Two verities of real estate investment

Over the past few days, I have been in San Francisco, and have had the privilege of meeting with four real estate executives whom I am trying to interest in participating with the Lusk Center in one way or another. They are all doing remarkably well, all things considered, and some of the things they said to me explain why. Two things stand out:

(1) When investing in real estate, underwrite the real estate without consideration for financing. Unless the deal earns an acceptable unlevered internal rate of return, don't do the deal.

(2) If a deal depends on a going-out (i.e. exit) cap rate that is lower than the going-in (i.e., purchase) cap rate, don't do the deal.

The Truth About Amsterdam, RE: Bill O'Reilly loves Amsterdam

Amsterdam has a great orchestra, too.

Michael Lacour-Little says it's all about the refinances

He points me to:

Why are so many homeowners underwater on their mortgages?

In crafting programs to prevent foreclosures, policymakers have assumed that the primary reason homeowners owe more on their home than it is worth is that they bought at the top of the market. In other words, they’ve lost equity primarily through forces beyond their control.

A new study challenges this premise and finds that excessive borrowing may have played as great a role.

Michael LaCour-Little, a finance professor at California State University at Fullerton, looked at 4,000 foreclosures in Southern California from 2006-08. He found that, at least in Southern California, borrowers who defaulted on their mortgages didn’t purchase their homes at the top of the market. Instead, the average acquisition was made in 2002 and many homes lost to foreclosure were bought in the 1990s. More than half of all borrowers who lost their homes had already refinanced at least once, and four out of five had a second mortgage.


The original loan-to-value ratio for these borrowers stood at a reasonable 84%, but second and third liens left homeowners with a combined loan-to-value ratio of about 150% by the time of the foreclosure sale date.

Borrowers, meanwhile, took out around $2 billion in equity from their homes, or nearly eight times the $262 million that they put into their homes. Lenders lost around four times as much as borrowers, seeing $1 billion in losses.

“[W]hile house price declines were important in explaining the incidence of negative equity, its magnitude was more strongly influenced by increased debt usage,” writes Mr. LaCour-Little. “Hence, borrower behavior, rather than housing market forces, is the predominant factor affecting outcomes.”

If other housing markets across the country offer similar findings, then the study argues that current “policies aimed at protecting homeowners from foreclosure are misguided” because lenders, and not borrowers, have born the lion’s share of economic losses.

Borrowers that bought homes without ever putting any or little equity in their homes could have seen huge returns on investment simply by extracting cash through refinancing. “Why such borrowers should enjoy any special government benefits such as waiver of the income taxation on debt forgiveness or subsidized loan modifications to reduce their borrowing costs is at best unclear,” the authors write.

Michael is a co-author of mine (and was a student at Wisconsin while I taught there), and has a gift for slicing up mortgage data. On the policy question, we might think about treating the half who did not refinance differently, as they were drowned by the flood.

An Interview with Kenneth Arrow, Part One - Conor Clarke

An Interview with Kenneth Arrow, Part One - Conor Clarke

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Stanley Fish and Chris Rock make the same point

Fish writes about Henry Louis Gates' time at Duke:

I flashed back 20 years or so to the time when Gates arrived in Durham, N.C., to take up the position I had offered him in my capacity as chairman of the English department of Duke University. One of the first things Gates did was buy the grandest house in town (owned previously by a movie director) and renovate it. During the renovation workers would often take Gates for a servant and ask to be pointed to the house’s owner. The drivers of delivery trucks made the same mistake.

The message was unmistakable: What was a black man doing living in a place like this?

At the university (which in a past not distant at all did not admit African-Americans ), Gates’s reception was in some ways no different. Doubts were expressed in letters written by senior professors about his scholarly credentials, which were vastly superior to those of his detractors. (He was already a recipient of a MacArthur fellowship, the so called “genius award.”) There were wild speculations (again in print) about his salary, which in fact was quite respectable but not inordinate; when a list of the highest-paid members of the Duke faculty was published, he was nowhere on it.

The unkindest cut of all was delivered by some members of the black faculty who had made their peace with Duke traditions and did not want an over-visible newcomer and upstart to trouble waters that had long been still. (The great historian John Hope Franklin was an exception.) When an offer came from Harvard, there wasn’t much I could do. Gates accepted it, and when he left he was pursued by false reports about his tenure at what he had come to call “the plantation.” (I became aware of his feelings when he and I and his father watched the N.C.A.A. championship game between Duke and U.N.L.V. at my house; they were rooting for U.N.L.V.)

And now Chris Rock:

I will give you an example of how race affects my life. I live in a place called Alpine, New Jersey. Live in Alpine, New Jersey, right? My house costs millions of dollars. [some whistles and cheers from the audience] Don't hate the player, hate the game. In my neighborhood, there are four black people. Hundreds of houses, four black people. Who are these black people? Well, there's me, Mary J. Blige, Jay-Z and Eddie Murphy. Only black people in the whole neighborhood. So let's break it down, let's break it down: me, I'm a decent comedian. I'm a'ight. [applause] Mary J. Blige, one of the greatest R&B singers to ever walk the Earth. Jay-Z, one of the greatest rappers to ever live. Eddie Murphy, one of the funniest actors to ever, ever do it. Do you know what the white man who lives next door to me does for a living? He's a f**king dentist! He ain't the best dentist in the world...he ain't going to the dental hall of fame...he don't get plaques for getting rid of plaque. He's just a yank-your-tooth-out dentist. See, the black man gotta fly to get to somethin' the white man can walk to.

I have a question for Senator Grassley

Does he really believe that all the white guys he has voted for "set aside [their] personal preferences and prejudices?"

Featured on today's USC Home Page

A story on Dr. Patricia Harris, who makes house calls.

I was on Bloomberg TV today

I have to admit it is fun. The clip is at http://tinyurl.com/GreenHousing.

Program Note

I will be on KPCC's Airtalk with Larry Mantle at 10:05 today.

Manuel Adelino, Kristopher Gerardi, and Paul S. Willen are skeptical...

...that the paucity of loan modifications is a function of securitization.

There is widespread concern that an inefficiently low number of mortgages have been modified during the current crisis, and that this has led to excessive foreclosure levels, leaving both families and investors worse off. We use a large dataset that accounts for approximately 60 percent of mortgages in the United States originated between 2005 and 2007, to shed more light on the determinants of mortgage modification, with a special focus on the claim that delinquent loans have different probabilities of renegotiation depending on whether they are securitized by private institutions or held in a servicer’s portfolio. By comparing the relative frequency of renegotiation between private-label and portfolio mortgages, we
are able to shed light on the question of whether institutional frictions in the secondary mortgage market are inhibiting the modification process from taking place.

Our first finding is that renegotiation in mortgage markets during this period was indeed rare. In our full sample of data, approximately 3 percent of the seriously delinquent borrowers received a concessionary modification in the year following their first serious delinquency, while fewer than 8 percent received any type of modification. These numbers are extremely low, considering that foreclosure proceedings were initiated on approximately half of the loans in the sample and completed for almost 30 percent of the sample. Our second finding is that a comparison of renegotiation rates for private-label loans and portfolio loans, while
controlling for observable characteristics of loans and borrowers, yields economically small, and for the most part, statistically insignificant differences. This finding holds for a battery of robustness tests we consider, including various definitions of modification, numerous subsamples of the data, including subsamples for which we believe unobserved heterogeneity to be less of an issue, and consideration of potential differences along the intensive margin of renegotiation.

Since we conclude that contract frictions in securitization trusts are not a significant problem, we attempt to reconcile the conventional wisdom held by market commentators, that modifications are a win-win proposition from the standpoint of both borrowers and lenders, with the extraordinarily low levels of renegotiation that we find in the data. We argue that the data are not inconsistent with a situation in which, on average, lenders expect to recover more from foreclosure than from a modified loan. At face value, this assertion may seem implausible, since there are many estimates that suggest the average loss given foreclosure is much greater than the loss in value of a modified loan. However, we point out that renegotiation exposes lenders to two types of risks that are often overlooked by
market observers and that can dramatically increase its cost. The first is “self-cure risk,” which refers to the situation in which a lender renegotiates with a delinquent borrower who does not need assistance. This group of borrowers is non-trivial according to our data, as we find that approximately 30 percent of seriously delinquent borrowers “cure” in our data without receiving a modification. The second cost comes from borrowers who default again after receiving a loan modification. We refer to this group as “redefaulters,” and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months. For this group, the
lender has simply postponed foreclosure, and, if the housing market continues to decline, the lender will recover even less in foreclosure in the future.

We believe that our analysis has some important implications for policy. First, “safe harbor provisions,” which are designed to shelter servicers from investor lawsuits, are unlikely to have a material impact on the number of modifications and thus will not significantly decrease foreclosures. Second, and more generally, if the presence of self-cure risk and redefault risk do make renegotiation less appealing to investors, the number of easily “preventable” foreclosures may be far smaller than many commentators believe.

Ideally, a lender would like to know whether a borrower will either (1) self-cure; (2) be cured by a loan modification that has no reduction in balance; (3) be cured by a loan modification that has a balance reduction or (4) is beyond help. If anyone can figure out how to write a contract that induces the borrower to reveal their type, they will have the solution to the crisis. The closest I can think of is one that allows borrowers to short-sell their houses (a la Hancock and Passmore) with reference to some sort of price index, so as to prevent gaming of the sales process.

Praise be to the NYT On Language Column (h/t Patricia Harris)

A brief history of singular pronouns:

One tweeter asked plaintively, “Can we just accept that ‘they’ can be used as singular?” But another wrote, “I HATE it when people make improper use of plural pronouns for gender neutrality!” Several suggested writing around the problem (“Sometimes I try to alternate he and she, but bleh”). One tweet seemed to sum up the general attitude: “Damn you, English language!”

Traditionalists, of course, find nothing wrong with using he to refer to an anybody or an everybody, male or female. After all, hasn’t he been used for both sexes since time immemorial? Well, no, as a matter of fact, it hasn’t. It’s a relatively recent usage, as these things go. And it wasn’t cooked up by a male sexist grammarian, either.

If any single person is responsible for this male-centric usage, it’s Anne Fisher, an 18th-century British schoolmistress and the first woman to write an English grammar book, according to the sociohistorical linguist Ingrid Tieken-Boon van Ostade. Fisher’s popular guide, “A New Grammar” (1745), ran to more than 30 editions, making it one of the most successful grammars of its time. More important, it’s believed to be the first to say that the pronoun he should apply to both sexes.

The idea that he, him and his should go both ways caught on and was widely adopted. But how, you might ask, did people refer to an anybody before then? This will surprise a few purists, but for centuries the universal pronoun was they. Writers as far back as Chaucer used it for singular and plural, masculine and feminine. Nobody seemed to mind that they, them and their were officially plural. As Merriam-Webster’s Dictionary of English Usage explains, writers were comfortable using they with an indefinite pronoun like everybody because it suggested a sexless plural.

If it is good enough for Chaucer it is good enough for me. I will from now on use "they" as my gender neutral singular pronoun.

Have Existing Home Sales Started to Rise?

NAR reported that Existing Home Sales rose 3.6 percent in June. In response to this, MSNBC notes:

"The turnaround in the housing market appears finally to be here and indeed may be gaining some speed," wrote Joel Naroff, president of Naroff Economic Advisors Inc.

Stocks jumped on the news, with the Dow Jones industrial average rising above 9,000 for the first time since early January.

The NAR numbers suggest that sales have stopped falling, and this is doubtless a good thing. But the numbers really don't support the idea that sales are rising--yet.

The reason is that the NAR Existing Home Sales number is a seasonally adjusted annualized number. This is a correct method for reporting (or at least I have reasons to think it is correct, as I am partly responsible for the development of the Existing Home Sales Methodology). But a seasonal adjustment is a statistical measure, and as such cannot be known with precision. June is a month that requires lots of adjustment, because June sales are always higher than sales in the average month. I am guessing that 3.6 percent is inside the 95 percent confidence interval of seasonally adjusted sales, so the best interpretation of the NAR release is that sales were flat or better in June.

The really good news in the report is the fact that the share of sales that are non-distressed sales is rising.

Two ideas for appraisal reform

Lawrence Yun of NAR is complaining that appraisals are preventing legitimate real estate transactions from occurring. Because of the way appraisers sometimes choose comparables, I have some sympathy for this view. And as I noted in an earlier post, Rhonda Porter says the Home Value Code of Conduct is nothing more than a way to line the pockets of Appraisal Management Companies. I have some sympathy for this view as well.

But we should not go back to the days when appraisers were basically paid to stay out of the way of the consummation of a deal. So let me suggest two proposals:

(1) Appraisers should not be allowed to see the offer price of a house. This is the only way their valuation will be truly independent.

(2) Appraisers should use valuation techniques that allow them to report a standard deviation of their estimate. Subdivision tract houses will have small standard deviations; architect designed villas will have large standard deviations.

We could then move to a pricing rule where Mortgage Insurance will be required if (1) the LTV based on appraised value is greater than 80 percent or (2) there is a greater than five percent chance that the true value of the house implies an LTV of 95 percent.

Step (1) would be easy to implement, and I think would help a lot. Step (2) will require lots of training (and perhaps different parameters from those that I am suggesting).

We need to stop kidding ourselves that we can measure house prices precisely. We need to start measuring the level of imprecision.

Rethinking California's Revenue Structure

California Assembly Speaker Karen Bass, who has no particular allergies to progressive taxes, cites an astonishing statistic about California Income Taxes: that 144,000 Californians (out of 38 million) pay half the state's income taxes. As I will discuss below, this does not necessarily imply that California taxes are, overall, too progressive, but it does mean that state income tax revenue is too undiversified. When such a small share of the population makes up such a large share of the revenue base, the fiscal conditions of the state will swing wildly with the fortunes of a few. This is what we have been witnessing here in California.

On the other hand, California has a very high sales tax as well, and everyone pays it. The best evidence I know suggests that the sales tax is regressive over the short term, but is more or less proportional over the life cycle. There is no question that the size of California's sales tax dampens the overall progressiveness of state revenue collections.

Finally, there is the property tax, which is completely detached from the ability to pay it, because of Proposition 13. Within a condominium complex, one can find two identical units that pay extraordinarily different levels of property taxes (sometimes by a factor of 10 to 1), because taxes are based on the price a property owner pays at the time of acquisition.

For California to have stable fiscal conditions going forward, it will need to broaden its income tax base and equalize its property tax base. I am not holding my breath.

The Joy of Great Cities

Last night, at the invitation of friends of ours, my wife and I went to a concert of the Pasadena Pops at Descanso Gardens. I wasn't quite sure what to expect: I am always suspicious of "pops" concerts (I love the Rolling Stones, but really don't want to hear Satisfaction played by a 100 piece orchestra) and community orchestras vary tremendously in terms of quality and spirit. I can enjoy music that is less than perfectly polished, but I find indifference difficult to take.

The punchline, of course, is that the concert was a gas. In the first place, the band has a conductor named Rachael Worby, who introduces the pieces with charm and who, more importantly, knows how to make an orchestra sparkle. Her beat and cues were so clear that even the most obtuse player would know what she wants. Second, the program, featuring Saint Saens, Gershwin, and Chansons sung by Karen Akers, was delightful.

But the really extraordinary thing was the caliber of the playing; one does not expect such precision in rhythm and tuning from an orchestra in a city of 150,000 people. But of course, the orchestra is drawing on a population of musicians who are drawn to Los Angeles because of opportunity, but also because they can find lots of other good musicians. I went to the Pasadena Symphony Web Site, and alas could not find a list of the players. My suspicion is that a number of the players are studio musicians (or people hoping to become studio musicians). And so it is throughout the region. One can go to free student recitals around LA, and hear music, from Palestrina to Riley, performed well.

I suspect that this is an example of agglomeration at its best (I can only suspect because I know of no formal test), and is a reason why the Londons, Parises, New Yorks and Los Angeleses of the world retain their special places for long periods of time.

Why the consequences of past discrimination persist over generations

I just read President Obama's most recent speech on race. It is another extraordinary speech--his ability to be at once sophisticated and accessible never ceases to amaze me.

To oversimplify, the speech has two themes: that individuals, whether discriminated against or not, must take control of their owns lives as best they can, but that the legacy of Jim Crowe will not go away quickly--that there are structural conditions in society that to place impediments in the paths of success for minority children.

The point reminded me of an award winning thesis by Kate Antonovics I read while I was at Wisconsin. One of the papers she generated from the thesis has the following summary:

Thus, initially disadvantaged groups may become trapped even though there is always a
unique within-generation equilibrium. That is, in contrast to standard models of statistical discrimination, repeated coordination failures are not needed to generate persistent discrimination.

Rather, statistical discrimination changes the transmission of earnings across generations by leading parents’ investment behavior to depend upon the distribution of income in the parents’ racial group. Thus, statistical discrimination and racial inequality are self-reinforcing, and multiple equilibria can arise.

When parents have limited resources to invest in their children, it becomes harder for children to migrate to a higher income class than their parents. In a world that was truly characterized by equal opportuntiy, children's fortures would be independent of their parents. We should at least strive to move to the point where children's fortunes are independent of their parents' race.

John Y. Campbell, Stefano Giglio, and Parag Pathak estimate that Foreclosed houses sell at a 28 percent discount

The results imply two problems with thinking about house prices through the lens of the Case-Shiller Index.

In Southern California, somewhere in the neighborhood of 40 percent of sales are distressed sales. If lenders make decisions that are based on Case-Shiller, they will underestimate the value of transactions that are taking place in the absence of distress. Appraisers seem to be taking a Case-Shiller view of the world right now, and so deals are getting undone. There is reason to believe that when buyers are willing to place 20 percent down on a house, they actually believe the house is worth the offer price.

On the other hand, let's say we move to a world where only, say, 20 percent of sales are distressed. This will produced an observed increase in the index Case-Shiller Index of 6 to 7 percent--even if nothing is really changing about underlying house prices. This could lead markets to become too optimistic too quickly.

The rigors of the USC Masters in Real Estate Development Program

A student of ours emails:

I just wanted you to know that this assignment got me out of a traffic ticket this morning.

La Cienega was shutdown to due an accident and I was trapped. So, I made a u-turn which included driving over a curbed median. A motorcycle cop pulled me over and gave me a lecture about how this isn't Texas (I have texas plates) and "cowboy driving" is not acceptable....whatever that means. So I told him that I had to get to campus for the mid- term and I had a limited amount of time to complete the homework assignment. I pulled out assignment #3 to make my story credible and he took it with him when he went back to his motorcycle.

When he came back he told me that it seemed like the assignment was going to be enough punishment and he let me go.

We have a new Census Director!

Robert Groves was confirmed. The vote to invoke cloture was 78-15. Why did this take so long? Why is the Senate so.....Senatorial?

Jan Hatzius has a Great Sense of Humor

His GDP forecast for 2009 goes four places right of the decimal point. (it is - 2.8753%).