Goodbye For Now...

As of 9/1 I will be starting a very challenging new position, and between then and now we will be relocating from Seattle to Los Angeles. On the down side, I expect it will be many months before I will be able to make time for regular posting. On the plus side, I expect I will have a whole new set of topics to talk about when I resume posting.

Thanks to my regular readers - blogging is a lot more fun when you know someone is reading. I will be back when circumstances allow.

Now is a Great Time to be a Major Tenant: Part 2

A few weeks ago I posted about the opportunity for a major tenant to lease at 250 Montgomery Street. A major New York law firm did such a deal last week. From the Wall Street Journal article, Reduction in Rent for Law Firm Proves Patience Is a Virtue:

In 2007, when the law firm of Orrick, Herrington & Sutcliffe LLP began looking for a new location for its New York office, rents in a prestigious building that suited their tastes ranged from a pricey $120 to $140 a square foot.

What a difference two years and a massive global recession make.

Last week, in the largest Manhattan office lease so far this year, Orrick finalized a deal for 220,000 square feet in "Black Rock," headquarters of CBS Corp. at 51 W. 52nd St. The deal provided the law firm with a huge bargain over 2007 prices. Sources familiar with the deal said Orrick will pay monthly rent in the low- to mid-$70-a-square-foot range.

But it gets better. The landlord, CBS, agreed to spend $150 a square foot to renovate the space, leaving Orrick with little to no out-of-pocket costs to set up the new office.

That’s $33 million for tenant improvements the landlord is eating, and capping the rent reduction at 7% trims more that $133 million off the value of the building.

Knowing When to Stop

When you think about bad CRE loans, most people picture homes being demolished in Victorville, unsold high rise condos in Miami, or vacant office buildings in Orange County. But how about Minnesota? From a Minneapolis Star Tribune story (hat tip Calculated Risk):

Minnesota ranks fifth nationally, with 50, or 12 percent, of its banks carrying particularly high levels of dead real estate loans, according to an analysis done for the Star Tribune by Foresight Analytics, a financial research firm in Oakland, Calif. Only Florida, Georgia, Illinois and California have more banks at such levels.

A key quote:

Bank consultant Robert Viering, principal of River Point Group Inc. in Monticello, had that lesson drilled into him when he was a regional credit officer at the former Norwest Bank. A credit manual, circa 1990, warned him and his colleagues: "The pivotal issue in CRE lending is knowing when to stop. Restraint must be initiated by bankers because historically borrowers have been unable to recognize the warning signs. Commercial real estate lending should not be viewed as the cornerstone of a loan portfolio."

Stopping, of course, involves saying no before the problem is evident. This is something people are very bad at doing (for more on that, see my post Rising Markets Create Lender Losses).

More on Fractured Condos

Fractured condos are condo projects where only a portion of the project is sold to individual owners, and the remaining units are rented to tenants. A couple of recent examples:

The Millworks at Novato (from the Marin Independent Journal):

Millworks, a 420,882-square-foot residential/commercial project at De Long and Reichert avenues, had a grand opening in May but has only sold two of 124 condominiums situated above a Whole Foods grocery store slated to open next spring.

"Because of the mortgage market, it's really hard to get condo loans right now," said Mike Ghielmetti, president of Pleasanton developer Signature Properties. "A lot of the folks who are interested in buying there have homes to sell, and it's just a slow market. This is what we have to do for an interim period to make this viable."

Unit financing is a huge issue – Fannie and Freddie won’t buy unit mortgages until the project is at least 50% sold out, so these days the only available financing for unit purchases tends to be the construction lender on the project. It seems likely the construction lender on this deal refused to do that (construction lenders are not keen on holding long term fixed rate mortgages in portfolio). I suspect the other problem with this project is it’s pretty big for the size and niche it fills – how many people are there who want to live in downtown Novato?

Siena in Corona Hills (from GlobeSt.com):

 

A buyer from Fontana has acquired 189 units of a broken 296-unit condominium conversion project from its lenders for $14.25 million in a deal that says much about the state of the multifamily market in the Inland Empire today, according to Paul Runkle of the Inland Empire office of Hendricks & Partners in Temecula, who brokered the sale. The property is the Siena in Corona Hills at 2125 Highpointe Dr., formerly an apartment complex known as the Crossing…"This comp says that a quality, broken condo deal that was leased up with rentals, that was not readily financable, and was widely exposed, eventually sold at at 8.93% cap on an all-cash basis," Runkle says.

There are enough numbers in the story to piece together the before and after on this deal:

The moral to the story on this one is, don’t buy an apartment project on a 3.55% cap rate.

See previous post “Are Fractured Condos a Good Investment Opportunity” for a discussion of some of the hazards of doing these deals.

Borrower Risk, Net Worth, and Liquidity

You are considering making a $10,000,000 loan to one of two borrowers. Both borrowers have a $10,000,000 net worth and $1,000,000 in cash. Your astrologer has told you one borrower will default and the other won’t, but she can’t tell you which one. You are allowed to ask each borrower three questions. What do you ask?

Here are my questions:

What are your total liabilities (contingent and non-contingent)? A borrower with $10,000,000 in net worth with $20,000,000 in assets, $10,000,000 in liabilities and $1,000,000 in cash is a great risk. A borrower with the same net worth and liquidity comprised of $100,000,000 in assets and $90,000,000 in liabilities is toast in a significant downturn.

How did you make your money? If the answer is investing in the same market and kind of real estate as the loan you are considering (for example, multifamily in Dallas), the borrower is a good risk. Any other answer (selling a software company, dentistry, UPS driver, playing poker, aerospace engineer) is a problem. I know this from personal experience because I’ve approved and subsequently regretted making loans to borrowers with these former occupations. Each time I thought we had mitigated the risk – I now believe you can’t mitigate inexperience.

What was the value of CRE assets you owned in 2001? The answer should be at least $2,000,000 – enough to tell you they had some holdings in the last downturn. If the answer is less than that it means they made all their money in easy times. Ideally, a borrower would have been through the 1989-1994 trough, but those guys all have a net worth a lot bigger than $10,000,000.

I believe the answer to these three questions tells you pretty much everything you need to know about a borrower.

Commercial Real Estate Market Stability and Government Centers

Last week I posted on the merits of college town markets (although I glossed over the reasons – Chris Rodriguez goes into more detail in his post “Commercial Real Estate in College Towns – Recession Proof”). Markets with heavy concentrations of government employees also weather the storm better.

The charts below show the 12 month percent change in employment for the largest market in the state, and that state’s capitol. Starting with the state that’s always the worst:

Employment losses in Lansing are half those of Detroit. Next, Washington:

Employment loss in Olympia is a quarter of that in Seattle. On to Texas:

Austin is one of the few places that hasn’t lost jobs at all.

No discussion of government centers is complete without looking at Washington DC. Job losses there are half what they are in the nearest major market (Baltimore):

Government centers don’t always outperform; Sacramento and Albany performance is about the same as Los Angeles and New York respectively. But, as a general rule the relative stability of government jobs provides a safety net for their markets.

All data from this BLS site.

Retail CRE: Which Deals Get Renegotiated?

One answer: new, incremental deals in outlying areas. Calculated Risk put up this post a few days ago:

“We’re dumbfounded. We’ve been working on this deal for four-and-a-half years. I don’t know how, all of a sudden, the numbers don’t work.” JMW Development Principal Mark Johnson

From the Minneapolis / St. Paul Business Journal: SuperTarget planned for Woodbury now on hold (ht Arnold)

“Target recently informed JMW that it would not proceed with the project unless it receives “a pretty significant discount” from its previously negotiated deal, JMW Principal Mark Johnson said.
“We’re dumbfounded,” Johnson said, noting that Target officials had told him as recently as June 24 that the project was on track.”

Maybe Target has lowered their retail sales estimates for the store? Just saying ...

Woodbury is an outlying Minneapolis-St. Paul suburb, and already has a Target (“B” on the map below) which is eight minutes from the site of the proposed new store (“A”).

When it negotiated the deal for the new store Target was anticipating new residential growth in Woodbury which is now not going to happen. Without growth the new store won’t hit its numbers, and will cannibalize sales from the older store.

Preserving Favorable Financing in Bankruptcy

Section 1124 of the Bankruptcy Code allows borrowers to reinstate debt under certain conditions. Via Zero Hedge, an excerpt from a letter from Watchell Lipton reporting a settlement in the Spectrum Brands bankruptcy case:

Section 1124 of the Bankruptcy Code provides that if, pursuant to its Chapter 11 plan, a debtor cures all nonbankruptcy defaults under a debt instrument and does not alter the rights of the debtholders, the reorganized company can “reinstate” the debt on its original terms, without the consent of the debtholders. Thus, the success of a “reinstatement” strategy depends on the debtor’s ability to craft a feasible plan that does not violate the terms of the relevant loan documents and allows the debtor to remain in compliance with the loan’s terms post-bankruptcy. Because many secured credit agreements negotiated over the last several years have favorable interest rates and contain so-called “covenant lite” provisions (few or no financial covenants and permissive negative covenants), such companies have a strong incentive to try to take advantage of reinstatement.

Although I’ve not heard of the section being applied in a real estate case, this would seem to be a mechanism a borrower could use to restructure junior or mezzanine debt while leaving favorable first lien debt in place.

The complete Watchell Lipton letter can be found at the Zero Hedge post.

REITs Positioning to Take on CRE Debt

As banks pull back from CRE debt and the CMBS market lies dormant, REITs are raising capital to step in. From REIT Wrecks:

In addition to LRCF, Alliance Bernstein, Angelo Gordon, Apollo Global Management, Colony Capital, Starwood Capital and Western Asset Management have all registered to raise equity for their own Mortgage REITs…

The filings make for great reading. Ladder said there is now an “unprecedented market opportunity" to originate well-priced loans. Colony said that the the credit crisis was causing an "over-correction" in commercial real estate debt and that there would be a "protracted opportunity" originate attractive loans. Alliance's new REIT, Foursquare Capital, said that the "current distressed condition in the financial markets" would allow it to buy mortgage assets at "significantly depressed trading prices and higher yields." As for Barry Sternlicht and Starwood, their filings were even more emphatic: "the next five years will be one of the most attractive real estate investment periods in the past 50 years."

For more on the logic of this move, see my post, “Why Now is a Great Time to be a CRE Lender.”

Commercial Real Estate Market Stability and College Towns

If you’re looking for CRE markets that are insulated from downturns, college towns are a good place to start. The Creative Class post “Where Unemployment Is Worse Than Expected” analyzes the performance of various metro areas in this recession. Here’s one of their graphs:

Low and to the left is good (Iowa City), high and to the right is bad (Detroit, Kokomo and Elkhart). An excerpt from the post:

College towns number among the best performers, doing much better than predicted: Champaign-Urbana, Illinois, home to University of Illinois (-2.2); Iowa City, University of Iowa (-1.81); Manhattan Kansas, Kansas State University (-1.82); College Station, Texas, Texas A&M (-1.74); New Haven, Connecticut, Yale University (-1.54); State College, Pennsylvania, Penn State University (-1.47); Boulder, Colorado, University of Colorado (-.93); Austin, Texas, University of Texas (-1.0); Ann Arbor, Michigan, University of Michigan (-.94); and Ithaca, New York, Cornell University (-.97), among others.

The correlation isn’t perfect; for example, the metros with the major Oregon universities (Eugene and Corvallis) have both underperformed. However, the relatively stable employment base and demand for services created by large universities tend to buffer these markets. And, since employment is the most important determinant of CRE performance, CRE in these markets tend to do better.

Picking the Right Distressed Asset Broker

If you’re selling in this market, almost by definition you, your asset, or both are distressed. It’s also pretty likely that unless you were selling assets back in the early 1990’s you’ve not been a seller in a market like this. What to do?

The short answer is to find someone who is successful at moving similar product in your market. For example, if I were the unfortunate owner of undeveloped land in Hesperia, California, I would call John Reeder at Sperry Van Ness, because John recently brokered the sale of this 55 acre parcel there:

There certainly is a lot of vacant land in Hesperia, isn’t there? SVN’s Dealbreaker site also has information on lots John brokered in Victorville. The guy who can sell land in a market made famous by a lender demolishing mostly completed homes is the guy I would want selling my asset.

Brokers who are successful in this market are not necessarily the brokers who were successful in happier times – the skill set and often the buyers are different. From Lansner on Real Estate’s post “Big Money Now in Selling Foreclosed Homes”:

Power has shifted away from the traditional model of real estate agents representing homeowners to agents specializing in selling foreclosed homes, new data show…

Most traditional agents haven’t been able to adapt to those changing circumstances because selling foreclosures requires different skills: the ability to deal with evictions, making repairs, managing large numbers of vacant properties, plus paying out large sums of your own money, then pursuing reimbursements.

In tough times, you need an expert - for example, Leo Nordine, the Los Angeles REO broker the New Yorker profiled in their April 6, 2009 issue (abstract here).

Real Estate Values, Uncertainty, and Anchoring

Everyone knows that real estate values today are much different than the values assigned to the same real estate two or three years ago. Elena Panaritis argues that value uncertainty is the underlying cause of our crisis in her Financial Times post “The Real Estate Roots of the Crisis in the US”. Some excerpts:

Traditionally, economists are trained to assume that pricing in general is a point of equilibrium defined by almost perfect market forces, where the demand and supply meet and neither the buyer or seller has a huge informational advantage. The traditional model also assumes that markets are frictionless and transaction costs are near zero especially when we deal with the supply side. From that they continue to assume that systems (rules, regulations, norms) that define the tradability of assets are given and near perfect. But this is rarely the case. In reality the systems that define supply of land and real estate tend to be full of transactions costs and information leakages, and that makes it really difficult to follow the old maxim that a price or value based on how much one is willing to pay is necessarily the right price.

Until the United States accepts that it has a badly flawed approach to establishing and verifying real estate property rights and to determining the valuation of property, until it puts in place a system that homogenizes and standardizes the underlying securitized assets of real estate and housing - the same way securities are required to be homogeneous prior to being traded in bundles - these underlying real estate assets will continue to be toxic.

That’s all true, but how do you improve a market that is illiquid and thinly traded, and how do you homogenize assets as heterogeneous as real estate?

I like the approach advocated by Richard Green in his post “Two Ideas for Appraisal Reform”; acknowledge the uncertainty and disclose it right in the appraisal. An excerpt:

Appraisers should use valuation techniques that allow them to report a standard deviation of their estimate. Subdivision tract houses will have small standard deviations; architect designed villas will have large standard deviations.
We could then move to a pricing rule where Mortgage Insurance will be required if (1) the LTV based on appraised value is greater than 80 percent or (2) there is a greater than five percent chance that the true value of the house implies an LTV of 95 percent…
We need to stop kidding ourselves that we can measure house prices precisely. We need to start measuring the level of imprecision.

Richard’s other idea is also a good one:

Appraisers should not be allowed to see the offer price of a house. This is the only way their valuation will be truly independent.

Appraisers use the contract sales price as an anchor point, where there is an anchor there’s a good chance there will be anchor bias.

Of course, back in the old days underwriters and review appraisers did this work themselves. Appraisers conclude a value, but they also report the raw comparable data. Generally, appraisers try to bracket a property by selecting some comparables worth less and some worth more. Part of the underwriter’s job was to look at these comparables and assess the implied uncertainty. For example, if the contract sales price and the appraiser’s concluded value was $400/sf and the comparables were all $350/sf or lower, you knew your value had a high degree of uncertainty.

Some CRE lenders still do this work, but I doubt it happens much on residential transactions. Richard’s suggestions are a good substitute.

Zombie Banks’ Distressed Assets

John Reeder’s post Distressed Assets Market and FDIC Closures on Real Property Alpha is a must read for those that want to understand what’s going on with regional banks. An excerpt:

Our business working in the commercial real estate industry (see the Deal Breaker site, or upcoming Sperry Van Ness auction) puts us on the front lines of the current blow-up that is going on in the banking industry.  Capitalization levels in financial institutions have a large impact on whether they are willing or able to dispose of distressed construction loans, commercial REO, or A&D loans.  The general rule of thumb is that the more distressed the bank, the less potential that you are going to be able to make a deal with that Bank on their non-performing assets.  It’s difficult to digest this reality as the potential that a distressed bank offers in the way of inventory can be enticing.    However, the chances are that the bank has not written down the value of the asset to real current market, so selling at today’s prices means that the bank has to take an additional hit to their capital and the really distressed banks can ill afford the additional hit.

Read the whole post, there’s much more. I have two small contributions to John’s points:

• Even if a bank conscientiously marks its bad assets to market, it will still probably incur smaller losses at any given point in time if it holds the asset instead of disposing it. The marks are based on appraisals less a discount for sales costs. This number will almost always be higher than what a bank actually realizes on a sale, because appraisal values tend to lag actual market trends (more on that in the Lansner on Real Estate post “Were Appraiser’s Late to the Price Collapse?”). So, a bank can adopt a hold strategy and still be in regulatory and accounting compliance. The risk, of course, is that by hanging on to the asset, the bank continues to be exposed to further value losses if the market continues to deteriorate, and may ultimately incur an even bigger loss.
• In most cases the management and staff working on the problem assets at the smaller banks are the same people who originated the deals. There are whole sets of cognitive biases which predispose people to overvalue what they own (endowment effect, post-purchase rationalization), continue to do what they've done in the past (status quo bias, sunk cost effects, loss aversion), and expect a positive outcome to their choices (optimism bias, and valence effects). The consequence is the management at these banks may genuinely believe these assets can be salvaged given time, while someone with less involvement would say it’s time to take the loss.

My point is that, while I am sure some banks are consciously manipulating their accounting, I am also sure many banks believe they are doing the right thing.

Are Fractured Condos a Good Investment Opportunity?

A fractured condo project is one in which only some of the units have been sold. They occur when sales stall, and usually the construction lender ends up owning the project. Some see these projects as a great investment opportunity. An excerpt from Unnatural Rent:

In fact, one of the more promising investment opportunities may be taking over broken condo developments, for instance, a 100-unit project that only has 20 units sold. It should be possible to acquire the unsold units in a block and then rent or sell after the market recovers.

And from Realty Times:

Hedge funds, private equity "vulture" groups and individual investors are all shopping aggressively to pick up these distressed units at deep, deep discounts that start at 40 percent and go much lower.

New Valley LLC, a Miami-based subsidiary of Vector Group Ltd., a New York Stock Exchange-traded company, says it's got $250 million in cash ready to invest in South Florida fractured condos or in troubled rental projects.

Vanessa Grout, vice president of acquisitions, told Realty Times that the situation has become so dire for some developers of prime condo projects this year that her firm sees "pivotal opportunities" right now to pick up high-quality, well-located condos at once-in-a-lifetime prices.

There are some huge drawbacks to such projects:

• You have to deal with the owners of the units which were sold. These people are typically very unhappy. In a perfect world the project buyer repurchases these units, but often these owners will hold out for a premium price.
• Buying a large block of units from the developer may put you in their shoes if there are construction defects. The combination  of angry unit owners and construction defects can be really unpleasant.
• Many multifamily investors won’t touch these projects, with the result that the pool of potential buyers is smaller. This can make an exit harder.
• The project may have failed as a result of condo market conditions or a bad price point, or it may have failed for more fundamental reason (bad location, poor design). It’s not always easy to sort out the cause of the failure, and a bad condo project is likely to be a bad rental project too.
• For all the reasons above, it’s very, very difficult to get financing for these projects. Conventional multifamily lenders (e.g., Fannie and Freddie) won’t touch them, which doesn’t leave many sources in this market.

These deals will get done, but it’s not easy money.

New Blog Feature

Most of my posts are prompted by what I read on other sites, but I don’t have time to discuss everything I find interesting. I’ve added a “Shared Item” gadget on the right sidebar under the email subscription for these posts by others. I hope you find them interesting too.

The Problem With Medians

Prices, vacancy rates, rents - most pronouncements of real estate trends are the medians of a set of data. These reports are largely meaningless, or, even worse, actively misleading. Lansner on Real Estate’s post “Is Median Price Giving Bum Signals?” quotes John Burns, and Orange County housing consultant, on the subject:

We are extremely concerned that policy makers, banking and real estate industry executives, investors and others will use misleading home price data to conclude that home prices have stabilized. They have not. These same influencers used this data in 2006 and 2007 to make decisions, many of which have proven to be poor decisions. It was a tough lesson, and hopefully one that won’t be repeated. This is a complex issue. Here is why: Reported home prices and home price indices rely on a small sample of transactions that represent far less than 1% of the owned homes in an area.

The data problem is serious for homes, and exponentially worse for commercial real estate because there are even fewer transactions. The problem is an ongoing theme over at Calculated Risk; see “Misleading Housing Price Data” and “Median Price Mix Example”, for example.

An alternative is the “same store” trend, which compares sales prices and operating data from the same property over time. The problem with using this approach for commercial real estate is that property and price performance are idiosyncratic. For example, land values can change radically as a result of permits being obtained or a local building moratorium being imposed. The loss of a major tenant can have a big impact on the value and operating data of an office or retail property. A new, incompetent property manager in a multifamily property can cause a big spike in vacancy. There are so many micro factors which can influence prices and performance that in my opinion it’s very difficult to draw macro market conclusions from the relatively small samples we have to work with. 

Certainly we can identify major sustained trends, but if some told me their data showed office values are down 30% in a market, my conclusion would be prices are down somewhere between 15% and 45%.

What’s the solution? When it comes to commercial real estate, I don’t think there is one – there are just not enough transactions to draw meaningful conclusions.  Employment trends provide a good proxy for commercial real estate performance; I’ve yet to see a real estate market getting better when the market is losing jobs. I’ll believe CRE and residential markets are getting better when we start seeing employment growth again.

Why Lenders Don’t Modify Loans

Economists at the Federal Reserve Bank of Boston and Atlanta have researched "Why Don’t Lenders Renegotiate More Home Mortgages?". Their conclusion also applies to commercial real estate:

We argue for a very mundane explanation: lenders expect to recover more from foreclosure than from a modified loan. This may seem surprising, given the large losses lenders typically incur in foreclosure, which include both the difference between the value of the loan and the collateral, and the substantial legal expenses associated with the conveyance. The problem is that renegotiation exposes lenders to two types of risks that can dramatically increase its cost. The first is what we will call “self-cure” risk. As we mentioned above, more than 30 percent of seriously delinquent orrowers “cure” without receiving a modification; if taken at face value, this means that, in expectation, 30 percent of the money spent on a given modification is wasted. The second cost comes from borrowers who redefault; our results show that a large fraction of borrowers who receive modifications end up back in serious delinquency within six months. For them, the lender has simply postponed foreclosure; in a world with rapidly falling house prices, the lender will now recover even less in foreclosure. In addition, a borrower who faces a high likelihood of eventually losing the home will do little or nothing to maintain the house or may even contribute to its deterioration, again reducing the expected recovery by the lender.

Adam Levitin at Credit Slips has an excellent follow up post, and makes the point that modifications make sense even after taking into account self cure risk and redefault risk. He also nails the real reason more modifications aren’t being done:

I think servicer capacity is a major concern that applies across the board.  To start with the bulk of servicer personnel at most companies aren't even in the US; they've been outsourced.  Doing a mod is like underwriting a new loan in a distressed situation.  That's a skill, and I don't think it's what servicers were looking for over the past decade when they moved operations to India. Instead, they were looking for low-cost labor for their routine ministerial tasks, and it will take a long time for the industry to acquire the workout talent it needs.

I highly recommend reading both of these pieces – together they will give you a better understanding of modification dynamics than anything else I’ve seen written over the past 3 years.

Why Haven’t There Been More Construction Loan Defaults?

Delinquency rates for CRE construction loans are “only” 12%; why is that?

Distressed Volatility quotes testimony from Richard Parkus - Head of CMBS and ABS Synthetics Research, Deutsche Bank (italics mine):

90+ day delinquency rates are currently in the 12% range for construction loans in bank portfolios, but are somewhat higher for construction loans in regional bank portfolios. In fact, I am perplexed by the fact that construction loan delinquency rates are only 12% at this point. However, I believe that this can be explained by the fact that they are typically structured with interest reserves which are sufficient to cover interest payments until the expected completion of the project. Thus, construction loan delinquency rates are currently artificially low due to interest reserves, but will likely rise dramatically within the coming 6-12 months. In my view, losses on construction loans are likely to be in excess of 25%, possibly well in excess, which would imply losses of at least $140 billion. This, of course, would be disproportionately borne by regional and local banks."

I agree with Parkus that interest reserves are responsible for keeping these loans afloat. Most construction loans are indexed to LIBOR, or less commonly, Prime. This chart from FedPrimeRate.com shows what has happened to these rates:

Construction loans started in 2005 or earlier were mostly refinanced before CRE permanent lenders pulled back, and CRE construction lending declined dramatically during 2008. As a result, the construction loans still out there were originated most during 2006 through the first half of 2008 (the period inside the ellipse on the chart above). The interest reserves on these deals were sized assuming prime would remain around 8%, and LIBOR would be at around 5%. Since then, prime has dropped to 3.25% and 1 month LIBOR is 0.29%. As a result, an interest reserve sized to carry a loan for two years can now cover interest costs for four years or more. So, even though projects are not hitting the occupancy and rent levels projected, many lenders are willing to extend these loans because the interest can be kept current from the original interest reserve without increasing the loan commitment. The hope is markets will recover before the reserve runs out or interest rates go up.

Illiquidity = Risk, Commercial Real Estate is Illiquid, Therefore Commercial Real Estate is Risky

Illiquid investments are risky. From the Knowledge at Wharton Post “Why Economists Failed to Predict the Financial Crisis”:

"When there's a default in one kind of bond, it causes reassessment of all the risks," says Wharton economics professor Richard Marston. "I don't think we have really fully learned from the LTCM crisis, or from other crises, the extent to which things are illiquid." These crises have shown that market participants can rely too heavily on the belief they can quickly unload securities that decline in price, he says. In fact, the downward spiral can be so rapid that it leaves investors with losses far larger than they had thought possible.

In the current crisis, he says, economists "should get blamed for the overall unwillingness to take into account liquidity risk. And I think it's going to force us to reassess that."

The dotcom bust and accompanying recession had little effect on commercial real estate market, in part because problems were concentrated in high tech markets, and mostly because falling interest rates freed up cash flow and boosted leveraged returns. You need to go all the way back to the early 1990’s to recreate the current sensation of free falling commercial real estate values. Almost twenty years was plenty of time for investors who had no idea how illiquid CRE can be to enter the market (see my post Waves of Stupid Money for a discussion of how investors who don’t understand the risks can skew a market).

Trust and Workout Negotiations

Two consecutive posts on trust showed up in my Google Reader (Trust, by Jonah Lehrer on Frontal Cortex, and A Matter of Trust, by Randy Pennington on the Sales and Sales Management Blog), which led me to think about the lack of trust inherent in most workout negotiations.

First, is trust a necessary condition to do a loan workout? No – people who don’t trust each other can reach an agreement. However, it is much easier to reach an agreement when one or both sides are not scrutinizing every detail of the transaction. And, if you don’t trust the counterparty, every potential circumstance down the road needs to be considered and addressed. Given the uncertainties in the real estate market that’s almost impossible to do, with the result that no agreement is reached.

Here are Pennington’s elements of trust and how they relate to real estate workouts:

Character: Every discussion of trust begins here. Character defines an individual’s approach for dealing with themselves and others. It is the demonstration of the values adopted for basic living. Individuals who embody basic principles such as honesty, trustworthiness, loyalty, justice, patience, and duty find that their ideas and recommendations are readily accepted. The nagging question of motive lingers when character is in question.

To know someone’s character requires you have a prior relationship with them. Sometimes borrowers and the people on the lender side of a workout know each other; much more often, they do not. Even when the borrower and the lender personnel have a relationship, there’s a good chance it has been a fair weather relationship. When formerly amicable relationships are tested by difficult circumstances, both sides often perceive the other as betraying the relationship.

Competence: How good are you at your job? How much do you know about your product? Can you answer my questions with confidence and authority? Professionals who earn my trust are competent. They recognize their individual strengths and weaknesses and commit to continuous growth in all areas of individual performance. An excellent reputation for honesty will be rendered useless if it is matched with incompetence.

Again, if you don’t have a track record with someone it’s hard to assess their competence, and in a workout situation there is generally plenty of doubt about the other party’s ability. From the lender’s perspective, the presumption is often the borrower’s incompetence has contributed to the current situation. On the lender side, workout people rarely have time to study the deal, and have very high caseloads leading to a lack of responsiveness. From the borrower’s point of view, this lack of familiarity and apparent indifference can easily translate into a conclusion the workout person is incompetent. 

Communication: Outstanding presentation skills contribute to effective communication. Unfortunately, too much emphasis has been placed on the importance of the pitch. Communication that builds trust is about listening. The ability to understand others creates a bond that encourages interdependence and enhances commitment. We tend to trust those who appreciate our goals, struggles, joys and situation.

There is usually surprisingly little actual communication between the borrower and the lender during a workout discussion. The borrower sends in a proposal, the lender reviews it and responds, and either an agreement is reached or negotiations break down. Face to face meetings are rare, and it’s pretty unusual for there to be more than two or three conversations of any length. Usually the communication constraint is on the lender’s side; workload considerations restrict how much time is spent talking about a deal.

Also, even when there is communication it often destroys trust instead of creating it. Many borrowers and lenders think posturing is an integral part of negotiating, and that it’s to their advantage to take a hard line. Sometimes that’s true, but more often it just makes it more difficult to reach an agreement.

Consistency: The sales professional that sold me my first car from Sewell impressed me with his competence and communication. That, combined with the company’s reputation for character, led to the initial buy decision. Purchases two through nine have been made because of consistency. Every person at every level has continued to perform in a manner that re-earns and maintains my trust. Confidence that your performance will be in line with past experience frees others from worry about protecting themselves from an unpredictable response. 

Verifying consistency requires multiple transactions. Workouts are usually one-off affairs, so neither party establishes a track record with the other. Given the opportunity I like to try to break my workouts into some incremental steps to establish some trust (for example, “You send in a payment while I get an updated appraisal, I will hold off from filing the foreclosure”). The more usual “dual track” approach (“I’ll file the foreclosure so I don’t lose any time and we’ll see if something can be worked out before the sale date”) is the antitheses approach.

Courage: Earning and maintaining trust in an increasingly competitive and demanding world requires courage. Challenges must be confronted head-on in a manner that respects diversity; demonstrates professional business practices; and maintains personal integrity. True courage requires commitment and the willingness to accept personal risk. It fosters admiration and sets in motion a series of events that influence long-term success.

Neither side in a workout is typically up for taking much additional personal risk. The borrower has generally already experienced substantial losses and has exhausted his or her resources. On the lender side, it is much easier to look back and see the time and value lost when a workout attempt fails, and much harder to identify what might have been gained by a successful workout.

Considering the obstacles, it’s not surprising few deals are worked out.

Complexity, Predictability, and Cascade Effects

Duncan Watts has a great piece in the The Boston Globe titled, “Too Complex to Exist.” I love the illustration:

Some excerpts:

ON AUG. 10, 1996, a single power line in western Oregon brushed a tree and shorted out, triggering a massive cascade of power outages that spread across the western United States. Frantic engineers watched helplessly as the crisis unfolded, leaving nearly 10 million people without electricity. Even after power was restored, they were unable to explain adequately why it had happened, or how they could prevent a similar cascade from happening again - which it did, in the Northeast on Aug. 14, 2003…

Traditionally, banks and other financial institutions have succeeded by managing risk, not avoiding it. But as the world has become increasingly connected, their task has become exponentially more difficult. To see why, it's helpful to think about power grids again: engineers can reliably assess the risk that any single power line or generator will fail under some given set of conditions; but once a cascade starts, it's difficult to know what those conditions will be - because they can change suddenly and dramatically depending on what else happens in the system. Correspondingly, in financial systems, risk managers are able to assess their own institutions' exposure, but only on the assumption that the rest of the world obeys certain conditions. In a crisis it is precisely these conditions that change in unpredictable ways.

In the article Watts proposes some regulatory steps to limit the complexity of financial systems. I am not optimistic; it is very hard to restrict activities until a problem is obvious (see my post “Rising Markets Create Lender Losses” for more on this). I think a more pragmatic route is for institutions to create firewalls within the organization so that the failure of one business line doesn’t take the whole institution down (e.g., AIG’s CDS operation pulling down the insurance business).

Are Banks Failing to Mark Down Toxic Assets?

There is a widespread believe that banks are failing to mark their toxic assets to their true value (see, for example, the Economist’s View post “The Fall of the Toxic Asset Plan”). A commenter on this post, however, has a rejoinder that rings true to me:

I believe banks are generally marking to market their troubled assets at appropriate levels, not due to empirical evidence but in view of the audit & regulatory environment faced by the employees who have to sign off on the prices. I must temper the conspiracy theorists who believe banks have not made a sincere effort to mark down prices to "fair value", whatever that is in these markets. On the ground, today's audit teams are paranoid about valuation (PCAOB is watching) and a small cottage industry has grown up around the now 2 year old problem of valuing illiquid assets. Nobody at the big banks wants to sign off on prices they will later be accused of keeping too high. It's just not how it works inside these firms. They may wind up being in error but not for lack of analysis and pulling in every piece of imperfect market info available.I have performed a lot of valuation work that suggests prices are fairly conservative relative to base case expectations of future losses on a given asset-- certainly in the residential private label securities area where much of the problem resides.

There is just no upside to signing off on unsupported values. On the other hand, there is plenty of uncertainty about what values will actually be realized – see my post “Valuing Note Purchases” for more on this.

Why Lenders Don’t Do Principal Writedowns

If only lenders wrote off principal on loans in default, our problems would be solved. Gretchen Morgenson  on her New York Times article So Many Foreclosures, So Little Logic:

If banks have written down the value of these loans to the 40 cents on the dollar that they are fetching on foreclosures — the only true value for these homes right now — then why don’t they bite the bullet and reduce the loan amount outstanding for the troubled borrowers? That type of modification would be far more likely to succeed than larding a borrower who is hopelessly underwater with yet more arrears.

And today The Big Picture quotes Mark Hanson of Hanson Advisors (via Barron’s) on why loan mods are not the answer:

Loan mods are designed to keep the unpaid principal balances of the lender’s loans intact while re-levering the borrower. Mortgage modifications turn homeowners into underwater, overlevered renters for life, unable to sell, re-buy, refi, shop or save. They turn homeowners into economic zombies.

The belief that principal writedowns somehow solve a problem that other types of modifications can’t is wrong. Overwhelming, loan defaults are caused by income curtailments – the borrower loses a job, households break up, people become ill (long post on this topic with additional links here). Such situations have two characteristics; (1) they are binary, in the sense that a borrower goes from being able to make a full payment to being able to make only a drastically reduced payment, or no payment at all, and (2) they are often temporary. These are the cases where lenders typically offer repayment plans which allow unpaid installments to be repaid over time, with the result that when the forbearance period is over the payments go up. Sometime that works, and when it doesn’t a different form of relief is necessary. But it would be just crazy for a lender to offer a permanent, irreversible principal reduction in these cases.

For those cases where a long term reduction in the payment amount is necessary, let’s look at the numbers. Let’s suppose the value of the property today is 50% of the amount owed:

The payment relief under these two structures is identical, so each borrower is in the same position to save and spend, and each is as likely to default if there is a further decrease in income. Each borrower can move if they want to: either can just walk away, or negotiate a sale with a buyer. In the case of the borrower with the payment modification, it will be a short sale, but lenders do those all the time.

There are really two issues. The first is a classic principal-agent problem; the borrower knows their true financial condition and is in a better position to know the value of the property than the lender. Lenders are understandably reluctant to lock in a loss under these circumstances. The second issue is, who gets the upside if the property is worth more than $200,000 or the value increases later? It’s the borrower with the principal writedown, the lender with the modification. Lenders are reluctant to give up the upside, because debt is supposed to be paid before the equity holder.

Please note, I am not saying that lenders are doing a good job of modifying loans (just the opposite; see Mortgage Modification Blues, for example). But, is there any reason to think lenders would do a better job processing principal writedowns? I’m saying that lenders need to get better at modifying loans where appropriate, and principal writedowns are not the solution.

Debacle at 250 Montgomery Street: Now is a Great Time to Be a Major Tenant

GlobeSt.com has a story about the debacle at 250 Montgomery Street in San Francisco:

Realty Finance Corp. of Connecticut has sold its original $47-million loan on a class A office building here for approximately $25 million or $200 per square foot, according to a source familiar with the transaction. The building is 250 Montgomery St., a 15-story, 126,736-square-foot office building completed in 1989 at a cost of about $41 million.

The borrower, Lincoln Property Co., paid approximately $47 million or $405 per square foot for the building in late 2006 and defaulted on the loan in late 2008. Prior to the note sale Lincoln agreed to hand over the property to its new creditor in lieu of foreclosure…

Chris Seyfarth, a partner in Ernst & Young’s transaction real estate group tells GlobeSt.com the pricing of the 250 Montgomery note sale--50 cents on the dollar, just like the Hancock Tower sale in Boston--suggests that San Francisco is no different than any other major metro in that real estate values have plummeted. That having been said, he adds that 250 Montgomery is only 55% leased so it’s hard to suggest that the new price point is definitely 50% of what it was at the peak.

The 57,000 square feet of vacant space represents a great opportunity for a major tenant. Here are the numbers:

In 2006 Lincoln would need to lease the building at rents which would result in net income of $22.25/sf in order to get a 6% return on its purchase price. Based on its 2009 purchase price (47% lower than Lincoln’s), the new owner can get a 33% higher return than Lincoln, and still drop the rents 29%. This is what Jeff Bernstein was talking about in his post on Urban Digs, “Holes in the Dike”:

This is the transmission mechanism whereby lower rents are enabled in a market due to distressed properties being turned over at a much lower prices. It just doesn't take a lot of this kind of activity in a soft market with high vacancy rates to crush rents.

The beneficiaries of this debacle are the new owner, the building tenants, and the tenants in the market who see the new leases at the lower level and push for reductions in their own rent. The losers are Lincoln’s lenders and the owners of other buildings in the market who will be pressured to reduce rents. Lincoln itself appears to walk away unscathed since it looks like they had no money of their own in the deal (read about that here).

Up to now, income declines have been primarily a result of lack of demand. Income declines are likely to get much, much worse as more transactions like 250 Montgomery occur and rents adjust to the new market.

Debacle at 250 Montgomery Street: Other People’s Money

GlobeSt.com has a story about the debacle at 250 Montgomery Street in San Francisco:

Realty Finance Corp. of Connecticut has sold its original $47-million loan on a class A office building here for approximately $25 million or $200 per square foot, according to a source familiar with the transaction. The building is 250 Montgomery St., a 15-story, 126,736-square-foot office building completed in 1989 at a cost of about $41 million.

The borrower, Lincoln Property Co., paid approximately $47 million or $405 per square foot for the building in late 2006 and defaulted on the loan in late 2008. Prior to the note sale Lincoln agreed to hand over the property to its new creditor in lieu of foreclosure…

In its first quarter filing with the SEC in March, Realty Finance said the loan matured in March 2009 without payment, pushing it into default. At the time, Realty Finance expected to lose between $0 and $11 million on the sale. The actual loss appears to be closer to $22 million. Whitehall Street Real Estate Funds reportedly had an additional equity position in the building that has been completely wiped out.

So Lincoln paid $47 million in 2006, Realty Finance loaned $47 million, and Whitehall had an equity position? That would suggest Lincoln had little if anything in the deal at any point. Call me old fashioned, but when a major investor like Lincoln (which at the time was perfectly capable of raising cheap equity or borrowing at a low cost of funds) brings in an equity partner like Whitehall, the only conceivable reason is to eliminate it’s risk in the deal. Red flags should go up under these circumstances – I’d love to know what Whitehall and Realty Finance were thinking.

Why Now Is a Great Time to Become a CRE Lender

What would you do if you won the lottery? My wife and I have speculated about this, and we’ve always been pretty much in agreement (travel, a big loft in a major city, more travel, etc.). We haven’t played this game lately, however, because now I want to buy a bank and specialize in CRE lending, which is a goal I can tell she is not enthusiastic about.

To be clear, now is not a good time to have been a CRE lender. From Jeff Bernstein post on Urban Digs, “Holes in the Dike”:

According to Globe Street, Realty Finance Corp. has sold an original $47 million loan on a Class A office building at 250 Montgomery Street in San Francisco for approximately $25MM. The building was reportedly only 55% occupied, so obviously debt service by the borrower, Lincoln Property Co., was an issue.

I do not want to be Realty Finance – I want to be the bank loaning to the buyer. Jeff continues:

What we have to do is look ahead at how the new owner of 250 Montgomery Street is likely to act. The new owner has not been disclosed in this case, but is said to have been another real estate private equity firm. This firm now has a great new basis cost in the building and lots of incentive to be aggressive in getting it leased up. This is the transmission mechanism whereby lower rents are enabled in a market due to distressed properties being turned over at a much lower prices. It just doesn't take a lot of this kind of activity in a soft market with high vacancy rates to crush rents.

The most secure loans are loans where the real estate has plenty of upside, and the only real estate with upside these days are deals which have a low basis compared to the rest of the market. Those are the loans I want to make.

There are other reasons for lenders who have not previously done CRE lending to jump in now:

• Spreads are really good. Borrowing at 1-2% and loaning at 6-7% is a nice business.
• The most important rule in CRE lending is to loan to people who have experience in the property type and their market. By definition, those people already have lending relationships. However, many of those relationships have been disrupted as lenders have pulled back, and the lenders that remain are generally not known for their customer service. Imagine half the NFL teams disbanded over the summer; there would be a lot of talented players looking for a new home. Now is a great time for a smart, customer-focused bank to pick up some great free agents.
• CRE lending is relationship oriented, and the relationship is between the borrower and the loan officer. Loan officers are in the same position as the borrowers described above; many are twiddling their thumbs because their employers have pulled back. Now is a great time to build a team of high producers who have established client networks. The same is true for other necessary talent (underwriters, processors, etc.).

Of course, I’m not likely to win the lottery, especially since I don’t play (you probably knew that if you follow this blog). My wife does play, but if she wins I’m pretty sure we will not be buying a bank. However, some people are going to take this opportunity to jump into CRE lending and do very well.

After the Honeymoon: Trusting Loan Brokers

Should a loan broker who has established a successful relationship with a lender be trusted by that lender? Not according to research by Mark Garmaise, a finance professor at UCLA Anderson (working paper “After the Honeymoon: Relationship Dynamics Between Mortgage Brokers and Banks”). From a July 6, 2009 Financial Times story on the research:

The financial industry’s vaunted belief in trust and long-term relationships is being challenged by research showing that before the crisis US mortgage brokers fed loans of deteriorating quality to the banks they did most business with.

By questioning the prevailing wisdom that dealing with well-known counterparties is more fruitful and less risky than venturing into new relationships, the academic study puts in doubt one of the banking sector’s most enduring beliefs.

The key findings of the study:

• The quality of the loans submitted by the broker deteriorates over the course of the relationship
• The volume of loans submitted grows even as the quality deteriorates
• The effect is stronger for geographically distant brokers
• Even though the bank’s ability to evaluate the quality of the broker’s loans increases over time, the bank is increasingly reluctant to terminate the relationship.

It’s easy to dismiss this as a problem unique to loan brokers, but what if it’s true in other situations where initial monitoring is high and then relaxed over time? For example, the first few times you use a new appraiser you might carefully scrutinize the work. Do you need to do that every time, or can you relax? It’s a big enough topic for a separate post, but I think the answer (for commercial real estate, at least), is to check the key elements every time, no matter who you’re dealing with. Finley Peter Dunne had the right idea: “Trust everybody, but cut the cards.”

Rising Markets Create Lender Losses

People anticipate the future will be like the past. From a DNA article, “Why Economists Can’t See a Recession Coming”:

Robert J Barbera, chief economist, Investment Technology Group, in his book The Cost of Capitalism -- Understanding Market Mayhem and Stabilizing our Economic Future, writes: "Since the economy is not in a recession 80% of the time, the safe strategy is to predict recessions only when they have already arrived! That means you're right 80% of the time. Simply put, forecasting the recent past is the way to go and it is the dominant strategy employed by professional forecasters…Most of the time, tomorrow bears a close resemblance to yesterday. After all, both industry and economic trends tend to last for years, not for days. Once we acknowledge that we confront a world of pervasive uncertainty, it is quite reasonable to decide until circumstances change, we will plan as if present circumstances are likely to persist."

This approach to forecasting guarantees lenders will take losses. If you don’t say no when markets are rising, you are certain to have significant exposure at the top of the market which will create losses when the market softens. This time around, although everyone knew at an intellectual level that home prices could go down, the long term trend of rising house prices made it easy to justify rating models and lending decisions which didn’t adequately weight this possibility.

“Evidence” on the Foreclosure Crisis

Stan Liebowitz, an economics professor at University of Texas, Dallas, has an op ed piece in the Wall Street Journal touting the results of research he has done using “a huge national database containing millions of individual loans”. His conclusion:

The analysis indicates that, by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home.

My first reaction was, like Barry Ritholtz, “Duh”. If you have equity in your home and can’t pay your mortgage, you sell the home, pay the loan off and pocket the equity. Equity = No Foreclosure.

But, (as Barry also notes), the piece is weird:

A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.

Time out; that means 53% of all foreclosures are on homes that have equity. Does that sound right to you?

The accompanying figure shows how important negative equity or a low Loan-To-Value ratio is in explaining foreclosures (homes in foreclosure during December of 2008 generally entered foreclosure in the second half of 2008).

I think these are all legitimate contributing factors, but I question some of the conclusions Liebowitz draws. For example:

To be sure, many other variables -- such as FICO scores (a measure of creditworthiness), income levels, unemployment rates and whether the house was purchased for speculation -- are related to foreclosures. But liar loans and loans with initial teaser rates had virtually no impact on foreclosures, in spite of the dubious nature of these financial instruments.

Anyone involved in the crisis can tell you the liar loans and low teaser rate loans were the first to default. You wouldn’t expect to see many of them left by the second half of 2008 (survivorship bias at work).

Also, this a very mixed bag of contributing factors. Negative equity is a factor at the time of default (do I sell the property or allow it to be foreclosed?). A low down payment and a low FICO score are factors at origination. The unemployment increase in 2008 and rate resets happen after origination and before foreclosure. If I’m a low FICO score borrower with a low down payment, a rate reset, no equity, and I lost my job, what caused my foreclosure? Regression analysis can parse out the first four variables if done correctly, but how does the fifth variable enter into the equation? I suspect Liebowitz’s analysis is flawed, especially since he concludes more than half of foreclosed properties have equity.

Hoping for some answers, I checked out Liebowitz’s home page. There’s no reference to this research, and precious little on real estate at all (mostly copyright stuff). If one uses the word “evidence” in one’s title, shouldn’t the evidence be available?

I agree with many of Liebowitz’s conclusions, but it would be nice if they were coherently supported. Also, it’s depressing that some many bloggers have uncritically endorsed the piece without question.

Mortgage Modification Blues

The New York Times article "Paper Avalanche Buries Plan to Stem Foreclosures" documents the logistical nightmare of processing single family mortgage modifications. An excerpt:

A note in the system shows that the bank confirmed receiving documents on April 29 — pay stubs, tax returns, a letter disclosing her hardship, bank statements. Since then, the company has been waiting for WaMu to review the file.

But when Mr. Lavi calls, a representative coolly discloses that the application has been rejected because one document, a proof-of-insurance form, is missing. He must start over.

“The file had been submitted properly, and you didn’t put the pieces together,” Mr. Lavi says, his body quivering with anger. “I’m not going to stand in line again for another six months.”

He demands to speak to a supervisor, but the representative says none is free. He hangs up and redials, hoping to land in a different call center. Eventually, he reaches Chase’s executive offices, where Becky takes over the call.

“We’re not taking cases now,” she says calmly.

“Why was I transferred to you?” Mr. Lavi asks. Becky does not know. He implores her to keep the file open while he faxes in the lone missing document.

“Impossible,” she says, warning of “the sheer amount of papers coming in.”

So, to get a modification on a WAMU (now Chase) loan, you need pay stubs, tax returns, and bank statements? Contrast that with the process of getting the loan in the first place, as reported in the New York Times piece, “Saying Yes, WAMU Built Empire on Shaky Loans.” An excerpt:

As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and schoolteachers with incomes rivaling stockbrokers’. He rarely questioned them. A real estate frenzy was under way and WaMu, as his bank was known, was all about saying yes.

Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows. The borrower was claiming a six-figure income and an unusual profession: mariachi singer.

Mr. Parsons could not verify the singer’s income, so he had him photographed in front of his home dressed in his mariachi outfit. The photo went into a WaMu file. Approved.

Proper underwriting (of new loans and modifications) is labor intensive. Most servicers never had the proper underwriting infrastructure in place to originate the loans, and they certainly don’t have it now that those deals need modifications.

More at my post, “Why Did WAMU Abandon Underwriting Standards?”

Five Underwriting Issues Which Kill CRE Deals

I have an article in the July, 2009 commercial edition of Scotsman Guide which talks about five underwriting issues CRE lenders are focusing on, and which frequently kill deals in this environment:

• Upcoming loan maturities on the Sponsor’s other deals
• Sponsor liquidity
• Sponsor exposure to distressed loan types (e.g. condo construction loans)
• Lack of Sponsor experience in the market and/or property type
• Project dependence on tenants in a weak industry.

The link may take you to a free registration page…

The Commercial Real Estate Landslide

Disasters are interesting, as evidenced by the success of shows like Destroyed in Seconds (30 minutes of one disaster after another, courtesy of the Discovery channel). A while ago the show aired this video of a landslide in Japan:

The images have stuck with me, and I think there are some strong parallels to what is going on in commercial real estate:

• First and most obviously, a disaster is going on, and if you’re in its path it’s a very bad thing.
• As bad as it is for those to be caught in the path, it’s important to realize the whole mountain is not involved. The landslide affects only a portion of the exposed area of the mountain – most of the mountain remains unchanged.
• The earth in the landslide moves from an unstable position to a stable position.

I was reminded of these facts while visiting with a very experienced real estate investor last weekend. I’m guessing he was in his 70’s, and had some money in a development deal that has a poor prognosis. In this CRE landslide he is going to lose a small portion of his net worth in an unstable deal which was exposed. But, he is confident he will buy other people’s exposed deals at stabilized, lower prices which will recover his losses and more over time.

It’s easy to forget that most CRE is not actively traded, is not fully leveraged, and is owned by people with substantial resources who are looking forward to buying busted deals.

How to Best Index Commercial Real Estate Performance?

Currer Bell (whose blog Unnatural Rents is highly recommended) asks a great question in a comment to my post criticizing Moody’s REAL index:

I agree that the small sample size makes this index of questionable value. But the larger question becomes: How do you build an index to track commercial real estate performance? Moody's/REAL have gone for a repeat-sale methodology (pros: price movement isn't affected by changes in product mix; cons: very small sample sizes). NCREIF's NPI is appraisal based instead (pros: much larger sample size; cons: appraisals are slow to reflect the market, on the upside and the downside).
It's one thing to just throw up your hands and say "There isn't enough data." But institutional investors want to benchmark performance (maybe that's a problem, too, but it's pretty intractable at this point). And the truth is I don't know what the right answer is.

I don’t know the answer either (although I’ll make an attempt below – I too hate to just throw up my hands when the question is hard). However, I’m pretty sure the answer is not repeat sales, both because the sample size is small and because individual CRE property values are subject to large fluctuations which are not attributable to general market movements. For example, a neighborhood shopping center might be worth X 3 years ago, and is now worth 0.5X because the anchor grocery store closed. With a large enough sample these individual property fluctuations might cancel out, but with a small sample size I think the problem is hopeless. And, I agree with Curren that an appraisal based index has severe limitations; Lansner on Real Estate’s article “Were Appraisers Late to the Price Collapse?” documents the problem.

A partial answer is to look at changes in property rents and vacancy rates. There are a number of sources for this data (for example, MPF, REIS, and PPR). If you don’t want to spend the money or need an idea of what’s going on in a market they don’t cover, I can tell you with confidence that the trends these providers report closely parallel the 12 month change in employment levels in a market, and that data is readily available for free for almost any market at this BLS site. However, looking at income performance alone won’t tell you much about value trends; you need to know what’s going on with cap rates to answer that question.

Maybe the best CRE index is the performance of a REIT ETF like SPDR Dow Jones REIT?

My guess is the peak for this ETF roughly coincides with the CRE peak, and the current price is down roughly 65% from the peak. That seems extreme, but maybe that’s where we’re headed. I know I have a number of readers who know much more about REIT values than I do; if this is a dumb idea I’d genuinely welcome your comments.

Bend, Oregon, and Elkhart, Indiana: Employment

I was in Bend, Oregon on Friday. For those not in the Pacific Northwest, Bend is famous for its unemployment rate. From the AP, on June 3:

The Labor Department said Wednesday that unemployment in April rose from a year earlier in all 372 metropolitan areas it tracks. Indiana's Elkhart-Goshen's rate jumped to 17.8 percent, up 12.7 percentage points from a year ago. The Indiana region, which posted the largest increase from last year, has been pounded by layoffs in the recreational vehicle industry.

The second-highest jump occurred in Bend, Ore. Its rate rose to 15.6 percent, up 9 percentage points from last year.

So how much is Bend like Elkhart? If you look at unemployment, they’re pretty similar:

Bend:

Elkhart:

However, the change in employment is a much different picture. Absolute numbers:

And percentage change:

 

Elkhart has lost almost 15% of its employment base – Bend less than 5%. Unemployment figures are interesting, but in evaluating the health of a local economy I think the number of people with jobs is much more relevant.

Employment data from this BLS site.

Housing Was Not Massively Overbuilt

It’s widely taken as a given that because we have too many empty housing units now and because prices have collapsed, that housing was overbuilt. For example, from Unnatural Rent:

In addition, the recession and rising unemployment have slowed down new household formation, encouraging people to live with roommates. In many markets, apartment rents are unlikely to post any growth during this year, and some may even see declines.
This drop in demand has been combined with a massive increase in the supply of housing (both single family and multifamily) over the past decade. While office and industrial did not experience a huge wave of overbuilding, that isn't quite the case for retail and multifamily.

This is true in a sense – if we had fewer housing units now the situation would be better.  However, throughout the bubble years supply and demand were balanced. My argument is premised on the idea that additions to housing supply should roughly correspond to additions to employment:

1 new job = 1 additional unit

Obviously, not every person who gets a job creates a new household, but households are also created without jobs, and in my experience nothing too bad happens to housing markets where job growth exceeds new housing additions. The data for job creation and residential permits issued since 2004 is summarized below:

Supply and demand were in synch until 2007. In 2008, demand went off a cliff, which goes to show that jobs can be lost faster than residential development can wind down.

I think this data also supports the notion that the bubble price escalation was driven by easy financing, and not fundamental demand.

Employment data is from this BLS website, permit data at this Census Department website.