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.
