An Insider's View of the Real Estate Train Wreck, Part I

The first time I spoke with real estate entrepreneur Andy Miller was in late 2007, when I asked him to serve on the faculty of a Casey Research Summit. And there was no one in the nation I wanted more than Andy to address the critical topic of real estate.

My interest in Andy was due to the fact that he has been singularly successful in pretty much all aspects of the real estate market, including financing and developing large projects – such as shopping centers, apartment communities, office buildings, and warehouses – from one end of the country to the other. His expertise has also allowed him to build an impressive business providing assistance to large financial institutions that need help in dealing with problem commercial real estate loans. As you might suspect, business is booming.

Back in 2007, however, what most intrigued me about Andy was that he had been almost alone among his peer group in foreseeing the coming end of the real estate bubble, and in liquidating essentially all of his considerable portfolio of projects near the top. There are people who think they know what’s going on, and those who actually know – Andy very much belongs in the latter category.

In fact, he initially refused to speak at our event, only agreeing very reluctantly after I had hounded him for several months. The reason for his refusal, I later found out, was that he had spoken at several industry events before the real estate collapse and had been all but booed off the stage for his dire outlook.

So far, Andy’s real estate forecasts continue to come true. As you’ll read in the following excerpt from my latest interview with Andy, who now spends considerable time each day helping the nation’s biggest banks cope with growing stacks of problem loans, he remains deeply concerned about the outlook for real estate.

GALLAND: No one has been more right on the housing market in recent years. So, what’s coming next? Some of the housing numbers in the last few months look a little less ugly. Could housing be getting ready to get well?

MILLER: I don’t think so.

For all intents and purposes, the United States home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the US were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA.

If it’s true that most of the financing in the single-family home market is being facilitated by government guarantees, that should make everybody very, very concerned. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe, because private lenders for single-family homes are nervous. Lenders that are still lending are reverting to 75% to 80% loan to value. But that doesn’t help a homeowner whose property is worth less than the mortgage. So when the supply of government-facilitated loans dries up, it’s going to put the home market in a very, very bad place.

Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper.

The public doesn’t have any idea of the scale of the guarantees the government is taking on through Fannie, Freddie, and FHA. It’s huge. If people understood what the federal government has done and subjected the taxpayers to, there would be a public outrage. But you can’t get people to focus on it, and it’s very esoteric, it’s very hard to understand. But it’s not something the bond market won’t notice. The government can’t keep doing what it has been doing to support mortgage lending without pushing interest rates way up.

Refinancings of single-family homes are very interest-rate sensitive. Consumers have their backs against the wall. They have too much debt. Refinancing their maturing mortgages or their adjustable-rate mortgages is very problematic if rates go up, but that’s exactly where they’re headed. So anyone who’s comforted by current statistics on single-family homes should look beyond the data and into the dynamics of the market. What they’ll find is very alarming.

GALLAND: On that topic, recent data I saw was that something like 24% of the loans FHA backed in 2007 are now in default, and for those generated in 2008, 20% are in default, and the FHA is out of money.

MILLER: Fannie Mae had a $19 billion loss for the third quarter of 2009, and they are now drawing on their facility with the US Treasury. We have all forgotten that Fannie and Freddie are still being operated under a federal conservatorship. On Christmas Eve, the agency announced that it was going to remove all the caps on the agencies.

GALLAND: So what about commercial real estate?

MILLER: When I saw what was happening in the housing market, I liquidated all my multi-family apartments, shopping centers, and office buildings. I liquidated all my loan portfolios, and I’m happy I did.

It occurred to me in 2005 and 2006 that the commercial world had to follow suit. Why? Because it’s a normal progression. Obviously, when single-family homes decline in value, multi-family apartments decline in value. And when consumers hit the wall with spending and debt, that’s going to have an impact on retailers that pay for commercial space.

Furthermore, the financing for retail properties had gotten ludicrous. The conduits were making loans that they advertised as 80% of property value when they originated them, but in reality the loan-to-value ratios were well over 100%. And I say that to you with absolute, categorical certainty, because I was a seller and nobody knew the value of the properties that I was selling better than I did. I had operated some of them for 20 years, so I knew exactly what they were bringing in. I knew what the operating expenses were, and I knew what the cap rates were. And, you know, the underwriting on the loan side and the purchasing side of these assets was completely insane. It was ludicrous. It did not reflect at all what the conduits thought they were doing. They were valuing the properties way too aggressively.

I became very bearish about the commercial business starting in late ‘05.

GALLAND: Beyond the obvious, that the real estate market has taken pretty significant hits and some banks have been dragged under by their bad loans, what has really changed in real estate since the crash?

MILLER: I think the first thing that changed was that people learned that prices don’t go up forever. Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of their properties had been financed too aggressively, but still, I don’t think even at the fall of Lehman, anybody was predicting a wholesale collapse in commercial real estate.

But they did see they should be more circumspect with loan underwritings. In fact, after the fall of Lehman, they completely stopped lending. I think they realized we had been living in Fantasyland for 10 years. And that was the first change – a mental adjustment from Alice in Wonderland to reality.

Today it’s clear that commercial properties are not performing and that values have gone down, although I’ve got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios. People still do not understand how grave this is.

To be continued…

David Galland,
for The Daily Reckoning