Building Marketing Intelligence Q2 2013

12009 2010 2012 20132011

D

D+

C+

A+

A

-21%

-12%-9%

+15%+18%

VOL 1 Q2 2013

Staying Ahead of Housing’s Next Cover Story

Building MarketIntelligence

2

Table of Contents

2 Front Running the Fed

4 Staying Ahead of Housing’s Next Cover Story

6 Acquisitions, IPOs, and Private Placements, Oh My!

8 Gen Y—You’ll Have to Wait

10 You Can’t Argue with the Math: The Inevitable Recovery

14 Lot Premiums Are Back!

16 Raise the Yellow Flag: Apartment Construction Now a Concern in Many Markets

18 May the Force Be with You... Or Else, Your Home Values Will Go Down

21 A Strategy to Navigate the Housing Cycle

22 About John Burns Real Estate Consulting

with the intent of flipping out at a significant profit. Speculators are now emerging. While bank loans do not seem to be playing a role in the speculator boom, we won’t be surprised to see high LTV loans reemerge later this year, probably by non-banks. In the last cycle, the banks eventually bought the non-banks or purchased their securities.

FED STIMULUSThe Fed is buying $45 billion per month in mortgage-backed securities in a clear attempt to raise home prices. They are succeeding. We are already having conversations with numerous clients about the bubble that can easily be created if home prices appreciate rapidly. THE POWER OF MORTGAGE RATESA family who can afford a mortgage payment of $1,000 per month could have gotten a $165,000 mortgage in November 2008, when mortgage rates were 6.05% and the Fed stimulus known as QE1 began. That same family’s $1,000 per month payment now qualifies them for a $222,000 mortgage. They can afford a 34% more expensive home!

e are very bullish on housing and already thinking through the impact that 3.5%

mortgage rates can have if prices rise substantially due to the interest rate stimulus. The Fed has put 34% more purchasing power into the pockets of homeowners, and investors are taking advantage.

PREDICTING THE FUTUREWe think home prices are poised to rise significantly, and we aren’t the only ones. Investors of all sorts are piling into the housing industry. Here is some of the evidence:

> STOCKS. Home building industry stock prices have risen to late 2003 levels (see below) while new home sales are still near historic lows and less than half of normal levels.

> LAND. Our finished lot value index is showing near peak pricing in Phoenix, Dallas, and Orlando.

> SPECULATORS. Investors and speculators are different. Investors buy homes at a great value and rent them out cash flow positive. Speculators buy homes

W

BY JOHN BURNS, CEOFront Running the Fed

3

PRICE/INCOME VERSUS PAYMENT/INCOMEA simple comparison of current price/income and payment/income ratios shows that:

> 133 of 134 markets are underpriced from a payment/income status.

> 69 of 134 (only half) are underpriced from a price/income status.

The five most undervalued housing metro areas are:

1. Vallejo-Fairfield, CA

2. Yuba-Sutter, CA

3. Detroit, MI

4. Las Vegas, NV

5. Stockton, CA

The five least undervalued housing metro areas are:

1. Honolulu, HI

2. Boulder, CO

3. Louisville, KY

4. Portland, OR

5. Orange County, CA

While 3 of the 5 most undervalued markets are dealing with significant municipal distress, and 4 of the 5 least undervalued markets have become permanently more expensive due to supply constraints, the point is that low mortgage rates have created a tremendous distortion

in the market that could easily result in tremendous price appreciation and overpriced homes someday in the future—if/when mortgage rates return to normal. The 124 markets not shown in the lists are the ones where housing is most susceptible to bubble pricing. THE FUTUREWho knows what future mortgage rates will be? Here is some perspective. The median 30-year, fixed rate conforming mortgage rate over the last:

> 42 years is 8.15%

> 30 years is 7.45%

> 20 years is 6.52%

> 10 years is 5.72%

With rates currently at 3.53%, prices can go up 28% nationally just to equal normal affordability over the last 10 years. If that happens, that will create price/income ratios that are 27% above their historical norms. What happens if mortgage rates then go up? UNPRECEDENTED RECOVERYInvestors of all types are assuming that the Fed’s unprecedented intervention in the mortgage market will keep mortgage rates low for a very long time, resulting in tremendous price appreciation. This is going to be an interesting housing recovery!

S&P Super Homebuilding Index

100

200

300

400

500

600

700

800

900

1,000

1,100S&P Super Homebuilding Index

Source: S&P updated through Apr 2013; 514

4

A picture is worth a thousand words, and in this case, so is a magazine cover. In both good times and bad the media loves a juicy housing story, as demonstrated by the cover images shown below. In 2005, TIME Magazine’s “Home $weet Home” captured the buying euphoria at its peak, while housing’s demise dominated headlines from 2006-2010. Over the last few years however, the headlines have become increasingly rosy once more. As Money Magazine’s April 2013 issue succinctly phrased it, “Housing is Back!” PRICES ARE A LAGGING INDICATOR

Magazine covers tend to focus on what is happening in home prices, which is a lagging indicator. Note how Phoenix home prices were up in 2005/2006, which was the best time to sell, and down in 2011, which was the best time to buy. Compare the covers to our Housing Cycle Risk Index™ (a leading indicator) and our Burns Home Value Index™* (the most current snapshot of home prices available).

OBJECTIVELY VIEWING THE CYCLE

Tools such as our Housing Cycle Risk Index™ (HCRI) enable investors to make better decisions throughout the housing cycle, staying ahead of both recoveries and downturns. As background, our HCRI tracks the health of market fundamentals (demand, supply, and affordability) and has proven to be a very good 1-2 year leading indicator for home price appreciation/depreciation. A rising index usually means price appreciation is likely to occur, while a declining index usually means price depreciation is likely to occur. When the HCRI increases from a D to a B, it is time to invest. When the index falls from a B to a D, it is time to divest. When the HCRI has reached a C or better and is improving, we recommend investing with more optimism, including investing for the long-term. According to our Burns Home Value Index™ (BHVI), Phoenix home prices rose 41% in 2005. However, the

Staying Ahead of Housing’s Next Cover Story

50%

40%

30%

20%

10%

0%

-10%

-20%

2005 2006 2007

+41%

C

D+

F

+10%

-10%

BURNS HOME VALUE INDEX (BHVI)

Phoenix Housing Market

HCRI foretold trouble ahead, as evidenced by the C grade that year. By 2006, the HCRI had deteriorated to a D+, a clear exit/divest signal. Home prices subsequently plummeted. Finally in 2011, Phoenix housing fundamentals began to turn the corner, as evidenced by an HCRI grade of C+. This is when many smart investors began loading up on Phoenix, well ahead of the double-digit price appreciation seen in 2012 and 2013. The bottom line: paying attention to the media is good, but staying ahead of them is better.

BY RICK PALACIOS JR., Manager

5

*The BHVI provides an accurate view of home value trends for the entire market. Each month the BHVI is calculated based on an “electronic appraisal” of every home in the market, rather than just the small sample of homes that are actually transacting. The BHVI provides

home value trends at least 3 months ahead of other indices by analyzing transactions as they are negotiated, not closed, which eliminates the data lag embedded in indices such as Case-Shiller and adjusts for distressed sales mix.

2009 20102008 2012 20132011

F

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BURNS HOME VALUE INDEX (BHVI) HOUSING CYCLE RISK INDEX (HCRI)

Phoenix Housing Market

6

The housing market is on its yellow brick road to recovery, and transactions that will finance growth for builders and single-family rental operations are blossoming like the field of poppies in The Wizard of Oz. For the first time in many years, acquisitions, initial public offerings (IPOs), and private placements are simultaneously available to the housing industry. FORECASTING AN ACQUISITION BLIZZARD As a long-term merger/acquisition specialist, with over 85 transactions for homebuilders completed prior to joining John Burns Real Estate Consulting, I’ve been watching for the return of acquisitions. We have arrived at the point in the housing recovery when Wall Street expects the public homebuilders to produce both profits and growth. This growth will be difficult to deliver strictly from existing operations, as builders address labor shortages and construction delays and scramble to secure finished lots in the right places. The builders will augment internal growth with acquisitions of other builders, and in fact, several publics hired acquisition managers in 1Q13 to support their efforts. Faster than Dorothy clicked her ruby slipper heels, numerous preliminary acquisition agreements have been inked, and more are under discussion. If all of these transactions close, you can expect a flurry of M&A headlines in 2013.

MANY MOTIVATIONS DRIVE M&ABigger builders typically acquire local or regional builders for several reasons, and we can see the first two of these motivations in the crop of deals in process:

1. NEW MARKETS. To re-enter markets they left in the housing correction or to enter markets they didn’t get into in the last boom

2. MARKET SHARE. To increase their position in a current market, via control over lots and local talent

3. EXPERTISE. To bring special expertise in-house, such as Pulte’s acquisition of Del Webb’s active adult prowess

For their part, builders who are selling recognize that they can guarantee today a significant portion of the money they hope to make in the future by selling homes through the next housing boom. In addition, they are motivated by:

1. CAPITAL ACCESS. Access to affordable capital to compete more effectively and grow their businesses, as loans continue to be hard to secure and expensive

2. INCENTIVES. Desire to reward and keep their management team together to accomplish that growth

3. RETIREMENT. Interest in retiring with no succession plan, or possibly some are discouraging their family from a career in a cyclical and risky business

4. INVESTOR EXITS. Need for an exit strategy for investors

5. PERSONAL LIABILITY. Eliminate personal liability and never signing a personal guarantee to the bank again!

IPO WINDOW IS AN ALTERNATIVE FOR SOME BUILDERSSome builders who are great acquisition targets are instead tapping into the public markets directly. This is an unusual situation that has only happened once before in my 18 years of M&A, and it was at the same point in the housing recovery. In 1993, as the trajectory of the housing recovery off a bottom in 1991/1992 became

Acquisitions, IPOs, and Private Placements,Oh My!BY JODY KAHN, Senior Vice President

7

1991

0 0

10600,000

20

1,000,000

1,200,000

5

400,000

200,000

15800,000

25 1,400,000

1993

1993: Beazer acquires Panitz Homes (1st acquisition of new cycle)1993: Sundance Homes and INCO Homes IPOs

1994: Beazer Homes USA IPO1996: Meritage Homes IPO

2000: Lennar acquires US Home

2001: Pulte acquires Del Webb

2006: KHov acquires CraftBuilt Homes (last transaction of cycle)

2009: Pulte acquires Centex

1995

1997

1999

2001

2003

2005

2007

2009

2011

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Apr

-13

3

2

8 7 12 13 17 14 1 4 13

3

1

12

1

21 3 18 7 1 1 6

IPOM&AUS New SF Sales

# IPOs/Mergers & Acquisitions1

and US New SF Sales

1 Mergers & Acquisitions encompass the 13 public builders we track. This study does not include mergers and acquisitions between private entities.

Source: John Burns Real Estate Consulting (April 2013)

Not

able

Tr

ansa

ctio

ns

clear, a couple of IPOs of smaller, single market builders launched at the same time that the first builder acquisitions occurred.

Wall Street has largely bought into the housing recovery, and many investors are seeking affordable alternatives with upside potential versus the public homebuilder stocks. Successful IPOs by homebuilders TriPointe Homes and Taylor Morrison and single-family rental operator Silver Bay Realty Trust have ignited interest. Since investors could suddenly turn to other opportunities outside of housing, numerous builders are scrambling to pursue this window of opportunity. The commonalities are the housing focus and interest in tapping low cost equity and debt while Wall Street is beckoning.

PRIVATE PLACEMENTS FUEL GROWTH AND FUTURE EXITSHistorically, Wall Street has favored larger builders with a regionally diverse footprint, and we expect the same criteria to apply to the newer single-family rental operators. Armed with new capital, several great operators will expand their geography and increase revenues with an eye to an IPO or acquisition down the road.

TIMING IS EVERYTHINGWall Street’s attitude towards the housing sector can be capricious, and the opportunity for builders and single-family rental operators to launch IPOs can abruptly disappear. Private placements for builders typically have a longer season than IPOs, and merger/acquisition activity will likely continue through the next housing boom. Access to public equity and debt was a huge benefit to the public homebuilders through the housing correction and has also allowed them to buy lots and land to fuel their growth in the recovery. As national housing market experts, our team is supporting the wave of builders and single-family rental operators who want to level the playing field.

8

2. THE GREAT RECESSION. The persistent downturn that began in 2008 hit just as Gen Yers were coming of age, delaying the establishment of their careers and leaving many graduates struggling on the front lines of high unemployment, with 9.7% of those 20-34 unemployed compared to 6.2% amongst older age groups.

As a housing market researcher and member of Gen Y myself, I want to take a further look into what it will mean for community planners and builders. Surprisingly, we may not be that radical a departure from the norm.

WAIT FOR ITWhile the 25+ portion of Gen Y will grow significantly over the next three years, their anticipated influence will be delayed.

The home buying delay for this generation is a result of three things:

1. STUDENT LOAN DEBT.With 40% of the 18-29 year old population with established credit saddled with student loan debt, homeownership is taking a back seat.

You may think of tech-savvy Gen Y as contrarian, iPad-toting hipsters in search of super-green urban living, averse to all things suburban and unwalkable. Born between 1980 and the early 2000s, Gen Y looks poised to be the next big purchaser of homes and one that the homebuilding industry is eagerly anticipating. After all, they will quickly become the predominant generational group within the primary home buying age.

Gen Y

BY GREGORY TSUJIMOTO, Manager

2012

PRIMARY HOME BUYING AGE1

BY GENERATION

2017

80%

100% Boomers15%

Gen X41%

Gen Y44%Gen Y

29%

Gen X42%

Boomers29%

Source: US Census Bureau, 2010 ESRI125-29 Years of Age

60%

40%

20%

0%

You’ll Have to Wait

9

3. A CULTURAL SHIFT.

For the above reasons along with other sociocultural influencers, Gen Y is putting off major life choices like marriage and starting a family. Compared to previous generations at comparable points, fewer members of Gen Y are married, and starting their own households is a more distant priority. This notable shift is exemplified in the chart below, which shows a nearly 10% decrease in the marriage rate of 20-34-year olds in just a six year span.

ANTICIPATING GEN YHomeownership remains part of the American Dream across all life stages according to our Consumer Insights survey.

What’s more, when the time comes, Gen Y will have more conventional preferences for homes than we expect. Though delayed, their goals are more similar to the previous generations’ than not. As they begin to enter their 30s and 40s, and eventually marry and start families, they will turn to the suburbs just as their parents did in search of affordable housing and more space. In contrast, urban housing options are often higher priced with monthly fees and smaller in size which will be challenging for these expanding households. While Gen Y will have similar overall housing preferences to past generations, it is a group of design-centric consumers. They will expect more efficient and thoughtful floor plans marked by multi-functionality, technology integration, and the cross-pollination of indoor and outdoor spaces. You’ll have to wait for them, but they will eventually be the promised surge in the housing market. Plan accordingly.

“Gen Y is putting off major life choices like marriage and starting a family.”

MARRIAGE1 RATE OF 20-34 YEARS OF AGE

50%

41%

32%

45%

40%

35%

30%

25%

20%

2005 2006 2007 2008 2009 2010 2011

Source: US Census Bureau, American Community Survey1Married, not separated

10

ome prices have gone through a severe bear market for the past five years, after experiencing a strong rising market for several years before that. While some have

become discouraged about residential real estate, the time for discouragement is past. Today’s combination of low prices and low mortgage rates makes home buying very attractive. More than that, the real estate cycle itself is now far over—depressed, well below its long-term trend. The natural—and powerful—turn of that cyclic wheel in itself creates a major force driving appreciation of home prices over the next several years. To see this, we’ll look at one of the most cyclic areas of all: California.

The graph below shows median California home prices from 1972 to 2012, as reported by the California Association of Realtors®. There was a tremendous increase from $28,000 in 1972 to $560,000 at the height of the boom in 2006, followed by the recent bear market. Note the short-term recovery from 2009 to 2010 due to the tax credit. This was followed by a decline in 2011

and an increase in 2012. The case is very strong that the bottom is essentially defined and there is a great deal of room for recovery.

California, the most populous of the fifty states, is not one single market. The Central Valley is not the Silicon Valley. However, the great majority of California metros experienced a major housing boom in the last decade followed by a corresponding decline. Accordingly, it is appropriate to look at this large coastal—and cyclic—state as a whole on a high macroeconomic level. The graph to the right presents a synthetic variable that gives a measure of the underlying real estate cycle in California. It represents the amount that the market (after correcting for inflation and mortgage rates) is above or below its forty-year trend.

This graph reveals the sheer magnitude of the business cycle itself after inflation and mortgage rates have been factored out. This cycle can have peaks and troughs that are more than 50% above and below the trend. At

You Can’t Argue with the Math:

The Inevitable Recovery

California Median Home Prices$600,000$500,000$400,000

$300,000

$200,000$100,000

$-

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20081974

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2012

HBY CHRIS CAGAN, Vice President

11

present the indicator is more than 50% below trend, suggesting that a substantial recovery is not only possible but likely. Notice that the real estate business cycle went well over trend in the late 1970s, with prices rising very rapidly even after inflation, and even in the face of high (and rising) mortgage rates. This shows the inherent momentum and cyclic swing of the business cycle in action. Remember that a home is a hedge against inflation for the average person. Thus, inflation does not kill a real estate market if the cycle is in its positive phase. True, mortgage rates go up, but not enough to stop it; there is a rise even after allowing for higher rates and inflation. There was a settling back in the early 1980s, which was indeed partly due to the Volcker increases in interest rates to combat inflation, thus causing a recession, but

even more because the business cycle itself went into a bear phase. California real estate has been inherently cyclic even after other factors are allowed for. Here the business cycle is a fundamental of economics, just as is the law of supply and demand. There was a cyclic boom in the late 1980s followed by a cyclic bear in the 1990s, even though interest rates were going down during the nineties, enabling many refinances. The market simply had moved from bull to bear. What has been shown for California, of course, suggests similar conclusions for other cyclic markets and for most of the country in general. One can expect a basic cyclic bull market for several years, cleaning out the distressed inventory as it rises, then crossing its trend about 2017-and quite possibly overshooting on the other side. Barring an external catastrophe such as a major war or another event on that level, this new bull market seems almost unstoppable.

-60%

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Business Cycle PositionOver or Under Trend

12

Who’s Buying Today?Homes

Home Size1,500 to 2,500 SF is most preferred

Multigenerational50% would consider accomodating their elderly parents

Levels68 % want a single level

(or a two-story with a master on the first level)

32% want a two-story Secondary RoomsOffice rated #1

Bedrooms49% are looking for 4 or more bedrooms in their next home

LocationBuyers still want

suburban over urban

Living Areas62% prefer a Great Room

Living Areas62% prefer a Great Room

and prefer connecting to the kitchen

Kitchen Preferences76% gas appliances61% stainless steal60% separate cooktop

BuyersOnly 28% is a family buyer

Consumer Insights

13

CONSUMER INSIGHTS SURVEY

OVER30,000

SURVEYED

NATIONWIDESAMPLE

100+QUESTIONS

Know yourconsumer.

What do they call home?

What will they pay for?

What adds value to your bottom line?

Please visit www.WhatDoYouCallHome.com to participate in our 2013 Consumer Survey.

Consumer Insights

14

Lot Premiums Are Back!And Are Rising Substantially

NORTHWEST BUYERS ARE WILLING TO PAY UP FOR LARGE LOTS. SVP Ken Perlman reports that oversized lots are getting big premiums in Seattle, primarily because they are so rare. In the Pacific Northwest, builders have always priced each lot within a subdivision separately to maximize the lot prices and to capitalize on premium conditions. With rapidly increasing premiums in Seattle, Ken is doing more lot-by-lot premium analysis to help land buyers bid more confidently.

NORTHERN CALIFORNIA PRICE HIKES ARE DISGUISED AS PREMIUMS. Northern California VP Dean Wehrli notes that a few Bay Area builders are raising prices by increasing the premium attributable to specific lots. Interestingly, some of these “premiums” are on lots with no premium condition at all. Dean believes this is really just a disguised price increase, which will allow them to ditch the premiums if the market cools a bit.

SOUTHERN CALIFORNIA PREMIUMS HAVE DOUBLED (OR MORE). Southern California Senior Manager Paul Faye noted that he recently saw a $100,000 premium in the Inland Empire masterplan of Morgan Hill in Temecula, which is probably a record for the long-time community. Also, SVP Pete Reeb reports that golf course premiums at new home projects in Oceanside have doubled in the last year, increasing from around $35,000 per lot a year ago to around $70,000 per lot today.

TEXAS PREMIUMS ARE NO LONGER GIVEN AWAY AS INCENTIVES. Dallas-based Senior Manager Paige Shipp reports that lot premiums were never eliminated in Texas, although they were often reduced or removed during negotiations with buyers. Today, builders are standing firm on premiums as a way to control and capitalize on their better lots.

BUYER DEMOGRAPHICS IMPACT LOT PREMIUMS. Irvine-based VP Nicole Murray notes that builders are able to get considerable lot premiums for home orientation with good feng shui. In Southern California, builders have been able to command an additional 5% premium for homes facing north with average community lot size and open space. Cul-de-sac lots with good feng shui have commanded premiums above 20%. Home site orientation along a hillside also has considerable feng shui implications, characterized as a “home nestled into a hillside being blessed with material and non-material riches.” Communities with a large East Indian population should also be mindful of Vaastu Shastra principles, as builders may receive premiums for east-facing homes.

15

Premiums vary significantly, and summaries are given by select major region.

MIDWEST PREMIUMS ARE ONLY FOUND IN THE BEST LOCATIONS. Chicago-based SVP Lance Ramella reports that lot premiums have also returned in the Midwest, but only in the most highly desirable submarkets. This region is generally seeing premiums in the 2%-4% percent range for larger lots and cul-de-sac locations. Lots with open space or water views can exceed 5% premiums.

SOUTHEAST PREMIUMS ARE BACK. Atlanta SVP David Kalosis notes that most new communities offer base lots plus premiums now, even in townhome communities. As each new phase or building is released, lot premiums continue to gradually increase. He reports that “decreased incentives, coupled with increasing lot premiums, are compensating builders for rising materials and labor costs this year.”

DC PREMIUMS ARE LOW AND DEPENDENT ON THE SUBMARKET. SVP Ken Perlmansays premiums of 1%-2% are common on the Virginia side of DC and even stronger closer to the capital . DC is still recovering, with 4% incentives still common (down from 6% 18 months ago). Senior Consultant Kathleen Ripley, who visited 2 dozen communities in Southern Maryland, reports that premiums are very low and only on a handful of lots, as the area is heavily dependent on the military bases and defense contractors who are leery of the sequester.

FLORIDA PREMIUMS ARE ON ALL BUT THE WORST LOTS. Florida SVP Lesley Deutch visited 10 projects in North Tampa and noticed that all communities have premiums on all lots, except for highway frontage lots. Back-to-back lots have smaller premiums, and views/private lots have premiums up to 10% of base price. Lot premiums only increase when a builder starts a new phase or a new community.

16

UNIQUELY COMPETITIVE ENVIRONMENTWith homeownership costs at the lowest levels in decades and a surge in vacant single-family rentals, renters have plenty of options these days.

> The average monthly cost of homeownership is currently equal to or below the average rental rate in most markets.

> The move-out to purchase ratio (as reported by the apartment REITs) has risen to 14% from 11% in 2010.

The chart to the right compares the multifamily permit activity over the last 12 months to the 22-year average for the top 22 apartment markets.

Apartment builders continue to feverishly build to capitalize on rising rental rates and favorable demographics, but construction is reaching dangerous levels in some markets.

Raise the Yellow Flag

17

Apartment Construction Now a Concern in Many Markets

Note that the number of multifamily permits pulled over the past year significantly exceeds historical averages for the majority of markets. Construction activity has been especially elevated in tech markets like Raleigh, Austin, and San

Francisco, which are currently over 175% of historical norms. These markets have experienced strong job growth which will help absorb the additional supply. The only major markets where supply remains well below historical averages are Phoenix, Miami, Atlanta, and Chicago. SUPPLY REACHES ALL-TIME HIGHS IN SEVERAL MARKETSMultifamily permit activity is currently at the highest level in decades in Austin, Dallas, and San Francisco and nearing peak levels in Raleigh and San Jose. In contrast, permit activity in Chicago and Miami is only about 20% of peak. The chart above compares the multifamily permit activity over the last 12 months to peak levels for the top 22 apartment markets.

INCREASE YOUR RISK ASSESSMENT AND MONITOR THE JOB MARKETToday’s job growth, coupled with favorable demographics and sizeable pent-up demand, supports today’s construction levels. However, when job growth slows, apartments are the first to get hit. Our advice is to pencil in more risk than usual on any apartment deals in Raleigh, Austin, Dallas, and San Francisco.

BY ADAM ARTUNIAN, Senior Research Analyst

18

May the force be with you...

Or else, your home values will go downDeclining Police Forces Impacting Property ValuesBY SEAN FERGUS, Manager

It should not be a surprise that safety is a primary consideration in home buying. In fact, in our survey of almost 20,000 home shoppers, safety ranked above price when asked what were the most important characteristics when purchasing their next home.

So, what happens when a city cuts back on services such as police officers? Our consulting team is finding numerous instances all over the country where demand is declining in certain cities and rising in neighboring cities, and we believe the change is largely attributable to deteriorating services such as police, fire and school quality.

To provide the best feasibility analysis for our land buying clients, and to determine the best cities for our single-family rental landlord clients, we set out to identify which cities are in the most severe financial distress. We found the task somewhat overwhelming and even downright

misleading, as many cities that are well-known to be in dire straits had highly rated bonds. The best data we found is on the total number of police and crime. While simplistic, it goes to reason that cities who are cutting back on police are likely to be more amenable to criminals.

Location

Home Design

Safety

Price

Community Design

Accessibility

Prestige

0%

13%

30%

33%

55%

57%

58%

58%

20% 40% 60% 80%

Most Important Characteristics When Purchasing Their Next Home

350

320

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100

19

Continued...

One city’s pain is another city’s gain. Compare San Bernardino’s experience to the neighboring City of Ontario, which only cut police forces 3% from 231 to 224 over the same time period. Crime has only increased marginally from 2011 to 2012, climbing just 5%.

San Bernardino residents probably don’t know the stats, but they will sense the crime, and many will move next door to Ontario in coming years. While a 5% increase in crime is nothing to brag about, Ontario is likely to experience in-migration from their neighbors whose cities are less safe. We expect more price and rent appreciation in Ontario than in San Bernardino, which has already started to occur as illustrated in the chart below.

350 6,500

Violent & Property Crime

+25%

-10%

Police OfficersCity of San Bernardino

Sources: John Burns Real Estate Consulting; FBI Uniform Crime Reports

320 5,500

2904,500

340

3105,000

280

3306,000

300

270 4,0002007

330

343

324319

2964,688

5,867

2008 2009 2010 2011 2011 2012

3,000

2,600

2,400

2,800

2,200

300


+5%-3%

Police OfficersCity of Ontario


150

200

250

1002007

231 228 220 224 2242,615

2,734

2008 2009 2010 2011 2011 2012

0

50

100

150

200

250

300

350

400

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Ontario

San Bernardino

Sources: John Burns Real Estate Consulting; Zillow.com

Ontario & San Bernardino Single-Family Home ValuesZillow Home Value Index (Jan-00 = 100)Ontario & San Bernardino Single-Family Home Values

Zillow Home Value Index (Jan-00 = 100)


CALIFORNIA EXAMPLELook at the results in the City of San Bernardino, which is currently in bankruptcy. The number of police officers has steadily declined, while crime has risen. We counsel our clients away from investing in cities such as this, unless their investment thesis fully incorporates the negative changes we believe are occurring and will continue to occur.

20

FLORIDA EXAMPLEIn Florida, the City of Hollywood cut its police force from 320 officers in 2007 to 305 in 2011, and violent & property crime increased from 2011 to 2012 as illustrated in the charts to the right.

The nearby City of Fort Lauderdale actually increased police forces from 459 to 505 in the same time period, and experienced a 2% decline in total crime in the city. If these trends continue, we would also expect to see greater demand for homes in the Fort Lauderdale area and declining demand in Hollywood. We expect more price and rent appreciation in Fort Lauderdale than in Hollywood.

While the trend is more subtle than the Ontario and San Bernardino example, Fort Lauderdale has gradually started to experience more price appreciation compared to Hollywood.

DUE DILIGENCECity desirability changes over time, and changes in crime (and even perceived crime) play a huge role in those changes. For years, we have tracked crime statistics as part of our feasibility studies. However, we are now paying more attention to projected changes in crime. Builders and developers need to stay well informed of these police force and crime trends and should make them a part of any market research or feasibility study. Increased crime in a particular city will result in clear winners and losers for cities in a metro area, and builders and developers need to be well-informed on which cities these will be. We are searching for a way to accurately project changes in school quality too, based on the same issues. School district balance sheets are not created equally!

0

50

100

150

200

250

300

350

400

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Fort Lauderdale

Hollywood


Fort Lauderdale & Hollywood Single-Family Home ValuesZillow Home Value Index (Jan-00 = 100)

Fort Lauderdale & Hollywood Single-Family Home ValuesZillow Home Value Index (Jan-00 = 100)


250

300

5,500

4,500

4,000

3,000

5,000

3,000

350


+19%-5%

Police OfficersCity of Hollywood


2002007

320314 316 315

305

4,144

4,913

2008 2009 2010 2011 2011 2012

500

450

425

475

6,000

5,600

5,400

5,200

5,800

5,000

525


-2%

+10%Police Officers

City of Fort Lauderdale


4002007

459

484489

504 505

5,691

5,583

2008 2009 2010 2011 2011 2012

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The housing cycle is usually long and has five major stages, which are shown below. I began consulting to real estate executives’ right before a downturn that began in 1990 and ended in 1995. The subsequent expansion lasted 10 years. After 22 years of observing this cycle and studying past cycles, here is the best general advice I can muster for managing in the cyclical home building business.

Stage 1: The Bottom At the bottom, we suggest that you make long-term land investments by buying large assets with cash. Consider buying on the peripheral areas at steep discounts and with your own money so that debt and equity service is not a factor. This is a contrarian view, which is why it is a good view. Opportunity funds want 2-5 year returns and will be buying land in better locations. We suggest being very aggressive here, and avoid generating significant short term expenses such as interest payments or option payments. In most downturns, you can buy fully entitled land from the banks at less than the cost of the improvements that are already in place. If you are like most and can’t bear to think beyond 5 years, don’t plan on making much money from market appreciation.

Stage 2: The BeginningBuy land in the next cities that will become the great locations as the market expands. Continue making the long-term land investments discussed above. Underwrite aggressively if needed because your downside is limited. Raise money from diversified companies with long-term horizons, such as pension funds and insurance companies.

Stage 3: Nearing the PeakAt this stage, the risk is highest and so is the short-term return. In this last cycle, “Stage 3: Nearing the Peak” lasted for years. You never know for sure when the end of an expansion will occur. Implement an “Asset Light” strategy where you only own the land you need to fund operations, but have plenty of options with well-capitalized land developers and partners so you won’t run out of land during a downturn. Concentrate on locations where there are fewer home builders. Shed any high-density attached projects because the builder demand will be high today, but the consumer demand will be low tomorrow.

Stage 4: The Early DeclineSell your land. Early on, there will be plenty of optimists willing to buy it from you at a perceived discount. Cultivate your banking relationships, because they will be the land sellers of the future.

Stage 5: The Steep DeclineAdvise the banks. Help them decide what to do.

Stage 1: The BottomLend and invest aggressively. The downside is limited and most of your competitors will be still questioning the business after the losses they just sustained.

Stage 2: The BeginningKeep lending and investing aggressively.

Stage 3: Nearing the Peak Sellor syndicate your investments to other institutions. Syndications or participations are a great way to maintain your builder and developer relationships while reducing your risk. Consider a hedging strategy that will be expensive but will be worth it if the market corrects.

Stage 4: The Early DeclineSell your worst loans to other banks. Use renegotiations due to covenant violations to reduce your exposure. Keep a small percentage of the debt to your favorite clients. Staff your Special Assets Department early with experienced building industry executives - not just bankers - and incent them to act quickly. Raise some money for the future, but don’t spend it.

Stage 5: The Steep DeclineTake your lumps. Demand all that you deserve, but don’t push your borrower into bankruptcy. If you do, the lawyers will get rich and customers won’t buy their homes or lots. Hire outside expertise to provide independent analysis to the loan syndication group because you’ll rarely be able to reach consensus. Once you see stability in the market, buy back the loans from the other banks and start planning your expansion strategy.

Land Developer Strategy

Debt & Equity Strategy

A Strategy to Navigate the Housing Cycle

Stage 1: The Bottom

Stage 2: The Beginning

Stage 3: Nearing the Peak

Stage 4: The Early Decline

Stage 5: The Steep Decline

Finance Strategy

Stage 1: The BottomCash is king. If public, consider taking yourself private. Start a new company if you can.

Stage 2: The BeginningAt the beginning of the up cycle, secure long-term financing that won’t mature anytime soon. Throughout the up cycle, continue to push financing maturities out and use multiple sources of capital, from multiple industries (banks, pension funds, offshore, etc.). Don’t pay the expenses associated with land banking or option payments unless you are truly so efficient that you can make a great return while doing so.

Stage 3: Nearing the PeakConsider selling your company because growth-oriented firms tend to overpay for land and companies during this part of the cycle. You might also want to pay yourself a lot of money by going public, although you will certainly create a lot of expenses and headaches if you choose that route. If you are not a seller, stick others with the downside risk by using joint ventures or off balance-sheet financing. JV capital will be plentiful. Restructure all of your lots to be based on rolling option takedowns. This expense might cost 12% - 15% per year, which is why we recommend this strategy at this stage of the cycle rather than throughout the cycle. Refinance with more expensive non-recourse debt.

Stage 4: The Early DeclineLook around. Are competitive levels and/or affordability levels worse than usual? If so, you can count on the downturn being prolonged. Pay down your short-term debt obligations and build up cash reserves by selling your homes and land as quickly as possible, even at a loss, because the loss will be greater later. Many believe that losing money is somehow a sign of failure and disastrous to the balance sheet. They are wrong. This is a cyclical business. Recovering as much of the cash that you have already spent is what matters. Hire a great tax advisor too.

Stage 5: The Steep DeclineAll of your preparation should have paid off. While this isn’t fun for you, it is worse for others. Pay off all of the debt you are obligated to pay.

Stage 1: The BottomIf you bought land in an outlying area, sit back and wait for the market expansion to head your direction. Focus your home building efforts on good locations, and on perfecting an operating company that is efficient and profitable without the benefit of price appreciation. Value-oriented detached homes sell best.

Stage 2: The BeginningPut some cash back into the business to improve efficiency, and begin pulling some cash out of the business to diversify your investments and improve liquidity. Grow your business slowly with an emphasis on diversifying into new geographies or product types. Hire the right people and structure their compensation to align their incentives with yours over the very long-term.

Stage 3: Nearing the PeakPut even more money into process efficiency. Build more cost-effectively than your competitors. Avoid mid-rise and high-rise construction unless you are experienced at it and underwrite it with the additional risk it deserves. Avoid land development for the same reasons.

Stage 4: The Early DeclineDevelop a site-specific strategy to generate cash. This will not be possible at some communities, which should be halted. As one CEO executive told me, “The downturns are always longer and more painful than people think they will be.”

Stage 5: The Steep DeclineBuild homes for troubled banks and equity partners in a structure that provides them most of the upside and, more importantly, protects you from any downside.

Home Builder Strategy

BY JOHN BURNS, CEO

22

MARKET COVERAGE

JOHN BURNS REAL ESTATE CONSULTING OFFICES

Market Coverage

CONSULTING SERVICES > Strategic direction & planning > Home builder operations &

assessment > Demand analysis > Consumer research & focus groups > Economic analysis & forecasting > Litigation support & expert witness > Financial modeling > Project & product positioning

PROPRIETARY INDICESHousing Cycle Risk Index™: Our index of housing demand, supply and affordability fundamentals has foretold home price appreciation and depreciation by 1-3 years.

Burns Home Value Index™: Our home price index is 5 months more current than Case-Shiller and helped investors make decisions months ahead of the price increases that happened mid-year 2012.

Burns Finished Lot Value Index™: Our land value index helps investors understand home builder market value in relation to book value.

Burns Affordability Index™: Our index is the only measure that allows you to compare affordability across geographies over time.

RESEARCH SERVICES > Home builder, regional, metro

market, apartment, and building product manufacturer analysis & forecast

> Exclusive client events > Public builder call summaries > Weekly insight > Presentations & webinars > Consumer research > Proprietary surveys

We are a leading US real estate research firm offering published research, custom consulting, and advisory services with a laser-sharp focus on the housing industry. We provide clarity and direction in the age of information overload to help our clients make better decisions in their business pursuits.

Our team of more than 35 experienced housing analysts is heavily networked with builders, developers, and investors and are generating new relationships across the country everyday.

23

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50%

40%

30%

20%

10%

0%

-10%

-20%

2005 2006 2007 20092008

+41%

C

D+

F

-21%

D

+10%

-10%

F

Building Marketing Intelligence Q2 2013

Documents

Transcript of Building Marketing Intelligence Q2 2013