How to profit from recent troubles in real estate.
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.
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, 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.
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
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.