• The median property value was $209,300.
• The property types break down as follows:  Single Family 56%; 2-4 units 9%; and 5+ units 33%.
• The Foreclosure Outcomes chart is particularly interesting as it quantifies what you probably already knew.  Of the 5,400 properties, 63% were Cancelled as a result of a loan mod or short sale, filing error or legal requirement to re-file the notice after multiple postponements. The lenders took back just under 28% of the properties for disposal through their REO networks. Barely more than 9% or 514 properties were actually sold to 3rd parties at the Trustee’s Sale.  This limited supply partially explains why large investor groups who have broad geographic targets now dominate at the auctions.  Individual investors who only focus on a few specific neighborhoods are finding the supply so constrained that it’s hard to justify the time and effort of going to auction.
• The Foreclosure Discounting chart also quantifies the fact that margins have become compressed at the Trustee’s Sales.  The Winning Bid to Market Value discount for properties sold to 3rd parties is 22.5%.  That sounds reasonable until you take into account 3-4 months of time spent in the eviction process plus associated costs to get the former owner out; property repair costs; and the property cost of sale for the investor.  At a recent ULI breakfast panel on the state of the LA foreclosure market, one panelist estimated that the net margin was down to about 7% for properties acquired at auction.  This data seems to support that.

Limited inventories and reduced margins combined with the potential downside risk of large, unanticipated property repairs means that buying at the Trustee’s Sale is not appropriate unless you are a seasoned individual investor.

Contractor Inflation

Most homeowners rely on their contractor or a home designer to help them select appliances, finish materials and hardware.  Either of these choices can result in excessive costs.  Contractors tend to be very busy and they don’t like to shop around.  They also add a contractor’s mark up to all labor and materials (usually 10-15%).  But that’s not the big problem.  Contractors often rely on a network of suppliers that cater to contractors.  These companies deliver directly to the job site, provide favorable credit terms, etc., all of which make them the contractor’s best friend.  But not yours.  They pay for all that service by charging very high prices (which you the client actually pay via the contractor).   That basic white American Standard bathtub might cost might cost $250 from FaucetDirect.com and they provide free shipping.  The local plumbing supply store charges $600 and your contractor marks that price up so it’s almost triple the price you could be paying.  Sometimes your contractor will put in an ‘allowance’ for certain items such as carpet.  If the allowance looks high, the contractor will tell you that they will only pass on the actual cost to you if the allowance is too high.  That’s great in theory but what’s the use if they are still going to buy the item from an overpriced vendor?  I can’t remember ever getting back money on an allowance.  I expect to be going to an Ice Capades show in hell before a contractor ever writes me a check.

Designer Inflation

The problem with designers buying/recommending materials is similar – they rely on a network of high-convenience, overpriced suppliers.  Most designers take a markup on items they purchase as well.  Often they will tell you that you should buy from a certain supplier because they get a ‘designers discount’ of 10%.  That sounds good but if you are charged twice the price you could be paying elsewhere prior to the application of the 10% discount, the math is not very favorable for you.

Door Knobs & Cabinet Pulls

Door knobs provide a good illustration of potential savings because there are many doors in a house so there is a multiplier effect applied to your per item acquisition cost.  I remodeled my house a couple of years ago and my wife selected some very nice Emtek Basel Brass Modern Passage Leversets.

We have just 10 doors in our California bungalow.  The list price was about $125 for each.  At Handlesets.com they were $98.70.  At Taylor Security & Lock the price was $57.75.  I saved nearly $700 just on door hardware.

Savings can be even more dramatic on cabinet pulls because there are so many.  I recently remodeled a kitchen and we needed 37 pulls.   We bought these nice European bar pulls for $3.85 each from Knobs4less.com.  Now go to Restoration Hardware and look at the Spritz Pulls priced at $14 each.  Those are pretty similar but would cost almost $400 extra in total.  This illustrates that value is created both by sourcing your materials from the right vendors and choosing items that achieve your design objectives at the lowest possible cost.

Tactics

Generally when I negotiate an agreement with a contractor, I try to identify all the necessary finish materials, hardware, etc. (on a room-by-room basis) and who has responsibility for purchasing them.  As a rule, you want to assume responsibility for all high-value items (bathroom vanities and shower/bath trim, kitchen cabinets, doors, etc.) or high-volume items (cabinet pulls, door hardware, overhead lighting, tiles, etc.).  What you want to let your contractor buy is drywall, framing lumber, piping, wiring, etc.,  which is low value.  Other than that, you just want them to give you a price on all the labor and installation costs.

Tradeoffs

I expect to save a total of 15-20% of the total materials budget by buying myself.  On a recent $120,000 project, my materials cost was around $40,000 and I estimate that relying on a contractor or designer would have pushed that up to at least $50,000.  I may have saved less than 10% of the total budget but I can think of a lot of things to do with that extra ten grand.

The tradeoff is that I spent a substantial chunk of time on multiple nights surfing the Internet and shopping around for the best price.  Since you have to take into account shipping time, it’s best to spec out all your needed materials in advance, then order and stockpile them so items are immediately available when your contractor needs them.  Remember that since your contractor is used to super fast service, they tend to give you very little warning about when they will need critical items.  If you have to pay extra for 2 day shipping that will cut into your savings.

Value can be created in many ways by the real estate investor and intelligent selection and sourcing of finish materials is a significant value driver.

This concept can be translated into the real estate market.  We would define it as the property’s value based on prevailing cap rates using the stabilized net operating income (NOI) adjusted for prevailing market rents after your expected remodeling investment.  This assumes that you are able to re-lease units that have been remodeled at market rates.

Most properties that sell for less than their intrinsic value are distressed either by their current ownership or their physical condition, or both.  Generally the industry refers to foreclosure properties as ‘distressed’ because banks are not long-term owners and tend to be motivated sellers.  They won’t hold a property for years but instead will discount it to whatever level is required to sell the property within a few months.  These properties tend to sell at a discount to other similar properties that are listed for sale by owner-occupants in the market area.  Too many bank-owned properties in a given market area will drag down overall market prices over time.

Properties can also be physically distressed by deferred maintenance, functional obsolescence (tiny closets, no master bath, etc.) or poor (or dated) design choices in finish materials, features and appliances.  The best opportunities tend to be properties where the basic systems (roofing, plumbing, HVAC, electrical, foundation) are updated but design choices and finishes are poor.  It’s always best to spend remodeling dollars on items that are visible to potential tenants and buyers and will create value either by commanding a higher rental rate or purchase price.

In practice, we look for the highest rental rates in a market area. After inspecting the property, we develop a remodeling budget including the ‘have to repairs’ on major systems and the ‘value add’ cosmetic changes that build value through good design choices in finish materials, features and appliances.  We develop a projected basis (acquisition price + acquisition costs + remodeling costs) and then project cash-on-cash returns based on the increased rental rates.

Ideally we will see annual cash-on-cash returns of at least 6-7% during the holding period with an IRR of 12% – 15% included the sale proceeds.

In addition to calculating intrinsic value, we also like to look at several current property metrics to determine if we are getting a good deal including: price per unit, price per square foot and sale price.  Is this sale price near the low end in the market area? While these metrics don’t determine if the property investment is a good one, it’s reassuring to see that your prospective acquisition is being done at the low end of current market values.

Foreclosure Background and Timeline

California is a ‘deed of trust’ state which means that the property deed is held by a third-party trustee not the lender or homeowner.  Generally all foreclosures are non-judicial as lenders foreclose on the deed through a Trustee’s Sale rather than going to court.  In LA county, these sales are literally held on the district courthouse steps in Norwalk or Pomona.

The start of the process begins with the filing of a Notice of Default (NOD) when a homeowner is late on their mortgage payment (traditionally done if payment is more than 30 days late).  The homeowner then has 90 days to cure the default by making all late payments and associated fees.  After the 90 day period expires, the lender files a Notice of Trustee Sale (NOS) giving at least 20 days notice prior to sale of the property at auction.  In the state of California as a whole, during the first quarter of 2011, the average mortgage loan was more than 500 days delinquent when the property was sold at auction.

The property will be sold at auction to either an investor making a cash bid above the lender-set opening bid (with no opportunity for property inspection) or the lender will bid an amount equal to the Unpaid Principal Balance (UPB) of the mortgage plus penalties, fees, etc.  Since that amount is owed to the lender, they have no out-of-pocket cost to acquire the property.

If the lender purchases the property at auction, it is referred to as ‘bank-owned’ or ‘real estate owned’ (REO).   Banks generally assign properties to a third-party asset management company that handles the eviction (if necessary); ‘trash out’ and any required repairs; and assigns the property to an REO specialist real estate agent that will list it for sale and coordinate the property sale with the asset manager.

To recap, the market characterizes distressed properties at one of three stages:

• Pre-Foreclosure:  the property owner is up to 90 days late on their mortgage payment and a Notice of Default (NOD) has been filed.
• Auction:  the property owner is more than 90 days late on their mortgage payment and a Notice of Trustee’s Sale (NOTS) has been filed.   The borrower can catch up on payments and pay penalties due at any time prior to the auction.
• Bank-Owned or REO:  ownership of the property has now been transferred to the bank (or an investor) and it will be sold by a real estate agent in the future.

Most foreclosure investors buy properties at the trustee’s sale or when the property gets listed for sale in the local MLS.  In Los Angeles County, there are many active foreclosure investors and bidding is highly competitive at auction and for MLS-listed REO properties.

Investment Strategies

There are different acquisition strategies that are applicable at each stage of the foreclosure process.

Stage: Pre-foreclosure

During the pre-foreclosure stage, purchase offers can be made to the homeowner as a ‘short sale’.   That is, the sale price is less than the unpaid principal balance (UPB) and therefore requires approval by the lender (s) as well as the homeowner.   Because of the multi-step approval process, a short sale can take a long time to consummate, often a minimum of 45 days and frequently more like 90 days or more.   A short sale allows the borrower to get out from under the mortgage loan(s) but the amount of forgiven debt creates a tax liability.  While a short sale has a less deleterious effect on a borrower’s credit rating than a foreclosure, it is still a significant negative.

Stage: Auction

Buying a property at the Trustee’s Sale has several challenges.  It is an all cash purchase, literally requiring bidders to attend the auction with cashier’s checks.  There is no property inspection allowed so property purchases are true ‘as-is’ transactions.  Once the property is purchased, the former owner still needs to be evicted which can take 3-4 months.  Finally, auctions are frequently rescheduled either because the homeowner is pursuing a short sale or declares bankruptcy.   This means that acquisition visibility is very limited because a target property auction can be cancelled or rescheduled 3-4 times over a multi-month period.  Buying at auction requires a discount to market value of at least 15-20% in order to compensate for the associated risks.

Stage: Bank-owned (REO)

The blind spot for most investors occurs during the period after the lender has acquired a property at auction and before it is listed for sale on the MLS.  Banks don’t publicly identify which asset management company has responsibility for a specific property and asset management companies don’t identify which real estate agent in their network has been assigned responsibility for listing and sale of the property.  This doesn’t occur until a sign goes up in the front yard and the listing goes active in the MLS.

One strategy is to build relationships with asset managers and local REO agents who will let you know when an REO property is going to be listed for sale.  Ideally you should have the listing agent write the offer for you.  By having the listing agent write the purchase offer, they have the opportunity to retain 100% of the real estate commission rather than split it with a buyer’s agent.  In the industry this is referred to as ‘double-ending’ the transaction.  It’s perfectly legal as long as both buyer and seller provide written authorization.

This provides a powerful incentive to the listing agent to promote your offer and convince the asset manager to accept your offer.  Mathematically, another investor would have to offer twice the price for the listing agent to make the same money as they would by double-ending the deal with our offer.

To a certain extent, this has become standard practice in Los Angeles as competition for REO properties has intensified.  Investors need to be disciplined and prepared to lose multiple property bidding wars before they land the right opportunity at the right price.

If you bought during the 2005-2007 period, you’re probably still underwater and will be for a while yet.  The S&P Case Shiller Index for Los Angeles hit a peak in September 2006 and has declined by 38% since then.

However, even if you bought at the earlier peak in June 1990 and remained invested, your property today would have appreciated 70% even after this most recent large price decline which began in 2006.  If you had bought in 1995 and sold in 2005 your gains would have been much greater.

Of equal importance is the fact that you would have enjoyed rental income throughout that period.  The keys to success are a long-term perspective; a financial capability to ride through the cycles; and an acquisition price that produces a solid ongoing annual cash flow yield from the property’s rental income.  Long-term appreciation is what turns a good real estate investment into a great one.  However, it can’t turn a bad investment into a good one.  If you buy a property with weak cash flow at the top of the market, don’t depend on the market to bail you out.

You also have to believe in Los Angeles: the lifestyle, the weather, nearby beaches, deserts and mountains, the Hollywood glitz, etc.  If you think that what makes LA unique and attractive now, will continue in the future then real estate can be a good long-term investment for you.

Lastly remember that while general market conditions are influential on your real estate investment results, choosing the right property and neighborhood are even more so.  Valuation is based on a multiple of operating income. A highly desirable property in a highly desirable neighborhood will allow you to grow your operating income by raising rents at a rate that exceeds market-level growth.

Most housing market data sources are based on closed transactions which introduces a lag factor in the data.  A property will spend anywhere between 30-45 days under contract (or in escrow depending on the state) and then the data is compiled by a property data vendor.  This usually takes another 30 days or more depending on the county where the transaction occured.

Altos Research compiles its data based on current for-sale property listings collected from across the Internet.  Therefore price trends, listing inventory growth and other key metrics show up immediately in the Altos data.  Their price index correlates closely to  the S&P/Case Shiller Index.  Real IQ provides the analysis component.

This report will be highly valuable to housing market investors that want a leading indicator for the major markets.  Below are some of the highlights from the December report that summarize November market data: 

l        Nationally, the housing market continued to experience the widely-publicized pressure this month but a handful of cities have managed to buck the downward trend. Inventory levels displayed seasonal declines in many markets. 

l        Time-on-market continued to increase substantially, indicating that the decline in demand continues to outpace inventory reductions.

l        In San Diego, the first effects of the October wildfires became visible in pricing, inventory and time-on-market trends. Prices fell in San Diego by 5.8% during the last three months.

l        Significant price decreases were also observed in Detroit, Los Angeles, San Francisco and Las Vegas.

l        Miami experienced the longest time-on-market spans with an average days-on-market of 137 in November.  Minneapolis had the second highest average days-on-market at 125.

l        Three markets maintained price stability this Autumn – New York, Denver, and Dallas – though weakening demand indicators do not bode well for the near term.

Standard & Poor’s today released its S&P/Case-Shiller U.S. National Home Price Index for August 2007, and the credit crunch that recently roiled the mortgage market weighed heavily on home prices. Of the 20 markets tracked by the index, only five remain in positive territory over the past year.

However, the rate of appreciation in those markets has slowed, and even Seattle, the strongest market, showed a small monthly price decline. In fact, only two markets — Charlotte and Denver — showed a price increase for the most recent month.

Seattle is still up 5.7 percent for the past year; Charlotte is close behind at 5.6 percent; and Portland is up just 2.8 percent. Atlanta and Dallas are basically flat with 0.8 percent and 0.5 percent increases, respectively.

The worst-performing market had previously been Detroit with a 9.3 percent decline, but that dubious honor now goes to Tampa, which is showing a 10.1 percent decline over the past year. Previously hot markets including Los Angeles, Washington, D.C., Las Vegas, Miami, Phoenix and San Diego are all down more than 5 percent. The Composite Index of 20 markets was down 4.4 percent overall.

So where are we headed in the future? Investor expectations are reflected in housing-price futures and options traded on the Chicago Mercantile Exchange, which are based on a subset of the S&P/Case-Shiller U.S. National Home Price Indices. Expectations of future price changes are implied by the percentage difference in the index value for the relevant market (most recently published on Oct. 30, 2007, for August 2007 period) and the current price of traded futures contracts expiring on future dates.

Right now, investors are betting on a decline in the composite index of 7.6 percent by July 2008 (the futures contract expiring in September 2008 settles based on that period). They expect the index to still be down by 9.4 percent even in 2011. The most dramatic declines are expected in Miami with a decline of over 26 percent by 2011 and in San Francisco with a decline of over 25 percent by 2011.

As always, remember that these contracts are new and thinly traded relative to well-established foreign exchange or commodities contracts, and that means they are reflective of the collective wisdom of fewer investors.

For example, investors are currently expecting a decline in the Denver market of over 7 percent by late 2008, but that market has logged three month of successive price gains. Unlike coastal markets, Denver did not experience outsized appreciation and so the downturn has been very moderate. In this case, investor pessimism may be misplaced and result in losses on those contracts.

 This article was also published by Inman News.

Momentarily ignored was the company’s ghastly performance resulting from the recent credit crunch.  The cancellation rate reached 68% either because buyers got cold feet or their financing fell through.  That means the company is largely building ‘on spec’ in the teeth of a fierce housing downturn.

Beazer’s stock price was in the mid-40s at the beginning of the year and is trading at a bit over 9 today.  It’s hard to imagine a stock that better qualifies for the old Wall Street warning about trying to catch a falling knife.  Just because this one traded above $40 bucks a few months ago, there’s no reason it can’t go down $3, $2 or zero.

 In a multi-year housing downturn, there will be builders that survive and there will be those that don’t.

By looking at down markets in the late ’80s and early ’90s, we can make some observations on past real estate declines.

Price declines are relatively shallow. During most downturns, prices tend to decline in the range of 3-6 percent annually with cumulative declines of less than 20 percent. Los Angeles was the exception in recent history, experiencing a cumulative decline of more than 27 percent. Compare this with the NASDAQ index, which was over 5,000 at the height of the dot-com boom in 2000 and is still at only 2,791 seven years later. Of course, because houses are a highly leveraged purchase, a percentage decline even in the teens can eliminate your equity entirely if you bought too close to the market peak.

Down markets can be lengthy. Market observers frequently say that the market will turn up “next year.” This is often wishful thinking. Past downturns have persisted for a number of years, not just one or two. Real estate markets are often characterized as “sticky downwards.” That is, when home sellers don’t get the price they want, they opt to take their properties off the market and wait. While this behavior may cushion the downturn in prices short term, it tends to extend the duration of a market correction.

The big picture matters. Most downturns are a manifestation of larger economic conditions. Generally a national or local recession with substantial job losses drives real estate corrections. The current downturn in Detroit has been the most severe of any major market because of auto industry-related job losses. Many real estate markets declined during the national recession of the first Bush presidency in the early ’90s. In the case of the Los Angeles market decline, the downturn was extended and deepened by an earthquake and race riots.

Source: S&P Case Shiller National Price Index

So what does this mean for real estate professionals in the current downturn? Be prepared for the weak market to last a fairly long time.

In our view, prices are likely to continue to decline by low- to mid-single-digit percentages annually for the several years in the high-cost markets that had the greatest run-up. The wildcard is a recession. If that happens, we will take another downward lurch before we gradually settle to a bottom and begin the upcycle again.

This article was also published in Inman News.

To figure out when that will happen, housing economists study reams of data on building permits, housing starts, mortgage rates, loan resets, affordability indexes, job growth and a host of other factors including consumer psychology. Before you hear the answer from someone’s crystal ball, it’s worth establishing some historical context for your local market.

The most obvious questions are:

How long ago did the market hit its peak? Markets like Seattle, Charlotte and Atlanta are still rising. On the other hand, Boston peaked in September 2005, San Diego in November 2005 and Detroit in December 2005.

How far has the market fallen since hitting its peak? Detroit has fallen the furthest with a 12.4 percent decline as of July 2007, the most recent month for which the S&P Case Shiller indices have been published. San Diego and Tampa have both declined more than 8 percent so far. On the other hand, Chicago and Denver have fallen by less than 2 percent from their peaks.

How big was the run up in prices prior to the market peak? The big California markets all experienced increases of more than 200 percent in the 10-year period prior to hitting their peaks. Miami also soared more than 200 percent. In fact, 10 of the 20 markets in the table below all saw increases of at least 150 percent. The Midwestern markets saw much more restrained price appreciation with a low of 41 percent in Cleveland and a high of 117 percent in Minneapolis.

Looked at in this way, the contrasts are stark. Both the Los Angeles and Cleveland markets peaked in mid-2006 and both have fallen less than 5 percent, but Los Angeles appreciated 267 percent in the prior 10 years while Cleveland was up just 41 percent. You can reach your own conclusion about the desirability of living in Cleveland versus Los Angeles, but the downside price risk in your house would probably be a lot lower in Cleveland at this point.

While local market price direction is largely driven by local supply-and-demand factors, it’s worth considering your market’s recent past before you try to peer into its future.

This article was also published in Inman News.