Marterra Market Monitor - September 2023

YTD Activity

Home Sales Closed Units: 27

Home Sales Volume ($): $30,662,987

Residential Properties Leased: 88

Gross Collected Rent: $6,563,703.73

*Photo above is from a property we manage in Huntington Beach.

It looks like California mostly dodged a bullet with "Hurricane" Hilary; the state's wildfire insurance market is shambles. Our team is seeing deals fall apart because of an inability to get coverage. BEFORE YOU LIST YOUR PROPERTY FOR SALE, MAKE SURE YOUR ROOF, ELECTRICAL PANELS, PLUMBING AND HEATING SYSTEMS ARE IN WORKING ORDER. Its current state is prompting political action. Lawmakers, regulators, and Gov. Gavin Newsom are considering measures to address the issue. They are discussing a legislative deal that would allow insurance rates to increase, aiming to attract insurers back to the state and prevent further departures.

Potential changes might involve charging policyholders fees for covering risky properties and using forward-looking rate models that factor in expected natural disaster increases. While such moves could raise insurance premiums, there's a recognition that homeowners might need to face the actual costs of living in fire-prone areas. The insurance market has been shrinking, with major insurers like State Farm and Allstate scaling back due to wildfire risks and rising costs. Lawmakers are responding to pressures as even Southern California suburbs experience nonrenewals. Governor Newsom and Insurance Commissioner Ricardo Lara are involved in the discussions alongside lawmakers. However, consumer advocates caution that substantial rate hikes might not be well-received by the public. While no one wants to pay more for insurance, higher premiums are likely a better alternative to a singular state-run property insurance program.

Homebuilders are also joining the conversation, advocating for increased coverage under the state's last-resort insurer and a fee to address the plan's higher risk. Insurers are seeking the ability to base rates on climate change projections, though some argue this might not prevent their departure, citing similar issues in Florida. The challenge extends beyond California, with gulf states like Florida and Texas and, potentially, Hawaii. It will be interesting to see if the insurance industry requires intervention at the Federal level.

Link to article

H/T to Chris Ferraro, the smartest person I know in the insurance industry, for the article.

Also, a quick update: USAA is now reducing its exposure to California (link here). Here is a quick rumor - as of writing this, I cannot confirm, but I heard from a very reliable source that Nationwide will not be renewing ANY single-family landlord insurance policies in CA.

Single Family Transactional Market: Please read the entirety of this section - the first image is the setup; if you look at it and move on, you will come away with the wrong takeaway.

“There are three kinds of lies: lies, damned lies, and statistics.”

I acknowledge the irony of the statistics quote being followed by a refutation of the first stats, with a counter statistic, but hear me out.

The supply of homes for sale is now down 75% from its peak. We currently have, by far, the lowest number of homes for sale in recent history. Existing home sales are at their lowest since 2010. MORTGAGE APPLICATIONS ARE DOWN 50% FROM THE PANDEMIC BECAUSE THERE ARE NOT ENOUGH HOMES AVAILABLE FOR PEOPLE TO TRY TO APPLY FOR A MORTGAGE.

Over the weekend, we hosted an open house for what is most easily described as a single-family home in East Side Costa Mesa with an ADU. We had over 20 parties come through. Demand is holding up.

Residential Leasing Market: We continue to see strong leasing activity in our management portfolio. Rental rates and velocity remain strong at appropriately priced properties. However, we are seeing a shift in renter perspectives towards higher bedroom count homes and apartments, potentially an indicator of "household deformation," or tenants moving in with more roommates to lower their monthly housing costs.

Mortgage Rates/Market: Rates for 30-year fixed mortgages, 15-year fixed mortgages, and jumbo loans have all declined. However, rates for adjustable rate mortgages (ARMs) have gone up.

After consistently raising its federal funds rate in the ten consecutive meetings held in 2022 and 2023, the Federal Reserve decided to take a break at its June 14 meeting. However, this pause was short-lived, as the Federal Reserve resumed its rate adjustments on July 26 with a quarter-point increase.

The inflation rate, a concern, has now dropped to 3 percent, approaching the Federal Reserve's targeted goal of 2 percent. As a result, housing economists are suggesting that the central bank's aggressive efforts to combat inflation might be drawing to a close.

Mike Fratantoni, the chief economist at the Mortgage Bankers Association, anticipates that once the Federal Open Market Committee (FOMC) clearly communicates that they have reached the peak of the current rate cycle, mortgage rates are likely to trend downward. This expectation is based on the idea that reduced uncertainty about the future direction of interest rates will lead to a narrower difference between mortgage rates and Treasury benchmarks.

Commercial Real Estate (CRE): 1031 exchanges are historically an important component of the commercial and investment real estate world. A 1031 exchange buyer refers to an individual or entity participating in a real estate transaction under Section 1031 of the Internal Revenue Code, which allows for the deferral of capital gains tax by reinvesting proceeds from the sale of one property into a similar property. The party doing the exchange must reinvest the proceeds and replace the outstanding loan balance. This is the hook - most property owners who have outstanding debt on properties have lower interest rates than what they can get on a new loan today.

By way of example, a $1,000,000 loan (30-year amortization) with a 4% interest rate will have a monthly payment of $4,490, whereas an 8% interest rate will generate monthly payments of $7,337. This is a gross oversimplification, but it gets the point across.

The main issue is that most commercial loans have a Debt Service Coverage Ratio (DSCR). The debt service coverage ratio is a financial metric to assess a property's ability to cover debt obligations. It is calculated by dividing its net operating income by its total debt service payments. 1.2x is a common DSCR requirement, so the 4% loan would require $5,388 of Net Operating Income (NOI or income after all operating expenses are paid), whereas the 8% interest rate would require $8,804 of NOI.

Considering cap rates (a percentage used in real estate to indicate the potential return on an investment property, calculated by dividing the property's net operating income by its current market value) are generally below the interest rate in Southern California, we have negative leverage.

Let's wrap up this example and assume a property sells for $2m with a loan of $1m. The buyer must purchase at least $2m worth of real estate. Using the loan assumptions above with a 4% interest rate, the buyer can purchase a property at a 3.2% cap rate, which is pretty manageable, and at an 8% interest rate, a buyer would need to buy at a 5.3% cap rate.

$5,388 (monthly required NOI*12)= $64,656/$2,000,000 = 3.5%

$8,804 (monthly required NOI*12)= $105,652/$2,000,000 = 5.3%

It's likely with the higher interest rate and (in California, think Prop 13) higher property taxes, this new purchase would be a net negative for an exchange buyer. This is the same phenomenon limiting inventory in the single-family home market, but in that scenario, we are considering move-up buyers instead.

What's The Good Word: California plans to offer financial incentives to homeowners for constructing accessory dwelling units (ADUs), also known as backyard housing. The state budget, signed by Governor Gavin Newsom, allocates $50 million for this purpose. This initiative aims to address the housing shortage in California by encouraging more ADU construction. In the past, a similar program with a $100 million budget led to grants of up to $40,000 for homeowners to build additional housing units on their properties. The current program's guidelines are yet to be finalized, and the distribution process is being determined by the California Housing Finance Agency (CalHFA). While ADUs have potential benefits, they have been primarily constructed in wealthier areas due to high construction costs and limited financing options. To promote more widespread ADU development, experts suggest increasing the grant amount to cover costs for homeowners with limited financing options.

Link to Article

Below is an ADU we built in Costa Mesa.

Macro Observations: Last Friday, Jerome Powell's speech at the Economic Policy Symposium in Jackson Hole indicated that the Federal Reserve will "proceed carefully" with future rate increases. The CME's (Chicago Mercantile Exchange) FedWatch tool showed a 57% chance for a rate hike in November vs. 36.1% the week prior.

57% by no means a November rate hike is a forgone conclusion, Atlanta Fed President Bostic said if "not for stubborn (and lagging) housing services prices, the core CPI would be running at 2.6% on a year-over-year basis", which some argue is leading to an over estimate of actual inflation, as these numbers continue to work through the system, we should see CPI continue to trend down.

While we are still debating whether or not the Fed will raise rates again this year, Goldman Sachs is already projecting a 25 basis point reduction in Q22024.

Link to Article

Project Updates: We have several ongoing projects; here is a quick update on one.

Mission St, Costa Mesa: Construction is cruising on the two ADUs that we are adding to an existing 4-plex - Thanks to the foresight and some hustle from our general contractor, we were able to get the project "dried in" before "Hurricane" Hillary gave us any problems.

One the interior, we have nearly completed MEPs (Mechanical, Electrical and Plumbing - on our project there technically isn't any mechanical because we are not doing a central AC). The two photos below show our status on electrical, fire sprinklers and plumbing. Typically, this part of the project feels like it is going pretty slowly to the untrained eye. Once all of the MEPs are complete, we will come take a 3D tour of the property, so we will know the location of all the internal components in the event we have an issue in the future.