California Proposes to Eliminate 1031 Exchange Tax Benefits

In the midst of the worst real estate market in decades, bureaucrats in California have decided to make life in the Golden State even harder for real estate investors and professionals.

The California Legislative Analyst’s Office (CLAO) has recommended that property located outside California no longer receive the deferral of capital gains taxes offered by Section 1031.

California currently follows federal law regarding 1031 exchanges, permiting investors to exchange business or investment property for property of a like kind without paying state capital gains that might have accrued on the first property.

Under the new proposal, California would eliminate the tax exclusion for capital gains on like–kind exchanges involving out–of–state commercial property.

The reason CLAO gives for their proposal is that once the in-state asset is swapped for an out-of-state asset, the state losses all the gain since the owners will not report it.

The CLAO estimates that the state could gain revenue of approximately $25 million in 2008-2009 and $50 million in 2009-2010.

So, drowning under mountains of debt and overspending, California decides to go after its faltering real estate industry to help make up the shortfall.

CLAO’s argument in favor of eliminating deferral of state capital gains taxes for 1031 exchanges is specious at best. 

The Tenant-in-Common Association (TICA) has opposed the CLAO proposal.

We look forward to TICA mustering the facts and figures to blow it out of the water. 

If you would like more information or have questions or comments, you should contact Greg Ellis of TICA at gellis@ticassoc.org or 317.663.4176.

So far, no legislator has gone on the record in favor of the CLAO proposal.  We think it should stay that way.

Now is not the time to place greater burdens on the California real estate market.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

 

1031 Exchange Q and A: Unbuilt Property, Incidental Property, and IRS Deadlines

Bill owns a car wash in Chicago, Illinois. He wants to use Section 1031 to exchange his car wash for a tenancy-in-common interest in a shopping mall in Tuscan, Arizona, that will be built next year.

Can he exchange the real property involved in his car wash for real property that is not yet built?

What about the equipment and machinery used in the car wash?

Allso, Bill knows that under Section 1031, he has 180 days from the transfer of his car wash to identify replacement property and complete the exchange. He expects to transfer the car wash in late November, so he figures he has until late April to complete the exchange.

What would you advise Bill?

Bill can exchange his property for replacement property that is not yet built, so long as the replacement property is completed prior to the expiration of the 180 days.

The equipment and machinery used in the car wash (referred to as “incidental property” in Section 1031 exchanges) can be part of the exchange, so long as it meets the requirement that it is typically transferred with the real property of a car wash in standard commercial transactions and the total market value of the incidental property does not exceed 15% of the market value of the real property involved in the exchange.

Bill needs to be very careful if he transfers his relinquished property anytime after October 18.

Remember that the actual deadline for completing an exchange is the earlier of either 180 days from the date you transfer the relinquished property – or the date, including extensions, that your tax return is due for the year in which you transfer the relinquished property. Exchangers must report their exchanges on the tax return for the year in which the exchange begins.

Thus, if you relinquish property after October 18, you actually have less than 180 days to complete the exchange, unless you file for an extension.

If Bill transfers his car wash in late November, he should expect to file for an extension on his tax returns, unless he is absolutely certain that he can complete the exchange before April 15.

For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

Lawsuit Claims $80 Million Stolen in 1031 Exchange Scheme

More 1031 exchange accommodators are in very hot water.

And millions of dollars that people thought were going to be used for 1031 exchanges are missing.

Last week, Edward Okun and others were indicted in a 1031 exchange intermediary scheme that is alleged to have defauded clients of approximately $132 million.

A class action lawsuit has been filed in the California Superior Court of Santa Barbara County alleging that 130 people from 12 states lost over $80 million that they had placed with Southwest Exchange, Inc. (SWX) and several other 1031 exchange accommodators or qualified intermediaries (QIs).

The QIs are alleged to have been taken over by Donald Kay McGhan and other individuals with the purpose of stealing the money that had been entrusted to them to facilitate tax deferred 1031 exchanges.

The lawsuit claims that a “group of thieves discovered that these Exchange Accommodators were unregulated businesses holding large sums of cash that needed ready access to only a small percentage of the money to operate as going concerns. Pursuant to a conspiracy, these thieves purchased several Exchange Accommodators, gained access to their funds held in trust with the assistance of certain brokerage houses, stole the majority of those funds for personal gain, and caused over $80,000,000 in damages which was exposed when the real estate market finally cooled.”

According to the lawsuit, money held in trust by SWX was funneled to shell companies that Santa Barbara businessman Donald Kay McGhan set up to launder the funds, which were then withdrawn for his and his accomplices’ benefit.

The plaintiffs claim that the exchange accomodators were operated as a ponzi scheme by Donald Kay McGhan and his alleged accomplices.

Because the real estate market was hot in 2004 and 2005, money coming in for new 1031 exchanges could be used to cover funds deposited for previous exchanges that McGhan and his cohorts had already raided.

When the real estate market suddenly cooled at the end of 2005, the number of 1031 transactions declined and not enough money was coming in to cover the embezzled funds, according to the suit.

By April 2006, the scheme began to unravel as SWX faced liquidity problems, the lawsuit states, and by October 2006, approximately $80 million was missing from the trust funds.

The QI defendants in the lawsuit include Southwest Exchange, Inc. (SWX), doing business as Southwest Exchange Corporation and Southwest 1031 Exchange, and Qualified Exchange Services, Inc. (QES).

Individual defendants include Donald Kay McGhan, Jim J. McGhan, Dean A. Koch, Nikki M. Pomeroy, Albert Conton, Peter John Demarigny, Kyleen M. Dawson, and Megan L. Amsler.

Donald Kay McGhan, 73, was the founder, chairman, and president of the McGhan Medical Corporation, maker of silicone breast implants and for many years one of the Santa Barbara’s top employers. McGhan left the company, now called Inamed Aesthetics, in 1998, and the company later settled a fraud suit filed by the Securities and Exchange Commission alleging that McGhan had filed false financial statements that misled investors.  McGhan himself paid a $50,000 fine to the SEC.

Additional corporate defendants include Capital Reef Management Corp., Cennedig LLC, Medicor LTD, International Integrated Industries LLC, Ventana Coast LLC, and Sirius Capital LLC.

The plaintiffs also claim that major financial firms Citigroup, Salomon Smith Barney, and UBS Financial Services participated in the scheme.

There is also an ongoing criminal investigation.

You can see the complaint here.

Our advice:

If you’re planning to do a 1031 exchange, make sure that you perform due diligence in your choice of a QI or exchange accomodator, make sure that the QI is bonded, and make sure that you work with an experienced tax advisor and attorney who can help you navigate the 1031 exchange process. 

And, as we’ve said before, it is imperative that the Federation of Exchange Accomodators (FEA) work more closely with state and federal authorities to establish regulations for QIs that will restore and maintain public confidence.

UPDATE:

A $23 million settlement has been reached with UBS Financial Services, one of the defendants in the plaintiffs’ class action lawsuit.  You can read our post about the settlement here.

California Real Estate Continues Free Fall in Sales and Prices. Realtors Blame Credit Market. KB Home Hit Hard.

California real estate continues to free fall. 

In the latest seismic shock to hit California’s real estate market, the California Association of Realtors (CAR) reported that home sales in the Golden State decreased 28.5 percent in February compared with the same period a year ago, while the median price of an existing home fell 26.2  percent. 

Median home prices fell 27.2 percent from last year’s levels in the Inland Empire east of Los Angeles, 30.9 percent in Sacramento, and 39.1 percent in Santa Barbara County.

The California home price meltdown is more than three times as severe as the national decline of 8.2 percent in median prices reported this week by the National Association of Realtors.  Nationally, prices fell over the past year at a rate of $338 per week, while in California, prices fell at a rate of $2,788 per week.

According to the CAR, “The median sales price of an existing, single-family detached home in California during February 2008 was $409,240, a 26.2 percent decrease from the revised $554,280 median for February 2007.”

The February 2008 median price fell 4.8  percent compared with January’s revised $429,790 median price.

CAR attributed the continuing servere declines to the tight credit market.

“Although sales rose for the fourth straight month in February by 9.5 percent compared to the previous month, they continue to be dragged down by the ongoing effects of both the credit/liquidity crunch and tighter underwriting standards that have reduced the pool of qualified buyers who can obtain a loan,” CAR President William E. Brown said. 

CAR also called for legislative action to increase FHA loan limits, reduce FHA downpayment requirements, and include condominiums.

According to Brown, “It is crucial that FHA reform legislation currently under consideration by congress include higher loan limits for high-cost states like California,” he said. “The proposed legislation also includes a reduction in the down payment requirement for FHA loans and will include condominiums in the FHA single-family program, which will make it easier for buyers in the condominium market to qualify for loans.”

CAR’s Vice President and Chief Economist Leslie Appleton-Young said that the Fed’s recent action to reduce the federal funds rate “will have little near-term direct effect on the housing market.”

Adding to California’s real estate woes, Los Angeles-based KB Home, one of the nation’s biggest residential homebuilders and a major player in the California real estate industry, announced today that it posted a loss of more than $268 million in its first quarter as weak home sales amid a worsening housing market forced the company to take a large write-down related to falling home prices.

Its shares fell almost 4 percent in midday trading.

The average selling price of KB’s homes dropped 7 percent to $248,200 during the quarter, with homes in the West Coast posting the sharpest drop, falling to $392,600 from $470,400 a year earlier. 

”Until prices stabilize and consumer confidence returns, we believe inventory levels will remain significantly out of balance with demand,” Jeffrey Mezger, KB Home’s president and CEO said. ”We do not anticipate meaningful improvement in these conditions in the near term, as it is likely to take some time for the market to absorb the current excess housing supply and for consumer confidence to improve.”

New Regulation of Credit Industry is Now Inevitable. The Only Question is How Much Regulation, and with How Much Bite?

There can no longer be any question whether there will be new regulation of the credit industry in the wake of the housing meltdown and the mortgage crisis.

The only question now is the extent of the regulation and how much teeth it will have.

Treasury Secretary Henry Paulson eliminated any doubt regarding new regulation when he conceded that the Federal Reserve should bolster its supervision of investment banks while they are taking cheap money from the Fed’s new emergency program.

Paulson said that the Bush administration will soon put forth a blueprint for federal oversight in an effort to promote smoother functioning of financial markets.

”This latest episode has highlighted that the world has changed as has the role of other nonbank financial institutions and the interconnectedness among all financial institutions,” Paulson said.  ”These changes require us all to think more broadly about the regulatory and supervisory framework that is consistent with the promotion and maintenance of financial stability.” 

Greater oversight is necessary, according to Paulson, to “enable the Federal Reserve to protect its balance sheet, and ultimately protect U.S. taxpayers.”

Wall Street’s major investment banking firms, including Goldman Sachs, Lehman Brothers and Morgan Stanley, averaged $32.9 billion in daily borrowing over the past week from the new Fed program, compared with $13.4 billion the previous week. On Wednesday alone, their borrowing from the Fed reached $37 billion.

To add to the growing conservative consensus that greater federal regulation of the credit market is necessary, Wall Street Journal columnist Jon Hilsenrath wrote on the front page of the newspaper’s Money and Investing section that “if the government is going to intervene aggressively when bubbles burst, as it’s doing now, then maybe policy makers should do some new thinking about how to prevent bubbles in the first place.”

Democrats, both in Congress and on the presidential campaign trail, have called for more extensive and permanent regulation of both the credit market and the mortgage industry than that proposed by the Bush administration.

The final outcome will depend on who wins in November and what happens in the economy between now and the next Inauguration Day. 

But it is now clear that one consequence of the Bear Stearns bailout and the Fed’s cheap money policy for the major investment banks is to have made some form of new regulation of the credit market and the mortgage industry inevitable.

In the meantime, we’re still waiting for the enormous sums of cheap money that the Fed has pumped into the credit industry to make its way down the pipeline to the rest of us in the economy. 

What Property Qualifies for a 1031 Exchange? (Part Two)

To qualify for the tax benefits of an exchange under Section 1031, the property you want to exchange (or relinquish) needs to be “held for productive use in a trade or business or for investment.”

For income tax purposes, real estate is divided into four classifications: (1) property held for business use, (2) property held for investment, (3) property held for personal use, and (4) property held primarily for sale (“dealer property”).

Only property that is held for business and property held for investment qualify for an exchange under Section 1031.

Property held for personal use and property held primarily for sale do not qualify.

Section 1031 does not define either “held for productive use in a trade or business” or “held for investment,” but over time, court cases and IRS rulings have clarified what these terms mean in most instances.

Examples of property that is “held for productive use in a trade or business” and clearly qualify for a Section 1031 exchange include all buildings owned and used by a business, such as factories and office buildings, as well as rental apartment buildings.

Examples of property that do not qualify for a Section 1031 exchange are stocks, bonds, or notes, certificates of trust or beneficial interest, choses in action (a right to recover money or other personal property in a judicial proceeding), or other securities or evidences of indebtedness (with the exception of a 30-year or longer lease).

It does not matter if any of the excluded property items are related to real estate; they are always excluded from Section 1031 exchange.

For example, a note can never qualify for a Section 1031 exchange, even if the note is secured by real property.

Also disqualified from exchange under Section 1031 is inventory, stock in trade, or any other property that is held primarily for sale rather than business use or investment (known as “dealer’s property”).

Property is considered inventory, and therefore not qualified for a Section 1031 exchange, when it is held for sale to customers in the ordinary course of business. For example, if you own a business that sells airplanes, you cannot use one of those airplanes as qualified property for a Section 1031 exchange.

The dealer property exclusion rule also means that real property held for sale by dealers in real estate does not qualify for Section 1031 exchanges.

In determining who is a dealer in real estate, the IRS looks at the facts and circumstances of each case and makes its determination on a property-by-property basis.

While there are no hard and fast rules in this area, in general, the questions the IRS asks are: what is the nature of the taxpayer’s business; for what reason and purpose was the property acquired and/or transferred; for what length of time was the property held; what are the number and frequency of sales; what kinds of construction improvements and subdivision activity was undertaken on the property; did the property have income-producing potential; and what is the percentage of real estate sales as compared to the taxpayer’s other income.

It is important to note that you do not have to be in the business of buying and selling real estate to be treated as a dealer by the IRS. If you are required by the buyer of the relinquished property to undertake subdivision activities or other work in preparation for the buyer’s development of the property, you may be considered to be in a joint real estate venture with the buyer, and the IRS could disqualify the exchange as involving dealer property.

Similarly, an exchange under Section 1031 is not available for real estate “flippers.” “Flipping” property refers to the practice of buying real estate and then quickly reselling it (with or without making improvements) at a higher price.

Property that is “flipped” is not eligible for the tax benefits of Section 1031 for the same reason as the exclusion of dealer’s property. As noted, dealers in real estate may not use Section 1031 because they hold real estate for resale (that is, as stock-in-trade or inventory), and a quick resale (or attempted exchange) of recently acquired real estate signals to the IRS that the property is being used for inventory, not for productive use in a trade or business or for investment.

The bottom line is that you must remain aware of the requirement that both the relinquished and the replacement properties be held for use in a trade or business or for investment rather than resale. If the IRS concludes that either the relinquished property or the replacement property is held by the taxpayer for the purpose of resale rather than use in a trade or business or for investment, then the property will be disqualified from the Section 1031 exchange process
and capital gains taxes must be paid.

In deciding whether a particular property has been held for productive use in a trade or business or for investment, the IRS looks at how you have characterized that property on your tax returns. If you have historically taken depreciation on or reported rental income on a property, there should not be any problem with that property qualifying for a Section 1031 exchange.

Property that does not now qualify for a 1031 exchange can be recharacterized for tax purposes by using it for a trade or business or for investment.

Although there is no absolute rule regarding exactly how long the property must be held for use in a trade or business or for investment before it is recharacterized and can be exchanged – and the IRS insists that it will examine each exchange on a case-by-case basis – most professionals recommend planning for a holding period of two years.

In any event, the best way to ensure that this requirement is met is to consult with both your attorney and your tax advisor regarding the potential for any holding period problems in your agreement with the buyer for your relinquished property, as well as your future plans for your replacement property.

For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

For Part One of this article, click here.

For Part Three of this article, click here.

U.S. Court Rips Subprime Lender as “Ticking Time Bomb” — Faults New Century Executives and Big Four Auditor

The Final Report in the federal bankruptcy proceedings involving subprime mortgage lender New Century Financial Corp. was made public today by the United States Bankruptcy Court for the District of Delaware.

You can read the Final Report here.

Following an investigation that began in June 2007, the 550-page report reviews the accounting and financial reporting practices, loan origination operations, audit committee and internal audit department, and system of internal controls of New Century, once the second-largest originator of subprime home loans in the U.S.

According to the report, the now bankrupt mortgage lender used improper accounting practices while making risky loans, creating “a ticking time bomb” that led to the company’s collapse.

The New York Times has called the report “the most comprehensive and damning document that has been released about the failings of a mortgage business.”

The report states:

“New Century had a brazen obsession with increasing loan originations, without due regard to the risks associated with that business strategy.”

“The increasingly risky nature of New Century’s loan originations created a ticking time bomb that detonated in 2007.”

“Senior management turned a blind eye to the increasing risks of New Century’s loan originations and did not take appropriate steps to manage those risks.”

In one example cited in the report, New Century understated by more than 1000 percent the amount of money it needed to have on reserve to buy back bad loans. As a result, it reported a profit of $63.5 million in the third quarter of 2006, when it should have reported a loss.

New Century also failed to include the interest that it was obligated to pay to investors whenever it was forced to buy back bad loans.

In addition, the report concluded that New Century’s accounting firm, KPMG LLC, one of the Big Four accounting firms, actively enabled New Century’s improper accounting practices. 

Court-appointed examiner Michael J. Missal observed that “As an independent auditor [KPMG is] supposed to look very skeptically at any client, and here they became advocates for the client and in fact even suggested some improper accounting treatment that ultimately started New Century down the road it’s taken.”

The improper accounting also led to higher bonuses for New Century executives.

New Century once billed itself as “A New Shade of the Blue Chip.”

Creditors of New Century now say they are owed $35 billion.

The former subprime lending giant’s stock peaked at nearly $65.95 in late 2004 — on Wednesday it was trading at a penny.

You can read New Century’s Chapter 11 Bankruptcy filings here.

New Century is being sued by hundreds of investors and remains the target of a federal criminal investigation.

Mortgage Scam Website Still Online

We blogged yesterday about the federal indictment in “Operation Homewrecker” of Charles Head and 18 others for what the FBI alleges to be a major mortgage scam that defrauded homeowners of their houses, their equity and their credit.

Today we saw that a website of Charles Head’s company is still online.

The website of Head Financial Services (“The Smart Way to Shop for a Lender”) is hosted by the website for Huntington Beach News.

The website promises that you can “Get 3 competing mortgage bids with one easy form” and that “Lenders are standing by now to serve you.” 

 

A representative of the Huntington Beach News told us that the page was a paid advertisement.

He also said that he didn’t know who had paid for the page, but that he needed to take the page down.

The only link on the page is to Charles Head’s email at charleschead@aol.com.

UPDATE:

The Web page we originally linked to has been taken down.  You can see another Head Financial Web page that is still online here.

We’ve also found a reverse mortgage website that lists Operation Home Wrecker scammer Keith Brotemarkle as one of its brokers.  You can read our post here.

“Operation Homewrecker” Nets 19 Indictments for Mortgage Fraud Scheme — With More Charges Soon. Mortgage Brokers Alleged to be Involved.

Federal prosecutors in Sacramento, California, announced today the indictment of 19 people for mortgage fraud-related offenses under what it called “Operation Homewrecker.”

The indictment alleges that the leader of this nationwide scam is Charles Head, 33, of Los Angeles, California, who targeted homeowners in dire financial straits, fraudulently obtaining title to over 100 homes and stole millions of dollars through fraudulently obtained loans and mortgages.

The charges are divided into two separate indictments.

“Head One” involved a “foreclosure rescue” scam, netting approximately $6.7 million in fraudulently obtained funds taken from 47 homeowners, nearly all located in California. The allegations in Head One are that from January 1, 2004 to March 14, 2006, the defendants contacted desperate homeowners, offering two “options” allowing them to avoid foreclosure and obtain thousands of dollars up-front to help pay mounting bills.

If the homeowner could not qualify for the “ first option,” which virtually none could, they would be offered the “second option.” An “investor” would be added to the title of the home, to whom the homeowner would make a “rental” payment of an amount allegedly less than their mortgage payment, thereby allowing the homeowner to repair their credit by having the mortgage payments made in a timely fashion.

All of this was a scam.

The defendants recruited straw buyers as the “investors” who would then replace the homeowners on the titles of the properties without the homeowners’ knowledge. Once the straw buyer had title to the home, the defendants immediately applied for a mortgage to extract the maximum available equity from the home. The defendants would then share the proceeds of the ill-gotten equity and “rent” being paid by the victim homeowner.

When the defendants ultimately would sell the home, stop making the mortgage payment, and/or pursue an eviction proceeding, the victim homeowner was left without their home, equity, or credit.

The following defendants were charged in the February 28, 2008 “Head One” indictment: Charles Head, 33, of La Habra, California; Jeremy Michael Head, 30, of Huntington Beach, California; Elham Assadi, aka Elham Assadi Jouzani, aka Ely Assadi, 30, of Irvine, California; Leonard Bernot, 51, of Laguna Hills, California; Akemi Bottari, 28, of Los Angeles; Joshua Coffman, 29, of North Hollywood; John Corcoran, aka Jack Corcoran, 52, of Anaheim; Sarah Mattson, 27, of Phoenix, Arizona; Domonic McCarns, 33, of Brea, California; Anh Nguyen, 36, of Los Angeles; Omar Sandoval, 32, of Rancho Cucamonga, California; Xochitl Sandoval, 29, of Rancho Cucamonga; Eduardo Vanegas, 28, of Phoenix; Andrew Vu, 39, of Santa Ana; Justin Wiley, 28, of Irvine; and Kou Yang, 32, of Corona, California.

“Head Two” involved an alleged “equity stripping” scheme, netting approximately $5.9 million in stolen equity from 68 homeowners in states across the nation.

While still targeting distressed homeowners and defrauding mortgage lenders through the use of straw buyers, in this version of the scheme, Charles Head would receive approximately 97 percent of the stolen equity, while his “sales agents” and employees, and the other defendants, would receive either the remaining 3 percent of equity or a salary from the fraudulently-obtained funding.

Instead of recruiting straw buyers, as in Head One, in Head Two the defendants allegedly recruited strangers via the Internet. They also used referrals from mortgage brokers to identify and solicit new victim homeowners. Beyond advertising on the Internet, the defendants also would send “blast faxes” to mortgage brokers throughout the country and generate mass emails to potential victims.

Through misrepresentations and omissions, victim homeowners would be offered what appeared to be their last best chance to save their homes. As in Head One, these victims also were left without their homes, equity, or credit.

Those charged in the Head Two indictment include Charles Head, John Corcoran, Kou Yang, each also charged in Head One, as well as Keith Brotemarkle, 42, of Johnstown, Pennsylvania; Benjamin Budoff, 41, of Colorado Springs, Colorado; Domonic McCarns, 33, of Brea, California; and Lisa Vang, 24, of Westminster, California.

The FBI has seized lavish sports cars, a fleet of high-end Italian motorcycles, thousands of documents and a condominium in Miami.

It remains to be seen how far this scam reached, or how many people and institutions were criminally involved.

Prosecutors made it clear that more charges would be filed. FBI Special Agent Drew Parenti said his agency is now “focusing on the industry professionals, the ‘insiders’ who have manipulated the mortgage loan process for their own financial gain.”

Particularly ominous is the statement by federal prosecutors that the defendants “used referrals from mortgage brokers to identify and solicit new victim homeowners”

Whatever the reach of this investigation, we know it is barely the tip of the iceberg of mortgage-related fraud.

We note too that the defendants’ scheme is alleged to have begun in January 2004 – well before the mortgage crisis grabbed national attention – and that the indictment only covers conduct up until March 2006 – well before the mortgage crisis drove many tens of thousands more people into the kind of desperation that the defendants manipulated.

This is only the beginning.

We’re going to see a lot more mortgage fraud indictments.

And as conditions worsen for more and more people who can not pay their mortgages, we’re going to see even more new mortgage fraud schemes.

UPDATE

We’ve discovered the website of Charles Head’s “Head Financial Services.”  To see the website and read the story, click here.

We’ve also found a reverse mortgage website that lists Operation Home Wrecker scammer Keith Brotemarkle as one of its brokers.  You can read our post here.

Mixed Signs in the Tea Leaves: Residential Sales Up, Median Prices Down, Lower Home Supply, and Commercial Real Estate Stronger than Feared

Every day we read the tea leaves (in the form of news and the financial reports) looking for indications of where the real estate market is heading.

Our conclusion for today: mixed signals.

We are sceptical about the report today from the National Association of Realtors (NAR) of a 2.9 percent rise in exisiting home sales in Febuary 2008 over last month.

NAR’s chief economist Lawrence Yun sees the data as “encouraging” and a sign that the housing market is “stabilizing.”

Yun said: “We’re not expecting a notable gain in existing-home sales until the second half of this year, but the improvement is another sign that the market is stabilizing. Buyers taking advantage of higher loan limits for both FHA and conventional mortgages will unleash some pent-up demand. As inventories are drawn down, prices in many markets should go positive later this year.”

We’d like to believe it, but we note that NAR and its affiliates have a terrible track record in forecasting the real estate market and have often been forced to revise their figures to be less optimistic than originally stated.

For example, the California Association of Realtors now projects that 332,100 homes will sell this year, revised downward by over 2,000 sales from it’s prediction in October and that the median price of a single-family house in the state will drop 9% this year, as opposed to a 6% drop they expected in October.

We note, too, that the 2.9 percent growth in existing home sales claimed by NAR pales in comparison to the 23.8 percent drop since February 2007.

In addition, even accepting NAR’s report as indicating a positive blip on the radar, median home price figures remain gloomy overall, even according to NAR. NAR’s report today acknowledged that “The national median existing-home price for all housing types was $195,900 in February, down 8.2 percent from a year earlier when the median was $213,500.” And in California, the median single-family house price is expected to drop to $505,100 this year, compared to a 2007 median house price of $558,100.

Orange County Register columnist Jon Lansner quoted a report finding that home supply in Orange County was at an 11 month low.  According to the report, at the current pace of home buying it would take 7.5 months for buyers to take all of the current listings off the market.  It was at 6.09 months a year ago.

A more reliable report of good news comes from CBRE Torto Wheaton Research (TWR) regarding commercial real estate, stating that future commercial mortgage defaults and losses could be overestimated threefold.

According to the TWR report, “While prices have been slow to change in the commercial real estate equity market, the commercial real estate debt markets have been driven by increasing spreads, and decreased availability of mortgage capital.” In recent weeks, prices of the CMBX — a set of derivatives that provide insurance against default — and prices in the commercial mortgage-backed securities (CMBS) market are “out of line with what any likely future income stream of the underlying mortgages would suggest.”

The National Real Estate Investor observes that the TWR report shows that “Despite an expected incremental rise in vacancies across all major property types over the next few years, vacancies are still expected to remain lower than 2002/2003 peak levels, and the 2008/2009 period is projected to see rents to continue moving upward into positive territory. Currently, according to the report, CMBS and CMBX markets have priced in losses tied to doomsday estimates, more in line with 1992, at which point commercial banks lost 160 basis points.”

“One of the big differentiators between today’s ailing economy and that of 1992, is that there is currently an equilibrium with supply and demand in commercial real estate, which should weather the storm even as the economy is running out of steam. And, one of the biggest feared financial stressors — the collapse of a major investment bank — might still not bump the economy too far off its tracks.”

“As all eyes are trained on the JP Morgan buyout of Bear Stearns, which includes some $16 billion in CMBS, that is not likely to be the event that finally sets the price of CMBS. Dumping the bonds onto the market would likely make little sense given the Fed’s pledge to take in hand $30 billion of the ailing investment bank’s most illiquid assets, including both residential and mortgage-backed securities.”

We have some confidence in the TWR report and believe that overall the financial indicators for commercial real estate are much stronger than that for residential real estate.

One caveat is that if, as TWR asserts, the danger in the commercial real estate is mostly psychology of panic, another collapse of a major financial institution may make mass hysteria inevitable. Should another major credit institution do a Bear Stearns, the reprecussions could overwhelm the commercial real estate market as well as the residential market.

Regarding the drop in home supply reported by Jon Lansner, we take it with a grain of salt.  The numbers are small, and the report was confined to a small and perhaps non-representative area of the country.  We also don’t believe that over-supply of homes is a major culprit in the residential real estate crisis, and therefore don’t think that a slight decrease in the current supply will have much effect on prices.

We are not convinced by the NAR report that the residential real estate market is close to stabilizing. We think that NAR’s anouncement of stabilization in the residential real estate market is, at very best, premature, and more of the wishful projecting that has destroyed NAR’s credibility.  

The best that can be hoped for right now in the residential real estate market is volatility.

We hope too that NAR’s new chief economist, Lawrence Yun, who has worked at NAR as an analyst and forecaster since 2000, can somehow recover for NAR the credibility it lost when his predecessor and former boss David Lereah predicted an endless residential real estate boom and refused to face the facts even long after the bubble burst.

We will continue to read the tea leaves…

UPDATE:

For an update on commercial real estate, click here.