Building Marketing Intelligence Q2 2013

Building Market Intelligence A+ VOL 1 Q2 2013

A

C+

+15%

+18%

D+

D -12%

Staying Ahead of Housing’s Next Cover Story

-21%

09

-9%

2010

2011

2012

2013

1

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

Table of Contents

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

Front Running the Fed

BY JOHN BURNS, CEO

W

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 FUTURE We 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 2

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 STIMULUS The Fed is buying $45 billion per month in mortgagebacked 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 RATES A 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!

S&P Super Homebuilding Index 1,100

S&P Super Homebuilding Index

1,000 900 800 700 600 500 400 300 200 100 Source: S&P updated through Apr 2013; 514

PRICE/INCOME VERSUS PAYMENT/INCOME A 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

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 FUTURE Who knows what future mortgage rates will be? Here is some perspective. The median 30-year, fixed rate conforming mortgage rate over the last:

2. Yuba-Sutter, CA

> > 42 years is 8.15%

3. Detroit, MI

> > 30 years is 7.45%

4. Las Vegas, NV

> > 20 years is 6.52%

5. Stockton, CA

> > 10 years is 5.72%

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

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 RECOVERY Investors 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!

3

Staying Ahead of Housing’s Next Cover Story

BY RICK PALACIOS JR., Manager

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 20062010. 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.

50% 40%

+41%

BURNS HOME VALUE IN

30% 20% 10% 0%

+10% C D+

-10% -20%

According to our Burns Home Value Index™ (BHVI), 2005 2006 2007 Phoenix home prices rose 41% in 2005. However, the 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.

4

-10

F

*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.

Phoenix Housing Market A+

NDEX (BHVI)

HOUSING CYCLE RISK INDEX (HCRI)

C+

A

+15%

+18%

D+ D

0%

-12%

-21% F

2008

-9%

-21%

2009

2010

2011

2012

2013

5

Acquisitions, IPOs, and Private Placements,

Oh My!

BY JODY KAHN, Senior Vice President

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&A Bigger 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 6

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 BUILDERS Some 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

clear, a couple of IPOs of smaller, single market builders launched at the same time that the first builder acquisitions 25 occurred.

PRIVATE PLACEMENTS FUEL GROWTH AND FUTURE EXITS Historically, Wall Street has favored larger builders with a regionally diverse footprint, and we expect the same criteria to apply to the newer singlefamily 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.

1,400,000

IPO M&A US New SF Sales

1,200,000

1,000,000

800,000 1 600,000

400,000

200,000

2 1 3 1 1 4 6 1

0

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Apr-13

3 3 8 12 7 21 12 3 13 18 17 7 14 1

Notable Transactions

Wall Street has largely bought into the housing recovery, and 20 many investors are seeking affordable alternatives with upside potential versus the public homebuilder 15 stocks. Successful IPOs by homebuilders TriPointe Homes and Taylor Morrison and single-family rental operator Silver Bay Realty Trust have 10 ignited interest. Since investors could suddenly turn to other opportunities outside of housing, numerous builders 5 are scrambling to pursue this window of opportunity. The commonalities are the housing focus and interest in tapping 0 low cost equity and debt while Wall Street is beckoning.

# IPOs/Mergers & Acquisitions1 and US New SF Sales

2009:

2001: 2000: 1996: 1994: 1993: 1993:

1

Pulte acquires Centex

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

Lennar acquires US Home

Meritage Homes IPO

Beazer Homes USA IPO

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

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)

TIMING IS EVERYTHING Wall Street’s attitude towards the housing sector can be capricious, and the opportunity for builders and singlefamily 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.

7

Gen Y

You’ll Have to Wait

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.

BY GREGORY TSUJIMOTO, Manager

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 IT While 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.

8

100% 80% 60% 40% 20% 0%

PRIMARY HOME BUYING AGE 1

BY GENERATION Boomers 29%

Gen X 42% Gen Y 29%

2012

Boomers 15% Gen X 41%

Gen Y 44%

2017

Source: US Census Bureau, 2010 ESRI 1 25-29 Years of Age

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.

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

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 Y Homeownership 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.

MARRIAGE 1 RATE OF 20-34 YEARS OF AGE 50% 45%

41%

40% 35%

32%

30% 25% 20% 2005

2006

2007

2008

2009

2010

2011

Source: US Census Bureau, American Community Survey 1 Married, not separated

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.

9

You Can’t Argue with the Math:

The Inevitable Recovery

BY CHRIS CAGAN, Vice President

H

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

California Median Home Prices $600,000 $500,000 $400,000 $300,000 $200,000 $100,000

10

12

10

20

20

08

20

06

04

20

20

02

20

00

20

98 19

96

19

94

19

92 19

00 19

88

86

19

19

84 19

82

19

80 19

78 19

76

19

74 19

19

72

$-

Business Cycle Position Over or Under Trend 60% 40% 20% 0% -20% -40% 12

20

10 20

08

06

20

20

04 20

02

20

00

20

98 19

96

19

94

19

92 19

00 19

88

86

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84

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80 19

78 19

76

19

74 19

19

72

-60%

present the indicator is more than 50% below trend, even more because the business cycle itself went into suggesting that a substantial recovery is not only a bear phase. California real estate has been inherently possible but likely. cyclic even after other factors are allowed for. Here the business cycle is a fundamental of economics, just as is Notice that the real estate business cycle went well the law of supply and demand. There was a cyclic boom over trend in the late 1970s, with prices rising very in the late 1980s followed by a cyclic bear in the 1990s, rapidly even after inflation, and even in the face of high even though interest rates were going down during the (and rising) mortgage rates. This shows the inherent nineties, enabling many refinances. The market simply momentum and cyclic swing of the business cycle had moved from bull to bear. in action. Remember that a home is a hedge against inflation for the average person. Thus, inflation does What has been shown for California, of course, not kill a real estate market if the cycle is in its positive suggests similar conclusions for other cyclic markets phase. True, mortgage rates go up, but not enough to and for most of the country in general. One can expect stop it; there is a rise even after allowing for higher a basic cyclic bull market for several years, cleaning rates and inflation. out the distressed inventory as it rises, then crossing its trend about 2017-and quite possibly overshooting There was a settling back in the early 1980s, which was on the other side. Barring an external catastrophe such indeed partly due to the Volcker increases in interest as a major war or another event on that level, this new rates to combat inflation, thus causing a recession, but bull market seems almost unstoppable.

11

Who’s Buying Homes Today?

Consumer Insights

Home Size 1,500 to 2,500 SF is most preferred Levels 68 % want a single level

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

32% want a two-story

Bedrooms 49% are looking for 4 or more bedrooms in their next home

Secondary Rooms Office rated #1

Living Areas 62% prefer a Great Room and prefer connecting to the kitchen

Multigenerational 50% would consider accomodating their elderly parents

Kitchen Preferences 76% gas appliances 61% stainless steal 60% separate cooktop

Living Areas 62% prefer a Great Room

Location Buyers still want suburban over urban

12

Buyers Only 28% is a family buyer

Know your consumer.

What will they pay for?

What do they call home?

What adds value to your bottom line?

CONSUMER INSIGHTS SURVEY OVER

30,000

SURVEYED

NATIONWIDE SAMPLE

100+

QUESTIONS

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

13

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.

14

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.

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-toback 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.

15

Raise the Yellow Flag

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

UNIQUELY COMPETITIVE ENVIRONMENT With homeownership costs at the lowest levels in decades and a surge in vacant single-family rentals, renters have plenty of options these days. >> T he average monthly cost of homeownership is currently equal to or below the average rental rate in most markets. >> T he 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.

16

Apartment Construction Now a Concern in Many Markets

BY ADAM ARTUNIAN, Senior Research Analyst

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 ALLTIME HIGHS IN SEVERAL MARKETS Multifamily 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 MARKET Today’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.

17

May the force be with you...

Or else, your home values will go down Declining Police Forces Impacting Property Values

BY 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.

Most Important Characteristics When Purchasing Their Next Home Location

58%

Home Design

58%

Safety

57%

Price Community Design

33%

Accessibility

30%

Prestige

To provide the best feasibility analysis for our land buying clients, and to determine the best cities for our singlefamily 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 18

55%

13% 0%

20%

40%

60%

80%

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.

CALIFORNIA EXAMPLE Look 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.

City of San Bernardino Police Officers 350

6,500

340

343

330

6,000

330

320

324

310

5,500

319

300

-10%

290

296

5,000 4,500

280 270

2007

2008

2009

2010

2011

4,000

One city’s pain is another city’s gain. Compare San Violent & Property Crime Bernardino’s experience to the neighboring City of +25% Ontario, which only cut police forces 3% from 231 5,867 to 224 over the same time period. Crime has only increased marginally from 4,688 2011 to 2012, climbing just 5%.

2011

2012

San Bernardino residents probably don’t know the City of Ontario stats, but they will sense Police Officers Violent & Property Crime the crime, and many will 300 3,000 move next door to Ontario in coming years. While a 5% +5% 250 2,800 increase in crime is nothing to -3% 2,734 231 brag about, Ontario is likely 228 224 224 220 2,600 200 2,615 to experience in-migration from their neighbors whose 2,400 150 cities are less safe. We expect more price and rent 2,200 100 2007 2008 2009 2010 2011 2011 2012 appreciation in Ontario than Sources: John Burns Real Estate Consulting; FBI Uniform Crime Reports in San Bernardino, which has already started to occur Ontario & San Bernardino Single-Family Home Values as illustrated in the chart Ontario & San BernardinoZillow Single-Family Home Values Home Value Index (Jan-00 = 100) below.

Continued...

Zillow Home Value Index (Jan-00 = 100) Sources: John Burns Real Estate Consulting; FBI Uniform Crime Reports

400

Ontario

350

San Bernardino

300 250 200 150 100 50 0 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

Sources: John Burns Real Estate Consulting; Zillow.com

Sources: John Burns Real Estate Consulting; Zillow.com

19

FLORIDA EXAMPLE In 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.

City of Hollywood Police Officers

Violent & Property Crime

350

300

5,500

320

314

316

-5%

315

305

4,913

4,500 4,000

250

+19%

5,000

4,144

3,000 200

2007

2008

2009

2010

2011

3,000

2011

2012

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

City of Fort Lauderdale Police Officers

Violent & Property Crime

525 500

504 484

475 450

+10%

6,000

505

5,800

489

5,600

459

-2% 5,583

5,400

425 400

5,691

5,200

2007

2008

2009

2010

2011

5,000

2011

2012

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

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

Zillow Home Value Index (Jan-00 = 100) 400 350

Fort Lauderdale

300

Hollywood

250 200 150

DUE DILIGENCE City desirability changes 100 over time, and changes in 50 crime (and even perceived 0 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 crime) play a huge role in those changes. For years, Sources: John Burns Real Estate Consulting; Zillow.com 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.

Sources: John Burns Real Estate Consulting; Zillow.com

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!

20

A Strategy to Navigate the Housing Cycle 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.

BY JOHN BURNS, CEO

Finance Strategy

Land Developer Strategy

Home Builder Strategy

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

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 1: The Bottom If 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. Valueoriented detached homes sell best.

Stage 2: The Beginning At 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 Peak Consider 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 balancesheet 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 Decline Look around. Are competitive levels and/ or affordability levels worse than usual?

If so, you can count on the downturn being prolonged. Pay down your shortterm 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 Decline All 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 2: The Beginning Buy 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 Peak At 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 Decline Sell 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 Decline Advise the banks. Help them decide what to do.

Stage 2: The Beginning Put 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 Peak Put 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 Decline Develop 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 Decline Build 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.

Debt & Equity Strategy Stage 1: The Bottom Lend 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 Beginning Keep lending and investing aggressively.

Stage 3: Nearing the Peak Sell or 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 Decline Sell 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 Decline Take 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.

Stage 3: Nearing the Peak

Stage 4: The Early Decline

Stage 2: The Beginning

Stage 1: The Bottom

Stage 5: The Steep Decline

21

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

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.

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.

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

Market Coverage

MARKET COVERAGE JOHN BURNS REAL ESTATE CONSULTING OFFICES

22

RESEARCH SERVICES

>> H ome 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

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WWW.REALESTATECONSULTING.COM

23

50% 40%

+41%

30% 20% 10%

+10% C

0%

D+

D

-10%

-10%

-21%

-20% F

24

2005

2006

2007

F

2008

200