Real Estate Values, Uncertainty, and Anchoring

Everyone knows that real estate values today are much different than the values assigned to the same real estate two or three years ago. Elena Panaritis argues that value uncertainty is the underlying cause of our crisis in her Financial Times post “The Real Estate Roots of the Crisis in the US”. Some excerpts:

Traditionally, economists are trained to assume that pricing in general is a point of equilibrium defined by almost perfect market forces, where the demand and supply meet and neither the buyer or seller has a huge informational advantage. The traditional model also assumes that markets are frictionless and transaction costs are near zero especially when we deal with the supply side. From that they continue to assume that systems (rules, regulations, norms) that define the tradability of assets are given and near perfect. But this is rarely the case. In reality the systems that define supply of land and real estate tend to be full of transactions costs and information leakages, and that makes it really difficult to follow the old maxim that a price or value based on how much one is willing to pay is necessarily the right price.

Until the United States accepts that it has a badly flawed approach to establishing and verifying real estate property rights and to determining the valuation of property, until it puts in place a system that homogenizes and standardizes the underlying securitized assets of real estate and housing - the same way securities are required to be homogeneous prior to being traded in bundles - these underlying real estate assets will continue to be toxic.

That’s all true, but how do you improve a market that is illiquid and thinly traded, and how do you homogenize assets as heterogeneous as real estate?

I like the approach advocated by Richard Green in his post “Two Ideas for Appraisal Reform”; acknowledge the uncertainty and disclose it right in the appraisal. An excerpt:

Appraisers should use valuation techniques that allow them to report a standard deviation of their estimate. Subdivision tract houses will have small standard deviations; architect designed villas will have large standard deviations.
We could then move to a pricing rule where Mortgage Insurance will be required if (1) the LTV based on appraised value is greater than 80 percent or (2) there is a greater than five percent chance that the true value of the house implies an LTV of 95 percent…
We need to stop kidding ourselves that we can measure house prices precisely. We need to start measuring the level of imprecision.

Richard’s other idea is also a good one:

Appraisers should not be allowed to see the offer price of a house. This is the only way their valuation will be truly independent.

Appraisers use the contract sales price as an anchor point, where there is an anchor there’s a good chance there will be anchor bias.

Of course, back in the old days underwriters and review appraisers did this work themselves. Appraisers conclude a value, but they also report the raw comparable data. Generally, appraisers try to bracket a property by selecting some comparables worth less and some worth more. Part of the underwriter’s job was to look at these comparables and assess the implied uncertainty. For example, if the contract sales price and the appraiser’s concluded value was $400/sf and the comparables were all $350/sf or lower, you knew your value had a high degree of uncertainty.

Some CRE lenders still do this work, but I doubt it happens much on residential transactions. Richard’s suggestions are a good substitute.

Zombie Banks’ Distressed Assets

John Reeder’s post Distressed Assets Market and FDIC Closures on Real Property Alpha is a must read for those that want to understand what’s going on with regional banks. An excerpt:

Our business working in the commercial real estate industry (see the Deal Breaker site, or upcoming Sperry Van Ness auction) puts us on the front lines of the current blow-up that is going on in the banking industry.  Capitalization levels in financial institutions have a large impact on whether they are willing or able to dispose of distressed construction loans, commercial REO, or A&D loans.  The general rule of thumb is that the more distressed the bank, the less potential that you are going to be able to make a deal with that Bank on their non-performing assets.  It’s difficult to digest this reality as the potential that a distressed bank offers in the way of inventory can be enticing.    However, the chances are that the bank has not written down the value of the asset to real current market, so selling at today’s prices means that the bank has to take an additional hit to their capital and the really distressed banks can ill afford the additional hit.

Read the whole post, there’s much more. I have two small contributions to John’s points:

• Even if a bank conscientiously marks its bad assets to market, it will still probably incur smaller losses at any given point in time if it holds the asset instead of disposing it. The marks are based on appraisals less a discount for sales costs. This number will almost always be higher than what a bank actually realizes on a sale, because appraisal values tend to lag actual market trends (more on that in the Lansner on Real Estate post “Were Appraiser’s Late to the Price Collapse?”). So, a bank can adopt a hold strategy and still be in regulatory and accounting compliance. The risk, of course, is that by hanging on to the asset, the bank continues to be exposed to further value losses if the market continues to deteriorate, and may ultimately incur an even bigger loss.
• In most cases the management and staff working on the problem assets at the smaller banks are the same people who originated the deals. There are whole sets of cognitive biases which predispose people to overvalue what they own (endowment effect, post-purchase rationalization), continue to do what they've done in the past (status quo bias, sunk cost effects, loss aversion), and expect a positive outcome to their choices (optimism bias, and valence effects). The consequence is the management at these banks may genuinely believe these assets can be salvaged given time, while someone with less involvement would say it’s time to take the loss.

My point is that, while I am sure some banks are consciously manipulating their accounting, I am also sure many banks believe they are doing the right thing.

Are Fractured Condos a Good Investment Opportunity?

A fractured condo project is one in which only some of the units have been sold. They occur when sales stall, and usually the construction lender ends up owning the project. Some see these projects as a great investment opportunity. An excerpt from Unnatural Rent:

In fact, one of the more promising investment opportunities may be taking over broken condo developments, for instance, a 100-unit project that only has 20 units sold. It should be possible to acquire the unsold units in a block and then rent or sell after the market recovers.

And from Realty Times:

Hedge funds, private equity "vulture" groups and individual investors are all shopping aggressively to pick up these distressed units at deep, deep discounts that start at 40 percent and go much lower.

New Valley LLC, a Miami-based subsidiary of Vector Group Ltd., a New York Stock Exchange-traded company, says it's got $250 million in cash ready to invest in South Florida fractured condos or in troubled rental projects.

Vanessa Grout, vice president of acquisitions, told Realty Times that the situation has become so dire for some developers of prime condo projects this year that her firm sees "pivotal opportunities" right now to pick up high-quality, well-located condos at once-in-a-lifetime prices.

There are some huge drawbacks to such projects:

• You have to deal with the owners of the units which were sold. These people are typically very unhappy. In a perfect world the project buyer repurchases these units, but often these owners will hold out for a premium price.
• Buying a large block of units from the developer may put you in their shoes if there are construction defects. The combination  of angry unit owners and construction defects can be really unpleasant.
• Many multifamily investors won’t touch these projects, with the result that the pool of potential buyers is smaller. This can make an exit harder.
• The project may have failed as a result of condo market conditions or a bad price point, or it may have failed for more fundamental reason (bad location, poor design). It’s not always easy to sort out the cause of the failure, and a bad condo project is likely to be a bad rental project too.
• For all the reasons above, it’s very, very difficult to get financing for these projects. Conventional multifamily lenders (e.g., Fannie and Freddie) won’t touch them, which doesn’t leave many sources in this market.

These deals will get done, but it’s not easy money.

New Blog Feature

Most of my posts are prompted by what I read on other sites, but I don’t have time to discuss everything I find interesting. I’ve added a “Shared Item” gadget on the right sidebar under the email subscription for these posts by others. I hope you find them interesting too.

The Problem With Medians

Prices, vacancy rates, rents - most pronouncements of real estate trends are the medians of a set of data. These reports are largely meaningless, or, even worse, actively misleading. Lansner on Real Estate’s post “Is Median Price Giving Bum Signals?” quotes John Burns, and Orange County housing consultant, on the subject:

We are extremely concerned that policy makers, banking and real estate industry executives, investors and others will use misleading home price data to conclude that home prices have stabilized. They have not. These same influencers used this data in 2006 and 2007 to make decisions, many of which have proven to be poor decisions. It was a tough lesson, and hopefully one that won’t be repeated. This is a complex issue. Here is why: Reported home prices and home price indices rely on a small sample of transactions that represent far less than 1% of the owned homes in an area.

The data problem is serious for homes, and exponentially worse for commercial real estate because there are even fewer transactions. The problem is an ongoing theme over at Calculated Risk; see “Misleading Housing Price Data” and “Median Price Mix Example”, for example.

An alternative is the “same store” trend, which compares sales prices and operating data from the same property over time. The problem with using this approach for commercial real estate is that property and price performance are idiosyncratic. For example, land values can change radically as a result of permits being obtained or a local building moratorium being imposed. The loss of a major tenant can have a big impact on the value and operating data of an office or retail property. A new, incompetent property manager in a multifamily property can cause a big spike in vacancy. There are so many micro factors which can influence prices and performance that in my opinion it’s very difficult to draw macro market conclusions from the relatively small samples we have to work with. 

Certainly we can identify major sustained trends, but if some told me their data showed office values are down 30% in a market, my conclusion would be prices are down somewhere between 15% and 45%.

What’s the solution? When it comes to commercial real estate, I don’t think there is one – there are just not enough transactions to draw meaningful conclusions.  Employment trends provide a good proxy for commercial real estate performance; I’ve yet to see a real estate market getting better when the market is losing jobs. I’ll believe CRE and residential markets are getting better when we start seeing employment growth again.

Why Lenders Don’t Modify Loans

Economists at the Federal Reserve Bank of Boston and Atlanta have researched "Why Don’t Lenders Renegotiate More Home Mortgages?". Their conclusion also applies to commercial real estate:

We argue for a very mundane explanation: lenders expect to recover more from foreclosure than from a modified loan. This may seem surprising, given the large losses lenders typically incur in foreclosure, which include both the difference between the value of the loan and the collateral, and the substantial legal expenses associated with the conveyance. The problem is that renegotiation exposes lenders to two types of risks that can dramatically increase its cost. The first is what we will call “self-cure” risk. As we mentioned above, more than 30 percent of seriously delinquent orrowers “cure” without receiving a modification; if taken at face value, this means that, in expectation, 30 percent of the money spent on a given modification is wasted. The second cost comes from borrowers who redefault; our results show that a large fraction of borrowers who receive modifications end up back in serious delinquency within six months. For them, the lender has simply postponed foreclosure; in a world with rapidly falling house prices, the lender will now recover even less in foreclosure. In addition, a borrower who faces a high likelihood of eventually losing the home will do little or nothing to maintain the house or may even contribute to its deterioration, again reducing the expected recovery by the lender.

Adam Levitin at Credit Slips has an excellent follow up post, and makes the point that modifications make sense even after taking into account self cure risk and redefault risk. He also nails the real reason more modifications aren’t being done:

I think servicer capacity is a major concern that applies across the board.  To start with the bulk of servicer personnel at most companies aren't even in the US; they've been outsourced.  Doing a mod is like underwriting a new loan in a distressed situation.  That's a skill, and I don't think it's what servicers were looking for over the past decade when they moved operations to India. Instead, they were looking for low-cost labor for their routine ministerial tasks, and it will take a long time for the industry to acquire the workout talent it needs.

I highly recommend reading both of these pieces – together they will give you a better understanding of modification dynamics than anything else I’ve seen written over the past 3 years.

Why Haven’t There Been More Construction Loan Defaults?

Delinquency rates for CRE construction loans are “only” 12%; why is that?

Distressed Volatility quotes testimony from Richard Parkus - Head of CMBS and ABS Synthetics Research, Deutsche Bank (italics mine):

90+ day delinquency rates are currently in the 12% range for construction loans in bank portfolios, but are somewhat higher for construction loans in regional bank portfolios. In fact, I am perplexed by the fact that construction loan delinquency rates are only 12% at this point. However, I believe that this can be explained by the fact that they are typically structured with interest reserves which are sufficient to cover interest payments until the expected completion of the project. Thus, construction loan delinquency rates are currently artificially low due to interest reserves, but will likely rise dramatically within the coming 6-12 months. In my view, losses on construction loans are likely to be in excess of 25%, possibly well in excess, which would imply losses of at least $140 billion. This, of course, would be disproportionately borne by regional and local banks."

I agree with Parkus that interest reserves are responsible for keeping these loans afloat. Most construction loans are indexed to LIBOR, or less commonly, Prime. This chart from FedPrimeRate.com shows what has happened to these rates:

Construction loans started in 2005 or earlier were mostly refinanced before CRE permanent lenders pulled back, and CRE construction lending declined dramatically during 2008. As a result, the construction loans still out there were originated most during 2006 through the first half of 2008 (the period inside the ellipse on the chart above). The interest reserves on these deals were sized assuming prime would remain around 8%, and LIBOR would be at around 5%. Since then, prime has dropped to 3.25% and 1 month LIBOR is 0.29%. As a result, an interest reserve sized to carry a loan for two years can now cover interest costs for four years or more. So, even though projects are not hitting the occupancy and rent levels projected, many lenders are willing to extend these loans because the interest can be kept current from the original interest reserve without increasing the loan commitment. The hope is markets will recover before the reserve runs out or interest rates go up.