Landmark Links October 7th – Urban Legend

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Lead Story…  Chances are that you’ve heard tales about alligators living in the NY sewers, Coca Cola’s magical ability to dissolve teeth overnight, that Elvis Presley is still alive and in witness protection, or even the old  Weekly World News standby of a bat child found living in a cave. These urban legends and others like them have spawned a virtual cottage industry of cable TV shows and websites seeking to either prove or debunk their claims.  Likewise, if you’ve attended development industry conferences in the past 4 years or so, you’ve probably heard some variation of the following on a capital panel: “There is too much money chasing too few deals.”   It’s been repeated so frequently through the past few years that the concept of “too much money chasing too few deals” is almost universally accepted as truth in the residential development industry.  However, just like tooth-dissolving cola, it falls apart under further scrutiny when discussing for-sale residential real estate development.  When viewed from 30,000 feet, the previous sentences probably looks crazy.  Many private equity funds, hedge funds, etc have raised money to invest into housing development.  However, it’s not the amount of money raised that’s been problematic in recent years.  Instead it’s that the type of money available is often a poor fit for projects in need of financing in today’s relatively stable housing market.

In the years before the housing bubble and subsequent bust, private home builders typically utilized bank debt and pension fund capital to build subdivisions and master-planned communities.  The debt component was readily available and attractively structured and pension fund capital had relatively long investment horizons and reasonable return expectations when compared to opportunity fund money which was typically used for entitlement projects and other, more risky ventures.  It wasn’t unusual back then to have decent sized private builders in California build and sell several hundred homes a year or more.  With a couple of notable exceptions, they were not going to compete with public home builders when it came to cost of funds.  However, they were still substantial players in the market and were able to build at decent levels of production while often delivering higher quality homes than their public competitors.  This all changed when the housing market crashed.  Banks reduced exposure to the home building and development space by a substantial amount, as did pension funds.  Some left the space entirely.

At the same time that pension funds and banks were pulling back, opportunity funds ramped up their fundraising in order to capitalize on the carnage that the Great Recession wrought on land values.  They offered their prospective investors high-octane returns that would be realized when they bought trophy properties at bargain-basement prices in a distressed environment, to develop or sell as the market began to recover.  This capital was and is well suited for opportunistic investments brought on by a market crash – thus the label opportunity fund.  What it isn’t a great fit for is investing in home builder and land development deals in a stable market.  In reality, the window to buy distressed assets wasn’t quite as long as many had anticipated and the doldrums of 2010-2011 quickly gave way to a run-up in transactions and land values in late 2012 into early 2014.  All of which brings us to where we are today: a stable market with tight inventories where there is a ton of capital that has been raised – but very little of that capital has a return profile that fits where it is needed most: lot manufacturing and production home building.  There are several reasons that this is happening:

  1. Unrealistic Investor Returns in a Stable Market – As stated above, much of the capital that has been raised to deploy for home building and land development in the market today is much better suited for a distressed market than a stable one.  However, there is something bigger at play: equity funds are targeting the same mid-20% IRR returns with the 10-year Treasury yielding 1.75% that they were when the 10-year was yielding 5%.  All returns are relative, meaning that, in real terms, today’s targeted returns are actually substantially richer than they were when the 10-year was substantially higher.  This has more to do with fundraising and marketing than anything else.  Funds are reluctant to pitch investors at the returns they are likely to achieve (mid to high teens) since their competitors will still promise mid-20%s, meaning that they won’t be able to raise capital, even if the underwriting that they are using to get to those returns is aggressive BS.
  2. Private Builders Get Squeezed Leading to Less Competition – In order to offer high returns to investors in a lower return environment, funds need to grab a bigger piece of a smaller pie, leaving less for builders and developers.  Typically, this means putting steep minimum multiple hurdles in their waterfalls.  Ironically, minimum equity multiples are incredibly short sighted as it encourages builders to push prices rather than absorption since the multiple hurdle is almost always substantially higher than the IRR hurdle, leading to longer sell out periods.  As if that isn’t enough, the few bank lenders left in the space are typically quite conservative and require a full persona guarantee.  So if you are a builder, you now have to put up 10% of the equity or more in order to get a deal done and put your balance sheet on the line to finance it and you’re getting a smaller piece of the returns.  Eventually, you have to wonder what the point is.  This is a huge reason that there are very few decent sized private builders left – in many cases the reward simply isn’t worth the risk.
  3. Lack of Debt Capital Resulting in Broken Deal Structures – Many land deals purchased during the aforementioned 2012-2014 run-up were bought under the assumption that either debt would be available to improve lots or public builders would purchase paper lots.  Fast forward to 2016 and the public builders still don’t have much of an appetite for paper lots nor is there debt readily available for horizontal development.  That means that the owner is either going to need to sell for a substantially lower number than they had in their proforma (sometimes even a loss), or improve the lots themselves by raising additional equity.  As a result, many of the sites that were bought in 2013 with a business plan to entitle and flip are effectively underwater.  Mind you that home prices have almost universally INCREASED during this time frame but a lack of reasonably-priced development debt or public home builders with an appetite for paper lots has caused a stealth land correction of sorts that has been playing out for months.
  4. No Investor Appetite for Long Duration Deals – Ask an opportunity fund investor what they fear most and you will probably hear something about getting stuck in a multi-cycle development project.  High octane capital needs to get in and out relatively quickly in order to make the out-sized returns promised to investors.  Many opportunity funds are of the mindset that we are getting late in the cycle since prices have risen so substantially from the bottom despite the fact that housing starts in key production markets haven’t picked up much and inventory is still bumping along near record lows.  Many funds have been looking to trim project duration in an effort to ensure that they are out when the cycle inevitably turns.  As a result, there are some incredible opportunities out there that require capital to execute a 5-7 year business plan that no one will touch due to duration.  We have seen several of these sort of projects where sponsorship is strong and land basis is very attractive due to a lack of bidders.  However, it’s incredibly challenging to find capital that is willing to go out that far, even if the returns are exceptional.  This short-term mentality has left a large hole in the market for anything but bite-sized infill deals.

If this actually were a  market with the aforementioned “too much capital for too few deals” we would expect to be seeing increasing transaction volume and increasing land prices as the supply of capital led to a seller’s market. However, neither of these are occurring in all but a select few markets (at least on the west coast).  Instead, we are seeing light (at best) land transaction volume.  In order for the land market to turn the corner, either  the public builders need to regain their appetite for buying paper lots and developing them or we need more sources of capital that are properly aligned with the projects that they are financing under normal market conditions.

Home building and land development can both provide great returns in a healthy market. However, trying to finance these ventures with little-to-no debt and opportunistic capital raised to buy distressed assets is like trying to fit a square peg in a round hole.  Does this sound like a market with too much capital to you?  Better keep searching for those sewer-dwelling gators.

Economy

Pay Up: A look at who pays the most for housing, healthcare, energy and groceries by state.

Lag Time: How the psychology of the Housing Bubble helps to explain today’s odd labor shortage.

Commercial

Office Space: Open office concepts are becoming a bit less open as many tenants build out more private space.

Residential

Delusional Narcissism: Celebrities really suck at selling homes, mostly because they dramatically overestimate the value of their fame on the house they are trying to sell.

Flattening Out: Residential construction spending was down again in August despite strong gains in multi-family.

The Pendulum: There is a fairly strong demographic argument that we are approaching “peak renter.”

Profiles

Clowning: The clown industry (yes, there is such a thing) is not happy about all of the creepy clown sightings occurring across the US. See Also: Penn State students lose their minds after creepy clown sighting.  And: Someone even started a Clown Lives Matter movement, complete with organized protests.

Useless: Robo-callers and internet scammers have turned the National Do Not Call List into one big joke.

Soul Crushing: The average white collar worker will spend 47,000 hours on work email over his or her career.

Scapegoat? Meet the whiz kid behind the sketchy Russian mirror trades that are causing Deutsche Banks whole bunch of trouble that it really doesn’t need right now.

Chart of the Day

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WTF

Bite to Eat: Some lunatic threw an alligator through a Wendy’s drive thru window. Because, Florida.

Incestuous: A 68 year old man unwittingly married his 24 year old biological granddaughter. They don’t plan on getting divorced. Once again, because, Florida.

Crimes Against Humanity: Today’s video of the day is a bunch of adults beating the crap out each other in a massive brawl at a Chuck E Cheese in, you guessed it: Florida.  Kudos to the guy in the Eli Manning jersey who appears to have a much better arm than the real Eli Manning.  (h/t Ethan Schelin).

P.S.  I know that we spend a lot of time laughing at Florida’s expense on here. However, please keep Florida residents (including my parents) in your thoughts and prayers as they batten down the hatches to deal with Hurricane Matthew. Hopefully everyone will be ok so that they can get back to their goofy antics ASAP. 

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com

Landmark Links October 7th – Urban Legend

Landmark Links September 23rd – What’s the Point?

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Lead Story… Former Federal Reserve Chairman Paul Volker once said that the only useful modern financial innovation was the ATM.  While that’s a rather harsh assessment, there is a bit of truth to it.  Too often, financial products ranging from subprime loans, to derivatives to leveraged ETFs are created more as profit and marketing opportunities for those selling them than they are to fill an actual need of the people that they are being sold to.  That being said, I’m still somewhat fascinated by the FinTech industry because there are segments of the market that are not covered by traditional sources where FinTech companies can provide real value to consumers.  There have been several such products from online mortgage lenders to crowd funding platforms for real estate deals that fill a need.  I’m especially interested when a FinTech startup is aimed at our beleaguered national housing market.  Last week, top tier Venture Capital investor Andreessen Horowitz announced a new venture called Point which was created to invest in a portion of the equity in a home in exchange for a portion of the return when you sell or refinance.  Point lowers a homeowner’s monthly payment because you don’t pay current on Point’s equity investment and that all of their profit is realized upon sale or refinance of the home. Although this reduces a homeowner’s current pay, it could cost a lot more in the long term depending on whether your house appreciates and by how much.  When Point was announced via press release, the financial blogosphere when into a bit of a tizzy which was somewhat predictable given that: 1) The concept of offloading equity in a home, typically a family’s largest asset, has been around for some time but this seems to be the first time someone has attempted to do it in scale; and 2) Andreessen Horowitz is known for making smart investments – so people naturally assume that their involvement validates Point’s business plan.  I wanted to hold off on offering my opinion until I had time to do a bit of reading and research on the product.  There is still  a lot of information that hasn’t been released on how the product works but I’ve been able to piece together enough to get a decent ideal.

First off, let’s explain how the product works.  The best way to do that is probably the example from their own website:

 

Check if you qualify

Enter your address and answer a few questions. The process is free and takes less than 5 minutes.

5 minutes

  • You provide us with basic information about your home and your household finances.
  • To be eligible for Point, you’ll need to retain at least 20% of the equity in your home after Point’s investment.
  • We can instantly give you pre-approval or denial based on the information you provide.

Point Makes you an offer

Point makes a provisional offer to purchase a fraction of your home. We will provide you with an offer based on the value of your home today.

1-3 days

  • If pre-approved, we provide a provisional offer based on the data you provide.
  • The offer is typically for between 5% and 10% of your home’s current value.
  • We’ll ask you to complete a full application and provide documentation for our underwriting team.
  • If possible, we will improve on our pre-approval offer.

Schedule an in-person home visit

Pick a time for a licensed appraiser to visit you. We want to ensure the price is correct by checking the place out — no cleaning necessary 🙂

5-8 days

  • We will schedule time for a home valuation visit.
  • You will be charged for the cost of the appraisal, which is typically between $500 – $700.
  • The appraiser will visit and inspect your home.
  • We will share the appraiser’s report with you once it’s complete. The appraiser’s value is an important component of the final offer.

Point pays you

We usually send the money within 4 business days of closing.

3-5 days

  • We finalize the offer following the appraisal and receipt of all supporting application documents.
  • You will meet with a notary to sign the Point Homeowner Agreement.
  • Point files a Deed of Trust and Memorandum of Option on your property in your county recorder’s office.
  • Once the filings have been confirmed, we transfer the offer funds (less Point’s processing fee of 3% and the escrow fee) electronically to your bank account.

Sell the home or buy back from Point when the time is right for you

Point is paid when you i) sell your home, or ii) at the end of the term, or iii) during the term, when you choose to buy back. Regardless of the timing, there’s no early buyback penalty.

1 to 10 years

  • If you sell your home within the term then Point is automatically paid from escrow.
  • If you don’t sell, you can buy back Point’s stake at any time during the term at the then current appraised property value.
  • Point is paid a fraction of the home’s value. If the home has declined significantly in value, Point may be due less than its original investment.
 Sounds simple enough but as usual, the devil is in the details.  A few caveats:
  1. Point collects a processing fee of 3% upfront in addition to appraisal and escrow fees
  2. You need at least 20% equity in your home to qualify
  3. You are guaranteeing repayment in 10 years
  4. Point is in a preferred position, meaning that they get paid first in the event that your home loses value
  5. When Point first went live last week, they gave an example of their pricing on their website (they have since taken it down for some reason).  In this example, Point put up 10% of the value of the home and received 20% of the appreciation (net of any improvements done by the home buyer in return.
One of the primary issue holding back the market is a lack of capacity for down payments by first time home buyers.  Low interest rates may be great for monthly payment affordability but they do nothing when it comes to a buyer’s ability to save a 20% down payment for a conforming loan.  There is a real need for investors in this space and some platforms have tried to tackle it.  For example, FirstRex which was profiled by Bloomberg back in 2013 will put down up to 50% of a homebuyer’s downpayment in exchange for a portion of the profit.  However, I am not aware of there being a substantial need for people who already have a large amount of equity in their homes to be able to extract that equity, especially when cheap HELOCs or reverse mortgages ( for seniors) are readily available.  Both HELOCs and reverse mortgages allow an owner to extract their equity WITHOUT giving up 20% of the upside in their home.  In order to illustrate this I ran a scenario outlined in Point’s press release.  For the sake of simplicity, I didn’t include property taxes, insurance or maintenance as these would be the same with or without Point.  I also didn’t include any loan fees in an effort to keep things simple.  This analysis has 2 scenarios:
Scenario 1: Borrower buys a home for $500k.  Borrower takes out a $400k with a down payment of $100k.  The mortgage has a 4% coupon.
Scenario 2: Borrower sells $50k in equity (10% of the total value of the home to Point, reducing the loan size to $350k, again with a 4% coupon.  Under this scenario, Point gets 20% of the home price appreciation.
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As you can see, it’s substantially less expensive to use a traditional mortgage if you experience any home price inflation – and Point’s website and press release both imply that it will be targeting higher priced markets that will likely experience more inflation.  If a borrower lives in a market that experiences home price inflation of less than 2%, Point makes some sense.  Above that, it doesn’t appear to.
So what’s the Point (Pun fully intended)?  IMO, this would be a great investment program if it were structured as some form of down payment assistance (like the FirstRex example above) – I’m even willing to bet that they could get more aggressive splits if it were designed to fill that substantial need in the market.  However, as currently offered, it’s an expensive preferred position that sits in front of a substantial amount of equity (again, assuming that there is any home price inflation).  I’m just not sure that there is much of a need for a product that allows people with a lot of equity to extract it from their homes when HELOCs are available, cheap and flexible and reverse mortgages are an option for seniors.  Borrowers that need something like this (and would be willing to pay for it) to defray their down payment can’t qualify and those who would qualify have better options if they want to extract equity from their homes or finance a purchase.  As such, I just can’t see how this is something that will be very scalable in it’s current form.

Economy

Surprise, Surprise: The Fed chose not to raise rates at their meeting this week but signaled that 2016 rate increases are still likely.  For those keeping track at home, they did exactly the same thing that they’ve done at pretty much ever meeting this year.

You Want Cream or Sugar with That? Yes, there is a Millennial underemployment crisis but it only extends to those with liberal arts degrees.

Commercial

Bottom of the Barrel: The ongoing dumpster fire that is K-Mart announced that it’s closing 64 stores and laying off thousands of employees.  I honestly had no idea that there were 64 K-Marts still open to begin with.

Going Long: Blackstone jumped back into the logistics business after selling IndCor Properties in 2015 by purchasing a $1.5 billion mostly-west-coast portfolio from Irvine-based LBA.  See Also: How Amazon is eating the department store, one department at a time.

Residential

Flipper’s Back: Home flipping continues to make a comeback and is now at it’s highest level since 2010.  A lot of the activity has been taking place in secondary markets like Fresno which could be a good sign that things are getting better.

Soaring: According to the Federal Reserve Bank of St. Louis, urban rents in US cities are rising quicker than they have in any time in recorded history.

Kicked to the Curb: Cities are starting to follow New York’s example by allowing developers to eliminate or reduce parking requirements for condos and apartments in order to provide more density and cheaper prices.  However, there is a lot of concern over the impact of this move with regards to on-street parking in cities where mass transit infrastructure hasn’t kept up.

Profiles

Talking Your Book: One of Lyft’s co-founders believes that private car ownership will go the way of Johnny Manziel’s NFL career by 2025.

Grudge Match: Tesla’s battle with car dealers has the potential to reshape the way that cars are sold in the US.

The Paradox of Leisure: The rich were meant to have the most leisure time. The working poor were meant to have the least. The opposite is happening.  Here’s why.

Chart of the Day

Rise of the regional banks

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WTF

Terrifying: A crazy woman from New Zealand made a handbag out of a dead cat and is trying to sell it for $1,400.

Broken Clocks: Brangelina broke up this week, meaning that those tabloid headlines that you’ve seen every time that you go to the grocery store for the last 10 years were finally correct.  If you believe Us Weekly, they broke up at least 31 times in the last decade.

Hero: Meet the 110 year old British woman who attributes her longevity to drinking whiskey on a daily basis.  See Also: New study suggests that people who don’t drink alcohol are more likely to die young.

Hell NO: South Carolina residents warned about clown trying to lure children into woods.

Video of the Day: Watch a diver catch video of great white shark attack on his GoPro off the coast of Santa Barbara (don’t worry, no blood).

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com

Landmark Links September 23rd – What’s the Point?