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.