The Pursuit of Passive Income

Investors the world over were taught to exercise caution and use reasonable due diligence to discover  threats to investments. Since the fall of Enron, AIG and so many other companies we’ve learned about “Off-book” threats. Also called Off book debt, counter-party risk, derivatives, and the shadow market. It seems that in a the age of transparency, bolstered by instantaneous news and gigabytes of data to research on the net, things are less transparent than ever. 

We are in the housing business. Our competition for customers “renters” is more diverse than ever, and yet less trackable. We use the term “Shadow Market” to refer to all those homes, condominiums, hotel rooms, mobile homes, spare bedrooms, and units that we can’t track/qualify as competing rentals in our studies. 

What scares us the most is that we don’t know home much of it is out there, who controls it and when it can or will be released. Arizona ARMLS tracks how many listings are on their MLS system and the news out this week is that there are far fewer homes for sale in Arizona than we’ve seen in a long time. Where did they go? 

There’s a rumor that Bank of America has over 55,000 Maricopa County homes in their REO inventory. Some reports count as many as 100,000 additional homes in default or serious default in Maricopa County. These figures don’t account for the hundreds of thousands of homeowners under-water and considering strategic defaults. Is this a threat or are the lenders, banks, GSE’s and other entities committed to slowly controlling their release to the market?

Can we really assume that the numbers were are seeing are real? The first lesson in economics 101 was the relationship between supply/demand and pricing. Less supply in a market should lead to more demand and to higher pricing. But that’s in a natural market - one absent of manipulation.

I guess what gnaws at me the most is that the data suggests that there are less homes on the market than we’ve seen in years, there’s little more than a 2.5 month supply at current absorption and yet prices haven’t inched up a bit (actually reported to be down year over year by 4% when June 2010 is compared to June 2011). 

Clearly there has been a positive surge in rental activity. Lower vacancies and higher rents have been reported month over month in the Phoenix MSA. So there is some correlation with the data suggesting the limiting supply. 

I’ll throw one more observation out there. I was recently tempted to invest in the fix and flip market for single family homes. I found a few candidate homes and was set to make a run at the trustee sale auctions, until a friend showed me an insider report on that neighborhood. What appears to be a subdivision that’s has hit bottom and gaining some stability to the outsider, was clearly not. There were dozens of homes owned by lenders and others where lenders hadn’t started foreclosure despite owners not making payments in months. Driving through the streets on a Saturday I saw owners cutting the grass, washing their cars, kids playing ball in the street - not a hint that occupied, functioning homes were not even owned by the family anymore. Were they all in denial or did they all just accept the situation as normal? 

I’m absolutely encouraged that we are seeing higher rents and less vacancy. I’m happy to see that the lenders all appear to have formed some sort of a pact  to slow the release of homes to the ecosystem to keep things in balance. I’m just not sure how much of it is real.

As always, open to your thoughts and comments.

John P. Kobierowski

The “Buzz” among the politically charged today is centered around the Frank-Dodd Financial reform act. Over 2,000 pages in length, it contains only instructions to the regulatory agencies to create the policy - its a work in process and this seems to scare everyone.

What is clear is that we will see Fannie/Freddie and the other GSE’s scaled down and eliminated. The new rules put in place for loans to be securitized are going to be more stringent on private sector loans. 

-Real Down Payments of 20% (no secondary financing or carry-back)

-Higher credit scores

-Lower “Maximum” loan amounts. 

With just these changes, less than 36% of those who could have qualified for a loan today will qualify for a home loan after the new rules go into effect.

Pair this with the reality of a shrinking pool of first-time home buyers and lower consumer confidence in home ownership and we start to see a strong undercurrent of renters. 

Our markets in the southwest US (Phoenix, Tucson, Las Vegas, Reno, etc) have seen heavy adjustments in home values from the highs of 2005-2007, which should have lead to a buying frenzy. It didn’t because in these same markets, household income declined in-step with home values. Families buying power has declined which is creating a generation of renters.

Most surveys of the Phoenix apartment market report lower vacancy, increasing rents and lower concessions. Owners are experiencing a strong rental market.

Multifamily values have remained low mostly as a reflection of the distressed condition of the properties going to market. These buildings were cannibalization, and run on a shoestring while lenders pushed off foreclosures and owners struggled to run their failing assets. 

With the recent surge in acquisitions these buildings are bouncing back. We will soon see a new wave of properties hitting the market that are stabilized, clean, reset to today’s values and producing real (not Pro-forma) cashflow. 

We are returning to an investment market from the days of a trading market. 

I’m including a link to an interactive heat map from the Wall Street Journal on-line today, illustrating the states that will see the greatest changes to qualifying for a home loan. http://ow.ly/5qhAh 

It’s been a long dry-spell, but we are entering a market cycle where hard work will be rewarded with profit again.

As always, open to your comments and suggestions.

John Kobierowski

I have been spending most of my spare time meeting with and talking to owners and developers. I’m happy to report that most of the market seems to feel the market is turning for the better. I’ll elaborate on this in my next blog post. 

On another front, I read an article this past week about how the rest of the world is trimming their federal budgets. One startling bit of news was the dramatic cuts in public housing funding in the UK. The 2011-12 budget has been slashed by 60%. 

This is putting a tremendous amount of pressure on families who are in the UK’s subsidized housing system. Public apartments are closing and there are very few alternatives in the densely populated cities.

I mention this because the UK is not the only government forced to make hard cuts. Almost every country in Europe has been struggling to determine where to cut. 

Here on the other side of the pond we are approaching it in a different way. Yes, we are seeing some services cut, but HUD and HUD properties have not been tagged for the chopping block. We are are however certain that Fannie/Freddie/FHA and associated GSE’s will be trimmed and phased out ultimately. Even the mighty US postal service is changing. They are eliminating thousands of post office locations by not renewing their leases. 

I can’t help but wonder when we will see some of the US housing programs revamped or slimmed down. It might be a logical conclusion given the fact that cuts to defense, Medicare and other US entitlement programs seem to be the last cuts our citizens want to see. 

With an abundance of apartment vacancies, vacant foreclosed homes and growing REO portfolios, cuts to providing and subsidizing housing may be an easy cut here as well.

As Always. Open to your thoughts and comments. 

John

Is there really such thing as a “Bad” property? Can a good operator make the difference? Every property has it’s unique location, construction and functional differences. How much weight do you assign to the operator vs. the building in determining if it will be a star property? 

I have to admit I’ve sold some buildings with a long history of poor operations, through several management and ownership changes; it seemed like no one could get it right. I’ve also sold and owned great properties with a long history of good operations and the new owner then has horrible luck in matching the past operations. Is it the operator or the building to be blamed?

I’ve been pleasantly surprised to see the successes of first time operators who, as some would say, “don’t know any better,” turn around an historically poor operating property. Sometimes it’s as simple as their attitude, other times they have played to the building’s perceived faults (small units, transitional sub-market, student population, etc). Instead of fighting the building and forcing it into their operational mold, they work it’s strengths.

A few years ago I attended a luncheon where the keynote speaker was a former advisor to the White House on Latin Affairs. He challenged the audience (made up of mostly regional and national owners) to give some examples of what their Hispanic tenants want in a property. Then he listed what his group had learned through their surveys of traditionally strong Hispanic neighborhoods/communities. 

The audience listed things like having materials in both English and Spanish, having bi-lingual staff, etc. But the speaker went far beyond the basics. He explained how quickly the Hispanic population was growing in the US, how closely tied the families and communities were, the type of social activities they participated in and how they were slow to complain to outsiders. The colors that they would paint the buildings, what services they would appreciate, the office hours that worked better with their schedules, even flexibility in rent collection days due to their payroll periods. It was enlightening to hear how minor changes created a stronger property, decreased turnover and actually engaged the residents. 

In a market with so many housing choices, it may be smarter to understand the strengths of your asset, core tenants and the community that you are part of to gain market share. The fundamental premise of consumer marketing changed over 50 years ago when we realized we needed to figure out what the consumer wanted, cater to them and produce it rather than produce a product and figure out how to sell it to them. How can we we produce a product that the consumer wants? What does your core tenant group need? What makes your property more attractive, and conducive to their lifestyle?

Think outside of the box, otherwise you’re just another vacancy sign on the street…

As Always, open to your comments and suggestions.

John

A long time developer/owner, friend of mine and I were talking yesterday afternoon about “Ah..Ha ” observations that changed his perception, influenced his course of action and saved him from a few mis-steps in the market. 

We were discussing how important it is to visit your own properties without warning and at random. He told me he learned more about about his properties from his residents and staff that didn’t know who he was because he had stopped by a property early in the evening, on a weekend and dressed in his street clothes, then he learned from the monthly management reports. 

He told me the moment he realized the market was over heated in the last run-up in the late 1980’s. He said before we all realized what the tax law changes were about to do to the investment market and before the first Savings & Loan faltered, he saw how his parking lots we filling up with workman’s trucks. His newly built properties were full of pick-up trucks with toolboxes and racks. He continued that the trucks were still displaying license plates from everywhere but Arizona. 

His concern and “Ah..Ha..” realization was that his management teams were reporting strong occupancy and proforma busting income, but he saw that his renters were transient workers who had commuted to Phoenix to find work and since the construction market had already stalled, he knew these folks would soon move on to markets still building. Leaving him with empty units. He stopped building and started to sell out before the market toppled.

He came back after the crash, bought into the market and built when the timing was right. Again selling off the majority of his assets early in this cycle and keeping a few key buildings with good locations and very low debt.

He still regularly visits his buildings and noticed over the past year how much worse his parking lots are looking. There are more older cars, more residents working on their cars in the parking lots and the newer cars are falling into dis-repair (bald tires, cracked windshields, missing parts, etc) While his occupancy has been increasing and they have seen some rent increases, he is convinced that he’ll soon see much higher delinquency and evictions. He points to a weakening job market (more unemployment, under-employment) and higher fuel costs. He says his residents are forced to fill up their tanks first, then ration their remaining dollars between rent, food, clothes, etc. Fixing their cars is last on their list and to him it means they are cutting corners they can’t afford to cut. 

Increased costs for staples like food and gas are considered a disproportional tax on the people living from paycheck to paycheck. A monthly increase of $50 in fuel for a family comes directly out of another part of their budget. As we are witnessing, an increase in oil prices effects not just gasoline, but food costs. 

Rising oil prices have the effect of siphoning the dollars we would have hoped to have captured as rent increases. 

Whether my friend’s observations and conclusions play out as he suspects is yet to be seen.

As Always, I’m open to your thoughts and comments. 

John Kobierowski 

I enjoy hearing the one-liners, like folklore that grows out of each market. They are used to describe some lesson that we should have learned in the previous cycles.”The common sense lost” approach to teaching the next generation of buyers what the previous one learned. one such saying pokes fun at Phoenix and really sums it all up. It goes like this:

Question: What is the crop rotation for Phoenix farmers?

Answer: Cotton, soybean, subdivision.

Looking back at the last three cycles, I wonder if there isn’t more we can add to this…

Cotton, soybean, subdivision, short-sale…or

Cotton, soybean, subdivision, trustee sale, flip..

or maybe, cotton, soybean, subdivision, rental, assemblage, redevelopment… repeat?

When you compare our development cycles to other cities, there’s almost no place that compares to the speed we can do it in Phoenix. I think what took 20 years to run through now can play out in less than a decade. There are examples of communities that are probably wishing it would have taken longer so they wouldn’t have been straddled with the cost of the infrastructure they built to accommodate the market that never quite made it there. By the time the market picks up again, the improvements may be obsolete.

I recently heard that the city of Phoenix’s budget for sewer replacement of existing lines has for the first time exceeded the budget for new sewer line expansion. Oops, that’s right; there’s an economic life to our infrastructure. We’re still a newer city, with all the neat things like wide sidewalks, street lights, parks and underground utilities, all built from the best materials - 40 years ago? All that stuff needs to get upgrades and replaced. To put this in terms of our industry, we are going to have to budget more dollars for deferred maintenance then we realized. We’ve pushed the use of the infrastructure to the limits of it’s economic life.

Anyone who has lived in New York, Chicago, Detroit, Boston or any older metropolitan area understands the stress growth puts on an aging infrastructure. Some cities have bridges and roadways crumble before they complete the new improvements. Freeways seem to be under construction for decades.

We are entering a new age when it may be cost prohibitive to expand our city at the pace we have in earlier cycles. It may be cheaper to Recycle (renovate) and Reuse than to Replace.

As always, I welcome your thoughts and comments.

John