Added by on 2009-02-06

As the mortgage pool assets are written down, and the collective that is America takes its lumps for this “perfect storm,” one question that just sticks in the craws of everyone (but the scarecrow before he met the Wizard); why?

Real estate as an asset class has a classic growth story. The worldwide population continues to grow and, absent major war, shows no signs of trailing off. Aside from some of the underlying sub trends; such as employment migration, or better quality of life issues that are created from movement from the colder, industrial cities to warmer locales, the asset class should keep pace with expansion of population. How could such a rapid adverse trend take the pundits and the experts by surprise?

The market by which real estate lives and dies is a “closed market.” Buyers and renters don’t really drive the metrics as Adam Smith explained. Their “invisible hand” is really invisible. The participants that build, foster and ensure that trends have moved in lockstep with plans are the brokers, builders and the banks. The triumvirate of Bs starts with an interesting little story.

Homes in a fictional town are selling for $400,000. A builder buys a piece of land that is zoned to build 10 houses for $500,000. Building a home costs $110 per foot in this fictional town, so the builder creates 3,500 square foot homes for $435,000 cost and lists the homes for $1,000,000. The builder hires his brother to buy the first home for $1,000,000, and lends him $500,000 as down payment which allows the bank to make a loan to him easily. The builder makes $565,000 on this home, a $65,000 profit, and the market establishes a “comparable” value, the value used by appraisers to validate bank lending. When realtors get qualified buyers, they show this development and one by one the homes are sold until the builder has doubled their money.

The banks are not as fortunate. When the music stops this house really only cost $435,000 to build, which is its value. When the market is cooling, builders will build for lower margins, and ultimately through the cycles of building, for little or no margins to keep their assets working and to cover fixed costs. They will sell new houses for less and less money, each “comparable” sale reducing the value of the bank’s collateral. It’s worse in big cities and in giant developments, in which builders more than double their money on a leveraged basis. For banks it’s a horrid “Ponzi” circle that results in higher loans on developments, construction in progress and finished mortgage loans. In the savings and loan crisis it was bad, but in this consolidation the leverage, zero credit quality and loan diligence, will result in losses that are catastrophic.

So how do you stop the lies in real estate from ever happening again? Math. Lend against a home based on the “rental income.” Whatever a home, apartment or building would rent for, impute a cap rate against that based on economic assumptions and you’ll be fine. This allows investors to always come into distressed environments and obtain passive investment return, which brings buyers to the table in a distressed market. If you advertise real estate at ten times triple net (NNN) rental income, there will be a line of investors, at 14X, still interest and many potential suitors for an investment. The interest bleeds off as the multiple gets higher, but if you’re in that ballpark your losses will be nominal. Return to the old way and things will be fine.

Don’t be surprised if Case, Shiller continues downward revision of the pricing trends in real estate. They must know they will, they just don’t like to give bad news (the truth) all at once.

Be mindful, be careful and good luck!

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