Wednesday, December 31, 2008

Data Trap: Big Percentage Increases in Small Numbers

The Big Picture headline is "Home Sales Plunge". Existing sales in November were down 10.6% over November 2007. Bullet points are:

• Existing home sales were down 10.6% from November 2007, and off 8.6% from October 2008 (October sales were also revised downwards); Single family sales fell to the lowest since ‘97.

• Sales were for 4.49 million annualized — about 440k less than expected; This is the lowest level since the 1999, when the NAR added in Condos and Coops;

Here is the math, converting to a monthly interval:


How important a change is that? Well, in the 2nd quarter of 2008 there were roughly 75,715,000 owner occupied housing units in the US, so the change represents 0.06% of the occupied housing stock. Let’s look at it another way. In 2000 the Census identified 25,375 places (roughly, cities and towns, a more exact definition here). If two homeowners in each place decided last month to hold off from selling their homes, that would more than account for the difference. Yes, some of those places are very small, but on the other hand, New York City, Los Angeles, Chicago, and Houston probably had more than two such homeowners.

When people talk about percentage changes, make sure you understand the actual numbers involved and their relationship to the entire population.

Tuesday, December 30, 2008

Data Trap: Extrapolating from a Small Sample

The press release says “The nation's small businesses own 93% of all "toxic" mortgages and are at risk of defaulting on their loans/payments.” The story is picked up by Barron's and blogs (Mr. Mortgage 12/16/08 and The Mortgage Lender Implode-O-Meter). But, what is this assertion based on?

Felix Salmon (Market Movers) does a great job skewering the survey used as the basis for the release, which contains too many errors to list here. The problem pertinent to this post is the conclusion is derived by extrapolating 1,687 survey responses to a base of 16.2 million small business owners.

Now, it’s possible to obtain good survey results from small samples when you ask clearly defined unambiguous questions and you have a lot of information on your sample and population. There is no way you are going to get good results on who holds what kinds of mortgages and their risk of default with a population as diverse as small business owners.

I’ve previously posted on the tendency of lenders to make unsupported decisions on asset quality based on prior but limited bad experiences. Those bad decisions are based on biases rather than poor survey design, but the effect is the same: an incorrect conclusion.

Monday, December 29, 2008

Home Equity and Income Curtailments

The stereotype is the grasshopper home owner refinances or takes out a home equity line to buy that new big screen TV. No doubt to a certain extent that happens, but (via Economist's View) research shows:

..."In the early years of this century we saw a form of self-administered welfare payment develop where home-owners cash in on their homes, in boom times: to support children, smooth over a fall in income, or meet the costs of relationship breakdown." ...

I’ve previously talked about how income curtailment is usually the initial trigger for home defaults. This research suggests income curtailments were managed at least in part by drawing on home equity, but once that’s gone (or no longer available) defaults are more likely to occur. Lack of equity is also a factor in why workouts often don’t work; once the equity cushion is gone any income hiccup creates a new problem (more on that here).

Sunday, December 28, 2008

Single Asset CRE Borrowers: Not a Stupid Idea

The decision by the sponsor of Baywalk, a large retail complex in St. Petersburg, FL, to offer a deed in lieu of foreclosure has attracted some commentary from Traffic Court and Calculated Risk. Here is the full post from CR:

CRE Owner "Walking Away"

by CalculatedRisk on 12/20/2008 10:16:00 AM

From the St. Petersburg Times: BayWalk owner proposes deal to surrender deed, walk away (hat tip Terry)

Hoping to avoid drawn-out foreclosure proceedings, BayWalk owner Fred Bullard said Friday he is negotiating a deal to simply surrender the deed to the downtown entertainment complex and walk away.
Under the proposal, a bank would take control of the retail and restaurant portion of BayWalk and appoint a trustee to run the complex until a suitable buyer is found.

And good luck pursuing him for any penalities:

The technical owner of BayWalk, STP Redevelopment, has no other assets and was created solely to own BayWalk.

As I've noted before, CRE owners are much more willing to just walk away than residential owners.

The fact that STP Redevelopment has no other assets and was created solely to own BayWalk has no bearing on whether or not Mr. Bullard can be pursued. Standard procedure for CRE loans is to have the asset held by a single asset entity (SAE) to ensure the deal is isolated from problems with other assets controlled by the sponsor. For example, if the sponsor controls two projects each held by SAEs, and one becomes insolvent while the other is still solvent, the insolvent SAE files bankruptcy but the lender on the solvent project is not affected. If both assets were held in the same entity, both projects and lenders would be involved in the bankruptcy and the lender on the solvent project risks having it’s debt reorganized as part of the plan to save the insolvent project.

This structure does not necessarily put Mr. Bullard in the clear; the lender may have required guarantees from him or others in connection with the loan. The fact the asset was held in an SAE says nothing about the existence or absence of such obligations.

Whether or not CRE owners are much more willing to walk away than residential owners is a big, juicy topic. At this point, let’s just say I’ve not seen any evidence to support the assertion.

Saturday, December 27, 2008

Why Did Some Markets Bubble?

We all know there are large variations in how much housing markets have appreciated and depreciated. Here is a chart from The Mess that Greenspan Made which is a little dated but which gives you the idea of the upward trajectories:

CS Cities

(click for a larger image in a new window)

Here is a chart from Calculated Risk showing the latest peak to date drops for the cities in the Case Schiller Index:


(Click to open larger version in a new window). This post in The Big Picture has the change data.

Why is there such a large variation? Most of the explanations I have heard our vague references to speculators, fraud, imprudent borrowers, etc. somehow being correlated to the geography. Maybe, but I find it hard to believe these explanations can account for the differences between cities like San Francisco and Dallas. I think what is going on relates much more to do with demand, supply, and the demographics and characteristics of the housing stock of these cities than the character of the residents. Here is my theory:

The Bubble was Inflated by Easier Credit. I’m not going to spend any time documenting this premise, I think it’s fairly well accepted.

For a Bubble to Happen, You Need Demand (Incremental New Buyers). Easier credit opened the market to more low income buyers, who could now qualify for loans because income and credit standards were relaxed. If this is true, you would expect the bubble cities to have lower median incomes than non-bubble cities.

For a Bubble to Happen, You Need Supply (Incremental New Sellers). The focus has been on new construction, but new construction is only a small fraction of the existing stock. Existing home owners obviously buy and sell, but when an existing owner sells and buys there’s no change in demand or supply. The most likely new sellers of housing to newly qualified buyers are the owners of rental houses, and existing renters of homes are obviously candidates to buy. If this is true, you would expect bubble cities to have relatively high percentages of single family rental housing.

Are these hypotheses true? Here is a table rank ordering the Case Shiller cities (worst to best) which also shows their rank by median household income and percent of renter occupied 1 unit attached and detached housing of the total occupied housing stock. The median income and rental housing data are a custom report from the Census 2000 Summary File 4 which can be downloaded here. The larger the CS Rank number, the bigger the drop in house prices from the peak (e.g., Phoenix is the worst performer). For median income rank, the higher the number the lower the median income (e.g., Tampa has the lowest median income of the 20 markets). For renter occupied 1 unit structures, the higher the number the more such structures (e.g., Los Angeles has the most house renters).cs ranks

(Click on table to enlarge in a new window)

The hypotheses account for the worst six markets. #7, Detroit, is in it’s own private employment hell so I think it’s an outlier. Of the markets that are performing relatively well, we have Cleveland (relatively low income but also a low percentage of rental homes), and Portland and Charlotte (relatively high supply of rental homes but also relatively high income). Of the two factors, I think low median income is the more important. Most people do not think of Miami, Las Vegas, and Los Angeles as relatively poor cities (the influence of television, I believe), but they are.

On the whole, I think the data are consistent with the theory.

Friday, December 26, 2008

WORKOUTS 101 – Discovery and Attorney-Client Privilege

Usually income property defaults follow an orderly sequence. There is a default, the lender initiates the foreclosure and seeks the appointment of a receiver, the borrower files bankruptcy, the lender eventually obtains relief from stay and completes the foreclosure, and the property thus becomes REO. The only argument which occurs is over the value of the property during the bankruptcy proceeding, and even that is a gentlemanly debate between appraisers. I've been involved in any number of these when there is literally not a single discussion between the lender and the borrower during the entire process. A single lender workout officer can handle a lot of these simultaneously (during the early 1990's our group typically had 70+ loans per asset officer).

This situation changes radically if the lender decides to pursue a deficiency judgment or a guarantee. Every time I've done so there has been all out litigation warfare complete with lender liability claims, discovery, depositions, and sometimes even trials. If you know in advance you will never pursue remedies beyond your collateral you can stop reading. But, if you might go after a borrower, there are some procedures you should follow in advance of the fight which will save you heartache later on.

Discovery. These lawsuits are almost never settled before extensive discovery takes place, because the borrower is looking for something that will take them off the hook and there's no point in paying up until he or she is satisfied there is nothing there. This means the borrower's legal team will be looking at pretty much every piece of paper, email, electronic document, and report which mentions the loan. The cost of producing these documents is substantial and probably won't be recovered, and the more there is, the more likely it is that the borrower will latch onto something to use as a defense. Therefore, it makes sense to follow two simple rules when it looks like a loan may be headed for trouble:

  1. Keep the number of people involved to a minimum. Some banks like to get a group together to discuss their problem loans, which means everyone in the group will need to produce all their documents and emails related to the loan. It's much better to have a single officer responsible for the loan, so that only that officer and the manager(s) above that person are involved. In particular, restrict copies on email; if you send an email with a bunch of people copied, they will all be sucked into the process too.
  2. Keep written and electronic communication to a minimum. There are obviously action plans, loan rating forms, etc. which need to be completed, but the fewer the better.

Before you write anything, you need to pause and think about the fact the borrower's attorney will be reading it at some point in the process. When it comes down to it, beyond what is necessary for regulatory records there is not much that needs to be written down when working a problem loan.

Attorney Client Privilege and Work Product Doctrine. In general, information exchanged between you and your attorney is not subject to discovery. Similarly, materials prepared in anticipation of litigation are also generally not subject to discovery. But, as soon as you start sharing the information with people other than your attorney there’s an excellent chance you will lose these protections. The commonest mistake in real estate litigation relates to new appraisals of the collateral. Most lenders are smart enough to have their attorney order the appraisal – so far, so good. But when the appraisal comes in they promptly give it to the appraisal department for review and put the value in memos and reports which are sent to managers, accountants, etc. D'OH!! Again, keep the number of people involved to a minimum and ask your attorney before you disseminate information.

Thursday, December 25, 2008

Making the Neighborhood Stabilization Program Work

The Wall Street Journal reports local jurisdictions are having a hard time figuring out how best to spend the $4B HUD is distributing to them to help stabilize neighborhoods experiencing high level of foreclosures. Here are my suggestions, based on my experience at the Los Angeles Housing Department helping rebuild neighborhoods devastated by the Northridge earthquake.

The Northridge quake left tens of thousands of homes and rental units vacant and damaged. Some neighborhoods were affected much more than others, but in every neighborhood there were owners whose housing was not damaged, so comprehensive redevelopment was not an option. There was a real possibility some of the neighborhoods would remain blighted indefinitely if dramatic steps weren’t taken. Many homes and apartment buildings were either foreclosed upon or required lender cooperation in the reconstruction. The quake occurred in January, 1994, a time in Los Angeles when many residents and apartment owners had lost all the equity in their units due to economic conditions even before the earthquake. The parallels between this situation and foreclosure blighted neighborhoods is obvious.

In an effort to preserve the damaged housing HUD provided the City of Los Angeles with $400M in CDBG and HOME funds. The Los Angeles Housing Department developed programs which were extremely successful, and two years later almost all the affected properties in the target areas were back on line. Here's a link to a study published in 2000 which summarized the reconstruction.

The most important decision made was to leverage rather than replace private sector funding sources. The mechanism to accomplish this was to offer subordinate loans at 0% interest payable over 30 years with no payments for the first five years. The amount of the loan was capped at $35,000 per unit, the loans were only available in target areas (described below), and became due when the property was sold. This approach had several benefits:

  • The very favorable terms concentrated private sector reinvestment in the target areas
  • The predictable loan amount allowed buyers and sellers to factor the financing into their negotiations
  • The loan structure (as opposed to direct investment or a grant) created an annuity for the Housing Department; as the loans have been repaid the money is available for recycling into new programs.
  • Between three and four times as many units were assisted as would have been possible if only public funds were involved.

Another key decision was making the funds available for rental housing. When the loan was made on a rental unit, an income restriction was placed on the unit which at that time was above market, so there was no impact on the rent charged or the value of the unit. However, as rents have increased in Los Angeles these units have become an important component of the affordable housing stock. A restriction limiting the unit to tenants making 60% or less of the area median income would not have an immediate impact in most low and moderate income foreclosure neighborhoods, and would help ensure housing affordability in the years to come.

Other key components of the programs were:

  • A detailed inventory of the affected housing. An inventory is necessary both to select target areas and to monitor progress. This step is particularly important if there’s a possibility of getting more money if your programs are successful (which is probably going to be the case with the Neighborhood Stabilization Program). Information on foreclosures is readily available but constantly changing, so an active database (as opposed to a static snapshot) is necessary.
  • A focus on the areas which are most seriously affected, while paying attention to political geography. The Los Angeles Housing Department designated 17 neighborhoods as “Ghost Towns”, which were characterized by high concentrations of damage. Although these areas were primarily determined by need, a secondary consideration was to identify at least one neighborhood in each city council district that would receive funds. This was an important step to ensure broad political support in Los Angeles’ often fractious local government. Again, the foreclosure data is readily available but needs to be analyzed and monitored.
  • A multi-department effort. Although the Housing Department had primary responsibility for the effort, other departments played important roles. For example, the Department of Building and Safety, Public Works, and General Services played an important role in boarding up and securing vacant buildings, and the Los Angeles Police Department stepped up patrols to deal with disorder issues and squatters in the affected neighborhoods. Foreclosure-ravaged neighborhoods have similar needs.

Additional information on the programs is described in this report by the LA Housing Department. Compare this effort to the dismal housing reconstruction progress in New Orleans, where, for example, only 82 of an estimated 10,000 damaged rental homes have been brought back on line in the three years since the disaster.

The is an unfortunate tendency to want to treat each disaster as unique and to create new solutions, as opposed to adopting proven approaches which were created elsewhere. I hope this housing disaster will be different.

The Problem with Interest Only

There are a lot of CMBS interest only loans out there. Deal Junkie cites some numbers from REIT Wrecks:

Scheduled maturities of fixed-rate CMBS debt reach peaks of $98 billion in 2015, $128 billion in 2016 and $127 billion in 2017. 65% to 85% of those loans are interest-only for the entire or partial term. As for the near future, 80% of the loans maturing in 2008 and 2009 have been amortizing over the full term, significantly bettering the odds that these loans can be refinanced.

I’m not a big fan of interest only for reasons discussed below, but I think the focus on the higher refinance risk of IO loans is misplaced. To make my point, let’s look at what happens on a typical deal with a 10 year term and a 3 year interest only period. Here is the math:


The first thing to notice is the IO payment is 19% lower than the 30 year P&I payment. Obviously, a lower payment could be used to justify a higher loan amount, but to my knowledge in the CRE world people underwrote on the fully amortizing payment (this was apparently not true in the residential mortgage world). With CRE, the goal of the IO structure was to increase cash flow during the early years of the deal which resulted in a higher IRR for the borrower, and not to obtain a larger loan amount.

Next, notice in year 3 when amortization kicks in, the payment increases to 4% more than what the payment would have been under the 30 year amortization deal (because the loan has to fully amortize over 27 years instead of 30). 4% is not a big increase – it’s reasonable to expect operations would improve enough over a 3 year period to handle that (and, it was fairly common for lenders to agree to use a 30 year schedule at the end of year 3 anyway, so there would be no increase at all over what the payment would have been had it amortized from the beginning). The new payment amount is 29% higher than the IO payment was, but again that shouldn’t make a difference because the deal was originally underwritten assuming the amortizing payment. Here is a chart showing how the payments change:


(click to enlarge in a new window)

As long as the loan was underwritten to the fully amortizing payment to start with, the impact of the IO structure on payments is minimal.

What about refinance risk? The UPB on an IO loan will be higher than a loan which amortized from the beginning, but in the grand scheme of things there is not that big a difference. Here is a chart of the outstanding UPB of a 30 year amortization loan and a 3 year IO loan over the first 7 years:


(click to enlarge in a new window)

There is not a huge difference. Via The Big Picture, the NYT has a great training video from World Savings showing a loan broker explaining to a borrower what an idiot she is to worry about amortization:


(click the NYT link and scroll down to view the video). The irony is, he’s right; what happens to the market during the loan term is much, much more important than the amortization.

So why don’t I like IO loans? My concern is a tactical one, and relates to what happens if there’s a downturn during the IO period (like now, for example). When cash flow starts to approach breakeven owners get more attentive to their properties, and I believe that 19% payment difference between IO and amortizing payments results in IO borrowers being less focused during slowdowns. Also, if things get really bad one of the easiest modifications to do is to go IO for a while; there’s no loss to the lender, and the deferred principal is recouped at the balloon. If the deal is already IO, you don’t have that tool.

Wednesday, December 24, 2008

What “CRE Bust”?

Let me begin by saying that I think Commercial Real Estate (“CRE”) is going to take a big hit – I think it’s going to be at least as bad as the early 1990’s and it could easily be worse. My pulse quickens and my adrenaline starts pumping every time I see a subject line in my Google Reader proclaiming it’s here. That happens almost every day now (for example, Housing Wire, Calculated Risk, and Deal Junkie). But, delinquency rates for CMBS loans are practically nil (Deal Junkie again). What’s going on?

When I think CRE bust, I think of significant declines in the value of multifamily, office, industrial, retail, and lodging properties, accompanied by increasing delinquencies and foreclosures for these properties. There is some evidence values are declining modestly, and fundamentals (occupancy and rent levels) are starting to deteriorate, especially in the retail, lodging, and office sectors. But, there are no data to show we are remotely at bust levels in actual performance. When people are talking about being in a bust, they are talking about other things:

  •  Declines in Architectural Billings. This index is way down (see Housing Wire). That’s evidence there are fewer new projects in the pipeline. This is obviously bad for architects, contractors, and others whose livelihood depends on new projects, but it’s good for everyone who owns or has a loan on a project already under way or completed (now is not the time for more additions to supply). I would call this evidence of a new construction bust, but not a CRE bust.
  • Declines in Environmental Site Assessments (ESAs). Fewer ESAs are being conducted (Housing Wire again). An ESA is done when CRE is financed or sold, so this is a symptom fewer financing and sale transactions are happening. Fewer transactions is bad for ESA providers, brokers, loan officers, title companies, and others who make their living from transactions, but in and of itself it’s not bad for CRE owners or lenders.
  • Lower Demand For, and Tighter Lending Standards and Higher Pricing on CRE Loans. Demand for CRE loans is down, pricing is up, and lending standards are tighter for CRE loans (see Calculated Risk). These are all indicators of less CRE lending, but are not symptomatic of weakness in CRE itself. A CRE Lending bust, yes, a CRE bust, no.
  • Increase in Commercial Real Estate Delinquency Rates. The Fed reports CRE delinquency rates were at 4.73% for third quarter 2008, the highest level since 1994 (Calculated Risk again). The problem with this number is the Federal Reserve definition for CRE is so broad it’s almost useless - “Commercial real estate loans include construction and land development loans, loans secured by multifamily residences, and loans secured by nonfarm, nonresidential real estate, booked in domestic offices only” (Federal Reserve Charge-off and Delinquency Rates Statistical Release). Similarly, the FDIC says “commercial real estate (CRE) loans are exposures secured by raw land, land development and construction (including 1-4 family residential construction), multi-family property, and non-farm nonresidential property where the primary or a significant source of repayment is derived from rental income associated with the property” (FDIC CRE Guidance). When you dig into the call reports, it quickly becomes apparent the problems are in single family land and single family construction and development loans, and not in what most of us consider CRE (multifamily, office, retail, industrial, lodging). Call it what it is, please - a residential land and construction bust.

Again, I think CRE (as most of us think about it) is going to have real issues the next few years. But, we’re not there yet.

Tuesday, December 23, 2008

In Defense of a CRE “Bailout”

The blogosphere is abuzz with the news big commercial real estate owners want newly originated AAA CMBS paper to be eligible for purchase through the Term Asset-Backed Securities Loan Facility (see posts from Housing Wire, Clusterstock, Market Movers, and Calculated Risk. You can read the actual request here). Everyone is framing this as a bailout, but I think they’re missing what’s really going on.

The request talks about the large volume of CRE loans which are maturing, and the fact that the traditional sources that would ordinarily refinance these loans are out of the market. That’s true, but it doesn’t matter. If you have a good, performing CRE loan which matures and the lender or servicer is not willing to extend at a market rate, a bankruptcy judge will be happy to help. A simple extension at a market rate to protect real equity is about as straightforward a Chapter 11 plan as you can get. Yes, it would be nice if you didn’t need to go to court to refinance your loan, but these cases are not what the request is about.

The problem children are the CMBS loans which are underperforming and which can’t qualify for a new loan. Normally the lender would foreclose and sell the REO. During a credit crunch, the selling lenders finance the sales (they don’t want to, but there’s no alternative). With a CMBS loan, there is no one available to finance the sale – the security holders are not in that business. To move these properties without financing, CMBS servicers will offer huge discounts (remember, it’s not the servicer’s money so they won’t be hesitant to do so).

Why do the owners of performing properties care? Those discounted sales will become the comparables to establish value for performing properties, and the entire market will be devalued. Institutional holders who have to mark their portfolios to market will get clobbered. Further, the buyers of the greatly discounted properties will have a much lower basis and can drop rents and still make a reasonable return, which will also pull down the rest of the market.

What’s the public policy motivation to prevent this from occurring? It’s pretty hard to make a case that a CRE landlord deserves sympathy, but I’ll give it a try. If you rank ordered all the CRE in the country by asset size it would look like a power curve with a very long, fat tail. There are a  few very large projects, more large ones, many more medium sized, and a gazillion small ones. Most of the CRE in the country is not held by people like Donald Trump, it’s held by people who have assets but do not live lifestyles of the rich and famous. This is not a bad constituency to help.

If you don’t buy that, there are the financial institutions holding CRE debt. In every recession there are a lot of CRE loans which experience cash flow problems, and when a loan gets into trouble it gets marked down to the value of the collateral. If the only sales are deeply discounted all cash deals, you are going to see some huge writedowns. This will not be helpful. Also, when the buyers of the discounted properties drop rents, more CRE loans will have cash flow problems when they can’t compete with the lower basis properties, resulting in more foreclosures and a really nasty downward spiral. Avoiding this spiral effect should be the main goal of those working to avert a CRE crisis, and making financing available is essential to breaking the cycle.

Finally, we should consider what buying newly originated CRE loans really means. Fannie Mae and Freddie Mac are keeping the multifamily sector afloat, buying conservatively underwritten loans at attractive spreads (currently more than double the margin of single family deals). This could and should be a moneymaker for the Fed.

All things considered, this is a good proposal. Unfortunately, the requestors are not a sympathetic group and the reason for adopting it can’t be summed up in a sound bite, so it will probably not happen.

Sunday, December 21, 2008

Commercial Property Values Down 50%?

The Royal Institute of Property Surveyors says the value of commercial properties in the UK will fall by more than 50% by the end of 2010 (see Guardian article here). Is that forecast plausible? Could it happen here in the US? The answer to both questions is yes.

Income property value is a function of the cash flow it generates. The cash flow has the following components:

  • Gross Potential Income (GPI) – This is the total rent the property generates if it is 100% occupied.
  • Vacancy/Collection Loss/Concessions – This is a deduction for any unleased space, bad debt, or discounted rent.
  • Effective Gross Income (EGI) – GPI less Vacancy/Collection Loss/Concessions
  • Operating Expenses – Expenses related to property operations The usual categories are real estate taxes, insurance, utilities, repair and maintenance, management fees, payroll, administrative expenses (advertising, telephone, etc.), and a reserve for capital items.
  • Net Operating Income – The EGI less Operating Expenses.

The value of the property is the capitalized value of the NOI, and is determined by dividing the NOI by a capitalization rate (cap rate). The cap rate is the annual rate of return on an all cash purchase of the property. You determine the applicable cap rate for a property by looking at the cap rates of comparable properties which have recently sold in a project’s market (more here if you are not familiar with cap rates).

Here’s an example:


What does it take to produce a 50% decline in the value? Let’s say rents fall 10%, vacancies increase to 15%, operating expenses increase to 55% of EGI, and cap rates increase to 7%. Here is the math:


How plausible is it that such declines and increases will occur? Very plausible – all such changes are well within the shifts which have occurred in previous severe recessions.

Friday, December 19, 2008

WORKOUTS 101 – Where Will the Money Come From? Where Will It Go? Down the Legal Black Hole?

When an income property loan gets into trouble, you need to take a few minutes and realistically assess the sources of funds for the deal and how they should be used.

Potential Sources of Funds

  • Income from the property (NOI)
  • The property itself, i.e., you foreclose upon or take a deed in lieu of foreclosure on your collateral
  • The sponsor's outside resources (any cash or property the sponsor might contribute which is not your collateral)

Potential Uses for Funds

  • Your debt (principal, interest)
  • The property itself (operations, capital requirements)
  • Your attorneys and third party foreclosure costs
  • The sponsor's attorneys
  • The sponsor's outside obligations (other properties, living expenses, etc.)

Eventually I will discuss each source and use in more detail, but for now here are the two most common mistakes lenders make:

Starving the Collateral. If the sponsor is asking for a workout, the property has probably been on the slippery slope to default for some time. If you end up taking back the collateral, your recovery is going to be even worse if the property continues spiraling down. Spending pennies on the property during the workout period will save dollars in the end.

Over Reliance on Attorneys. Lenders tend to forget that money spent on attorneys does not get spent paying their debt and/or stabilizing their collateral. To the extent you minimize legal involvement, there is more money available for you. This is not to say attorneys shouldn’t have a role – they do. You need the attentive participation of an experienced attorney when:

  • You are an inexperienced workout person and you do not have full access to someone who is (e.g., a supervisor). In my opinion if you have not been directly involved in 50+ workouts you are not experienced. Pick your own number, but be aware people are generally overconfident of their own abilities.
  • You are absolutely certain you will recover every nickel of what you're owed plus costs. In this circumstance, it doesn't matter how much you spend, so litigate away. If you think this guideline fits your case you are almost certainly not experienced and should be hiring an attorney anyway.
  • You are too busy to focus on the deal; go ahead and outsource at $200 an hour if your organization is too stupid to staff its workout group adequately.
  • You work for an organization where you need to cover your ass. Even successful workouts tend to disappoint, and losses if a foreclosure or bankruptcy ensue almost always grow over time. No matter how experienced you are or how well you handle a situation, in some organizations it will not be good enough. If you work in such a place, you need an attorney participating in the deal to function as a lightening rod.
  • You have a realistic chance of extracting more outside resources from the sponsor if you litigate. Like certainty of collection, inexperienced people tend to think this is true more often than experienced workout people do.
  • Without litigation (a receiver, etc.) your sponsor is going to divert property income, waste the collateral, etc. Most lenders assume this will happen and are too quick to pull the trigger. If your sponsor believes he or she is the best person to run the property and that the deal can be saved, a receivership action is a direct route to a bankruptcy filing. That might be inevitable – in fact, if you think the sponsor is unfit to run the property you might as well get it over with. But, if you have time to monitor your deal and a cooperative, competent sponsor you are better off holding off on the receiver.
  • It’s time to document the agreement you've worked out. No matter how good you are, it's never a good idea to enter into an agreement without review by experienced counsel.

Wednesday, December 10, 2008

Executive Compensation and Market Share

I’ve previously argued the decision by Fannie and Freddie to stray from conforming conventional loans was attributable to their CEOs' desire to earn their pay by maintaining market share. Bloomberg, reporting on testimony by Dan Mudd, Fannie’s former CEO, before the House Oversight and Government Reform Committee:

A June 27, 2005, internal presentation by Fannie shows the company at a “strategic crossroad” to either “stay the course” or “meet the market” by increasing risk and entering the subprime market. In staying the course, Fannie noted that it would continue to lose market share, and generate lower revenue and profits. In meeting the market, the document shows that Fannie identified the subprime market as a source of growth. “The choice was presented relatively starkly in order to identify what the key issues were,” Mudd said in response to a question from Representative John Tierney, 57, a Massachusetts Democrat.

I see this as a compensation issue – you can’t reasonably expect executives being paid eight figure annual compensation to take actions (or refrain from actions) which will result in loss of market share.

Tuesday, December 9, 2008

Investor Litigation and Mortgage Relief Plans Revisited

It’s been a little more than a year since I last addressed this topic. As usual, things turned out a little differently than I expected.

Back then, the Market Movers theory was investors would not litigate over the modification plans because it would be hard to calculate damages, the litigation wouldn’t scale, and the bondholders were not a litigious group. I agreed with Felix that the economics of the litigation was not attractive and that the investors were not naturally litigious, but thought damages would not be hard to establish and that servicers would take a cautious approach which would lead to few modifications being done.

I think I was right about few modifications being done, but Felix and I both underestimated the desire of bondholders to get out from under the deals. The litigation has started (links to NY Times and Housing Wire stories). The bondholder remedy sought is the repurchase of the loans at par. That’s an ambition goal, but if they’re successful it would be a huge recovery. The threat may be enough to force a nice settlement, and the possibility will surely cause modification efforts on securitized deals to grind to a halt until the matter is settled.

Monday, December 8, 2008

Re-Defaults: Why Workouts Usually Don’t Work Out

A number of blogs are reporting and commenting on the fact that 50%+ of the loan modifications completed in early 2008 are back in default (see Market Movers Re-Defaults, Naked Capitalism, Housing Wire, and Calculated Risk here and here,

There’s no big mystery as to why most modifications don’t work out.

  • Borrowers generally make their payments until they can’t. With home borrowers, that happens when there is some kind of income curtailment (job loss, illness, divorce, etc.) and their savings are gone. With income property borrowers it happens when income from the property no longer supports the debt and the borrowers’ liquidity reserves are depleted.
  • If a modification is done, the lender almost always addresses only the income curtailment or operating income problem. So the borrower’s immediate problem is resolved, but there is no safety cushion if there is a new income curtailment or further decline in property income, because the savings/liquidity reserve has not been replenished.
  • As a result, any new income curtailment or further decline in project operating income results in an immediate default.

Why do lenders do minimal modifications? Imagine a modification which reduces the interest rate to what the borrower can pay, and provides a deposit into the borrower’s savings account in case they lose their job again or property income declines further. Even if you take a security interest in the savings account (itself an administrative nightmare), someone still needs to advance the funds to set up the account, which will increase the loss reserve on the loan. That’s not likely to happen with a portfolio lender, and the chances are nil on a securitized loan.

Of course, if values have recovered since the modification was done the borrower could sell the property. That hasn’t happened yet, and won’t for a long time. So, we can continue to anticipate most modifications will re-default, because every bump in the the road breaks an axle at this stage of the game.

Friday, December 5, 2008

Neighborhoods, Disorder, and Real Estate Values

Bad neighborhoods equal bad real estate performance. Most real estate professionals would agree with that statement, but a lot of us feel uneasy saying it, because historically bad neighborhoods have been defined by red lines on maps and linked to the resident’s income level and race. I have touched on this topic a few times before (here and here), but a recent study summarized in The Economist reminded me this is something I wanted to write about in more detail. What exactly constitutes a bad neighborhood, and how does a bad neighborhood hurt real estate values?

My view is as follows:

  • A bad neighborhood is a neighborhood where there are visible signs of decline and disorder. These signs include poorly maintained buildings, landscaping, and infrastructure, graffiti, litter, and indications of criminal activity (e.g., drug dealing and use, prostitution).
  • Responsible people (which I’ll define in a very limited sense as people who pay their mortgages and rent when due) do not like to be around disorder.
  • The aversion of responsible people to disorderly neighborhoods results in less demand for housing in those neighborhoods, resulting in lower values.

I came to this view via Wesley Skogan’s Disorder and Decline and George Kelling’s Fixing Broken Windows, both of which should be required reading for real estate investors, appraisers, and lenders. The latest research provides additional support for the idea that disorder leads more disorder, creating a self-reinforcing downward spiral.

Is approaching real estate investing or lending in a disorderly neighborhood more cautiously really just redlining in disguise? After all, aren’t such neighborhoods typically lower income, and aren’t the residents typically minorities?

One of the findings in Skogan’s research which really struck me was the fact that minorities and low income residents hate disorder in their neighborhoods as much as wealthier and white residents do. The income level and race of residents is not the cause of disorder, and they would be happy to be free of it. If you want to eliminate disorder in a neighborhood, you do it by allocating public funds to maintain and police the neighborhood properly. It’s true that minority and low income neighborhoods often get the short end of the stick when it comes to resource allocation. That’s a public sector problem that will not be fixed by private investment.

Thursday, December 4, 2008

Will Lower Interest Rates Help Home Prices?

I agree with CR about 90% of the time, but I think he’s off on his post yesterday about House Prices and Interest Rates. His argument is a plan to push home prices up by offering lower rates won’t help much because a rational buyer will realize artificially low rates now will not result in a higher resale value down the road. There might be some buyers who think like that, but I don’t know any. Many people prefer to buy if they can afford it, and interest rates are a key component of that equation. I’ve worked through the math in previous posts here and here.

Will Adding Recourse Provisions Improve Loan Performance?

There’s a very thoughtful criticism of Martin Feldman’s proposal to tie recourse provisions to loan modifications at Credit Slips. I think the post's criticism of Feldman's proposal is right on. I would add, I don't think there is any evidence to support the contention recourse loans perform better than non-recourse loans. One place to look for such evidence is loans which have subordinate home equity lines. Those lines are invariably recourse and in theory should perform better, but in fact they don't. The reality is that borrowers tend to pay until they can't, and at that point it doesn't matter if the loan is recourse or not, because there is nothing left to go after. I've written about why that's the case in the income property context here, and I think the logic is the same for home loans.

Wednesday, December 3, 2008

More on Banker Compensation

Compensation is a hot topic these days. From The Big Picture:

One of the maddening features of the financial crisis has been Wall Street’s constant insistence that without its mind-boggling compensation, talent will go elsewhere. On the face of it, this seems an empty threat from a group of hysterical prima donnas who don’t want to have to suffer the consequences for their actions. We focus a lot on pay for the top few at a public company (my, how that term has a new ring to it after the bailout) because public companies disclose the pay of those at the top.

Felix Salmon is ready to take the plunge:

Andrew Ross Sorkin is worried about what happens if you don't pay bankers enough money:

The trick, of course, is to dole out enough rewards to keep executives working, and working hard, but not to dole out too much...
Citigroup and other firms need to find ways to keep and attract talented people who can make smart decisions, without lavishing pay on them or rewarding them for shoddy performance...
Mr. Pandit and others -- to the extent you believe they are the right leaders of Citigroup -- or whoever takes their roles are unlikely to hang around if they're not amply paid.
The risk, Mr. Johnson said, is that if we taxpayers don't offer the possibility of a payday, we won't get the performance. "If you were in senior management and you knew you'd never get paid, you're not going to work as hard or you'll leave," he said. "It's actually worse if they stay. If you have a bunch of demoralized people hanging around, it will kill you."

I say, let's take the risk, and see what happens. I've now reached the point at which I simply don't believe people when they say that lower pay for bankers will result in worse performance -- especially since it looks very much as though it was higher pay for bankers which was at least partly responsible for much of the present crisis. Let's bring down pay, a lot, and see whether performance really falls.

Angry Bear provides a link to a history of the legislative efforts to limit executive compensation (the short story – meaningful restrictions were not passed).

Finally, Richard Epstein touches on the topic in a very interesting podcast on Happiness, Inequality, and Envy. Epstein believes the reason the wealthy are not measurably happier than others is that they have undertaken jobs whose conditions make them unhappy in exchange for high compensation. Pity the poor investment bankers who have to work 18 hour days and fly to Europe at a moment’s notice to close deals – where would the world be without them? We don’t envy them, because we understand the highly compensated bear a heavy burden. As Epstein notes, nurses don’t envy doctors, but the idea of people not pulling their weight makes us crazy.

I don’t think Epstein has it quite right; I’m with Felix on this one. I had one of those jobs. The work was challenging and felt important, and the people I worked with were interesting. Of course, the hours were long and travel gets old, but nice hotels and five figure closing dinners go a long way towards easing that pain. Is it really necessary to pay mid six figures and up to find good people to make that kind of sacrifice? I think not.

Epstein is right about the “pulling your weight” part. That is precisely why Robert Rubin disclaiming any responsibility for Citigroup’s problems makes people crazy.



Tuesday, December 2, 2008

Internalizing, Externalizing, and Compensation

There’s a great post at Naked Capitalism skewering Robert Rubin for his unwillingness to take responsibility for his role in Citigroup’s troubles. Rubin is an externalizer – bad things happened as a result of external forces and other people beyond his control (the opposite is an internalizer, who, when bad things happen, attribute the cause to themselves).

As Yves points out, it’s a little hard to justify paying someone $115M if, when things go badly, they claim they couldn’t have influenced events.

Sunday, November 30, 2008

50 Reasons to Dislike a Multifamily Project - Neighborhood Issues

Back in the early 1980’s I was a hatchet man for a multifamily lender that had a full pipeline but didn’t want to do any more business. My job was to review the loan request, visit the site if necessary, and find a way to kill the deal without getting sued.

I quickly learned this was a surprisingly easy task; there are few multifamily projects that don’t have flaws. Over the years I’ve refined the list, and I’ve settled in on 50 factors, which I’ll itemize in the next few posts.

Obviously, if you view all 50 as deal killers you’ll never make a loan. In fact, there are just a handful I would consider extremely important. The others are listed because there is some logic to the objection, and in combination with other factors may be a good reason not to do a deal.

This post deals with issues in the neighborhood. The first two issues are very important because they substantially reduce potential tenant traffic. The others on the list might offend some tenants, but probably not enough to substantially affect a project’s success.

Issue Comment
Lack of proximity to shopping, employment, services, freeways, transportation Tenants prefer easy access
Derelict cars, abandoned furniture, shopping carts, tagging, trash, poorly maintained properties Tenants prefer a well maintained orderly environment
Airport flight path Noise
Railroad lines Visual, Noise, Safety
Transmission lines Visual, Health
Pipelines Safety
High traffic streets Traffic, Noise, Safety
Landfills, wastewater treatment plants Visual, Health
Electrical substation Visual, Health
Manufacturing/distribution facilities Visual, Noise, Safety, Traffic
Pawnshop/pornography stores, etc. Visual
Stadiums, Playfields Traffic, Noise, Disorder
Schools Traffic, Noise, Disorder
Churches Traffic, Noise
Bars/Taverns Noise, Disorder

Tuesday, November 18, 2008

Big Banks and Big Compensation

Felix Salmon has a post Against Big, Public Banks:

There's a strong case to be made that banks, like law firms, should be boring and conservative and reasonably small and mutually-owned. That's one of the thing which worries me most about TARP and the $140 billion tax break being used to encourage huge banks to get even bigger still. The fact that all those huge banks are publicly-listed and therefore prone to taking excessive risks only makes matters worse.
I think the "prone to taking excessive risks" part ties in to my previous post about the huge compensation received by management at the big banks. These huge pay packages can only be justified by company performance, and giving up market share to avoid risk is not viewed as good performance until it's too late.

Tuesday, November 11, 2008

Fox Guarding the Henhouse? Bear Stearns Risk Manager Now at the Federal Reserve

Carol Baum has an opinion piece on the Bloomberg site about the New York Fed decision to hire Michael Alix, who was former chief risk officer at Bear Stearns at the time of its collapse. This story is interesting in itself, but it also provides an update on the status of a number of others associated with financial fiascoes, all of whom appear to have landed on their feet. Hopefully this is survivorship bias at work. I would like to believe for every scoundrel who lives happily ever after there are ten scoundrels toiling as clerks at Walmart whose stories won't make the paper.

Actually, as a former chief credit officer (for a much, much smaller organization than Bear Stearns, just $12B in income property loans), I have some sympathy for Mr. Alix. Although he had the chief risk officer job since just 2006, Alix was an 11 year employee at Bear and he had to be aware of the high wire the company was walking. But, if you were him, what would you do with that knowledge?

I think an apt analogy is the classic WWII movie scene in which there's a bunch of guys in a foxhole, and the enemy throws a hand grenade into the hole. Some credit officers in that situation see their role as saying something like, "Excuse me, but an object that looks like a hand grenade is now in our foxhole, and if it is a hand grenade and it explodes we could be injured or killed. But it might not be a hand grenade, and if it is it might not explode, and even if it does explode we might survive." Under this approach the credit officer has done his duty, tried to mitigate risk within the system, and he and his compatriots are probably dead.

Another approach is for the credit officer to yell "Grenade!" and, if no one reacts, throw himself on it. This would be the equivalent of telling your coworkers they're screwing up, and if they don't stop, calling up your regulator to shut the place down. Like throwing yourself on a grenade, this involves some personal risk and a great deal of courage. Here's a link to the fascinating story of a former coworker of mine who took that route at Indymac.

A third route is to shout "Grenade!" and, if no one reacts, exit the foxhole as quickly as possible. I think most people would say this is the course of action Mr. Alix should have taken, and before 2001 I think I would have agreed without thinking much about it. When I took my first big credit job (1997), I viewed myself as a circuit breaker. If the company I worked for overloaded, I would trip, and while I knew I was probably done with that company I thought I could go to another company who needed a circuit breaker. When the 2001 recession started and it made sense to turn deals down, it dawned on me that finding a replacement position during a recession might not be all that simple. The times when an assertive credit person is most likely to find his or her services no longer needed are the times they are least likely to find a new job. My response to this realization was to stockpile food in the basement and prepare for a long period of underemployment if necessary (thankfully, it wasn't), but another understandable approach would be for the credit person to step back and not make waves.

Compensation enters into this balancing act, but not in the obvious way. The standard view is that a credit person sells their soul to keep the big bucks rolling in, and I am sure that happens. However, the converse is also true; if you're not financially independent doing the right thing can be a hardship. This is especially true if others are dependent on you. Economists would like to believe you can structure compensation to incentivize people to do the right thing. I don't think that's possible with credit officers; in the end it's a character issue, not an economic one.

So, I have sympathy for Mr. Alix; he was in a difficult situation facing difficult issues. But, he should not have been hired by the Fed, as any economist knows. A basic tenet of principal-agent theory is that the threat of termination of the relationship is one of the ways to keep an agent from acting against the interests of the principal. If a credit person knows association with a major financial disaster will terminate his or her credit career, he or she is more likely to do the right thing. The hiring of Mr. Alix by a regulator to be a regulator is the most effective action I can think of to undermine that principle.

Sunday, November 9, 2008

Kerry Killinger, Daniel Mudd, and Richard Syron are not Stupid, Greedy, or Crooks

An article in today's Seattle Times says "Washington Mutual suffered an ugly death, leaving thousands without jobs, homeowners facing foreclosure, a civic crater in Seattle and a 100 year old institution flushed away by miscalculation and greed...Shareholders are also appalled by what they see as incompetence, and worse, by executives in their failure to protect the company...The Ontario Teachers Pension Plan Board of Canada, a major shareholder, has filed a securities class action complaint against Washington Mutual and some officers, including former Chief Executive Officer Kerry Killinger." Daniel Mudd, former CEO of Fannie Mae, and Richard Syron, former CEO of Freddie Mac, have been similarly lambasted (see, for example, His Name is Mudd) and the subject of calls for criminal investigations.

First, let me make clear that I don't know these men; they actually could be stupid, greedy and crooks. But, I think that's unlikely; my guess is they're probably really smart guys, and as honest and ethical as the rest of us (here are a couple of interesting posts arguing the elite really are elite, and the difficulty of assessing the ability of those at levels above our own). I think there is a much simpler explanation for the decisions which blew up their companies:

They tried to earn what they were being paid.

It's admirable, of course, to earn what you're given -if they didn't try to do that, they would be justly criticized. In 2007 Mr. Killinger's compensation was $14,364,883, Mr. Mudd's was $14,231,650, and Mr. Syron's was $14,497,981. What should they have done in 2008 to earn that money?

Lenders compete on price (interest rates, fees, processing costs), execution (speed and certainty of delivery of the promised transaction), and terms (leverage, documentation, covenants). By all accounts, all three companies were very competitive on price and execution. That leaves terms. As long as there are lenders willing to lend more aggressively (higher LTV loans, lower income ratios, less documentation, fewer reserves and covenants) conservative lenders will lose market share. You do not get paid $14M to lose market share.

In the old days (1970's and '80s), savings and loans were called 3-6-3 businesses; pay depositors 3% interest, extend mortgages at 6%, hit the golf course by 3PM. WAMU, Fannie, and Freddie were all stable, well run companies that could have made a good return making/buying secure loans, and their CEOs could have been on the golf course by 3. But, that would not be worth $14M. So, they tried to earn it by competing for riskier business, and they failed.

Workouts 101: Hold'em or Fold'em?

Income property workout people have been idling for many years now, but it looks like those days are over. This seems an opportune time for a series of posts outlining what I learned the last time around (1989-1994).

I will be laying these rules out in a series of binary choices - one or the other, true or false, yes or no. Obviously, there are a lot of moving parts to every income property workout, and it is tempting to try to weigh all the factors which could influence the outcome (formally, this is a Bayesian approach). The binary approach seems simplistic, but there is compelling evidence it can lead to decisions almost as good as more complex rule systems, and it's much simpler (important when you're up to your waist in alligators). If you want to delve into this topic further, a couple good books are Simple Heuristics That Make Us Smart by Gerd Gigerenzer and The Either/Or Investor by Clark Winter.

So, Hold'em or Fold'em? Although this decision applies at the individual loan level too, first the decision needs to be made at the portfolio level, i.e., do I liquidate the portfolio as quickly as possible (through a portfolio note sale, for example), or try to maximize value working out individual loans? There is no right answer - subsequent events which are unknowable at the time of this decision will determine whether or not the right decision was made, and even later the answer may not be clear. Here are some implications of an immediate liquidation:

  • Liquidation will almost certainly result in a higher immediate loss than holding the portfolio. The buyer is going to make a determination of the value to be realized from working out the portfolio, and this is almost certainly going to be less than the value a lender might reasonably justify to a regulator. For example, a lender might mark a loan to the value of the underlying collateral, but a buyer of the distressed note will start with the value of the collateral and then deduct a further haircut for the risk and time required to realize that value.
  • Since an immediate loss is involved, you probably wouldn't liquidate the portfolio unless you believed the market was going to continue to fall for a material time period. If the market turns around shortly after the sale, the buyer will have a windfall and the seller will have an unnecessary loss and will look stupid in the bargain.
  • It is much easier to make the decision to dump a portfolio if you were not around when it was originated. Prior involvement creates all kinds of biases which tend to keep people in situations once they've committed to them (see endowment effect, post-purchase rationalization, status quo bias, sunk cost effects, loss aversion, optimism bias, and valence effects). If you're the guy who is brought in to clean up the mess, it's much easier to attribute the problem (and the loss you take from the liquidation) to the old regime and move on.
  • Frequently if your organization is publicly traded the market has already built in the full loss (and maybe more) into your stock price, and a liquidation will actually improve the value of your stock (see, for example, SL Green's divestiture of their interest in Gramercy). This has some interesting implications if you are working out debt with a publicly traded borrower. You might assume they are interested in maximizing value, while they might see more value in dumping the collateral and disassociating themselves from the problem.

To summarize, although liquidation might result in a large immediate loss, there are some compelling reasons to consider it. This is especially true if it looks like the downturn is going to be protracted (as it does this time around). So why aren't many lenders liquidating their positions now? I think at this stage it's because there have not been senior management replacements at many institutions, and because many institutions cannot afford the hit.

Tuesday, November 4, 2008

The Slippery Slope to Default

When a borrower defaults on a multifamily income property loan, it is usually the culmination of a number of events and decisions over a period of months or even years. Once started down the default path, the end is very predictable. Ironically, lenders do a poor job of monitoring the progression, with the result that they can't accurately predict which loans will default.

The Slope

Stage 1 - Employment Downturn. Almost always, defaults occur when employment declines in a market. Obviously not all tenants depend on a job (retirees, students), but most tenants do, and when there is an employment downturn tenant turnover increases because tenants double up or relocate to better job markets. Also, tenant traffic decreases because fewer tenants are looking for housing. There is very little a borrower can do to stem turnover caused by economically distressed tenants or increase the number of tenants looking for housing.

Stage 2 - The Borrower Takes Productive or Counterproductive Steps to Increase Occupancy. To counteract increased turnover from economically distressed tenants, about the only productive response a borrower can make is to work harder to retain existng tenants. In a market where fewer tenants are looking for housing, the productive approach is to try to improve the project capture rate with more advertising and lower rents and/or concessions. There are a number of other things borrowers do (or don't do) which are counterproductive:

  • Lower Tenant Quality Standards. One approach to increasing a project's capture rate is to accept tenants with poor credit or rental histories.
  • Replace Capable Management. An owner may mistakely attribute the decline in occupancy to ineffective onsite or third party management. Obviously, an occupancy problem could be caused by ineffective management, but if the real cause is an employment downturn, blaming management will not help. In this circumstance the new management won't be more effective, and they could be worse.
  • Do Nothing. This strategy might work if the economic downturn is short and shallow, but is not constructive in a prolonged downturn because other owners will adjust to the new market conditions, and the project owned by the do nothing borrower will become increasingly uncompetitive.

Stage 3 - Economic Distress. This stage could occur simultaneously with Stage 2, or may appear later. It occurs when the borrower doesn't have the funds to increase advertising and/or properly maintain the project and turn the units. If he or she hasn't already done so, the borrower may cut tenant qualification standards and/or replace mangement. Often borrowers who were using professional third party management fire the company and manage the
projects themselves at this stage.

Stage 4 - Cycle Intensification. At this stage the counterproductive actions the borrower has taken reinforce the cycle. The reduction in tenant qualification standards results in tenants more susceptible to economic distress themselves, and often make it more difficult to attract or retain better quality tenants. Good managers and management companies do not want to be associated with poorly maintained projects and leave. Good quality tenants leave the project because it is not being properly maintained, and it is very difficult to attract good quality
tenants to a poorly maintained project in a soft market. Eventually the project does not generate enough income to service the debt, the borrower exhausts his or her reserves, and there is a default.

Loan Rating and Watch List Implications

Lenders attempt to anticipate defaults by using a loan rating system and a watch list of loans they believe are more likely to default. While this is obviously a good idea, lenders are often watching the wrong things:

  • Market Rents and Vacancies. Rent and vacancy trends lag employment trends - by the time rents are declining and vacancies are increasing borrowers are already at Stage 2. It makes more sense to monitor employment trends as the initial trigger for concern.
  • Focus on Physical Occupancy Instead of Net Rental Income Trends. Often lenders will focus on physical occupancy as a watch list criterion. Although low physical occupancy obviously signals a problem, a project may be maintaining good physical occupancy by cutting tenant quality standards, lowering rents, and/or offering concessions. A much better indicator is change in net rental income from the previous period.
  • Turnover. Although lenders usually get a rent roll at least annually as part of their monitoring process, they almost never look at a project's turnover (which is easily calculated by looking at the tenant move-in dates). A sharp increase in turnover is a good indicator of a potential problem.
  • Debt Service Coverage. Most lenders are fixated on debt service coverage as their primary watch list indicator. While it certainly makes sense to watch DSC, it can't be done in isolation. In an economic downturn if a borrower is making productive responses expenses should go up (primarily in advertising and maintenance line items). A project and borrower in economic distress will show a decrease in expenses as maintenance and other costs are deferred. Paradoxically, a project with a low debt service coverage created in part by high advertising and maintenance expenses has a lower risk of default than a project with a better debt service coverage because the owner is deferring maintenance and other expenses.
  • Property Condition. Most lenders monitor property condition with annual inspections, which is a good idea. However, there is almost never any continiuty in the inspection process - every year a different inspector looks at the property, so no one can say what the trend is until a project is in bad condition.

Initial Loan Decisions

The slope model also has implications for the initial lending decision:

  • Borrower Domicile. In my experience, borrowers who do not reside in the project's market (for example, a Los Angeles investor owns a project in Dallas) have a much higher default rate than borrowers who are close to the markets they invest in. Borrowers who are not close to their markets have difficulty taking early and appropriate steps at Stage 2 relative to local investors, which places their projects at a disadvantage.
  • Borrower Experience. Similarly, inexperienced borrowers have more difficulty reacting appropriately at Stage 2, and have much higher default rates.
  • Financially Weak Borrowers. Borrowers with limited net worth and liquidity are virtually always the first to default in a downturn, because they start out in Stage 3. Although most lenders consider experience and financial strength in their initial lending decisions, very few capture this information after the loan is approved and incorporate these factors in their loan ratings and portfolio analysis. I've never heard of a lender tracking borrower domicile as a risk factor.

10 Questions Income Property Lenders Should Ask Themselves

1. Do you know which loans in your portfolio are secured by properties whose owners live in a different market than the property?
2. Which loans in your portfolio have borrowers whose net worth is less than the loan amount and/or whose liquidity is less than 10% of the loan amount?
3. Can you say which properties in the portfolio experienced more than a 10% decline in net rental income from the last period?
4. Do you require the same inspector be used for project inspections from year to year?
5. Of the markets you lend in, which have experienced employment loss over the previous 12 months?
6. For properties with DSC ratios between 0.90 and 1.10, which are reporting maintenance expenses more than 20% less than originally underwritten?
7. How many properties in your portfolio have annual turnover rates higher than 70%?
8. Which properties replaced their management companies last year?
9. Which properties have moved from third party management to self management?
10. Which properties in your portfolio are owned by borrowers who have less than 100 units in that market?

Congratulate yourself if you can say yes to any of these questions; you are doing a better job of portfolio management than most. But, if you can't answer yes to all of them there is room for improvement in your monitoring procedures.

Wednesday, October 15, 2008

Multifamily Occupancy Rates: Four Things to Think About

(Note: If you make it all the way through this post, you'll probably end up thinking I've beaten a relatively simple concept to death, and you'll be right. However, the individual components discussed below tie into other issues, and I think having all this laid out exhaustively in one post will facilitate future posts).

Loan underwriters tend to think of occupancy rates as static. At any given time, you can divide the number of occupied units by the total number of units and get the physical occupancy rate. For any month, you can divide actual rental income collections by gross potential rents and get the economic occupancy rate. It's about as simple a calculation as it gets in real estate finance. However, what's actually going on is more complex, and understanding the four constituent components of occupancy rates is important in evaluating the risk associated with a project.

The first component is the Turnover Rate. If no tenant ever leaves a project, occupancy would always be 100%. However, all projects have turnover. Leading turnover causes are:

  • House purchase
  • Job relocation
  • Household changes (divorce, marriage, births, roommate changes). Such changes can affect both what tenants can afford to pay and how much space they need.
  • Changed economic circumstances (e.g., job loss, salary increase or reduction) necessitate/enable a move to lower cost or nicer housing
  • Death, illness
  • Dissatisfaction with current residence

As is apparent from the list, no project is immune from tenants leaving; in fact, the last item is the only one the project owner has any control over. Many people are surprised by how much turnover there is in a typical apartment project – in my experience 50%-60% of tenants leave a typical project every year. If you want to check this, it's relatively easy to get a rough idea of a project's turnover rate if you have a rent roll with move-in dates. Simply count the number of tenants who have moved in during the last 12 months and divide by the total number of units (this approach will understate the rate to the extent tenants have moved out during their first year of occupancy, but to get an exact count you would need to look at each month's rent roll).

The other components to the occupancy rate relate to the process of replacing these tenants. The second component is Traffic, which I define as the number of potential tenants who visit a project to determine whether or not they want to rent an apartment. A project's traffic is the subset of some progressively smaller sets:

  • Everyone in the market who is interested in renting an apartment in the project's submarket at a point in time (we'll call this group Potential Tenants)
  • The subset of Potential Tenants who are aware of the project (we'll call this group Aware Potential Tenants). A Potential Tenant could become aware of the project through advertising, a referral, or driving by the project. Let's define the Awareness Factor as the number of Aware Potential Tenants divided by Potential Tenants.
  • The subset of Aware Potential Tenants who actually visit the project and inquire about renting (we'll call these Prospects). An Aware Potential Tenant may never become a prospect; for instance, he or she finds an apartment at a competing project before visiting our project, or may drive by our project and conclude it's not for them based on design, maintenance, or location. Let's define the Inquiry Rate as the number of Prospects divided by the number of Aware Potential Tenants.

Like turnover, important elements of traffic are largely outside an owner's control. An owner can attempt to increase the number of aware tenants through advertising and referral programs, and can increase the number of prospects by enhancing a project's curb appeal. However, in an economic downturn fewer people are interested in renting apartments, so there are fewer potential tenants, and there's not much an owner can do about a project's design or location.

The third component of the occupancy rate is the Capture Rate, which is the number of prospects who lease a unit divided by the total number of prospects. If a prospect is not captured, it's generally because they didn't like the leasing agent, the specific features of the project or units as revealed by the tenant's inspection, or the price. These are all things the owner can control.

Here's an example to show how these components work together:

A 120 unit project has a 50% annual turnover rate (i.e., 60 tenants a year or 5 tenants a month leave). In this particular month there are 160 Potential Tenants looking for an apartment in the project's submarket. 25% of the Potential Tenants are aware of the project, 50% of these tenants come to the project and talk to the leasing agent, and 25% of these tenants like the leasing agent, the project, and the price and sign a lease:

160 Potential Tenants * 25% Awareness Factor * 50% Inquiry Rate * 25% Capture Rate = 5 New Tenants

So, for this month the project is full again.

Of course, it's pretty rare for the equilibrium to be perfect. Think of an apartment project as a leaky bucket with tenants dripping out the bottom. To keep the bucket full you have a hose, but the hose is too short so you have to spray the water in from some distance away. As long as you have enough water coming through the hose (potential tenants) and good enough aim you can keep the bucket full, but if the combination of water coming though the hose and your accuracy doesn't put enough water in the bucket to exceed the volume of the leak, the level of water in the bucket will go down.

The final component, Time to Turn, relates to economic occupancy. When a tenant gives notice they're going to move, a good onsite manager starts looking for a new tenant for that unit before the physical vacancy actually occurs. In an ideal world the first tenant moves out on the last day of the month, the new tenant moves in the next day, and no rent is lost. However, it's not an ideal world; units need to be cleaned, units aren't always leased before they become vacant, and tenants don't always move in immediately. As a result, turnover almost always results in economic loss, even if on a monthly basis you are 100% occupied. As a result, economic occupancy is always going to be lower than physical occupancy.

Let's see how these components work together. Let's say we underwrote a loan based on an economic occupancy of 95%, which is well supported by the project's history. The next year the project is on the watch list and the economic occupancy is 80%. What might have happened?


  • An increase in the Turnover Rate. Pronounced changes are usually related to the local economy or a change in resident management, but there are other interesting possibilities. For example, during the early 1990's in Southern California I was involved in a number of workouts on small projects which experienced 90%+ of the tenants moving out in one month. The pattern was the owner leasing a unit to someone fronting for a gang member, the gang moves in, and all the other tenants move out the next month.
  • Decrease in Potential Tenants. This is usually related to the local economy.
  • Decrease in the number of Aware Potential Tenants. This is usually related to a change in the owner's advertising.
  • Decline in the number of Prospects. This is usually the result of more competition in the neighborhood and/or a decline in the project's curb appeal.
  • A lower Capture Rate. This is usually related to as change in the pricing environment and/or a change in resident management.
  • Longer Time to Turn. This is a function of all of the above, plus maintenance staff capability, the condition the vacant units are left in, and management willingness to wait for a tenant to move in vs. gambling they can find a tenant who will take occupancy sooner.

Usually there is more than one factor at work. I think you will agree that it is not implausible that these events could happen to almost any project. Now, look through the list again and think about how an underwriter could anticipate such events. The answers fall into two groups:

  • Forecasting economic downturns. This is usually possible to some extent over the short term. The difficulty is that, while you may know the market is weakening, it's impossible to know if the downturn will be sharp enough to warrant rejecting the loan.
  • Owner decisions. You can't know that an owner won't make a future mistake, but you can mitigate the risk if you lend to experienced owners.