Analyzing Local Markets

Best Practices for Driving Higher Quality Lending, Portfolio Management, and Investment Decisions

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Overview
Contents
Introduction Best Practice #1 Best Practice #2 Best Practice #3 Best Practice #4 Best Practice #5 Conclusion Page 2 Page 3 Page 5 Page 6 Page 9 Page 10 Page 11

The local market factors impacting real estate lending, servicing, and investment decisions are growing in number and complexity. And given increased regulatory requirements and internal scrutiny, the need to incorporate a comprehensive view on how market conditions impact a property, its value, and the borrower is more important than ever. Unfortunately, given increased complexity, its also more difficult than ever to gain the necessary comprehensive view of market drivers. This guide addresses the key questions you must ask to understand the most important market drivers. More importantly, it details answers to these questions that leverage new, innovative tools to deliver the intelligence you need to make the right decisions.

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Are property values recovering in the market?

Thats a deceptively simple question. On the surface, you can look at a county and make the type of assessment illustrated in Figure 1 with Maricopa County, AZ. Property values have accelerated over the past year and would seem to be poised for more growth. So, is the answer to this first question Yes. Figure 1 Home Price Index: Maricopa County, AZ
230 210 190

HPI

170 150 130 110 90 Nov 02 Nov 03 Nov 04 Nov 05 Nov 06 Nov 08 Nov 09 Nov 10 Nov 07 Nov 11

Source: Case-Shiller HPI

Unfortunately, its not that easy. When you dig deeper using a more granular HPI, and look at more localized price trends in Maricopa County (Figure 2) you can answer the question Yes, but you can also answer No and Maybe.  Zip codes, like 85301 and 85029, where property values are still appreciating, appear to still be in a recovery mode. Property values here may still be underpriced.  In zip codes, like 85007, where property values are decreasing, the recovery either hasnt started, is stalled, or perhaps even over.  Zip codes, like 85837 and 85008, where property value trends are uneven would be put in the maybe bucket. Figure 2 Home Price Index: Select Zip Codes
210 190 170 150 130 110 90 70 50 Feb 10 Feb 12 Feb 02 Feb 03 Feb 04 Feb 05 Feb 06 Feb 07 Feb 08 Feb 09 Feb 11

85007 85008 85017 85029 85248 85301 85375 85387

HPI

Source: DataQuick Neighborhood Level HPI

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Figure 3 puts all of this into perspective.  The wide distribution of zip-level price appreciation changes illustrates that Phoenixlike all major geographies is comprised of multiple local markets. Any market analysis must consider valuation trends (and any trend for that matter) at the local level to be meaningful.  The spikes in the graph also suggest that while there are many local markets, you can cluster multiple zip codes into the same growth segments. Segmenting geographies like this allows greater flexibility when youre trying to establish a propertys value via comparisons to comparable properties. Your basis for comparison expands because you can make comparisons not only within a zip code but between two similarly behaving zip codes. Figure 3 Zip-level Price Appreciation Distribution - Phoenix

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What types of properties are showing the most/least robust appreciation?

Whether youre making a lending, servicing or investment decision, you also have to dissect your opportunity based on a number of key property categories such as price band, property type (single family residence vs. condo vs. duplex, etc.), and property characteristic clusters (4 bedroom/2 bath vs. 3 bedroom/1 bath). Year-over-year changes in property values within these categories is certainly a key indicator of market health, but there are other important variables to consider. Table 1 demonstrates this more comprehensive approach using Price Band as the category of analysis. Table 1 YOY Appreciation for Single Family Residences: Maricopa County
Price Band YOY Appreciation Momentum Sample (Number of Zips)
15 34 29 32 16 5 1 <$75,000 28.5% 0.93 $75,000-$124,999 25.0% $125,000-$174,999 23.3% $175,000-$249,999 20.0% $250,000-$449,999 16.5% $450,000-$749,999 12.4%
Source: DataQuick Neighborhood Level HPI

0.89 1.03 1.00 1.00 0.95

$750,000+ 17.5% 1.12

In addition to YOY appreciation, the analysis also considers momentum. Momentum determines whether property appreciation has increased/decreased in the past 3 months relative to the increase/decrease recorded in the previous 12 months. Momentum ratios greater than 1.0 indicate that property valuation appreciation over the past 3 months is higher than what was seen in the previous 12 months. In other words, appreciation is accelerating the value of adding Momentum is to understand whats happening in the market now. Its great that all of the bands in Maricopa County have seen healthy appreciation in the last year, but the increases have clearly slowed considerably for some bands in the past three months, including <$75,000, $75,000-$124,999, and $450,000-$749,999. Much of the deceleration in property values can be traced to shifts in the underlying supply and demand dynamics of the Maricopa County market that will be addressed in the next section.

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How is the supply of available inventory impacting property values? What demand factors are having the greatest influence on market trends and property values?
This supply question used to be simple. Track listings over time to understand how the inventory of available properties was changing in relation to market forces, property values, and demand. But with the collapse of the market and subsequent proliferation of distressed properties, this became a much more complicated, multi-faceted problem. Figures 4-8 highlight the many components that must be considered before an educated answer can be delivered. The graphs very much present a good news/bad news scenario for Phoenix. The good news in Phoenix is monthly foreclosure filings and REO inventory have seen steep declines of 50% and 46% respectively since 1Q11 (Figure 4). In response to this good newsas well as the general rebound in property values reported earlierit shouldnt be a surprise to see the an 88% spike in all listings (not just distressed properties) since the beginning of 2012 reported in Figure 5. Heres where the bad news starts to creep in though. Figure 5 also shows that since the beginning of 2Q12, listings haveat beststayed level, indicating the possibility of saturation. Possibility turns to reality (certainly for the distressed properties) when you look at Figure 6 and see the steady increase in Months Supply of REO Listings since the middle of 2011. Its not quite a buyers market, but the significant increase in supply in Phoenix certainly goes a long way to explain the slowing in property valuation Momentum being reported for several segments reported in section 2 above. After establishing the baseline of supply-side issues in a market, the natural next step is to look at how demand-side variables are being impacted by supply and how they, too, are driving property values and general market trends. Figure 4 New Foreclosures and REO Inventory in Maricopa County
30,000 25,000

20,000

New Foreclosures REO Inventory

15,000

10,000

5,000

Jun 10

Source: DataQuick RiskFinder Distress

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Figure 5 Number of Listings in Maricopa County

7,000 6,000 5,000 4,000 3,000 2,000 1,000 0

Condominium Single Family Residence

May 12

Feb 12

Apr 12

Jul 12

Mar 12

Aug 12

Jul 11

Jan 12

Aug 11

Nov 11

Dec 11

Jun 12

Source: DataQuick National Property Database

Figure 6 Months Supply of REO Inventory, Maricopa County, AZ

25

20

15

10

Jun 10

Source: DataQuick RiskFinder Distress

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Sep 11

Oct 11

Figure 7 REO Discount, Maricopa County, AZ

30%

25%

20%

15%

10%

5%

Jun 10

Source: DataQuick CMV-Distress

Figure 8 Distressed vs. Non-Distressed Sales in Maricopa County

70% 60% 50% 40% 30% 20% 10% 0% 12% 39% 33% 62%

September 2011 September 2012

13%

12%

15%

13%

Non-Distress

REO

Short Sale

Auction

Source: DataQuick National Property Database

Phoenix buyers had more choices over the last 12 months as supply surged. When you combine increased supply with a 41% drop in distressed discount property rates (Figure 7) and a the drop in REO inventory documented earlier (Figure 4), the significant change in the make-up of property sales in the County illustrated in Figure 8 isnt surprising. Specifically, non-distressed sales, which accounted for 39% of all sales in September 2011, jumped to 62% in Septemeber 2012. Buyers, when given the choice of a distressed or non-distressed property, are much more likely to opt for the non-distressed propertyespecially if they dont feel there are as many bargains to have in the distressed market. This analysis zeroed in on REO Inventory and Listings key indicators of market health. Other metrics that could have been factored into the analysis include local market statistics on foreclosure filings, negative equity, and shadow inventory.
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Is this a strong rental market?

This question isnt deceptively simple. Its just plain complicated. There are many important variables that need to be considered when evaluating the viability of a local rental market including: Rental rates and rent appreciation Expected property appreciation Property operational costs/operating margin Holding period Overall return Utilizing property intelligence from the DataQuick National Property Database, public domain rental data, and several market-driven assumptions, Table 2 presents real examples illustrating the overall return an investor would realize from investing in rental properties in the different parts of the country. Table 2 Tracking Investment and Rental Returns
Miami-Dade, FL Maricopa, AZ Riverside, CA Broward, FL San Bernardino, CA San Diego, CA

Average Single Family Residence (SFR) Value, 12/20091 Average SFR Value, 12/20121 Average Monthly Rent 4 BR SFR, 20092 Gross Rental Income (2009-2012) Net Rental Income (assumes 20% operating margin) Net Revenue from Property Sales w/o Rental Income Net Revenue from Property Sale w/Rental Income Overall Return w/o Rental Income Overall Return w/Rental Income Percent Return from Property Appreciation Percent Return from Rental Income
1 Source: DataQuick Automated Valuation Model 2 U.S. Department of Housing and Urban Development

$262,467 $308,029 $1,803 $67,539 $13,508 $45,562 $59,070 17% 23% 77% 23%

$241,258 $281,057 $1,567 $58,699 $11,740 $39,799 $51,539 16% 21% 77% 23%

$269,894 $285,935 $1,818 $68,101 $13,620 $16,041 $29,661 6% 11% 54% 46%

$309,267 $342,382 $2,385 $89,340 $17,868 $33,115 $50,983 11% 16% 65% 35%

$274,605 $277,861 $1,818 $68,101 $13,620 $3,256 $16,876 1% 6% 19% 81%

$514,853 $526,713 $2,326 $87,130 $17,426 $11,860 $29,286 2% 6% 40% 60%

The key assumptions used in this analysis: Holding period for the property is 3 years Rental operating return (rental income after operating expenses) is 20% Annual rental appreciation rate is 4% Two key insights flow from this analysis.  The first, and most obvious, is that Miami-Dade, FL and Maricopa, AZ Counties provideby farthe most attractive returns of the 6 local markets evaluated. When you consider property appreciation and rental return (net of operating expenses) these two counties deliver nearly a 2x return in comparison to the other counties.  Perhaps just as important though is what drives the largest returns. Specifically (and not surprisingly), high overall returns are driven much more by property appreciation than rental return. Using, Miami-Dade as an example, Table 2 shows that 77% of the overall return on the investment is the result of property appreciation during the holding period as opposed to just 23% for the rental return. The moral of this storywhich becomes increasingly more impactful as we move back to market conditions where steady property appreciation becomes the norm across most local marketsis that investors need to realize that while rental income can provide a boost to their expected gains, the lions share of the return will come from property appreciation. In todays and tomorrows market, its the first and most important factor to consider in making the investment.
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Does the market still offer attractive distressed property investments?

Distressed properties will likely always be available at a discount, but the pressing question for investors and savvy home buyers is where do those discounts remain high? Given market dynamics already discussed as well as the sheer increase in demand for distressed properties, its become apparent that some markets are no longer as attractive as they used to be. Like all of the other questions raised in this guide, there are clear distinctions in market behavior and trends in different geographies that can help guide you to the areas offering the best opportunity. Table 3 illustrates how local markets are behaving differently in this area.  In Maricopa County, AZ, the dynamics outlined earlier are clearly in play. Discount rates have fallen dramatically over the past year (41%) indicating far fewer bargains than whats been available in the past. The story is very similar in San Bernardino County, CA  Broward County, FL has a lower discount rate than its neighbor Miami-Dade, but rates have actually risen by 5% over the past 12 months. This would appear to be a market with a recovery thats been placed on hold and one where opportunity still exists. And even though Miami-Dade has seen a 10% YOY decline in the discount rates, the rates themselves are still at very high levels comparatively. South Florida in general appears to offer a greater chance for higher returns for distressed property investors.

Table 3 Discount Rates in Select Counties

Maricopa, AZ San Bernardino, CA Broward, FL Miami-Dade, FL

November 2011 Distressed Discount Rate November 2012 Distressed Discount Rate YOY Change
Source: DataQuick CMV-Distress

27% 16% -41%

27% 21% -20%

25% 27% 5%

38% 34% -10%

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Conclusion
The need for a comprehensive view of local markets has never been greater, but so are the challenges. Lenders, Servicers, and Investors must determine the right sources for the required intelligence, how to analyze the intelligence once its acquired, and finally, how to integrate it into existing work flows to ensure every decision about a property can be made with the confidence that the unique dynamics of the local market have been accurately considered.

DataQuick Delivers the Fuel to Drive Local Market Analysis

DataQuick has developed a number of advanced data and analytic components to drive more effective local market analysis. Many were utilized in the examples in this best practices guide. More importantly, these components can be deployed as either standalone solutions or integrated solutions to meet your specific needs. National Property Database Access to 125 million parcels and 250 million transaction history records covering the large majority of sales and loan activity in the United States. Neighborhood Level HPI DataQuick improves on traditional Home Price Indexes by tracking trends at the neighborhood level, delivering monthly updates, and tracking single family residences and condominiums separately. RiskFinder Distress An exhaustive database of 20 distressed property trend metrics. Monthly updates along with 10 years of history. Collateral Validation (CV) Reduces collateral risk by determining if a property value falls within an acceptable accuracy range. CMV Comprehensive, multivariate automated valuation model (AVM). CMV-Distress An AVM designed exclusively for distressed properties. Estimates discount expected for a Short Sale, Auction Sale, or REO Liquidation. CMV Portfolio An AVM designed specifically for portfolio risk management. Delivers higher quality by leveraging four sub-models in the calculation of a property value as well as a confidence score and forecast standard deviation. Market Intelligence (MI) A competitive intelligence and customer acquisition tool, MI reports real estate volume/activity and lender share based on customer-specific input criteria (geographic focus, loan products, competitors) RiskFinder RMBS Improves accuracy of RMBS portfolio valuations by incorporating post-origination intelligence (updated CLTV, occupancy changes, ownership changes) into default and cost models. Loan Position Modeling Sophisticated lien positioning modeling PropertyFinder A web-based search tool to access property level intelligence including property characteristics, transaction history, sales comps, valuation estimates, and neighborhood demographics.
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