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Three Arch Investors Quarter Newsletter July 2013 The second half of 2013 marks a rather significant change in the residential housing market: distressed
properties have been mostly absorbed. The foreclosure wave -‐ which began in 2009 -‐ is now in a clear and distinct downtrend. In fact, all the distressed housing funds that raised capital in the past 12 months have experienced an inability to find product at acceptable margins. Fund managers are
changing their mandates to hold properties for three to five years because they can no longer quickly resale or “flip” the homes -‐ as was the norm in the previous three years. The completion of this cycle is simply a logical next chapter as we move from “over supply” to “lack of supply.” This situation demands
a fundamental change in business models. Over the past three years, Three Arch Investors has created five separate funds that purchased REO and
foreclosed residential homes in the Western United States. Our five funds have generated average net returns in the mid-‐teens for our investors. However, beginning in March 2013, we found it increasingly difficult to maintain both margins and timely possession. This led us to conclude that the flipping model
has run its course. Due to new consumer protection acts, we have noticed changes in financial institutions’ policies that increase investors’ risks and exposure by attempting to sell homes via quit claims and deed assignments. The downtime for dealing with the eviction process, coupled with the skill
of defense attorneys in prolonging evictions, has lengthened the time period, causing costs to accelerate at the same time margins are squeezed.
While we have had a 95% success rate in our home flipping programs, in the current environment we are fairly sure that the odds of success have substantially changed. We simply are not comfortable with the level of risk that banks demand investors should assume. We have therefore moved most of our
funds out f the flipping model and will monitor the banks’ REO program towards year’s end.
Many investors were caught off guard and are quite surprised that we are now experiencing housing shortages. We see three reasons for these shortages:
1) Although family formation was postponed during the downturn, we now have a substantial number of 22-‐27 year olds leaving their parents’ homes. This has resulted in increased demand for both multifamily and first-‐time housing.
2) Investors who have rented single family homes have been absorbing significant inventory.
3) Over the last five years, production of new housing was off by 60%. Homebuilders are once again gearing up -‐ permits have gone from a low of 360,000 annual units to a projected 800,000 in 2013.
However, even with that substantial recovery, builders cannot meet the demand of the coming housing shortage due to the delays in getting actual housing permits.
On June 25th the monthly S&P/ Case Shiller Index reported their strongest uptick since 2006. Mr. Shiller indicated on CNBC that he believes house prices will continue to rise throughout the next 12 months.
Given this information and its potential impact on portfolios, investors should understand how they can best profit from a strong housing recovery.
While we believe housing markets will always be subject to boom and bust cycles, it is very advantageous to be a participant in the early part of any recovery. Three Arch Investors has over 35 years of experience navigating these cycles. We believe we are in a clear transition that requires
investors to move out of distressed funds or bond funds and to allocate a portion of capital to the production of new residential housing. It is clear that Private Equity and Opportunity Funds will shortly move to this model. This is simply the next logical step, given that we have absorbed most of the
surplus housing inventory or altered the usage pattern from ownership to rentals. We have seen a moderate spike in yields that will likely result in 10-‐year bonds hovering close to 3%
over the balance of the year. In addition, with job formation and GNP growth muted, housing is one of the bright spots in this current evolving recovery. In most markets we are experiencing the first signs of home values approaching their replacement cost -‐ which allows builders to compete with new product.
Historically, new housing has always done well when there is a close alignment between existing values and new construction prices, primarily because the public usually prefers the latest and greatest. Based on recent survey of 20 metropolitan areas, we expect most cities will reach parity in the next 18 months.
According to the May report by the Commerce Department, new homes sales are up a seasonally adjusted 2.1% with production of roughly 476,000 new homes. This is the highest rate since 2008 – yet still 50% below the normal production of the 1990-‐2006 period.
This information strongly suggests that redeployment of capital towards residential housing in the United States will be rewarded with outsized returns. We believe that our latest Fund is a timely and
compelling investment that will focus on financing and partnering with proven residential builders. We will be participating with developers that have well-‐located land parcels purchased below today’s values that require equity capital to finish their entitlements. Our objective is to balance the potential for
current income with future long-‐term capital gains, which we believe can still produce mid-‐teen returns.
If you desire to move out of bond funds in a likely rising interest rate environment, while reducing your exposure to stocks which have risen over 145% since the 2009 bottom, we strongly suggest
directing a portion of your investment funds toward residential housing. The housing recovery is just beginning and offers both current income as well as projected capital gains.
Please consult your advisor regarding this program, as this newsletter is not intended to be a solicitation nor a recommendation. Three Arch Investors sponsors real estate funds for accredited
investors only, and any information contained herein is not intended for the general public. Please consult with your own advisors to determine the suitability of investing in real estate funds.
Please visit www.threearchinvestors.com to read a number of articles that support our position, with well-‐known investors such as Sam Zell, Warren Buffet, Dan Loeb, John Paulson, Leon Black, and many others publically calling the housing bottom and recovery. Please feel free to contact us for additional
information on our upcoming Fund.