Friday, 6 April 2012

U.S. Housing - Excerpt from JPMorgan Annual Letter

The following is a great summary of the current U.S. housing situation from the 2011 JPMorgan shareholders letter.  A must read:

There has been a tremendous focus on the fact that housing prices remain depressed and, in fact, are still going down some. The large “shadow inventory” of homes in delinquency or foreclosure that has not yet hit the sale market adds to the fears that this will continue for a long time. New home construction still is very depressed – so, to most, the future looks bleak. However, if one looks at the leading indicators, all signs are flashing green – the turn is coming if it is not here already. We don’t want to be blindly optimistic, but the facts are the facts:
America has never stopped growing. The United States has added 3 million people a year since the crisis began four years ago. We will add 30 million people in the next 
10 years. 
This population growth normally would create a need for 1.2 million additional housing units each year. Household formation has been half of that for the past four years. Our economists believe that there is huge pent-up demand and that household formation will return to 1.2 million a year 
as job conditions improve.
Job conditions have been improving, albeit slowly. In the last 24 months, 3.45 million jobs have been created. 
On average, only 845,000 new U.S. housing units were built annually over the last four years – and the destruction of homes from demolition, disaster and dilapidation has averaged 250,000 a year. The growth of new households, even at a reduced rate, has been able to absorb all of this new supply, 
and more.
The total inventory of single-family homes and condos for sale currently is 2.7 million units, down from a peak of 4.4 million units in May 2007. It now would take only six months to sell all of the houses for sale at existing sales rates, down from 12 months two years ago. (This low of an inventory number normally would be considered a positive sign for future housing prices.)
While the shadow inventory mentioned above still is significant, it has shown a visible declining trend since peaking at the end of 2009, when the number of loans delinquent 90+ days or in foreclosure was 5.1 million homes. It now totals 3.9 million, and we estimate it could be 3 million in 12 months. The shadow inventory also may move more quickly as mortgage servicers get better at packaged sales and short sales and as real money investors start to buy foreclosed homes and rent them out for a good profit. Home prices still are going down a little bit, and they will stay depressed for a while. Distressed sales (short sales, foreclosure sales, real estate-owned sales) still are 25% of all sales, and these sales typically are priced 30% lower than non-distressed sales. As the percentage of distressed sales comes down over the next 12-24 months, their negative effect on housing prices will start to diminish.
Housing is at an all-time high level of affordability due to both low home prices and low mortgage rates. 
It now is cheaper to buy than to rent inhalf of the markets in America – this has not been true for more than 15 years. Relatively high rental prices can be a precursor to increasing home prices. 
At the same time, American consumers are finding more solid financial footing relative to their debt. The household debt service ratio, which is the ratio of mortgage plus consumer debt payments to disposable personal income, stands at its lowest level since 1994. This is a result of rapid consumer deleveraging – household mortgage debt now is down $1 trillion from its 2008 peak. (Reported U.S. mortgage data do not remove mortgage debt from an individual’s debt obligations until there is an actual foreclosure. It is estimated that $600 billion of the $9 trillion in currently outstanding mortgage debt is not paying interest today and effectively could be removed now from these numbers.) 
Recent senior loan officer surveys by theFederal Reserve show that, while there are not yet clear signs of credit loosening for new mortgages, at least the rush to tighten 
mortgage lending standards has abated.

Over the last two years, $2 trillion of mortgages have been refinanced, substantially aiding homeowner burdens. We expect another $2 trillion to refinance over the next two years, with approximately 10% coming from recently announced government programs, and, at that point, we estimate that only 15%-20% of Americans will be paying interest rates over 6%.

More jobs, more households, more Americans, good value – it’s just a matter of time.

HHC and BRP: Two U.S. Housing Ideas for the Backburner...

I would like to introduce two new investment ideas that have increased significantly in price since I bought them, but that I would increase my position in if their valuations were to fall back in the short term.  Rather than write a full out thesis on each (which I do not have time to do), I will release tidbits across time.  I firmly believe both are worth significantly more than their current trading prices. However, due to the recent run up in each stock and the markets in general, I would hold on to cash for the time being and wait for a better entry point - perhaps in the summer months when housing related stocks tend to lag.

The two ideas I am proposing to put on your radar are The Howard Hughes Corporation (NYSE: HHC) and Brookfield Residential (NYSE: BRP).  The following investment characteristics make both compelling investments:

  • strong alignment of management interests through insider buying and ownership
  • hidden value in the form of either overlooked real estate assets or acreage recorded in book value under valuations recorded up to a few decades ago
  • inevitable upside leverage to a housing recovery in the U.S.

As time goes on, I will pick certain aspects of each stock to explore, which perhaps may be expedited in the event that prices sharply fall for whatever reason and thus create an opportunistic entry point.  In this post, I will pick one theme that is common between the two: strong alignment in the form of insider ownership.

The Importance of Management Alignment

One thing I usually require in an investment is that management own a meaningful percentage of the company.  Though not a guarantee of success, I believe it reduces the likelihood that the CEO makes decisions that are adverse to shareholders but yet can benefit himself.  A common example of such a decision would be a CEO's decision to acquire another company with weak strategic fit that also carries a high price tag, thus decreasing per share intrinsic value.  How could low ownership by management result in bad decision making?  Can't hired managers with little or no ownership in the company still do a stellar job?  The answer is absolutely.  To make it clear, low ownership by controlling management does not translate into poor performance. However, it so happens that there tends to be a strong correlation between public company size and management compensation, and so often times CEO's are incentivized to grow the company for the sake of growth rather than make decisions based on building long term, sustainable per share value. This is especially so if the CEO was hired from outside the company, given a wack load of free five-year options, and not required to invest in the company from his own pocket.  In contrast, a CEO or founder whose net worth is fully vested in the company shares in the downside with you as well as the upside.  

A Look at Alignment in The Howard Hughes Corporation

The Howard Hughes Corporation was spun out of General Growth Properties in late 2010 as a development company.  Contained in it are 34 assets in the U.S., including three master planned communities, the South Street Seaport shopping area in lower Manhattan, and the Ward Centers in Hawaii.

The alignment technique in HHC is shared by JC Penney, thanks to a strategic hedge fund investor named Bill Ackman (of Pershing Square) who is a cornerstone investor in both companies.   In both HHC and JCP, the incoming CEOs committed substantial personal investments in the form of seven year warrants that will expire out of the money if the share price is not above a certain point by the sixth year of their investment.   The CEOs of Howard Hughes and JC Penney are thus hyper aligned.  That is, unlike you or me whose investment will be tied to whatever the share price is in six years, if HHC's share price is not at least $53 between 2016-2017, CEO David Weinreb stands to lose his entire $15 million investment.  On the contrary, his upside will be leveraged if he can in fact redevelop the properties as planned.

Another positive sign in HHC is the record of insider buying.  Numerous directors have made significant purchases since the stock began trading in November 2010, which is a vote of confidence especially given the real estate expertise and caliber of the company's directors (their profiles can be read on

A Look at Alignment in Brookfield Residential Properties

In the case of Brookfield Residential, the parent company (Brookfield Asset Management) opportunistically increased its ownership stake by buying shares in the open market last summer when the price was under $7 (now >$10).  Why would the parent company want to increase its stake when it already owned 72.5% of BRP at the time?   I think we all know the answer.  Brookfield Asset Management's investment track record is legendary, and when it buys shares in anything that trades in the open market - especially its own subsidiaries -  it is certainly worth paying attention to.

In the latest annual report, it was disclosed that a "certain executive" purchased two million shares within the last year through an escrowed share purchase program via the parent company.  I believe this is why the insider purchase was not reported through the typical channels (e.g. INK Research, SEDAR).  I do not know which executive purchased the shares, though I suspect it was Allan Norris, the current chief executive.

It must be remembered that strong alignment is no guarantee of investment success; however your  downside is more protected from management stupidity with characteristics such as those mentioned above.