Michael Keston Opines On Prospects For Housing Market Recovery

New homes starts, reports Reuters, increased 8.2 percent nationally in April, signifying a glimmer of hope in a beleaguered housing market. What importance do you place on this positive statistic? Is there reason for housing developers to hope the end of the housing crisis is near?

That statistic is just a blip. We'll see continued reductions in housing prices as long the inventory level of new homes and existing homes continues to rise.

It's a blip because some builders are finishing new homes, which increases the supply, but there is a very limited demand for the purchase of those homes. As long as buyers see the media asking, "When will prices stop dropping?" they have no incentive to go out and buy.

Secondly, the lenders have now started foreclosing on a lot of the properties, whereas, for months, they were waiting to figure out what to do and how to do it. Now, they're starting to foreclose on homes. That's another source of supply that's going to hit the market.

Between those two sources of inventory, the inventory levels will not drop. If inventory levels don't decrease, there will be a continuing drop in prices.

Among other things, you teach a course at the USC School of Policy, Planning, and Development on development finance. You've seen a lot of these cycles in your career. Is there anything different about this particular market challenge?

This is substantially different. I entered the real estate market in 1970 and was greeted by the first downturn that I would see in my career. Since then, I've seen three other major downturns. This one is very different for a bunch of reasons.

First, the industry was selling homes at a very good pace through July and August of 2007. Builders started a lot of houses in June and July, expecting that the pace would continue. About that time, the sales rate dramatically dropped off. It wasn't a slow drop-off; it was a very dramatic drop-off. The bottom seemed to fall out quickly. In past times, the slowdown was more stretched out over time and people had a chance to see what was going on. In this instance, builders who had pre-sold homes found out that the buyers were canceling suddenly. These were the homes that were started in May, June, and July to be delivered six or seven months later, and instead of being sold to buyers, they became standing inventory. As builders experienced 60 to 80 percent cancellations on the pre-sold homes, standing inventory continued to grow. Extraordinary incentives and price reductions were introduced to try to save the remaining backlog.

The second thing that is very different is that today: public builders have about 70 percent of the new home housing market, whereas in past years, it was 20 percent and then 30 and 40 percent, but never at the level that it is today. In the past, and even today, most private builders generally borrow with construction loans from individual banks that are 75 or 80 percent of the sale price of the home. When they sell the house, they have to pay back the bank a per-unit price to release the house from the note and deed of trust. Basically, private builders borrow on a per-project basis. That gives discipline to the market because, as prices go down, you have to try to hold your prices to at least the price that you have to repay the banks and other lenders.

The public builders do not borrow that way; they borrow using large lines of credit, which are tied to their overall inventory levels of land and housing. They are restricted, to a great extent, by financial covenants, such as debt-to-equity ratios, which are overall as to the corporation instead of the project. Their desire is to generate cash flow-to do whatever they can do, in whatever fashion-to keep them going. They don't have the restrictions on release prices to pay as each house is sold.

Public builders continue to look for the bottom where they can keep selling homes. That disrupts the entire market because they go below the price of builders sitting on a project-by-project price limit. The public builders have continued to lower the prices until they sell their inventory. That is a very different condition than it was in the past.

If you were giving a lecture to your graduate class this summer about the market, what would you instruct them to pay attention to over the next few quarters?

I would not look to start any houses in any market over the next two or three quarters until inventory levels drop substantially. No market has really hit a bottom, except maybe markets like Montecito and West Los Angeles, where the prices are holding in certain ranges. As more inventory becomes available, builders and owners of homes are going to be hard pressed to sell at the prices they anticipate.

The other thing is, the way you make a lot of money in this business is after prices stabilize for sometime. Then the sales prices of the homes tend to go up in each of the subsequent phases that are built. So, even if you made a mistake on your costs, you make it up as the sales prices go up. Over the next two or three quarters, I do not believe that we are going to see sales prices increasing. The best we can hope for is that sale prices stabilize. In that instance, prices are not going to stabilize at levels strong enough to make the level of profits that are necessary given the risks in the market.

Finally, the traditional lenders of construction loans in this market are not going to be players over the next six to nine months. I was at the USC Lusk Center 100 Conference a few weeks ago, and three of the largest lenders there said that they will not be lending money in the residential housing market over the near term.

You mentioned that there are still pockets at the high end-Montecito, West L.A. Are there any other pockets of opportunity? In a number of TPR's recent interviews, developers have said that you have to look at the current market sector-by-sector, in terms of geography.

There are other sectors-including certain places in Orange County, if you are near the water, or if you're selling something special, like a project that has large lots for horses-where if you have smaller projects with only 30 houses in the project, you'll find 30 buyers. But the larger projects, the general projects-I don't believe those projects are going to find a substantial number of buyers anywhere at this time.

Remember, in the housing business, it's not only the sales prices that are important, but also the velocity of sales. The interest charges keep running as long as you have unsold units. If you sell two homes a month versus eight homes a month, your interest costs will be four times what they would otherwise be at eight a month. Similarly, your advertising costs, overhead costs, and other fixed costs will multiply three and four and five times when the velocity slows down.

Not only are you hit by the reduction in prices, you're also hit by the increase in the fixed costs, which continue to run. To a great extent, many of the builders have lost the ability to pay interest, because interest costs continue no matter how much you cut down on the other costs and eliminate staff. It becomes a function of whether the lenders are willing to waive the interest or put it on hold. In practically all the cases that I am aware of today, the lenders have not yet been willing to say, "Let's work this out, why don't we stop the interest and see what you can do." In many cases, the lenders will bring in receivers to manage the property for the bank in place of the original builder. Or, they will move to foreclose on the property.

Other lenders have said, "That's not a good approach. If we do that, we'll get 40 and 50 cents on the dollar of our loan." They've decided to work things out with the builders. The builders sell for the maximum price they can get, and the lenders take whatever cash comes in, even though it might be somewhat less than the release price. But that will move the velocity and allow them to achieve the maximum dollars. In most cases, those lenders are getting 90-100 cents on the dollar, whereas the lenders who are taking properties back are putting them in big pools and selling the notes within those pools to institutional investors for anywhere from 30-60 cents on the dollar. When they sell the note, they've lost the rest of their loan principal amount.

When your students ask you what the makeup of the residential housing industry will be in 2009 and going forward, what do you tell them? What will the regulatory environment be like? Who will be the financiers?

In 2009, the participants will primarily be the public builders. There are a few private builders who have substantial cash and are buying selected projects so that they can continue to sell. Some of them are buying selected pieces of property-just the land itself-which they can hold for two to three years and wait until the market comes back. But there are very few private builders today who have not depleted their entire cash reserves by trying to hold on to the properties they currently own that are subject to bank debt. In that regard, there are larger syndicates-some hedge funds and distressed land funds-who are buying packages of loans. They expect to sit on most of them for two to four years until the market stabilizes and prices begin to rise.

In many regards, this is similar to the savings and loan problems from years ago. In many cases, when notes are sold at 30 or 40 cents on the dollar to a group of people like the big hedge funds and Wall Street firms, those new buyers go back to the original borrowers, whom the banks have foreclosed on, and sell the asset back to them for 70 cents. Not only does the new owner of the notes offer them at 70 cents, but they are willing to stretch the loan out and forego certain interest payments. In the long run, the ones who make out poorly are the original lenders, who are not able or willing to stretch out loans and even reduce principal paydowns.

As I look forward, I see a lot of hedge funds, distressed funds, and syndicates buying an increasing number of these notes, going back to the original builders, and trying to work something out. Or, in the case of raw land, sitting and holding it for two or three years and when the market turns, finding the best price from those builders who are going to pay for it. There is a lot of that beginning now with all of the excess land.

The interesting thing is, so far, a good amount of that excess land that has been sold today is not prime land. It's the land in markets that were probably the last to get hot and the first to die. That's where the builders own the most excess land. The prime land-which is really in coastal cities and cities where the amount of land and properties is limited so that if you want to go out and get a new entitlement, it's nearly impossible-those are the markets you want to hold onto the land with your last dollars. The markets where it's easy to get an entitlement and where an overabundance of land has been approved-those are the ones that are showing up on the market for sale. Many buyers are waiting on the sidelines until the owners are forced to sell what are considered to be the prime properties.

The question today is, are those who are buying that land doing so too early? Should they be sitting and waiting six to nine to 12 months because prices are sure to go down in the future and better located properties will be offered for sale?

What is your take on how the governmental and fiscal regulatory institutions, especially the Federal Reserve, are responding to the housing market crisis? TPR recently published a speech by Ben Bernanke, in which he said, "The Federal Reserve is addressing the foreclosure crisis in capacities other than that of a regulator, leveraging our strengths in research and data analysis, our regional presence, and the many contacts we have developed with local community groups, lenders, policymakers, and other stakeholders in this issue. In addition to regulation, and strong, uniform oversight, a different type of mortgage lender is critical to avoiding future problems." What are your thoughts and reactions to the regulatory initiatives being put forward at the federal level?

That sounds like Washington, D.C. and Congress double-talk. I am not sure exactly what that means. The Federal Reserve is looking at the mortgage lenders, the big ones, like Countywide, Fannie Mae, and Freddie Mac. The Federal Reserve has yet to attack the issue of the individual lenders, the larger and small banks, who have loaned money to people in the building industry. To my knowledge, there is very little regulatory pressure being put on the banks now, and banks themselves are struggling to figure out the right approach.

For each bank, there's a different approach. Some banks will sell their notes just to get out of them and get liquidity; other banks will try to work things out; there will even be some banks making new loans to their customers to build out of the problem. That flexibility is prudent because each situation is different. What caused the great debacle during the savings and loan crisis was that the regulators came in and essentially told everybody, "Even if you have a good customer who is paying his interest, if the appraised value of the asset is substantially lower than when you made the loan, you must foreclose." That created the chaos in the marketplace.

Regulatory oversight is good before certain problems exist and everybody knows the rules regarding how to deal with them. But in today's market, if the Federal Reserve, Congress, and other regulators come in and start pressing the banks to foreclose on everybody, then that will be a further disaster for the housing prices and the general real estate market.

Last spring, TPR published an interview with BIA/GLAV's Holly Schroeder regarding a BIA released study claiming a Metro L.A. shortfall of 300,000 housing units and a projection that the region would require 750,000 units in order to reach the national average for homeownership rates. Are these statistics still meaningful given the current housing and credit crisis?

In my opinion, these statistics will not play a part in what happens in the housing market today. First of all, California always seems to have higher demand than supply; I've seen that for 30 years. The other thing is that the national ownership percentages are generally higher than in California. California's homeowner percentage increased in the last two to three years, but it increased in a very artificial fashion. When people were granted loans on the basis of their stated income without credit checks (which is what happened with a lot of these mortgages), people got into the market who should not have been homeowners and didn't have the capacity to pay for the mortgages, the real estate taxes, and the utilities. We're a high cost, high price state, and people here can't afford to buy a house as easily as they can in other states where the prices are not so high relative to their income.

As the benefactor of the USC Keston Institute for Public Finance and Infrastructure, share with our readers how well you believe the voter-approved 2006 state infrastructure and transportation bonds are being invested to date; and, what, if any, is the nexus between public infrastructure investment and the depressed state of our housing markets-the subject matter of this interview?

We find that the central issue today is that the state needs $500 billion in new funds for transportation, ports, airports, and water systems that are not available through the traditional sources of the state budget.

The state raised $20 billion in 2006 through the sale of a bond for certain transportation programs. But transportation is only one piece of the puzzle, and $20 billion is maybe one year's worth of the dollars that are necessary to help the transportation problem. You have to sell $20 billion each year and we have only spent about 2 percent of the authorization. At this rate, it will take ten years to spend the 2006 bond funds, and that is much too slow. There are issues as to how to supply the water to the urban areas of the state that we haven't yet gotten our arms around.

We took a first step forward with the $20 billion, but there is no one in the state-from the governor's office to the speaker's office to the pro tem's office-who is comprehensively dealing with the question of how to replace and maintain our crumbling and inadequate infrastructure. They said, "Well, we spent $20 billion on transportation infrastructure last year, let's now address healthcare and other issues that are important." They have not put in place a process that will provide a capital program to spend $20 billion a year over the next 15 years, which is necessary to support our population and keep our economy strong and vibrant.

The majority of the California population increase, which is projected at 500,000 people a year, is coming from natural births. That means that people are going to be here whether we want them to be here or not, and it's the job of the Legislature and the Governor to accommodate and plan for those people. They are putting their heads in the sand if they say, "We're going to work on some other things."

Local government is probably the best resource to solve a lot of these problems, but the Legislature does not give local government the authority to charge user fees and tolls to finance the overwhelming amount of the infrastructure assets that have to be built. Even though local government is willing to put much of its own money on the line, the Legislature blocks their authority.

We are beginning to fall behind most of the countries in the world today, and also behind many of our own states, who are building gleaming new airports, new and efficient water delivery systems, wide modern freeways and all the other infrastructure necessary to compete in the 21st century global economy.

If the Legislature is not going to allow local governments to charge tolls or user fees without their project-by-project approval, we're not going to build the amount of infrastructure that we need in this state for the general purpose of improving our quality of life and sustaining the growth of our economy. It is not too late if we start now.