‘Amateur hour is over’

There are plenty of people these days with “I told you so” on their minds. The rash of subprime mortgage foreclosures that has been raging for the past year has caused several major mortgage lenders to shut down or file for bankruptcy, and the effects are now extending to the stock markets, where investors have poured money into bundles of these risky loans as the real estate market soared.

For years, rising real estate values have been tempting companies to lower their credit criteria and begin lending to subprime borrowers with questionable credit histories, confident the risk that these borrowers would default would be mitigated by the steadily increasing value of real estate. According to Moody's Investors Service, about 21 percent of all mortgage originations from 2004 to 2006 were subprime, compared with just nine percent from 1996 to 2004. In 2006, subprime mortgages accounted for about one fifth of the US home loan market.

Wall Street seemed to be encouraging the practice, bundling the loans into securities that were then sold to institutional investors. But as the housing market has slowed down, borrowers have been unable to make the increased interest rate payments that typically kick in after a few years with these subprime loans—in some cases, these interest rates have jumped from three percent to a lofty 12 percent.

Earlier this year, the bottom fell out. Borrowers and lenders thought increasing property values would make the loans less risky, but now that real estate values are dropping in much of the US, the bet isn't paying off. According to the default notice tracker RealtyTrac, there were more than 1.2 million foreclosure filings in 2006, an increase of 42 percent compared with 2005.

The defaults have forced several lenders, such as New Century Financial, to file for bankruptcy, and the reverberations are being felt in investment banks around the world. In July Bear Stearns announced that the crisis had made the assets of two of its flagship hedge funds worthless, sending its earnings plummeting. In Australia, $1 billion hedge fund Basis Capital revealed it has lost an estimated 80 percent of its value because of the crisis. KKR Financial Holdings said in August it had lost $40 million from nonprime mortgages and warned of a further $200 million hit. Dutch investment bank NIBC, which had €137 million in subprime losses, was sold to Icelandic bank Kaupthing for €3 billion last month.

Some real estate investors are even finding distressed opportunity investing in the struggling lenders. In June, Lone Star acquired subprime lending company Accredited Home Lenders for $400 million. At $15.10 a share, it was an acquisition price 72 percent lower than the Nasdaq-listed company's 52-week high of $53.45. However some opportunistic real estate firms are looking at the subprime meltdown's long-term effects for distressed property opportunities.

Subprime fallout
The meltdown will have many effects, but one of the most noticeable may be a change in home buying behavior by the US public. The crackdown on lending practices will mean a huge drop in the amount of people able to buy a home, while many who have already bought a house will be forced to default and move back into the rental market. Similarly, those currently in the rental market will most likely stay there for the time being.

John Williams, a managing director at San Francisco-based Carmel Partners, a private equity real estate firm that invests in multifamily rental properties, says this change in behavior could have a positive impact on investors with many rental properties in their portfolio.

“So far it's had a positive effect for us because, before, good renters were becoming bad homeowners,” he says. “Typically, the number one reason we would lose renters in our properties was a life change, like getting married or a job transfer. For the past few years, it's been buying a home. We were seeing a huge amount of turnover in our properties with people leaving to buy homes, and now that has virtually stopped. So our buildings have less turnover, higher occupancy, and now we can have rent increases.”

But it isn't just consumers that are changing their behavior. Developers are going to have to drastically change their strategies, as well. And, in some cases, Williams says, this will result in distressed investments for opportunistic real estate funds.

“Some homebuilders had taken their single-family land and got it re-zoned as multifamily land to build condominiums,” he says. “Now they've shut those projects down. We're looking at buying land from some homebuilders that had planned to build condominiums. We're looking at the feasibility of buying at a discount and putting up apartments.”

However, Williams adds that the days of widespread distressed opportunities are still a ways off.

“The problem is, right now [the homebuilders'] idea of the value of what they have is a lot bigger than what we think the value is,” he says. “The price that made sense for condominiums doesn't make sense for apartments: There's a difference of 20 or 25 percent and not a lot of people are willing to take that hit right now. But in the next six to 12 months, they're not going to be able to hold onto it any more and they are going to have to let go. Strong, well-capitalized homebuilders will just shut it down and wait five or six years. But the smaller ones will have to take the write-off now.”

Psychological effects
Russel Bernard, a partner with Connecticut-based Wesport Capital, says the change in home buying will be massive, not only with homebuyers unable to take advantage of subprime mortgages, but also with the general population.

“It's going to affect the general psyche in the market,” he says. “Even people who would never go to a subprime lender will say, ‘I'm hearing negative things about the real estate market, maybe I should be a little more cautious before going out and buying something. Even though my income level hasn't changed, perhaps I need to reassess.’”

Thus far significant distressed opportunities haven't emerged. But the defaults could be the tip of the iceberg. Many of the subprime loans were done in 2005 and 2006, and they haven't yet hit their reset state, at which point the interest rate will go up to a level that is likely unaffordable to the homeowner. It is unclear what actions the US government may take to prevent a massive defaulting on home loans, if it takes any action at all. But if the defaults continue at the current rate, the general appetite for home-buying could continue to shrink, providing an opportunity for distressed players to bet that the value on properties zoned for condos and to- own homes will plummet.

Westport has made a number of investments in bankrupt homebuilders. If home-buying slows, such builders and development sites that had planned to-own residential sites may emerge as an attractive distressed investment opportunity.

“I think that people over the last couple years believed trees grow to the moon, but the reality is that never happens,” says Bernard. “It's always a little bumpy, and we haven't had bumps in several years, particularly in housing. Amateur hour is over, and that's not necessarily a bad thing.”