MKC GLOBAL INVESTMENTS, LLC

JANUARY 2010

Andrew McCormick Managing Member

Bottom in Home Prices, a Decade Away Humans are an optimistic breed by nature. There are some pessimists (or “realists” as they prefer to be called) among us; but on balance humans believe in a better future. This ensures that investment professionals will continue to track investor psychology for many years to come. When the naturally optimistic demographic becomes a group of Doom and Gloomers (or vice versa), we take notice. The same is true for participants in the real estate as well as stock markets. The general public seems to believe the bottom in housing has arrived; however, I believe no one will make any money on their real estate investments for the next decade. There may be an exception or two with a fixer-upper or a foreclosure, but buying a home for your primary residence under typical circumstances will be a net loser. The real estate market has absolutely no sustainable drivers for a price floor, let alone price appreciation. With taxes, interest, maintenance and insurance, you are guaranteed to lose money, especially when compared to what you could be paying in rent for comparable property. In addition to the typical rosy outlook for the future, humans have a consistent tendency to only remember the recent pastconsistently forgetting important lessons from history. Home owners and real estate investors alike were all too accustomed to consistently rising real estate prices until 2006, when the subprime mortgage issues and real estate bubble began to take hold. Few people realize that home prices in the United States have only risen in a sustained manner twice in the last 116 years. Edward Kim, hedge fund manager of 2GTT, LLC, brought this fact to my attention and I know very few other people who are aware of this reality. This data can be found below in the American House Price Index created by Robert Shiller. Other than the two aforementioned periods, all others have either seen declining home values or periods of stagnant or volatile prices with a net zero change. In 116 years, only twice have home values appreciated in any rolling 8-year period, adjusted for inflation. The chart below shows data to 2006, the index now stands at about 146 for Oct. 2009.

In determining what the next decade will bring in terms of real estate prices, one must look at a number of fundamental factors to determine when a major bottom will occur. In addition to watching the price levels of real estate, we should also

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observe the mortgage markets, interest rates, home affordability, housing inventory, new construction, mortgage applications and the rate of home sales. Also, following the stock prices of home building companies may shed further light into the state of the industry, as the stock market proves to be an effective tool at discounting news and can be a leading indicator of major industry turns. Determining an accurate view of these aspects should clarify the future of the residential real estate market. Home Builder Stocks: The stocks of home builders have been weak and declining since August of 2009 while the broad stock market has rallied substantially. When these stocks cannot keep up with the broader market, there could potentially be a problem for that stock’s immediate future. Mortgages: The issues now lay with prime mortgages, as standard 30-year fixed loans are being defaulted on as people lose their jobs. Home values continue to decline putting more home owners “underwater”, owing more than the home’s value. Also, adjustable rate mortgages have just begun to hit their reset dates, forcing the owner’s monthly mortgage payment higher. This number of adjustable rate mortgage resets will increase each month until they peak in mid-2011. Rate of Home Sales: Moderation in the rate of decline in home sales has occurred, slowing down into Feb. 2009, but has since picked up. 2008 marked the lowest number of home sales since 1999; but due to stimulus packages, optimistic thoughts of a housing bottom and home buyer tax credits, this important factor has reversed for the worse. Mortgage Applications: Mortgage purchase applications are declining rapidly; “cliff dive” was the comment of one analyst. As of January 2010, the MBA Purchase Applications Index is at the lowest rate since 1997. Interest Rates: Mortgage rates are currently very low, and it is a great time to acquire debt; unfortunately the drivers for higher interest rates in the future are quite strong. Nobody knows when long-term interest rates will rise, because interest rates move in very long-term cycles. We will have to wait years for rates to raise, peak and then decline to meet this component of the real estate bottom model. Home Affordability: With all other criteria being equal, declining home prices mean affordability is rising. The important question to ask is how affordable are homes and will they get even more reasonably priced? All the other criteria here suggest they will. The National Association of Realtors releases its NAR Affordability Index every month. According to this index (the data is available from 1988); we currently have homes that are the most affordable on record. This index only once, for one month, dipped below 100 (over 100 means affordable and under 100 means unaffordable). It now sits adjusted at 145 and unadjusted at 176, the highest levels on record. Only once before has the index ever showed that homes were unaffordable! Barry Ritholtz of The Big Picture points out, if the index can’t indicate when homes are overvalued, how can we conceivable use it to determine when homes are affordable? Inventory: Currently real estate inventories are high. In early 2009, Credit Suisse estimated that inventories would rally to 11 months worth of supply placing them at the highest level since at least 1988. This is insignificant compared to the “shadow inventory”. The shadow inventory is comprised of all properties/units that will be on the market, but are not yet listed. This number is estimated to be extremely high and is comprised of several items: bank owned properties (including Fannie Mae and Freddie Mac) that have not been put on the market yet and the number is rumored to still be growing, foreclosures in process, new condos in high-rise towers not yet listed and current property owners waiting for a rebound in prices to sell. Amherst Securities Group, LP estimates there are 7 million units in shadow inventory or 135% of a full year of existing home sales. Housing Starts: Since 1959 (with some exceptions), whenever the number of housing starts dropped below 1,000,000 it signaled at least a temporary low in housing prices. As of March 2009 housing starts dipped to 510,000. Observing the rental market will be necessary as well. Currently, rental vacancies are at 30-year highs, depressing rents. If the real estate market cannot make a bottom due to the consumer wanting to own their own home, it could make a bottom

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from an investment valuation standpoint of income potential. Unfortunately, this also is changing for the worse. As residential rentals rise in number and their corresponding rents fall, home values themselves must decline to warrant any investment. A tiny part of a large series of needed inputs to the real estate bottoming model is unfulfilled. Real estate, like long-term stock market cycles, takes many years to play out. I continue to be shocked, as people comment as to why they should buy a home (or even worse a condo) now more than ever before. I am convinced that if this data were for any other industry, people would feel the same way I do. We are brainwashed with the belief that owning your own home is the American Dream. However, when people are conditioned into believing a home should be the cornerstone of their portfolio, they blind themselves to the overwhelmingly negative data.

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