PETS IN RENTAL HOUSING

A March 2007 survey of apartment renters by www.Apartments.com found that 84.4% of the renters surveyed owned a pet.  Some major apartment property owners such as Forest City and Lincoln Property Co. are taking note of this and acknowledgeing that pet owners love their pets and, in many cases, have trouble finding apartments that will accept pets.  Some of these apartment owners are adopting the attitude that they want to be pet friendly in order to attract more tenants.  One apartment owner has even gone so far as to have a dog in the lobby of the building to welcome prospective tenants.  Of course they screen the pets for good behavior and charge additional fees for the pets in accordance with the market.

With the rapid growth in the idea that pets are really “part of the family” it will behoove apartment owners to review their “no pets” policies periodically and see if they need to make some modifications to be competitive.

THE OVER-HOUSED ECONOMY

In a recent analysis summary Torto Wheaton Research concluded that a major factor in the housing markets and how soon they would return to more normal markets is the number of vacant homes in the United States.  This inventory of 18 million vacant homes (including seasonal homes) represents 14% of the total housing stock.

New foreclosures that are taken back by lenders add to the supply and houses sold and occupied by owners or tenants reduce the supply.  New homes finished by home builders, of course, add to the supply of vacant homes until they are sold.  New family formations that result in new units being occupied reduce the supply of vacant homes.

Torto Wheaton believes that a continuation of current demographic and economic trends should mean that the excess inventory of vacant homes should be reduced to normal levels by sometime in 2009.

SENIOR HOUSING DEMANDS

A recent article in “Commercial Property News” reports that by 2010 there will be 100 million people in the U.S. over 50 and that seniors are more active than earlier generations and are demanding different kinds of retirement housing than in the past.

The senior’s housing industry is changing from a need-driven market to a choice-driven model according to the article.  Today’s seniors expect more choices and are looking for larger living units with more amenities including spa/wellness centers, media rooms and theaters, libraries, off site transportation and internet access.

They are also more inclined to stay close to their friends and families instead of moving away to areas such as Florida which have attracted many retirees in the past.  They want to be able to live an independent lifestyle but still be close to areas and facilities that they are familiar with.

Obviously if these trends continue they will affect the migration patterns within the states.

The article below by Anthony Downs, one of the most highly respected real estate economists in theU.S. just appeared in the December issue of the “National Real Estate Investor�.  It provides some excellent background and observations about what is happening today in commercial real estate financing.

THE GREAT REAL ESTATE CREDIT FREEZE OF 2007

By Anthony Downs     Dec 1, 2007 12:00 PM

By late October 2007, U.S. credit markets for most real estate lending became almost frozen because of uncertainty among both lenders and borrowers about how to value specific types of property. This confusion arose from problems among subprime residential loans.

In subprime markets, many operators made loans on flimsy credit terms to low-income buyers, securitized those loans, put them in collateralized debt obligations (CDOs) or special investment vehicles (SIVs), and tried to sell those instruments to investors.

At first this tactic appeared attractive because of the high yields on subprime loans. But subprime defaults began to rise beyond what packagers and investors expected. Some investors were not being paid off as scheduled. These investors included many foreigners unfamiliar with U.S. home lending practices. They relied on AAA ratings made by U.S. credit rating agencies to support their decision to buy such paper.

Investors flinch

As subprime defaults made headlines, other originators of subprime loans were still trying to sell securities that included similar loans. But potential investors refused to buy this paper at the same rates that the originators had expected. Consequently, the originators could not sell the paper they were putting into CDOs or other SIVs at the prices they needed to cover the home loans they had made.

Therefore, firms owning those originators, or banks who had lent the originators money, found

themselves having to advance large sums to keep the originators from going broke. This chain reaction exposed the problems that Bear Sterns had with two of its hedge funds, and affected a lot of other hedge funds and originators.

Although subprime loans were less than 15% of all residential mortgages outstanding, many CDOs contained a significant amount of subprime paper. Therefore, uncertainty had a much broader impact than the total amount of subprime loans would imply. Such broadening was provoked by the frequent lack of transparency in CDOs. Many investors had bought them for high yields without knowing all they contained.

Once widespread uncertainty arose about the value of CDOs, many investors who had been making real estate loans without doing traditional due diligence began to reconsider. They recognized their own loans could also default, even if those loans were not subprime. So uncertainty about values of real estate debt securities became rampant.

Rating agencies stumble badly

The basic cause of poor real estate underwriting was immense competition among investors with lots of capital seeking good yields in markets where property prices had soared and cap rates had fallen. After stocks crashed in 2000, a huge amount of global capital was looking for someplace to go in real estate. Pressure to make loans that ostensibly had good yields became intense. Eager investors were often given no time to complete normal due diligence before having to commit funds.

As a result, credit terms deteriorated into covenant-light loans unsupported by much due diligence. But once most lenders realized that they might become vulnerable, they started demanding more covenants, more time, and higher interest rates to cover their actual risks.

The resulting unwillingness of investors to buy commercial paper backing various types of high-risk instruments was reinforced by skepticism about the major rating agencies. Those agencies had apparently closed their eyes to the poor-quality underwriting supporting not just subprime lending, but other lending as well.

Suddenly, AAA ratings were almost meaningless. This frightened even more investors who had relied on such ratings, and the credit freeze became endemic. The rating agencies should be ashamed of themselves.

The stakes grow higher

The subprime contagion then spread to the private equity market. There, a few major banks had made huge loans to enable private equity firms to buy large publicly traded corporations. The banks committed these big loans to private equity buyers at fixed prices over the London Interbank Offered Rate (LIBOR).

But when banks securitized those big loans and tried to sell the pieces in investment markets, investors began demanding higher yields than the banks’ initial spreads over LIBOR. Investors were seeking to protect themselves from increased uncertainty. Some banks were left with huge commitments they could not cover without large losses.

Banks affected by the credit crunch faced two alternatives. They could sell their securitized paper immediately and take major losses. That would give them back enough money to continue in the lending business. Or they could hold the big loans without selling parts to others, in hopes that investor uncertainty would soon dissipate and they could then sell their paper at smaller losses.

But if investors held out long enough, the banks would be out of the lending business for quite a while because the loans they had made had consumed so much of their capital. Big banks need to keep lending because the interest generated from their big loans does not provide high enough yields to meet their earnings targets. To hit those targets, they need to charge a lot of activity fees in addition to interest. Thus, they have to stay in the lending business.

On the other hand, bond investors had three alternatives. They could stop making loans unless they obtained better covenants and higher interest rates to offset the greater risks they perceived. But this would slash their own yields on capital, since they would have to park that capital in low-paying money-market funds or U.S. Treasuries until bank behavior changed. After all, investors were paid to get good returns on the capital entrusted to them, which often came from pension funds or other contributors.

The second option was that investors could accept banks’ lower yields if the banks could offer more proof that the paper the banks were selling was properly underwritten. Thirdly, investors could simply accept the banks’ lower yields and therefore accept higher risks without getting any higher returns. But most investors by then perceived a large increase in uncertainty that raised their risks, for which they believed they deserved more compensation.

Don’t bank on a January thaw

This overall situation amounted to a standoff between banks and loan originators on one side, and investors loaded with capital on the other. Who would blink first? Neither side wanted to yield. Both sides therefore decided to stand pat for a while. Both were betting on a gradual reduction of willingness to stay out of the game by people on the other side. Each side initially thought that only the highest quality deals would be underwritten.

The conventional wisdom was that as confidence gradually returned among investors, more and more average deals would get through the process, and eventually the market would return to normal — though probably with higher underwriting standards and somewhat higher interest rates. At least that is where the real estate lending game stood as of late October. How long it will stay frozen or semi-frozen is difficult to predict. But both sides hope it will not remain frozen long enough to severely damage either side. Don’t bet too heavily on the outcome.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at anthonydowns@csi.com.

With all the negative news about the residential loan markets and the fact that some of that “bleeds

through” to the commercial loan markets it is nice to hear some good news about commercial loans. 

As investors who formerly bought bonds backed by residential loan portfolios have “fled to safety” in

the form of U.S. Governmernt Securities they have driven the prices of those securities up and the

yields down.  One of those securities represented by the 10 Year Treasury Index has fallen from a

rate of over 5.00% to 4.00% in the last few months.  Since the rates on most commercial real estate

loans over $1,000,000 are based on this 10 year index this has kept the rates lower than they might

otherwise have been if the index had remained at 5.00% or higher.  The good news is that this is

generally a good time to be shopping for commercial real estate loans.

The National Council of Real Estate Investment Fiduciaries maintains an index of returns on

institutional real estate investments and recently reported that the annual returns have averaged

12.7% over the last 10 years.  This compares very favorably to the S&P 500 index over the same

ten year time period of 8.4%.  We believe that individual investors should be able to achieve similar

returns if they are buying and managing properties wisely.

The article below was published recently by Torto Wheaton Research, the research arm of CB Richard Ellis.  They are a well respected research organization in the real estate area.  This article was written by Joh Southard, SVP, Director of Research & Chief Economist

WORRY, DON’T PANIC

Commercial real estate faces more challenges today than it has for several years. That said, however, the recent failures of the residential real estate market have led to far too much innuendo that commercial real estate is “next.” For those less familiar with the industry: that they share the words “real estate” does not indicate that residential and commercial real estate have much else in common.

During normal periods, residential and commercial would share the characteristic of being influenced by the economy, and some of the weakest analysis I have seen has taken this to mean that what happens to residential will always happen to commercial. Not so. What is not normal about this period is that the decline in residential is leading the economy, rather than being caused by a recession. As such, past cycles tell us little about what will happen to commercial real estate this time. Put a different way, commercial real estate is no more related to residential real estate than auto sales, airline bookings, or myriad other industries that are affected by the economy.

Most importantly, commercial real estate has not exhibited the same pattern of building that has been seen in residential real estate so far this decade. While residential already faces a significant overhang of space even without a decline in employment, commercial markets are almost universally in a very balanced position, where fundamental demand is pushing up rents. This can be contrasted with the bust of 1991, in which a recession compounded what was already a problem of overbuilding in the commercial markets. You wouldn’t recognize this difference by looking at some of the price movements that are occurring today, for example, the CMBS market reaching record spreads. One could go so far as to point to instances where short sellers seem to be playing off of the confusion that results from this false association between commercial and residential, thanks to the “real estate” label.

While panic may be an opportunity, the reasons for worry are the same as those shared across many industries. The slowdown in the economy that we project will mean less demand for commercial real estate. Furthermore, if you are a believer that the challenges of the current economy will drive us into recession, commercial real estate would suffer the consequences like many others.

The global re-pricing of risk is also a source of worry. Again, commercial real estate shares this concern with many other categories of investment, from emerging market government bonds to, depending on the day, the U.S. stock market. Even here, this pricing is often measured in spreads over U.S. Treasuries, and to the extent that Treasuries have been declining, the effect has been neutralized so far. In the past we have highlighted concerns about pricing on the equity side and the effect of capital on the debt side, but none of these concerns should be remotely compared to some of the stories of headlong denial of risk that have emerged from the sub-prime debacle.

While it is true that bad decision-making will be exposed if either recession worries or pricing worries come to fruition, it is ironic that the public markets seem to have been the creators of noise in the system in this year, both as the market crested and then as sentiment swung in the opposite direction. Now, many of those players that were viewed askance for not being subject to daily public market pricing scrutiny (private developers, insurance company lenders) are using their longer-term focus to take advantage of the swings of today’s market by having a deep, informed knowledge of the industry that some of the financial players setting today’s public prices may lack.