business and finance.  Those who neglect it are asking for trouble.  As it is now, we have rising Alt-A delinquencies, and rising losses on mortgage loans.  This trend should persist until homeowner vacancy rates begin to fall again, and prices stop falling.
  6. In commercial real estate, rents are still rising in the office space.  I’m a little skeptical about the staying power of that trend, because vacancy rates aren’t low, except in highly desirable areas like Midtown Manhattan.  Away from office, thoug,h prospects are not as good.
  7. Beyond that, the trouble with commercial real estate is that borrowing costs often exceed current yields.  The valuation levels embed a high level of growth in rent, which may or may not happen.   Part of the valuation problem is private equity, which is willing to borrow a lot more than REITs would.  My guess is that equity REITs are a good place to avoid for now.  Gains should be limited, and they bear the risks of a slowdown in private equity, slowing/falling rents, or a rise in financing costs.

That’s all for now.  The media can howl about subprime, but it’s really just a sideshow in the total set of problems facing residential real estate.