State of the Market Report by Gil Holt

My market pundits spent the latter half of 2006 and the first quarter of 2007 issuing dire warnings of a pending credit crunch. Although the stock markets continued to soar to new highs as we entered 2007, it was not long before the subprime mortgage began to grab headlines — and for all the wrong reasons. Given the bevy of activity, Tetra thought it opportune to discuss where we are now, where we are heading, and what is all means.

Where We’ve Been

Throughout history, periods of rapid economic expansion or contraction have also featured counter cycles of credit and liquidity. Early in the decade, Alan Greenspan spent a lot of time substantially lowering the overnight lending rate, decreasing the costs of borrowing — creating vast amounts of liquidity into the global financial system. Mr. Greenspan lowered the discount rate after the stock market crash of 1987, the collapse of Long Term Capital Management in 1998, the “dot-com” collapse in 2001, and 9/11. The availability of cheap money supported increased investment and speculation in residential real estate.

Everyone, from multinational corporations to the weekend home flipper, began to focus on investing in residential real estate. Why did the boom hit residential real estate over commercial?

1. Residential real estate has lower barriers to entry:

a. During the peak of the housing boom, a speculator could acquire a property for zero dollars out-of-pocket. Capital requirements for commercial real estate are much, much higher.

b. The technical, legal and financial expertise required for commercial development is much greater than for residential speculation.

2. Product Cycle: Houses could be “flipped” in a week or a month where commercial properties take years to develop.

The result: the median home price in the United States rose 40% from late 2001 to 2006. Gains from real estate became a birthright instead of an earned privilege and a record amount speculation in the market ensued.

Where We Are

Fed Chairman Ben Bernanke raided the credit party we all enjoyed by raising the discount rate from a historical low of 1% in 2004 to 5.25%. Other nations also raised rates, further constricting the supply of money. Additionally, as foreclosure rates have risen, banks have raised their lending standards. The resulting liquidity crunch has created uncertainty and made investors nervous. The picture is not all dark, however. Due to strong fundamentals like job growth and population growth, home prices in secondary/tertiary markets and the southeast have maintained the same steady, moderate appreciation they experienced throughout the “boom” period. Plus, retail and office real estate remained strong across the country, even in markets where residential real estate is struggling.

Where We Are Going

Ben Bernanke had already thrown his hat in the ring with an aggressive rate cut, rallying the markets at least in the short term and making a strong case to lender to not overly constrict their lending. There is likely more shake out to go in the financial markets. Look for home builders in these markets, particularly on the high-end, to cut prices and offer big incentives to accelerate this absorption. On the consumer side, distressed homeowners have already received some help from the Bush Administration and, in the coming election year, will likely receive more. In general, we expect these “boom” markets to sort themselves out over the next 12-18 months and then return to historical rates of growth. We also expect the steady rate of appreciation in the commercial sector, as well as the southeast, to continue as populations in these markets swell. History has shown that a crisis in confidence is sometimes worse than the actual problem itself. This ongoing correction will continue to benefit value oriented investors with diversified holdings, such as The Tetra Companies.

The Course Tetra Charts

Throughout the housing boom, The Tetra Companies remained disciplined in its commitment to value-creation and adherence to the diversity of our portfolio. While other firms, under the guise of opportunistic investors, over-weighted residential and single family housing developments, Tetra did not follow the herd. We continued to allow the regional market to dictate each and every exit strategy for our developments. Tetra also mitigates investor risk by diversifying throughout product lines as well as across regions of the South Eastern United States. This approach always has, and always will, protect our investors from massive cyclical swings in any one component of real estate while allowing us to achieve superior returns on invested capital. Although we did not enjoy the enormous speculative run up in residential markets such as Las Vegas, California, and Arizona, what was once called “missing the boat” is now being called “clairvoyant”.