Big Short redux? Signs of a real estate bubble are peeking out

After the banks fail, the commercial, industrial and housing markets crash and credit tightens up throwing the country into a recession, it all seems so obvious. We should have known we were living in a real estate bubble.

But participants in a raging segment of the economy, like we have in real estate now, never know. Most of them, anyway. It’s not only difficult to predict the end of a boom, but against optimistic human nature. We want to enjoy good times. Hard to fault that desire, yet signs of a bubble, fueled by easy money policies by the Federal Reserve and high demand for real estate after years of underbuilding, are becoming more obvious every day. Here’s what’s on my radar.

A WARNING FROM MOODY’S ABOUT COMMUNITY BANKS, plus an eerie Big Short-like statistic

The Federal Deposit Insurance Corp. (FDIC), in its 2016 Quarterly Banking Profile, reported that while the banking industry saw a 2 percent drop in profits, community banks income rose 7.4 percent. That’s ostensibly a good thing but not in Moody’s eyes. The big profits are being produced by commercial real estate lending, which the rating agency sees as credit negative.

Why? Because Moody’s knows what I learned as a longtime banking reporter. Early in my career at the now defunct El Paso Herald-Post, I covered dozens of bank and savings and loan failures. Later at the Rocky Mountain News, I reported on more than 30 Colorado S&Ls that either failed, were sold off for a pittance or merged into another institution. Banks failed too. The reason? In every case it was exposure to commercial real estate (CRE).

Moody’s wrote: “When the CRE market deteriorates, as one of our key indicators suggests has already begun, community banks’ creditworthiness will deteriorate more than larger banks, as was the case in the last recession. Community banks grew CRE loans 11.9% during the past 12 months, compared to 9.4% for all other banks. Within CRE, 19.1% growth in multifamily and 16.3% in construction/development loans led the increase. Moreover, community banks increased their unused CRE loan commitments by a substantial 22.7%.”

Commercial real estate by nature is a grownup’s game. It takes investors with large, diversified balance sheets, extensive knowledge and experience and the patience to weather economic storms, not to mention the courage to buy low and sell high. In my experience, backed by Moody’s opinion, community bankers possess neither the expertise nor capital to compete in CRE.

Moody’s also published a chart that to me showed an eerie resemblance to 2007, the year that things began to fall apart. The agency tracks loan-to-value for commercial mortgage-backed securities, or CMBS. It’s an important indicator because it tells us how much equity these securities carry. Loan-to-value has recently surpassed the 2007 peak. These are the type of securities that bore the same credit quality scrutiny and scorn of legendary fund manager Michael Burry. And we know how that one went.

Participants in the CMBS markets will no doubt say that credit underwriting standards are better than they were in 2007, that banks have to pass stress tests that require them to carry more cash reserves. All of that may be true, but I’ll believe it when I see it. In my opinion, when massive economic tidal waves hit, there’s not much refuge. Everybody gets wet, and everyone looks foolish when just a year ago they looked so smart.

THIS REAL ESTATE BUBBLE DIFFERS FROM OTHERS

John Rebchook has covered real estate since 1983, and he was a colleague of mine during the salad days of business journalism at the now-shuttered Rocky Mountain News during the early 1990s. “Chook,” as he is known to friends, was a copy machine and powerhouse who wrote more stories than anyone at the newspaper. He carries on now at his own website, Denver Real Estate Watch, sponsored by 8Z Real Estate.

Denver is a prime example of rising commercial and residential real estate prices, a national leader. Rebchook told me there has never before been a time in Denver when homes have appreciated so much more than the inflation rate. Housing prices have risen every month since 2012. Last year, while the economy appreciated 2 percent, Denver housing prices rose 12 percent, Rebchook said.

“It’s uncharted territory. It can’t go up forever,” he said. “Apartments are being built right now that require a $75,000 to $100,000 income to afford them. Who has that kind of income? And add student debt to that burden. Apartment prices are up to about 30 percent of people’s income.”

Every month Denver area residential prices set a new record, while inventory remains low. All of the sellers market stories run rampant, from frothy auctions where a house sells $100,000 over asking price to aggressive sellers’ demands during the negotiation process. So how does this market differ from all of the others Rebchook has covered during his long career?

“It’s different than other markets. We’ve never had rock-bottom interest rates before,” he said. “Rates have artificially pushed the market up. Yet at the same time bank underwriting is not as lax as it was. Some say they are too tight.”

Signs of a softer market are present. Rebchook said sales were down 11 percent during the first five months of 2016 compared to 2015. Under-contract homes dropped 8 percent and fewer new homes are entering the market. That’s partly because it’s difficult for builders to make money on cheaper homes, which are in the highest demand.

Meanwhile, institutional money seeking higher yields than the bond market produces has been pouring into multifamily apartments and condos. You can’t swing a dead cat in the metro area without hitting an apartment building under construction.

“People have been saying for the last four years that the apartment market is overbuilt and heading for a crash but every year we’ve seen double-digit gains. A lot of smart people think it will crash but those same people are building anyway. As long as a developer can get non-recourse financing, he will take the money,” Rebchook said.

AND ONE MORE SCENARIO FROM A FORECASTER

Marcel Arsenault, CEO of Real Capital Solutions in Louisville, Colo., made his name, and not to mention millions, making correct calls on real estate markets. He recently wrote an article for the Colorado Real Estate Journal titled, “Negative trifecta is coming to Denver market.”

He believes the push by millennials to apartment living will alter in two to five years. His disaster scenario is as follows:

  1. Multiyear overbuilding above population demand.
  2. Millennials finally converting from renters to homeowners.
  3. A future recession, around 2019.

Predictions by someone as smart as Arsenault, the Moody’s report and my own experience covering real estate are warning enough for me. While it’s true that Colorado’s population growth rate ranks second in the nation and that residential building activity is below historic norms, it’s also true that no one ever repealed the laws of supply and demand. As soon as the jobs disappear, all those people could just as easily move somewhere else, and then how does your demand look?

It’s a good time for contemplation of all these developments.

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