Lecture 12: Real Estate

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Lecture 12 Real Estate
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Real Estate an Important Asset Class

• Until recent stock market boom, single family
  homes value in US approximated value of entire
  stock market.
• Home mortgages 1999 4.62 trillion Consumer
  credit is only 1.46 trillion. US National debt
  held by public is only 3 trillion
• (Source FRB, Balance Sheets for US Economy)

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Real Estate Partnerships as the Major Example of
a DPP

• Real estate limited partnerships represent the
  most important example of a Direct Participation
  Program (DPP), a class of investments that also
  includes oil and gas exploration programs and
  equipment leasing programs
• Direct participation DPPs are flow-throw
  vehicles and investors can deduct program losses
  on personal taxes
• Tax shelters until the Tax Reform Act of 1986
  losses used to offset passive income. Now,
  genuine businesses.
• DPPs escape the corporate profits tax
• IRS requirements, notably limitation of life

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Limited Partnership Structure

• General partner runs the business, does not have
  limited liability
• General partner must own at least 1
• Limited Partners are passive investors, with
  limited liability, rights to vote, can replace
  general partner
• General partner or associate usually runs the
  offering to sell units to investors
• Give additional performance-oriented compensation
  to the general partner

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Accredited Investors

• Regulation D Accredited investors include
  individuals with net worth in excess of 1
  million or with income in excess of 200,000
  (300,000 joint income) in each of the last two
  years
• National Association of Securities Dealers (NASD)
  requires suitability files and suitability tests
  for DPPs

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REITs

• Real Estate Investment Trusts (REITs) were
  created by US Congress in 1960 to allow small
  investors access to real estate investments.
• Before 1960, public companies that owned real
  estate would be considered businesses, for which
  their earnings would be subject to corporate
  profits tax. So, until 1960, real estate was
  typically owned by partnerships, not suitable for
  small investors.
• Today, institutions invest in REITs too.

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Restrictions on REITs

• 75 of assets must be in real estate or cash
• 75 of income must be from real estate
• 90 of their income must be from real estate,
  dividend, interest capital gains
• 95 of income must be paid out
• No more than 30 of income from sale of
  properties held less than four years
• These prevent regular businesses from being REITS

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The 3 REIT Booms

• First boom Late 1960s interest rates rose above
  deposit rate ceilings at banks, depositors fled
  to mortgage REITs. But, with recession of 1974,
  many REITs defaulted. Economic Recovery Tax Act
  of 1981 favored partnerships.
• Second boom Tax Reform Act of 1986 eliminated
  advantages of partnerships, so investors switched
  to REITs.
• Third boom Starting 1992, many private real
  estate companies found it advantageous to go
  public as REITs, specialized REITs developed.

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History of Mortgages

• In 1920s, 5-year term loans common, balloon
  payment due in five years, or refinance or sell
  house.
• In 1930s, decline in nominal home prices and rise
  in unemployment caused massive defaults
• Mortgage lending industry turned to long-term
  annuities

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Kinds of Mortgages

• Conventional, fixed rate mortgage
• Adjustable rate mortgage (ARM)
• Price level adjusted mortgage (PLAM) payment
  adjusted to inflation so constant in real terms
• Dual rate mortgages (DRAMs) same as PLAM but
  interest rate floats
• Shared appreciation mortgages (SAMs)
• First mortgages on purchase of home
• Home equity loans

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Conventional Mortgages

• Homeowners fixed rate mortgage an annuity whose
  present value equals the initial loan.
• Traditionally, payments are monthly and
  compounding is monthly. With maturity m years and
  mortgage rate r we have

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New Haven Savings Bank

• Founded in 1838 as part of the Savings Bank
  Movement that began in UK at begin of 19th
  century. A major mortgage lender
• Philanthropic mission to protect small savers.
  Charter requires conservative investments
• No savings bank went bankrupt during great
  depression
• Savings banks accumulate huge piles of assets,
  tempting takeover

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Statement from NHSB Directors

• In NHSB's case, formidable business risks have
  been steadily emerging over the last several
  years.
• The Board has a fiduciary responsibility to make
  sure that NHSB is successful, and it is clear to
  us that the Bank has to grow if it is to break
  out of its current stagnation. If NHSB were to
  rely just on its history and goodwill in the
  community, it would risk the very real
  possibility of becoming obsolete over time.
• These are unique challenges, and they call for
  outstanding leadership. NHSB is fortunate to have
  just that in its President and CEO, Peyton R.
  Patterson, and her executive management team. The
  Board brought Ms. Patterson to NHSB based upon
  her history of being able to jumpstart momentum
  at financial institutions, and her strong belief
  in community banking. Our confidence in her and
  her team has been confirmed in numerous ways, but
  most notably with the pending acquisitions of
  Savings Bank of Manchester and Tolland Bank, and
  the proposed plans to convert the Bank to public
  ownership.
• We are aiming to put more money back into the
  community -- NHSB is more than quadrupling the
  size of its Foundation, by allotting to it 30
  million of the stock raised through a public
  offering.

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CT Banking Commissioner John P. Burke, Approval
of Conversion Jan 2004

• The New Haven Saving Bank (NHSB) submitted an
  application on September 30, 2003 for the
  conversion from a mutual saving bank to a capital
  stock bank and for the acquisition of and
  subsequent merger of the Savings Bank of
  Manchester and Tolland Bank with and into NHSB.
  The combined entities will operate under the name
  NewAlliance Bank.
• To address the comments received on the concern
  the new institution would be sold in the near
  future, the approved plan of conversion restricts
  the acquisition of more than 10 of any security
  of the Holding Company without the prior approval
  of the Commissioner for a period of 5 years
  following completion of the conversion.

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NHSB Conversion Plan

• As part of the Plan of Conversion, New Haven
  Savings Bank will conduct a subscription offering
  of common stock to eligible depositors, in
  accordance with applicable conversion rules.
  Pursuant to governing regulations, the common
  stock is being offered for sale in a subscription
  offering, in descending order of priority, to 1)
  New Haven Savings Bank account holders with a
  balance of at least 50 or more on June 30, 2002
  2) New Haven Savings Bank's tax qualified
  employee stock benefit plans, including the
  employee stock ownership plan 3) account holders
  with 50 or more on deposit as of the quarter end
  before receiving approval 4) New Haven Savings
  Bank Directors, officers and employees and 5) New
  Haven Savings Bank Corporators.

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NHSB Shares Likely to Soar

• NHSB sent prospectus to its depositors on Feb 19,
  2004
• Price per share 10, maximum order 70,000 shares
• Deadline to order shares March 11, 2004
• As many as 102.5 million shares may be sold
• SNL Financial report Feb 20, 2004 the stock
  price will most likely jump 40 percent to 50 on
  the day the company goes public

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Fannie Mae

• Federal National Mortgage Association, created by
  Congress in 1938 to create a secondary market for
  FHA approved mortgages. Borrows money, buys
  holds mortgages.
• 1944 allowed to buy VA (Veteran Admin. Loans)
• 1954 Congress makes Fannie Mae a mixed ownership
  corp., with private owners
• 1968 Pres. Johnson signs bill making Fannie a
  fully private corporation
• 1976 Conventional loans outnumber FHA VA
• Still does not do jumbo loans (above 275000)

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Freddie Mac

• Federal Home Loan Mortgage Corporation (Freddie
  Mac) created by Congress in 1970.
• From beginning, it securitized mortgages sold
  pools of mortgages, called a participation
  certificate (PC) to investors.
• In 1981, Fannie began to compete with Freddie in
  pooling mortgages, with its mortgage backed
  securities (MBS)

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Implicit Govt Guarantee of GSEs

• Complaints that the Government Sponsored
  Enterprises have unfair advantage
• Richard Baker, Chairman of House Banking
  Committee, has introduced a bill to regulate GSEs
  and limit their business
• Stiff opposition

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Private Mortgage Insurance (PMI)

• Companies, such as MGIC, insure Fannie Freddie
  against losses on their mortgages
• Both Fannie Freddie require that mortgagors buy
  mortgage insurance if down payment is less than
  20.
• Controversy with recent real estate price
  increases, LTV has declined below 80 for many
  homeowners still paying for mortgage insurance.
  The PMIs dont notify them.
• Impossibility of PMIs insuring GSEs in a major
  downturn is another issue.

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Collateralized Mortgage Obligations (CMOs)

• CMOs divide the cash flow of a mortgage
  pass-through security into a number of tranches
  in terms of prepayment risk.
• Sequential-pay CMOs (first created 1983) First
  tranche receives first principal payments, after
  it is paid off the second tranche receives
  principal payments.

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Behavior of Single Family Home Prices

• Not a random walk, substantial inertia
• Occasional booms and busts
• Shared movements over wide regions of country,
  but not shared over entire country
• Boom of late 1980s infected many of largest
  cities of world

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Characteristics of Real Estate Booms

• Case Shiller Surveys of Homeowners 1988, 2003
• Surveyed recent homebuyers in Anaheim CA (boom),
  Milwaukee WI (no boom) and Boston MA (post-boom)
• Nearly 1000 responses each survey

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Long-Term Expectations

• On average over the next ten years, how much do
  you expect the value of your home to change each
  year?
• Los Angeles Milwaukee
• 1988 2003 1988 2003
• 14.3 13.1 7.3 11.7

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Fears of Being Left Out

• Housing prices are booming. Unless I buy now, I
  wont be able to afford a house in the future.
• Los Angeles Milwaukee
• 1988 2003 1988 2003
• Agree 79.5 48.8 27.8 36.4
• Disagree 20.5 51.2 72.2 63.6

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Perceptions of Excitement

• There has been a good deal of excitement
  surrounding recent housing price changes. I
  Sometimes I think I may have been influenced by
  it.
• Los Angeles Milwaukee
• 1988 2003 1988 2003
• Yes 54.3 46.1 21.5 34.8
• No 45.7 53.9 78.5 65.2

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Word-of-Mouth Communication

• In conversations with friends and associates
  over the last few months, conditions in the
  housing market were discussed.
• Los Angeles Milwaukee
• 1988 2003 1988 2003
• Frequently 52.9 32.9 20.0 27.6

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Stock Market is Best Investment

• The stock market is the best investment for
  long-term holders, who can just buy and hold
  through the ups and downs of the market.
• 1996 1999 2000 Oct 2001
• -Feb 2002
• 1. Strongly agree 69 76 63 60
• 2. Agree somewhat 25 20 34 31
• 3. Neutral 2 2 2 3
• 4. Disagree somewhat 2 1 1 5
• 5. Strongly disagree 1 1 0 1
• (U. S. Individual investors numbers for 2000
  are mid-year, after peak of market.)

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Real Estate is Best Investment
Real estate is the best investment for long-term
holders, who can just buy and hold through the
ups and downs of the market. Los
Angeles Milwaukee 2003 2003 1.
Strongly agree 53.7 31.3 2.
Agree somewhat 33.1 45.9 3. Neutral
10.3 11.3 4. Disagree somewhat
2.7 9.1 5. Strongly disagree
0.0 2.1
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Effects of Real Estate Booms Crashes on
Financial Institutions

• Default rate on mortgages is function of loan to
  value ratio, which declines as prices rise, rises
  as prices fall.
• Mortgage insurance companies suffered massive
  losses in 1980s with decline of real estate
  prices in Texas. MGIC in great trouble then.

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Real Estate Market Today

• Late 1990s have shown solid price increases in
  many cities
• San Francisco increased 28 1999 III to 2000 III,
  fell 4.5 between 2001-I and 2001-IV .
• More low downpayment loans today
• Risk of stock market decline harming real estate
  market, thereby the PMIs, and mortgage lenders