Real Estate Financing: How Bad Will It Be?
A continuing series of discouraging news about the economy and residential real estate in particular is indicating a bad year(s) for investors and homeowners alike. What initially was primarily a "pricing collapse" now threatens to end up as the worst recession for the past half century. The Federal Reserve Board, faced with a choice of preventing a deflationary environment or causing a sharp rise in inflation, has already cut the discount rate to 3.5 percent (as of this writing) and has indicated it may repeat the drop as low as the one percent that was reached in 2001, when recession or worse last threatened.
Parallels are being drawn with the Japanese deflation of the 1990s, when home prices lost two-thirds of their value after tripling over the previous 15 years. The decline in value lasted for a total of 14 years and only recently has begun to rise slightly. As a result, home prices in 2007 in Japan were only slightly above the level of two decades ago.
Some economists believe that despite some disturbing similarities between the two housing busts, this is not likely to happen here because the Federal Reserve seems prepared to take aggressive action to stabilize housing markets. At the same time, other trends such as decline in overall productivity that supports economic growth and much lower expectations and confidence in the marketplace may mean that a relatively long period must pass before the American economy resumes growth.
Securitization Shortfall
Since builders are always willing to build and buyers anxious to buy, the
problem has not been lack of either supply or demand. Instead, the problem
has been one of excessive financing by lenders utilizing the mortgage-backed
securities (MBS) market to distribute debt—some of which turned out to be
bad debt— throughout the world. When irresponsible
or badly advised homeowners on one end bought without consideration of their
ability to pay, investors on the other hand bought mortgage securities that
(as the ratings agencies now acknowledge) were not properly evaluated.
By one estimate, in 2007 a total of $450 billion in new loan originations occurred. MBS apparently also account for about half of the total $300 billion of outstanding commercial real estate debt. According to some commentators, this year commercial mortgage-backed securities issuance will drop below $100 billion. The fact that real estate finance has come to rely so much on securitization means that the present situation is having profound effects.
With investors unwilling to buy MBS at almost any price, the intermediary lenders (banks in most cases) cannot sell their mortgage backed paper and so must now choose between keeping the securities on their balance sheets or selling them at a loss. Neither option is appealing. As a result, additional lending by banks is likely to be sharply restricted in the near term. Ultimately, the issue is not one of overbuilding or poorly performing properties, but rather the broader issue of liquidity that has touched the entire banking sector. The inability of the holders of MBS to "mark to market" because no active trading market existed meant that losses remained hidden until they grew much larger.
A Question of Valuation
The true problem underlying the entire residential real estate market has
not been that homes were not worth what they sold for, but rather that the
persons purchasing them were unable to maintain payments as interest rates
rose. The rise in interest rates, in turn, was not due to the rise in
general inflation, but rather the fact that the mortgages
used to finance the purchases were falsely represented since the initial
payments were a form of "loss leader" that brought in buyers unqualified to
buy a home under normal conditions. The failure to appreciate this fact
enabled the
mortgages to be securitized and sold as high credit financial instruments.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Anthony La Malfa is a senior manager in the Real Estate & Hospitality Services Group in BDO Seidman’s New York office. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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