Leverage

General Real Estate Investing
1

The press has recently made a big deal about the Bear Stearns Hedge Fund debacle. In short, the portfolio managers had unexpected losses in AAA securities. The way that CDO’s work is that they use highly leveraged money and dice up the cash flows from these bonds to creat synthetic bonds and sell off new cash flows to investors. They are predicated on LEVERAGED MONEY. Keep in mind that AAA corporate bonds are the same rating as US Treasuries… the same rating as risk free government guaranteed debt. I know the manager of this fund and can assure you that he is no dummy.

Who cares about Wall Street and what one fund manager screwed up? First, if one fund blew up, there is likely more as this particular fund invested in relatively high quality assets. There is a ton more that do the same thing with high yield and distressed assets… if one AAA fund can blow up, believe me, a lower quality one can just easily. Since this blowup, lending to hedge funds has tightened. Despite whats going on in equities, corporate bonds are getting annihilated right now. It’s only a matter of time before the equity markets go south.

What the hell does this have to do with real estate? When I first got onto this board, many people touted that real estate was a great investment, and better than equities, because of the ability to highly leverage your investment. I maintained that leverage is not always a good thing-- it’s only good in a bull market. As I have said this many time before, leverage is a two way street. If bonds, and eventually stocks tank, it WILL have an effect on real estate. I dont think we have seen the beginning of this. On bloomberg, there is a story about the Miami RE market. Currently, there are 20k condo units for sale. Because of the # of projects that were in the pipeline, an additional 23k units are expected to be in the market in the next few months. Thats close to 50k units on the market! Keep in mind that lending standards WILL get more difficult, taking a lot of potential buyers out of the market. Now, throw in all the funky mortgages having resets in the next couple years and there is more downward pressure. I think whats going on in miami WILL spread to other areas. Once we start seeing unwinding of leveraged money, the market will move remarkably lower.

Be careful folks.

2

Er, is this right? From what I read, I thought these hedge funds were deep into subprime mortgages and related derivatives… Definitely, i.e., NOT AAA stuff.

3

Yes. Without getting to detailed… These CDO’s dice up the cash flows and create different tranches on synthetic securities, all with different ratings. The underlying securities can be distressed or junk, however, they create AAA, AA, A, BBB and equity tranches based on “first to default”. If there are losses, they hit equities first, then BBB, then A and so on. The thought was that losses in the underlying securities, based on historical default rates, could never reach the AAA tranche. Once these mortgage losses started hitting the AAA tranche, they were in trouble. Typically the higher the rating on each tranche, the more leveraged it is. Once their are defaults in a trnche, the CDO gets margin calls and needs to sell in order to meet it. One can argue that the AAA tranche should not have been rated AAA, but S&P and Moody’'s rated them that, which has always bothered me. I have been on wall Street for 12 years and have traded many CDO’s. Do not believe the typical news sources-- they do not understand these products. The takeaway is that many banks bought what they thought was AAA and AA securities and they are not in fact AAA & AA. AAA means an almost zero likelihood of default, so much so that its virtually zero. BUT, thats obviously not true in this case. This will have an effect on banks lending practices.

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Brain,

I agree 100% with what you said. The big question is what else can we do to protect ourselves? My strategy has been to buy at a big discount. My total LTV is about 55% and I’m currently only buying properties at less than 50 cents on the dollar. I have no doubt that as the economy tanks, there will be a larger supply of tenants. The only question is whether the tenants will be able to pay rent?

I need to do some more research on previous crashes, especially the 1929 crash, and how that affected property owners, particularly landlords. Do you have suggestions for any good books?

I am also wondering if the stock market has topped out. The new high yesterday was with mediocre volume. Also, all the talking heads are bullish - what could be a better sign of a top?

Mike

5

Well, petemfa will disagree with me, but the 1929 crash/depression was a lot different. there’s a lot more financial controls in place that were enacted since then, which will prevent this from hapeening again. having said that, i think we are in for a very long period of declines in all markets. whether its reversion to the mean or just general declines, we are going lower. the market CANNOT sustain the well above average market returns. certain RE markets had 10+% annual returns for several years. It doesnt take a rocket scientist to know that average returns are what, 3-4%???

in terms of books, i would ask pete-- he seems to be the resident doom and gloomer and will probably be able to tell you the worst case scenario. no offense meant, pete. im a bit more moderate. in reality, things will turn out somewhere in between both of our opinions, BUT in no way, shape or form is the market moving higher anytime soon.

personally, i have been trying to wholesale with the intention to rehab at some point. im starting to think that this is the time to buy rentals and nothing else. rents should be ok as more homes are foreclosed and lending standards are tightened. people need a place to live, but fewer people will be able to afford buying homes. where i live in the NYC metropolitan area will prob weather this ok. there is very little free land and proximity to manhattan is at a premium. as long as wall street is still making money, this area will do well.

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Regarding equity markets-- you can’t have real estate declining, corporate bonds declining, treasuries rallying and equities rallying. It doesnt make sense. Either equities are wrong and the others right, or vice versa. But, you cannot have a flight to quality (treasuries) and equities making new highs. ALso, if corporate profits are good (equities rallying), wouldnt corporate bonds rally too? YES, but in fact, thats not the case. Throw in a slumping RE market and it doesnt take a genious to to figure out. Equities will go lower. Once a meaningful sell off happens, the doors could come off. Not sure what the impetus for that is, but something will set it off

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With 50k condos on the market in Miami I should be able to get them cheap, maybe if I go down there with $100 or so I can get 5 or 6 of them.

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would u mind picking up a couple for me?

9

How about this, send me $20k and I’ll buy up an entire development while I’m there. Or better yet, $100k and I could probably buy a few developments and a few developers.

10

Im in miami, how bout you send me all the money and ill buy all of miami

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I agree 100% with NJREstudent’s comments. The crash of 1929 WAS a lot different. Things never repeat EXACTLY.
We won’t see anything like the 1930’s because as Brian said many things have been put in place to keep that kind of devastation from happening again.

I don’t consider ANY of my comments to be doom and gloom, it’s really just facing a set of probabilities. No one here or anywhere knows what will happen, but we can look at probably outcomes based on FACTS we have today.

As Brian stated the CDO market is basically a black box, no one knows how bad the loses will be. It does not look good though. The RAMIFICATIONS of potential future loses ARE being seen RIGHT now.

A lot of people are asking “What should I do now???”
The answer to that is just wait, just wait. There is no reason to be buying property in a market that has JUST started a decline. I contend that RIGHT NOW is the MOST DANGEROUS TIME to buy homes. Think about it, most places have yet to see BIG price declines, prices have weakened but they are no where NEAR the potential lows that this market could see.

As far as the depression goes…Do you know that the majority of bank failures that occured during the 1930’s were actually caused by bad real estate lending??? It’s true! Most people believe that banks failed because of the stock market crash. Some did, but the majority became insolvent because of a big decline in real estate which happened BEFORE the stock market crash. That boom/bust hit FLORIDA the hardest. A little ironic huh?

Sit back, watch what is going on around you. NONE of it looks good, none of it. If you can’t steal it DON’T BUY IT! Personally my buying has SLOWED considerably. I’m in no rush, the more cash I have on hand the better I’ll be in 2008 and 2009. 2008 will see (3 times) 3X the number of ARM readjusts that went off in 2007. As prices continue to fall and interest rates rise, more and more people will face foreclosure. That is a FACT, not an opinion. As Brian stated with the Miami example, more and more inventory coming online, with tougher lending standards, and higher interest rates does NOT add up to INCREASING prices. Factor in a terrorist attack of any size, which our goverment has been warning about lately and you have a nice combination.

I don’t know about you guy’s, but in the Northeast we’ve got condo projects that HAVE to be built because the money has already been loaned. These things are EVERYWHERE up here. Mostly converted mill buildings. They are NOT SELLING, and we have a boat load in final phase construction RIGHT NOW. When you can’t sell 'em you DISCOUNT 'em, which leads to more price declines.

A good friend of mine just finished a total rehab on a 2 bed 1 bath SFH, he went completely thru it, new electric, plumbing, siding, roof, hardwoods, the whole show. This guy knows what he’s doing, he priced the home at $189K (good price) He just lowered it 3 weeks ago by $10K and STILL has it. He’ll be lucky if he walks away with $9K in the end. It all points to a TIGHTENING market.

There is nothing WRONG with waiting things out. Legendary Real Estate investor Sam Zell became a BILLIONAIRE by knowing when to do NOTHING. And nothing, is THE hardest thing for investors to do, we all want to be out there DOING it, but in these times patience will be rewarded, Handsomely!!!