To Fund Investors of Beach Front Properties LLC - Where we are today and the Canary in the coalmine

Dear Fellow Investors:

THE RECESSION IS OVER according to Michael Hartnett the chief global equity strategist for Bank of America Merrill Lynch (LA Times - July 15, 2009).  Sadly as per the bearish stance I've maintained for quite some time, I see things getting worse in our fair state.

Cynical fund manager is celebrating the wonderful report from BofA Merrill Lynch

Our state legislature just closed a $26,000,0000,000 deficit through cuts and accounting gimmicks.  No solution was going to bode well for the 8th largest economy in the world and the downward spiral will continue for some time.

As discussed in my last letter six months ago, the chart most important to the operations of our investments is the unemployment rate.  The higher it goes, the fewer people there will be to spend money and drive our economy.  There will also be fewer employed who can pay rent.  Figure 1 includes the chart from February’s letter along with the latest available from California’s EDD.

Figure 1

Source – California EDD

At the end of June, unemployment in California was at 11.6% while nationally it was 9.5%. The duration of unemployment is at a 60 year high as seen in Figure 2.

Figure 2

The unemployment rate is higher when involuntary part-time workers are factored in.  The projection in Figure 3 shows the level of labor market slack will be the highest since World War II.

The results of the rise in unemployment / under employment are higher delinquencies, more vacancies, less traffic coming to see our vacancies and lower rents (either through “rent specials” or dropping the monthly rent).  Nonetheless throughout your portfolio the results are better than the market in occupancy and in rents charged.

The trend operationally at our properties will be difficult for the foreseeable future but the management team is focused on attaining the best possible results.  Management is also working to lower costs wherever possible either through new technology (low energy lighting and appliances) or from negotiations with vendors due to our economy of scale.

The challenges hitting our operations will cause lower Net Operating Incomes (NOI’s) and more importantly jolt investors who believed the mantra of a few years ago that buying Southern California apartments was as stable as buying bonds.  At least that was the justification for paying very high prices for properties that would need increased rents and stable occupancy to achieve a positive return on the investment.  While the difficult economy is hitting all sectors, the properties being most affected are those in the “A” market and those with smaller units (studios and 1 bedrooms).

As properties are seeing an erosion of their NOI’s, those purchased in the last few years with a lot of debt are now in foreclosure or are struggling to stay afloat.  What does that mean for the valuation of apartments and will there be increased distress in the commercial sector? 

Let’s delve into these questions by looking at forward indicators.  Prior to the housing market collapse, defaults in RMBS (Residential Mortgage Backed Securities) that were backed by residential loans rose precipitously.  As defaults are the first stage that leads to foreclosures and then to price declines, they were the canary in the residential coal mine.

As in the residential market, many multi-family loans were securitized into bonds and sold off as CMBS (Commercial Mortgage Backed Securities).  The defaults in CMBS backed by multi-family are rising quickly. 

MULTI-FAMILY CMBS DELINQUENCIES

While the recent vintage is defaulting at an alarming rate, even those funded prior to 2006 are seeing high delinquencies.  This trend mirrors the housing mortgage securities which saw higher defaults in loans made towards the end of the price peak.

Occupancy in multi-family will continue to decline due to the economy/unemployment and the increases in the Shadow Rental Market (single family houses that are bought by investors and turned into rentals).  There is a big wave of single family foreclosures coming through the pipeline as the unofficial moratorium (roughly from December 08 – April 09) is over and I expect investors to be significant buyers.

In the Southwest United States, the biggest drops in occupancy have been in Las Vegas, Phoenix, and California’s Inland Empire and Lancaster/Palmdale area.  Of those markets, CMBS defaults are currently highest in Nevada.  Arizona and California have thus far avoided steep rises in multi-family loan delinquencies but that is likely to change.

Prices of Commercial Real Estate (CRE) are falling as is Residential.

COMMERCIAL AND RESIDENTIAL PRICE INDEX

Conclusions

Rising mortgage delinquencies, falling prices and negative rent / occupancy pressures are the perfect storm which will cause owners with high leverage (75%+ LTV loans from 2005-2008) to do “cash-in” (pay off existing debt with cash and new loan) refinances if their loans come due anytime soon.  Or they must renegotiate with their lenders who might not want to foreclose.  Owners who don’t focus on their management will see dramatic income declines along with the devaluation of their property for refinance or sale.

I forecast that Capitalization rates will continue to increase using real operating numbers (not proforma) while negative pressure continues on net operating incomes (NOI’s) so prices will be trending downward. 

I am already seeing purchase opportunities with stabilized (properties in need of repositioning) cash on cash returns that are higher than I’ve seen in years.  I’m being extremely finicky though as I think the fruit will get juicier with less downside risks if continued patience is exercised.

I’ve also recently spent time on the ground in Phoenix, Las Vegas and the Inland Empire of Southern California to monitor the distressed single family home market.  My belief is that it is not the right time to begin acquiring distressed houses.

California will drop 30%+

Euphoria, Euphoria, Euphoria!
Affordability index is nearing historic lows
The percentage of buyers that are using variable rate loans are increasing significantly.

No market goes in one direction.

Lenders have "relaxed" their qualifications for loan approvals.

Equity markets (stocks/bonds) have not been attractive in the past 3 years to investors. The money has been funneled into a "safe harbor" (the real estate market)
Foreclosures will be increasing significantly.

Do NOT buy in California, Phoenix, Los Vegas and Honolulu

Apartment Reporter - Dealing with Deleveraging

My forecast for the economy, both locally in California and nationally, is UGLY. There is much discussion about moral hazards, nationalization, and bailouts. I won't be mentioning any of these issues as you are hearing about them ad nauseam, so I will share my thoughts about how the economy will be affecting real estate.
The world is in the process of deleveraging, led by my favorite asset class. Lending and borrowing lost normal rationale as greed took over. History is repeating itself in that postbubble crashes are always painful. The bigger the party, the more painful the hangover, and we have yet to fully realize just how extravagant the gala really was.

The credit being extended fueled a "fluff economy" that allowed people to live lifestyles and invest in things they quite simply could not afford. That economy is over, and its long overdue death has taken (and will take) millions of jobs that fed the credit binging and serviced those who spent the fruits of their borrowing. Many more job losses will come as companies cope with the fact that consumers have far less money to trickle out of their pockets. While this will be extremely unpleasant, it is the normal cycle that follows such exuberance.
The legislators in the state of California sadly budgeted government spending based on taxes collected during the boom/fluff times. Last week those same legislators came back for the 2nd time in 6 months to rebalance the state budget. This time they cut spending (again), raised taxes, and are counting on federal funds to fill a $46,000,000,000 gap. Many jobs will be lost, wages will be cut, and for those who can still pay taxes, they will have less money to take home. Note to California's favorite tourist destinations Las Vegas and Hawaii: Your customers will have less money with which to gamble and buy suntan lotion, which does not bode well for your economies…

Unemployment rose more than 3% (from 5.9% to 9.3%) from December 2007 - December 2008 in California. As California is in a state of disarray, that rate will continue to climb for some time.
The repercussions from the massive job losses haven't hit commercial real estate operations nearly as much as I anticipate that it will. Higher vacancies and delinquencies are coming!

What other shoes will drop? Expect ugly solutions from legislators. One of the main targets for tax increases will surely be property owners and we will likely see the re-emergence of the proposal for a split roll to California's Proposition 13. This would make non-owner-occupied properties (rental properties) "reappraisable" instead of the current annual 2% cap on increases. There will be more code enforcement inspections and other ways to tax the rental property owner from municipalities/counties as they look for new schemes to raise revenue. In other words, we will see higher fees from the government to operate.

These are the Chinese symbols for "Crisis." They are also the exact same for "Opportunity." Something to keep in mind in these crazy times!

To Fund Investors of Beach Front Properties LLC

If you have been a multi-year reader of mine then you are used to my bearish tone about the real estate market. The wanton disregard for fundamentals by investors, lenders and Wall Street led to the bubble which has now popped.  The questions to pose now are; are we at the bottom yet and if not yet, when?  As your loyal real estate economist my answers are NO to the first question and to the second I say that it will be when a buyer can achieve a return on investment in real estate that is significantly higher than "risk free investments" (i.e. US Treasuries and FDIC insured bank accounts).  The last begets a third question which is how far are we away from a positive investment scenario? 

Earlier this month I was asked to speak at a distressed real estate conference in Las Vegas (clearly they were gluttons for my bear talk).  As that city's real estate market was one of the most overheated, I arrived a day early so that I could gauge the market.  I visited 6 foreclosed homes to see how far the prices would have to drop for an investor to make a positive cash flow at current rent levels with normal expenses.  In past downturns, pricing hit bottom when investors bought up houses and they were able rent them for profit (a return to the basics of real estate which is a property is worth a multiple of its rents).  After running the numbers on my sample homes, I found that the prices need to drop at least 33% from the current asking prices.  (Note that 2 of the 6 homes didn't even have a for sale sign on the property indicating that the selling bank isn't motivated and/or supervising their listing agent.)  Should the Las Vegas economy fare worse than it is today, rental occupancies and rent prices will be negatively affected.  Lower rents/occupancies coupled with the possibility of higher borrowing costs would push the 33% estimated drop even further.

Tip of the Iceberg

While the underlying bonds securing sub-prime loans along with the firms that underwrote them have seen their value plummet, the actual real estate has not yet reset its value to the market level.  The correction thus far is just the beginning.  For Las Vegas, Phoenix and Southern California, it is going to take more time for the prices to fall to the point of stabilization as there is excess supply along with far tighter lending standards directly following the years of essentially "no" standards.  As in any wild swing of the market pendulum, I would expect that we will be able to purchase properties for less then their replacement value and enjoy strong cash-flows for our willingness to once again be contrarian investors and invest in a punished asset class.

Our property management company Beach Front Property Management, Inc. is beefing up its management team as the business is growing fast due to an increasingly difficult rental market and also sadly because owners who purchased close to the peak are in desperate need of cash-flow.  The company is currently assisting two clients through foreclosure and has turned down business from other owners who were deemed to be likely heading to bank repossession.  The executive and staff recruitments have been focused on those who have experience in repositioning properties from prior market swings.  This will make purchasing larger pools of troubled assets much easier since as investors we make our profits on the purchase price and a focused approach to management.     

Sniffing out Opportunities

Because all owners are facing the same issues we're dealing with, yet may not be in the same strong financial position, I anticipate opportunities in non-performing loans, foreclosed properties, broken condominium deals and repositioning of mismanaged commercial units to begin showing themselves.  Recently, I've started analyzing deals again as there is a lot of distress yet few buyers, especially for troubled assets.

We have been patient for quite some time and do not mind continuing our stay on the sidelines until the right deal can be sniffed out.  I would rather buy as the market begins turning upward than catching a falling knife.

To Fund Investors of Beach Front Properties LLC.

As you may recall, in recent years as others rushed in to buy Southern California residential and commercial real estate, with the exception of one purchase, I was not a buyer. I could not make economic sense of the premium prices being paid and therefore refused to pay them (but did sell many properties during this exuberant time). Now those who paid those premium prices are vulnerable to a potentially steep market price decline. If rents should decline, those of us who bought at much lower prices can cut our rents and remain profitable as we keep our apartments filled.

In my letter 6 months ago I predicted that foreclosures would continue to increase and the credit tightening would become a credit crunch. My forecast today is that things will continue to get worse but at a faster pace than last year. While I think the US real estate market will suffer, the local markets of Southern California will deteriorate including the prime locations in Los Angeles and Orange County which will be hit harder then the macro US real estate market in general because the speculation here was so intense. I believe we are still in the early stages of this downturn and that the underlying valuations got so skewed (through undisciplined financing and rampant speculation) that a correction albeit painful is the healthy solution. The more the government involves itself, the longer it will take for the mess to resolve itself.

We are in an interesting economic pickle, the Federal Reserve is lowering the overnight rate which has caused the treasury yields to fall yet on commercial loans (see Beach Front IV and NPI Beach Front in this letter) the spread has widened which has kept interest rates up. On the operations level, we get many resumes when we post for job openings showing a weakening job market yet our employees are feeling the same inflationary pressures that we do in higher maintenance costs and thusly we have to pay them more. I do not believe that the Federal Reserve will be successful in inflating out of this housing crash. . .

Yes, I'm still the bear in the room!

In my observations of the real estate market, I believe the sweet spot will be in single family houses. My eyes are on Phoenix and Las Vegas. I've chosen those markets due to the huge opportunities we expect along with the strong population growth history and future potential (Sunbelt). Traditionally in real estate downturns, the housing market hits bottom when investors step in and purchase which happens when pricing makes sense for rental ownership. The homes become "shadow rentals" which are difficult for the apartment industry to track yet it is hard felt on their occupancy. As my focus has always been opportunistic real estate investment, I have been waiting years for the coming crash which I believe will be a vulture's paradise.

The apartment market that will get a boost when people lose their homes to foreclosure and rent at multi-unit properties will conversely be hurt when those same foreclosed homes become shadow rentals for investors. This will create opportunity to buy apartments in those same markets that we bought houses. We will see apartment foreclosures and properties where the owner just wants to recover as much equity as they can (take their lumps and move-on).

To Fund Investors of Beach Front Properties LLC.

So far, the local economy of Los Angeles / Orange County has continued to do well.  We noted however that in hiring some new managers for apartments in Orange County, we received many resumes from people recently unemployed (or whose employment terms changed to 100% commission) from the mortgage banking industry.  Orange County and in particular the city of Irvine has employed many people in this industry, including those employed by New Century Financial Corporation which filed Chapter 11. 

In my February letter, I predicted that lenders would tighten credit standards while foreclosures increased.  Both have happened and I'm expecting more foreclosures and a credit crunch which I'll describe herein.

This letter will be filled with good news / bad news inconsistencies which belie a feeling that the real estate market and local economy are in a state of flux.   According to many of my friends who also own/run local companies there is wage pressure and a difficulty in finding qualified employees.  Prices for items used to maintain our properties along with the labor rates are inflating as are energy prices.  That said, last night I authorized 3 - 5% rent increases in most of our apartments as our occupancy rates remain high.

At the same time, the housing market continues to weaken particularly in the outlying areas of Lancaster, Riverside and San Bernardino.  Delinquencies and foreclosures are rising, prices are stagnating and lowering while financing becomes more difficult as lenders have largely phased out 0% down payment mortgages and stated income (subprime) loans.  In the past few years, it was easier to acquire home financing than it was to rent one of our units as we verify income stated by those applying to occupy our rentals.  It is my belief that the lack of fiscal discipline in making loans to people who were not good credit risks along with allowing little to no down payment fueled home price appreciation and thusly fed liquidity into our economy which will now come back and haunt.

  

In Multifamily real estate where we focus, we've benefited from the rise in barrier to entry for home buyers (in spite of the non-existent lending standards) as prices have inflated which allowed us to consistently run properties with very low vacancies.  We've also been able to raise rents over the last 10 years.  As liquidity has looked for returns, California apartments and more recently office properties have looked like "can't miss investments."  In the last couple of years, I've heard real estate economists compare apartment investments in Los Angeles and Orange County to bonds; both in terms of security and yield.

As someone who lives and breathes the day to day operations of these "bonds," I fail to understand the "paradigm shift by institutional investors who understand the solid economics (rising population and underdevelopment of affordable housing) and stability of these investments."[1]  To me, this was reasoning for paying very high prices and accepting low yields on properties which are already operating at optimum capacity.  When I stopped buying apartments "en masse" at the end of 2002, it was because of the cap rate compression / lowering of yields which inverted the risk/reward analysis that I run before pulling out my check book.  Or quite frankly, I must not understand the paradigm shift and my belief that real estate is cyclical and not secular is wrong. 

I believe the peak in this current cycle has passed (likely the top was in 2005) as there has been a slight cap rate decompression but unleveraged returns still remain lower than the cost of borrowed money which I don't feel is sustainable.  Borrowing costs are rising while the 10 year treasury is nearly the same as it was last summer, the spread has risen approximately 50 basis points (1/2%) from last year due to investor reluctance to invest in mortgage debt.  

While I'm sure you must think that I'm wearing a giant bear suit while writing this forecast, I still believe strongly that commercial real estate investment in Southern California can be very smart given the demographics of the area, the good weather, the diversified economy and quite frankly it is a desirable place to live.  When the yields are back at a level that rewards the buyers who assume the risk of increased vacancies / delinquencies along with the actual costs of running a property for the long-term (new roof, painting the building, plumbing and electrical repairs) then I will be acquiring more properties.  Today, you can get a similar yield with no risk by putting your money in the bank.

As Warren Buffett says, "be greedy when others are fearful and fearful when others are greedy."

 

2003 - Fearful Kyle  

2004 - More Fearful Kyle

2005 - Most Fearful Kyle

2006 - More Fearful Kyle

2007 - Fearful Kyle

Our properties were purchased with fundamentals in mind, at prices that made good sense for long-term holds.  As a value investor, I'm comfortable with the long-term prospects and focus daily on the real estate market of Southern California.

To Fund Investors of Beach Front Properties LLC.

There are wage pressures on Southern California employers as the minimum wage was just increased in the state and will be increased again in January of 2008. Not only has there been wage growth but finding good employees while never easy is especially difficult due to the low unemployment. The tight employment market with increase wages is a positive for us as rental housing providers.

In certain submarkets which are inhabited largely by first generation Latino immigrants, we've JUST (Q1 2007) started seeing a BIG jump in immigration sweeps by Immigration and Customs Enforcement (ICE) which was formed in the wake of 9/11. While motivation for the sweeps might be political, the reality is that like Bank of America and Western Union, we have been and are able to do business with the "undocumented" through use of other forms of identification (a Social Security Card isn't necessary). We recently lost 2 long term residents from a property in Santa Ana as they skipped (moved out without giving a 30 day notice) after ICE came looking to question someone in each household. Depending on the intensity and duration of the sweeps / enforcement, there will be a negative impact to our operations.

My opinion about the Southern California housing market is that prices have dropped even though the numbers released by the California Association of Realtors show slight gains. As we have a realty company (Beach Front Realty) and had several listings last year, our sellers' experiences were different than advertised by the realtors lobbying group. Houses are sitting on the market longer and serious sellers are lowering prices. If homes are "priced right," there are buyers in the market and properties do sell. The housing market has not crashed though and is still near historic highs.

In the apartment sector, the flow of funds into real estate continues although buyers started balking at buying properties with a capitalization rate lower than the rate of their 1st Trust Deed. This has caused prices to come down a bit. Prices for office properties have showed continued strength due to the tightening of occupancy which has pushed rents up, submarket specific of course.

On the horizon there are rumblings from lenders, particularly those who have made subprime loans (HSBC, New Century Financial, Countrywide) that lending standards are being tightened while reserves for non-performing loans are being increased. This will make it difficult for a large number of home owners to refinance since the lender holding their current loan (many are adjustable) now won't make a new loan to them. It will also take a percentage of potential buyers out of the market who have helped drive the housing boom. I am expecting to see a jump in foreclosures in the housing sector which will give apartments a temporary boost but should drag on the economy as a whole.

As I write this letter today, I must confess that while I look forward to making new purchases, Southern California is still too pricey while 2nd tier cities which might seem interesting by comparison are actually trading at historically low rates of return. Therefore, I sit on the sidelines waiting for investment opportunities that motivate me to risk my money which has been and always will be the prerequisite for creating new Beach Front investments. I'm always looking. . .

To Fund Investors of Beach Front Properties LLC.

My opinion about the Southern California real estate market hasn't changed much over the last 3 years as there is little value for an investor to purchase at current prices.  Inventory of unsold properties is increasing while interest rates continue to move higher.  I believe that the only way that we won't see significant price reductions (ignoring the prognostications of both the National Association of Realtors and the California Association of Realtors) is if we have a large rise in wage growth.  Over the last several years, more than 70% of local purchases were made using adjustable rate mortgages (or short-term fixed loans that will float adjustable after 3 or 5 years) and this might well cause large portfolios of debt and the properties they secure to go back to the bank.  

In the commercial sector, the flow of funds into real estate has been enormous and the allure of converting apartments to condominiums has caused capitalization rates to fall below interest rates.  I believe this trend to be unsustainable and thusly temporary.

Beach Front has continued to be cautious when others are aggressive in the same contrarian manner that we were aggressive when others were cautious.  Our purchases have always been made as "value investments" and not based on predicting market fluctuations whereby we'd be happy owning even if the resale market were closed for ten years.  I'm very patient (as evidenced by this long dry spell) and am waiting until solid opportunities come along before actively investing again.

To Fund Investors of Beach Front Properties LLC.

My tone about the Southern California market hasn't changed from my predictions over the last 2.5 years. For the first time in many years, housing prices in Los Angeles over a six month period actually showed a decline in value.  While statistics can be manipulated, I will share that our brokerage arm, Beach Front Realty has seen a drastic slowing in the market.  

Properties last year got many immediate showings and received plenty of offers.  The listings now sit longer with little to no activity and buyers have become increasingly picky.  The question on everyone's mind is does the market slow (to a soft landing as the California Association of Realtors and many other economists predict) or does a sizeable correction occur.  For many reasons, I subscribe to the latter opinion.

Should values in real estate go in the direction that I predict, I believe that the regional economy and rental market will also suffer.  That said, our portfolio is very low leveraged versus the current values and we'd expect to manage though difficult times.  Over the next 6 months however, a majority of our portfolio will be coming off of three year fixed rate loans and will become variable.  We are watching the market and will be in communication with you should we decide to initiate refinances.

In the last letter, I described my travels to rural locations in the central and southern United States to educate myself about mobile home parks.  As I have many friends and associates that invest heavily in this asset class, I wanted to understand their enthusiasm.  After trips to some very small cities, I could not find value at the current prices that would make for solid risk/reward investments.  No offers were made and no projects in this asset class are being reviewed at this time.  

July 26, 2005To Fund Investors of Beach Front Properties LLC.

CHICKEN LITTLE KYLE
Instead of continuing my prediction of the correction in the real estate market that doesn't want to come, I will say that fundamentals remain unfavorable for value investors and we are comfortable with our position on the sideline. I can't remember what precipitated the dot.com correction but I remember the fall-out for those who invested on the sole bet of appreciation. The sky will fall when it falls. . .

I'm in the process of educating myself on the intricacies of other real estate asset classes, focusing mainly on mobile home parks. I've traveled to Georgia, Texas and Oklahoma and while I'd like to think that I've found something that other real estate investors have overlooked, it appears that there is plenty of equity chasing deals in "everything real estate." Before syndicating any deals in a new asset class, we would make the initial purchases ourselves so that we could beta-test. So far however, I haven't found anything worth purchasing.
In my February letter, I introduced a market that we had just visited, Berlin, Germany. We initially looked at doing a joint venture with a Berlin based developer. We opted against the venture with him as he wanted to buy a billion dollars worth of real estate throughout Germany right away much like large funds managed by George Soros, Cerberus and Blackstone are doing as a macro-play. Instead, we opted for a smaller and more focused approach on apartment properties in Berlin like we did in Southern California and Shanghai. This investment won't be without risk as Germany is suffering from the worst recession since World War II and is in dire need of structural economic change. Thusly, the real estate market has suffered and we see this as a contrarian investment with large upside if/when Germany makes the needed changes.

California will drop 40%+

That's it!

To Fund Investors of Beach Front Properties LLC.

Last week, we traveled to Berlin, Germany as we heard about the depressed real estate market where purchase prices are far below replacement costs and yields are attractive due to the risks involved in investing in the recessionary economic environment. We are currently in the process of evaluating the potential opportunities. We will update you should we choose to commit our own money to Berlin housing.

To Fund Investors of Beach Front Properties LLC.

Pricing for real estate in Southern California continued to surge in the first quarter of 2004 but appears to have slowed and possibly peaked in the 2nd quarter. In Orange County, the manager of a Remax office told me that inventory of available single family homes for sale was quickly building as sellers rush for profit taking and buyers aggressiveness has become more subdued. Only 13% of the population in Orange County can afford a median priced home, which is an all-time low. In Southern California as a whole, approximately 18% of the population can afford a median priced home. At the same time, approximately 75% of new home buyers were opting for adjustable rate financing, presumably so they can stretch in purchase price and afford the payments as fixed rate loans come with a higher interest rate and payment. On multi-family (apartment) properties, the prices hit new highs in all areas around Southern California do to several factors:

1. Very low interest rates
2. Stable asset class for which to invest
3. High barrier to entry for new home buyers and for new apartments

My thoughts on each factor are as follows:

1. Interest rates
The current rates (which went up in the 2nd quarter) are artificially low. Mr. Greenspan has indicated that he is inclined to move the overnight rate up in the coming quarters if the economy continues to improve and signaled that the Fed would be aggressive if inflation becomes a concern. The overnight rate of 1.25% is just 25 basis points off of an all-time low and the rate should level off at around 4%. This would push the 30 year fixed rate loan on a single family residence above 8%. It would also push the adjustable rate loans up as well. If the rates move up, we can expect an increase in foreclosures since so many homes have been purchased using adjustable rates, little down payment, and often times very little borrower qualification ("stated income," sub-prime lending for bad credit, etc…) as more and more loans have been packaged off to Fannie Mae and Freddie Mac. The last point is of particular concern since lenders / mortgage brokers don't have to portfolio the loans they write and thusly the incentive can be solely on closing the transaction. The higher interest rates will create a squeezing effect for those with adjustable loans, leaving them less spendable income for cars, trucks, televisions, and restaurant visits (a negative for the economy). It will also cause the affordability index (referenced above at an all-time low) to temporarily sink further. This WILL cause home prices to fall which in turn will turn houses upside down (the debt being higher than the asset value) for those who purchased late in the cycle with little or nothing down and for those who used their homes as credit cards during the refinance mania of the last few years. Historically those who are upside down are more likely to let their homes go back to the bank than those that have equity built up. Lastly the feeling of wealth will disappear (like it did when the dot.com bubble burst) which will cause the household spending to be curtailed and real estate won't be the "smart" investment anymore.

Regarding interest rates on commercial properties, I would expect them to go up as well since they are primarily based on spreads over the U.S. Treasury bond yields. The treasury yields have fallen consistently as the overnight rate has been moved down. Since a large percentage of the ownership of our bonds is from foreign investors and foreign governments (over 1/3 owned by Japanese and Chinese), factors beyond the control of the Fed could cause those rates to become violent if large sell-offs occurred.

2. Stable asset class
I feel safe investing my money in apartments due to the fact that everyone needs a place to live, even in down economies. With that said, there is risk in any investment and the reward for taking this chance is return on investment which we emphasize in a "cash on cash" return analysis. I view appreciation (with the exception of equity created by a "value add" opportunity) as gravy to a good deal and don't like the idea of buying an asset solely on the hope that it will be worth more simply because of market appreciation. The fundamentals by which I evaluate deals for purchase at Beach Front have brought me to the sidelines and will keep me there until the risk/reward ratio balances again. Whether other investments like equities become more favorable in the near-term or not, I believe factors will cause the euphoria of purchasing apartments in Southern California to wane.

3. High barrier to entry
The high barrier for purchasing real estate in Southern California as equated in the affordability index will continue although it will become more favorable for home buyers. Housing prices as discussed previously will go down but compared to most areas west of the Mississippi River, Southern California will remain prohibitively high for most renters to become home owners. Our properties in Southern California (and Austin) are located in "in-fill" locations, meaning there isn't abundant available land in that particular submarket to build new properties. Furthermore, our apartments are B - C class properties with a focus on the middle to low end renter while the overwhelming majority of new units built target the high-end renter. Most of the municipalities do NOT want new apartments built as they are viewed (and I was told this explicitly by the Santa Ana City Manager) as drains on public resources. Because of the high barrier to entry for new competitors, we decided not to sell and instead hold on to a number of properties in the portfolio. We expect them to weather any difficult markets and continue to do well in the future.

Pricing for real estate in Southern California

Pricing for real estate in Southern California has continued to rise as the market has gotten to a state that I can only describe as euphoric.  Over the last several years when we were buying our cash flowing daisies in lieu of fancier roses, it was clear that we were buying far below the intrinsic values of the assets.  The entire portfolio has benefited greatly from the lowered interest rates, our California tax laws (Proposition 13 which bases property taxes on the respective purchase prices), the large raises in rents, and from the comparatively low prices we paid to purchase our properties.  We began selling some of the flowers out of our garden as they began getting priced as roses.  Over the last year our daisies have traded on Tulip valuations and we are completing the last of our sales at the end of this month.  The market may allow for some or all the buyers of our flowers to flip for profit if the frenzy continues but I'd rather sell a year early than a day late.  We have refinanced the majority of the remaining portfolio in short-term fixed rate loans to give us flexibility to switch to longer term fixed rate debt or to sell as we have kept our options open. 

Southern California isn't immune from bubbles and while it is a great place to live and invest, if one purchased a property in 1990, they wouldn't have been able to sell for profit until 1999.  Therefore I am waiting for the market to correct while looking for contrarian opportunities in several cities throughout the Western United States.

Sale prices measured

Sale prices measured in price per unit, price per square foot, capitalization rates and gross rent multipliers are continuing to set records caused by the lowest lending rates seen since 1958 coupled with the massive amount of equity chasing multi-family real estate in Southern California. While I believe that apartment investments in Southern California remain a solid bet over the long term, the market is working against the fundamentals we use to identify a property to purchase and thusly we have nothing under contract. I continue my daily review of every new deal but as long as the euphoric nature of the current market continues, I will keep my pen in my pocket.

Commercial Real Estate in Southern California

Commercial Real Estate in Southern California is becoming speculative.

Affiliate Company

The Strand in Hermosa Beach is a tri-plex on the beach that is fully rented and collected. Beach Front Property Management is the current management company. Contact us at 562-981-7777 if you are interested in our services.

Rental real estate in Southern California

Rental real estate in Southern California is VERY undervalued.

Housing prices in Southern California

Housing prices in Southern California going down and will continue this trend.