Investors absorb distressed properties at feverish pace

In the second post I wrote for the IHB back on March 3, 2007, I discussed a basic truth of housing markets:

Cashflow Investors have a different agenda; they want to turn a monthly profit from ownership. For them, the cost of ownership must be less than prevailing rent for them to make a return on their equity investment. Cashflow Investors form a durable bottom. If prices drop low enough for this group to get into the market, the influx of investment capital can be extraordinary.

In a declining market, a market where by definition there is more must-sell inventory than there are buyers to absorb it, it takes an influx of new buyers to restore balance. Since it is foolish to buy with the expectation of appreciation in a declining market, the buyers who were frantically bidding up the values of properties in the rally are notably absent from the market. With the exception of the occasional knife-catcher, these potential buyers simply do not buy. This absence of buyers perpetuates the decline once it starts. Add to that the inevitable foreclosures in a price decline, and you have an unending downward spiral. It takes Rent Savers and Cashflow Investors to enter the market to provide support, break the cycle and create a bottom.

It’s taken 5 years, but this process is happening right now, and the low end of the housing market is finding its footing.

The federal reserve’s counter-cyclical interest rate policy is designed to force capital out of safe harbors like interest-bearing bank accounts into riskier asset classes. With CD rates under 2%, the 8%+ cap rates of residential rental housing is very attractive. Cash investors are flocking to these assets despite falling prices because that asset class has superior returns. The activities of these buyers is what ultimately puts a bottom in the housing market.

Investors Swarm Housing, Raising Concerns

Published: Thursday, 29 Mar 2012 | 11:11 AM ET

By: Diana Olick

CNBC Real Estate Reporter

The number of homes sold to investors more than doubled last year, as rising rents and low-priced distressed properties fueled demand. Investors, half of them using no mortgage, bought 1.23 million homes in 2011, a 65 percent jump from 2010, according to the National Association of Realtors. Half of the homes purchased were distressed properties, that is, foreclosures or short sales (when the bank allows the home to be sold for less than the value of the mortgage).

Rising rental income easily beat cash sitting in banks as an added inducement,” says NAR’s chief economist Lawrence Yun. “In addition, 41 percent of investment buyers purchased more than one property.”

I’m shocked. Something Lawrence Yun said is not complete bullshit. Cash buyers are buying distressed properties as cashflow investments. The number of distressed properties purchased for cash will increase sharply again this year as private equity funds start buying more properties. 

Half of investment buyers said they purchased primarily to generate rental income, according to the Realtors’ report. 34 percent wanted to diversify their investments, as 2011 saw a volatile stock market due to the debt crisis at home and overseas.

While nearly half of investment buyers said they were likely to purchase another property within two years, housing and mortgage analyst Mark Hanson calls them a “thin cohort” and worries that they add ever more volatility to the current housing recovery.

“They are fickle and volatile. They will go away on the slightest of conditions changes.

Yes, the cashflow investors will go away once prices rise enough that cashflow no long makes sense. By then, the speculators buying for appreciation will take their place. Value buyers always give way to momentum buyers. That’s the way markets work.

They also won’t chase prices higher or buy new homes from builders. Lastly, without the heavy flow of distressed supply, there is no U.S. housing market recovery. Distressed sales ARE the market,” says Hanson.

I’m not sure what Mark’s point is regarding the flow of properties. These properties must be pushed through the foreclosure process, and when it’s done, it’s done. These foreclosures are a necessary part of the market healing process, and investors are needed to absorb them.

Foreclosure supply is still running high, with 65,000 completed foreclosures in February of this year, according to a just-released report from CoreLogic. 862,000 foreclosures were completed in the twelve months ending in February. While there are still 1.4 million homes in the foreclosures process, all of these numbers are coming down, albeit very slowly, and sales of bank-owned properties (REO) are speeding up.

Even the Realtors are concerned, like Hanson, that new programs by the government and banks to sell foreclosed properties in bulk discounts to large-scale investors, will cut off a robust individual sales market for smaller investors.

“Small-time investors are helping the market heal, since REO inventory is not lingering for an extended period,” says Yun, clearly looking out for his Realtor constituents. “Any government program to sell REO inventory in bulk to large institutional companies should be limited to small geographic areas.”

I used to worry about crony capitalists buying up all the inventory, but that isn’t going to happen. There is far too much of it. Lenders own $30 billion in California single-family homes.

Ponzis create distressed properties

Many distressed properties are from peak buyers who overborrowed and now find themselves underwater. However, a second group of distressed properties was created by those who overborrowed at the peak — the Ponzis.

About 40% of the population are spenders who will borrow money to live beyond their means. Some are more responsible than others, but anyone with a propensity to spend is not going to resist taking free money when it’s offered. And lenders were giving free money to loan owners.

With so many people prone to take the free money, it shouldn’t be surprising so many overborrowed and lived the good life. Each of these Ponzi borrowers must be recycled.

  • Today’s featured property was purchased on 1/10/2003 for $369,000. The owners used a $295,200 first mortgage, a $73,800 second mortgage and a $0 down payment.
  • On 2/19/2004 they refinanced with a $370,000 first mortgage and a $48,000 stand-alone second. That’s $48,000 in Ponzi borrowing after just one year of ownership.
  • On 4/10/2006 they refinanced with a $528,500 Option ARM with a 1.5% teaser rate.
  • They quit paying sometime before May of 2010 and got to squat for at least 16 months.

If none of these Ponzis had borrowed and spent their houses, we wouldn’t have so many distressed properties, and there would be much more equity to support a move-up market.