Lecture 12: Real Estate

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)

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

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

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

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.

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

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.

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

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

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:

Mrrr 12)12/1(12/

1

12/

1paymentmonthly balance Mortgage

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

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.

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.

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.

“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”

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)

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)

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

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 don’t notify them.

• Impossibility of PMIs insuring GSEs in a major downturn is another issue.

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.

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

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

Figure 5 Los Angeles Real Home Price Index and Employment

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Figure 8 Milwaukee Real Home Price Index and Employment

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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%

Fears of Being Left Out

“Housing prices are booming. Unless I buy now, I won’t 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%

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 Milwaukee1988 2003 1988 2003

Yes 54.3% 46.1% 21.5% 34.8%No 45.7% 53.9% 78.5% 65.2%

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%

“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.)

“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%

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.

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