Real Estate Slowdown, Subprime Meltdown--Now What?

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We at Morningstar had long believed that the runup in real estate prices from 2001 to the end of 2005 was unsustainable and had to end at some point. We've also been bearish on property REITs during that time, as most of their returns came from price appreciation--driven by ever-higher estimates of underlying property valuations--rather than dividends and dividend growth. My colleague Craig Woker went as far as comparing the real estate bubble to the dot-com bubble of the late 1990s and 2000. He detected the same emotional approach toward purchasing real estate that people adopted toward purchasing stock in Webvan.com and Pets.com--the "so many people can't be wrong" rationalization. Arguably, buyers were more confident in their real estate purchases because real estate is more tangible, with real intrinsic value.

Signs of Weakness
Since 2005, we've seen several signs of weakness. Growth in real estate prices has slowed significantly, and reported prices have dropped precipitously in a few of the most speculative areas, such as Miami and San Diego. However, we think the decline is far more severe than headline numbers would suggest. Sale prices can be propped up by having a buyer purchase at the list price, while the seller throws in incentives such as free upgrades, parking spots, and help with closing costs, assessments, and even mortgages. A more telling metric is the drop in sales volume and the buildup of inventory. It stands to reason that if sales volume remained at normal levels, price declines would be more severe. But perhaps the canary in the coal mine was the retirement of www.condoflip.com--a Web site catering to speculators who flipped condos sight unseen.

Subprime Meltdown
The riskiest companies took the first hit. With the prices of real estate seemingly heading in only one direction, subprime mortgage originators resorted to bad underwriting and exotic products to create an illusion of affordability. We had identified a possible liquidity crunch as a key risk for these companies, but the speed of the meltdown was surprising. Seemingly overnight, these companies were hit with two crushing blows. An expected uptick in delinquencies forced the lenders to repurchase delinquent loans, and at the same time, creditors closed off the financing spigots, causing a liquidity crunch and leaving firms vulnerable to liquidation. Indeed, several of them have filed for bankruptcy or shut down operations, and more bankruptcies could be on the way. We would suggest that only the most aggressive investors speculate on these firms.

However, we believe more conservative investors can profit from this meltdown as well. All this real estate doom and gloom has served up opportunities to invest in several high-quality businesses at bargain prices. We heartily agree with Buffett's maxim of buying to the sound of cannons and selling to the sound of trumpets. We've identified companies whose businesses are temporarily suffering due to real estate exposure but are fundamentally sound and should prosper when things return to normal. Moreover, these companies are not at the mercy of fickle and skittish short-term financiers, whose sudden cold feet could drive an otherwise viable company out of business. We would put these firms on our watch list and pounce at 5-star prices.

Homebuilders
Homebuilders, as one might expect, have been the most prominent casualty of the slowdown in residential real estate. The industry has experienced severe compression in gross margins, the markup charged to homebuyers over land and building costs. Record cancellations have eroded the pricing power of these companies, forcing them to batten the hatches to wait out this downturn. Worse, most of these companies extrapolated 2005 trends into the future and got caught with too much land on their balance sheets, using costly debt to carry this (for now) dead asset. However, we've identified some builders that have avoided this problem and are positioned to weather the storm.

• Meritage Homes MTH
  Meritage Homes is one of the largest builders in the nation, and importantly, has a large presence in Texas to balance out exposure to boom-bust states such as California, Nevada, and Florida. It was at the top of the class in maintaining a lean inventory throughout the boom due to its deft use of options. Today, it sits with less than one year's worth of owned land based on current order rates, and less than six years' worth including option commitments. It's easy to see why Meritage will likely fare better in the current downturn than competitors. To add icing to the cake, its shares trade at less than book value. Though the market is currently fixated on the company's exposure to formerly hot markets, we see opportunity.
• MDC Holdings MDC
  MDC Holdings, like Meritage, stresses holding less land on its balance sheet, allowing it to earn impressive returns on capital. Its total land position, at less than three years of lots based upon current production rates, is among the lowest in the industry. This is important, as it means less possibility of impairments and also gives the company a leg up on competitors once the eventual upturn arrives. Without a bloated balance sheet, MDC will be in a position to reload its land pipeline at significantly cheaper prices. Though industrywide returns will be depressed for several years, MDC should be among the leaders going forward.PAGEBREAK

Title Insurers
We believe that the title insurance industry is healthy and has demonstrated the ability to weather troughs in real estate cycles. The industry serves multiple segments that usually perform independently. For example, despite a double hit of weak seasonal and cyclical factors in the residential market in the fourth quarter of 2006, all three companies we cover--First American FAF, Fidelity National FNF, and LandAmerica LFG--showed decent profits, propped up by commercial real estate. We expect the companies will grow along the lines of population and household increases. Solidifying the moat around these companies is the fact that, despite the bad press and regulatory concerns, there is no substitute to the role the title companies play in real estate transactions.

• First American FAF
  This company has rapidly gained share profitably, and the ancillary products that augment title revenue are way ahead of the competition. Even better, the company recently bought CoreLogic, a data management company that customizes and markets information derived from First American's enormous real estate database. The company is leveraging this data to become a leader in providing real estate information, which adds to economic returns.

Mortgage Insurers
Mortgage insurers provide protection to lenders making real estate loans to lower-income home buyers, who want to enjoy the benefits of home ownership but are unable to afford a 20% downpayment that the secondary market requires. Barring a recession that leads to outsized job losses among the lower-income demographic, the mortgage insurers should weather the current storm in fine shape, in our opinion. Over an economic cycle, mortgage insurers have shown the ability to withstand recessions, competitive threats, and regulatory scrutiny. We believe the fundamentals are good for this industry, particularly due to the increased housing demand from minorities and immigrants. Long-term forecasts predict a growing percentage of the population pursuing the American dream of home ownership, and mortgage insurers assist many first-time buyers in taking this step.

• MGIC Investment MTG
  MGIC's decision to acquire Radian Group RDN is timely because it strengthens MGIC's moat. The acquisition increases MGIC's size, giving it a better chance of navigating the choppy, cyclical nature of the mortgage-interest-sensitive real estate markets. The combined entity will also possess the added benefit of multiple executions of credit enhancement through financial guaranty capabilities, an area in which Radian has traditionally excelled.
• PMI Group PMI
  Captive insurers with large lenders such as Wells Fargo WFC have been steadily eroding PMI's market share in the U.S. The company has combated this by expanding internationally, carving the second-largest presence in Australia. A growing portion of market participants now opt for customized mortgage pool protection outside of the government-sponsored secondary market. Via its lead investment in financial guarantor FGIC, PMI hopes to use cutting-edge marketing to meld mortgage insurance with credit-enhancement services.

Banks
We've identified a high-quality bank that has been unfairly punished because of its perceived vulnerability due to exposure to subprime mortgage originations and real estate loans held on the balance sheet. Large banks have a diversified revenue stream and are less dependent on real estate loans and mortgage originations than they once were. What's more, banks tend to hold the best-quality loans on their books and typically experience charge-off rates of less than 25 basis points on mortgages.

• Wells Fargo WFC
  Wells Fargo is one of the best-run banks in the country. The firm, in all fairness, has a larger exposure to real estate than the average large bank and, according to Inside Mortgage Finance, is the largest subprime mortgage originator. However, the firm's underwriting is exceptional, resulting in the mortgage portfolio sporting minuscule charge-offs. Wells Fargo's ace in the hole is its large mortgage servicing portfolio, which acts as a natural hedge to its mortgage loan origination business.

Jim Ryan and Eric Landry contributed to this article. Ganesh Rathnam owns shares in First American and call options on New Century Financial.