Other factors pushing back against positive housing momentum
Market view from New Oak Financial
“With home prices up 12% year-over-year for September, the housing market represents the brightest spot of the US recovery,” says James Frischling, President and Co-Founder of NewOak. “However, slowing growth and the 0.2% increase in home prices from August to September was the smallest gain since the beginning of the year.”
Given the strong recovery and performance witnessed in housing, a slowdown in the appreciation of prices was expected by many economists, especially with rising interest rates. But there are also significant headwinds buffeting the housing market in the form of tax increases, spending cuts, regulatory changes and healthcare reform. Coming together, these headwinds are pushing hard against progress on jobs creation and consumer confidence.
Sure the recent jobs report was better-than-expected, but a significant percentage of the jobs created were in lower-paying sectors. Leisure and hospitality, especially food services, were strong contributors to the October report along with retail sales. However, the uncertainty facing businesses are forcing many industries to hold off on hiring and many are cutting worker hours below 30 a week to avoid the healthcare mandate. As the Affordable Care Act is now being implemented, consumers are learning more about the increased costs they will face and this will impact their spending.
A lack of job creation and a concerned consumer does not suggest the good times will keep rolling for the housing market. The Fed’s easing and zero interest-rate policies have armed Wall Street and many hedge funds with the capital to deploy and the housing and stock markets have been the primary beneficiaries.
Significant home price appreciation should come along with a healthier economy, including a better job market. If home prices are pushed out of reach for the buyer, gravity will take care of the rest.
Commercial Real Estate: Approaching a Bubble?
“Everybody is searching for yield in commercial real estate, and some are chasing it to smaller markets to achieve 8+% capitalization rates with as-rented income,” says Ron D’Vari, CEO and Co-Founder of NewOak.
Shortly after the crisis, international and institutional capital found commercial real estate in gateway cities (e.g. Manhattan, San Francisco and Los Angeles) fairly attractive from both income and capital appreciation standpoints. However, the demand for prime commercial properties soon exceeded the supply. Given that the lease incomes on these properties were still protected by long term leases with established corporations, there were much fewer forced sellers and broken leases than tertiary markets. Substantial new capital from institutional and overseas investors quickly poured into the sector causing a rebound and forced down the cash-on-cash yields to near pre-crisis levels.
The smaller markets were not so lucky. Many newly built commercial properties lost key tenants, and a great many went dark or became fractionally occupied with substantial rent discounts. As a result commercial rents and prices plummeted and many owners/operators gave the keys back to the banks and walked. This was because they could not fully service their debt and/or their equity had vanished. Despite very attractive yields even with as-rented income, most institutional investors were restricted from investing in B and C property categories and could not take advantage of the unique bargains to be found.
With much tighter capitalization rates approaching 6% in major cities, banks and investors are forced to give a fresh look at secondary and tertiary markets which they would have avoided otherwise. Capitalization rates in mid-tier cities such as Houston are around 7 to 7.5% in the central business district and wider in suburban markets. Investors that are able to consider tertiary cities are looking to make over 8.5% with current leases.
Given attractive rents and competitive economic conditions, many businesses have considered moving out of major cities. Despite the still anemic economy, the business migration has helped stabilize commercial property lease incomes in cities such as Reno, Nevada, and Charlotte, North Carolina. The CMBS market also has become more amenable to reopen, lending in tertiary markets to properties rented to established corporations. As a result, equity investors in secondary and tertiary markets are able to borrow from banks over 65% of their purchase price and create an attractive return while interest rates remain low.
While the gap in the capitalization rates between prime and secondary markets are expected to close, the rents will remain relatively low in tertiary markets as new properties are built. The tertiary commercial real estate markets are not yet in the bubble zone but are not for the faint of heart either. There is high risk that rising interest rates will soon scare away the new buyers. Hence the current investors will face a fairly illiquid market for their investments. In the meanwhile, everybody is happy as the specialty real estate funds show high returns and bankers and brokers make their commissions.
Unsettling Settlements: US and European Banks in Crosshairs of Regulators
“There remains important questions and unknowns about regulators monitoring role,” says Asim Ali, Managing Director of NewOak. “What is it about large financial institutions and financial misconduct that is so difficult to untangle? Is it the opacity embedded within certain classes of financial assets? Is it the financial myopia associated with material returns? Is it the absence of due diligence processes associated with governance, risk management, and compliance or lack of well-articulated financial regulatory framework?”
These questions may sound like rhetorical statements, but they raise important questions about the ‘form’ and ‘function’ of the financial system, especially the role of regulators in monitoring different nodes of financial compliance. Let’s take three recent examples: 1) mortgage-backed securities (MBS) and the financial debacle of 2008; 2) the London Inter bank Offered Rate (LIBOR) rigging; and 3) the allegations of manipulation of foreign exchange markets.
In the case of MBS, the flurry of recent settlements with many leading financial institutions may yield some political dividends for the US government, but we still don’t know what exactly these institutions did wrong or if it was general over-exuberance and a financial bubble? In other words, unless we know where the culpability lies behind the MBS fiasco, enacting myriad indecipherable regulations and striking settlements is a short-term solution.
For now, settlements galore are a ‘win-win’ proposition for the US and European governments and the banks. The banks want to put these matters behind them, move on and begin the work of restoring their reputations, while governments and regulators want to be seen by the public as actively pursuing and disciplining these financial institutions for their profit-at-all-costs mentalities and lax risk management thereof.
Still, the two-fold question remains about the ‘form and function’ of the financial system, especially with respect to the issue of securitization and MBS, and the appropriate role of regulators in the regulation of financial institutions, the due diligence responsibilities of institutional investors and their basis for investing in structured securities.
Collusion alledged
Similar analysis could be deduced examining the second case around the LIBOR where some European and American banks allegedly colluded on inter-bank interest rates. Again, banks under scrutiny desire to reach settlements with regulators, minimise reputational damage and move on – even as the global financial system was shaken due to manipulation with the LIBOR benchmark that is, according to The Economist, “used to set payments on about US$800 trillion-worth of financial instruments, ranging from complex interest-rate derivatives to simple mortgages.” Likewise, in the final case for the US$5.3 trillion foreign exchange market, regulators have again found themselves in a reactive mode over allegations of foreign exchange rate fixing.
What these cases illustrate is it is insufficient to file lawsuits against the banks but then agree to settlements that penalize monetarily but provide no real long-term solutions to strengthen financial governance and compliance and avoid inherent potentially irrational short-term behavior by the entire market.
This is clearly evident from analyzing these three examples of financial markets that have had ‘systemic’ effects: the MBS-driven credit crisis, the LIBOR rate fixing and the foreign exchange market—the last two of which unfolded well after the 2008 financial crisis that spawned tighter regulations and more aggressive pursuit of financial misdeeds.
Yet, the reality seems to be that regulators are still trying to design an effective oversight model without having a full grasp on the “form” and function” of the financial system. In the meanwhile, as regulatory uncertainty continuous to weigh in on the markets, the banks, investors, and borrowers are in search of ways to get back to a smooth functioning securitization market to serve all parties, investment and capital.
