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Disclaimer: Bryan Church’s Real Estate Corner is not presented or intended to be used as investment, legal, tax, or as any other advice and should not be used as a basis for any type of decision.  Consult a professional before making any decisions.  

What is Happening in the World and How It Affects California Real Estate

As Accredited Real Estate Schools, Inc. comes up on its 20th year in business, I have been urged by my colleagues to start a real estate blog that deals with California real estate. I would like to take a look at what is happening in California, why it is happening, and what will likely occur in the future. Of course, the only way to correctly predict the future is…well, there isn't a way to correctly predict the future. Therefore, we will look at possible and likely scenarios in light of what has happened in the past to come up with what we think might happen to California real estate in the future.

One of the biggest changes to the real estate market over the last year or so has been caused by four private equity firms (Blackstone, et. al) that bought up over 45,000 single-family homes located in select markets throughout the U.S. Big Wall Street money has tended to shy away from single-family home investments in the past because they are too scattered and are therefore more difficult to manage than larger "institutional grade" multi-unit residential apartment buildings. Small mom and pop investors have dominated the single-family rental market over the years—taking advantage of the cash flow from single-family rental properties, and then when the time is right, converting them to owner-occupied use and reaping all the price appreciation benefits that come with increased demand for single-family homes and attractive financing that provides exciting (at least for the mom and pop investors) returns over their holding period. Over the years I have always wondered why Wall Street did not try to get in on this bonanza; well, they finally figured out a way to mess up this market too—just like they messed up the misnamed "subprime" lending market from 2001 through 2008. It was mortgage-backed securities and derivatives back then that allowed Wall Street hedge funds and other lenders to loan as much as they wanted to just about anyone who could "fog up a mirror," sell their loans as "A" rated mortgage-backed securities to unsuspecting investors located all over the world, and do all this without going to jail. I was wondering when the repeat performance would occur.

So, if it worked back then...maybe it'll work again today. This time it's rent-backed securities and derivatives. This time Wall Street private equity firms bought up a bunch of single-family homes in nine or so markets located around the U.S. and artificially drove up prices of single-family homes in those markets. With each sale, its use as a sales comparable affected approximately 90 other surrounding properties, so their purchases drove the market upward during their buying spree. You might think that the appraisals would catch up with them; however, since the private equity firms paid all cash for the properties, there were no appraisals to sound the alarm. Probably nothing illegal about it either. These private equity firms can pay as much as they want for properties. However, the result was that real estate prices increased in many markets and investors who purchased these rent-backed securities were happy about their collateral positions. If the income stream from the rents declined in value in the future, the investors could also liquidate the property and get some, if not all, of their money back.

The private equity firms then "over-improved" the single-family homes they purchased (because after all they were flush with cash) so they could get the best quality tenants available in the market. Mom and pop single-family investors could not immediately compete with these over-improved properties and ended up with second tier tenants who didn't have as good a credit rating or solid jobs. The private equity firms then took these high quality cash flows, bundled them together, and then sold the income streams as rent-backed securities on Wall Street. Investors purchased these securities expecting a certain return on their investment, allowing for the fact that the income stream was backed by actual tangible real estate (i.e., the single-family homes). The increase in value of the single-family homes showed investors how their collateral position for these securities was increasing and allowed the private equity firms to show a lower perceived risk (and higher security prices) than the properties probably justified.

The result has been a large number of rehabilitated single-family homes that have provided good quality housing for a large number of tenants located throughout the U.S., and it forced the mom and pop single-family owners to "over-improve" their properties as well, so they could compete with the private equity firm properties. Once the mom and pop single-family investors get their properties up to the quality of the private equity firms, that is when the private equity firms may have problems. The mom and pop owners will be out to steal the private equity firms' high quality tenants as their leases come due (6 months to 1 year out).

The question is what is going to happen in those nine markets (where this occurred) when prices start declining as a result of the private equity firms' not buying anymore single-family homes, and investors' security positions become more and more tenuous? We will see how this plays out over the next year or so as the private equity firms start losing their high quality tenants to shrewd mom and pop operators.

A second factor that has caused an increase in real estate values is the movement of money out of the stock markets and into tangible assets, like real estate. Over the last year or so we have seen the stock markets increase to record levels, mostly caused by Quantitative Easing by the Federal Reserve Bank (FED). The FED has been buying billions of dollars worth of mortgage-backed securities and treasuries, thus increasing the amount of outstanding debt, as well as increasing the balance sheet of U.S. dollar in circulation from $800 billion a few years ago to over $4 trillion today.

Unfortunately, much of this "stimulus" money has gone into the stock markets, rather than new businesses, thus moving the DOW to over 17,000 a short time ago. These increases have been occurring while the U.S. and California's economic data has been dismal at best. Investors aren't dumb, they see our fiat currency—that hasn't been backed by gold since 1971—inevitably going south like everything else.

In response, they have been moving their money out of the stock markets, dutifully paying their capital gains taxes, and then buying real estate in well-located areas throughout California and the U.S. I call this money "phantom equity" because as soon as the stock markets experience a serious "adjustment" (similar to 1929, 1987, and 2008) all this money will be gone forever—easy come, easy go!

The good news is that California is well-located due to its vibrant economy and has benefited from the influx of cash into our real estate markets. This increased demand for real estate in California has helped drive real estate prices upward—along with the private equity firm purchases mentioned earlier.

So, in a nut shell we have seen two real estate bubbles that have been due to financial manipulations, rather than solid economic data. Bubbles tend to take profits from the future and give them to the entities that are in the market today. Then it takes the market many years to find equilibrium again, unless another bubble comes along and the roller coaster continues.

Real estate investors must buy at the bottom of a real estate market and sell at the top—if they want to make any money at all from their investment. Real estate agents, on the other hand, can work in any type of real estate market because people always need to buy and sell real estate--as well as have it managed by us.

Check back in a few days as we examine interest rates, where they are headed (if anywhere), and the future of real estate in California.

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