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.

Waves of Stupid Money, and One Eye Money

 The Psy-Fi Blog has a post on Edward Miller’s research into irrational gambling, which gives some insight into bubble psychology. An excerpt:

Edward M. Miller in Do The Ignorant Accumulate the Money has done some research around the effect on the stockmarket of slot machine investors and reckons that there are periods where waves of stupid money can genuinely cause the rough efficiency of the market to break down. He also shows that these effects can’t last forever – if the stupid money is going into unproductive assets the lower return on these will eventually affect prices, especially as sensible money will be going into cheaper, productive ones.
In fact this isn’t too surprising to anyone with a background in social psychology – you don’t need to really understand economics to recognise that waves of irrational behaviour can sweep through groups linked by social ties. One of the oddest forms of behaviour is that a group’s overall opinion on some subject will tend to be more extreme than the average opinion of the group members. This polarisation effect is to do with the instinct towards group conformity and in the markets can lead people into taking more extreme and committed positions on individual stocks and markets than they would have taken on their own.

“Waves of stupid money” is an apt description of commercial real estate investors and lenders at the peak. Similarly, a general partner I know characterized the money he received from some investors as “one eye money”; cash someone whose primary business was not real estate would give him to invest, and which they would keep only one eye on.

Don’t be part of the wave, and keep both eyes on your money.

Construction Lending Blues

Although most of what you read about CRE loan problems refers to CMBS loans, the reality is construction loan defaults are a much, much bigger problem. The reason you hear so much about CMBS is availability bias; CMBS loan performance is closely monitored and loan level data is readily available, while construction loan performance data is extremely fragmented.

John Reeder at Real Property Alpha notes:

When you go home at night and turn on the lights, you don’t have to think about what it took for that light switch to turn on.  Somebody had to develop a power plant.  Somebody had to develop the utility infrastructure to deliver the power.  The neighborhood you live in is likely part of a development that somebody had to get approved.  The store where you buy your groceries is part of a retail center that had to be built.  It wasn’t always there.  But these are things we take for granted.  The difficulty of development does not weigh on us.

And yet development is hard.  Even experienced developers fail… all of the time.  In order to bring projects online you have to make it through a gauntlet of challenges that includes buying the land right, proposing a marketable project, obtaining environmental clearances, getting discretionary zoning actions approved, getting through construction within budget, and enduring market cycles.

If a construction project makes the headlines, it’s usually a big deal that’s blown up in a conspicuous way. For example, construction at the Las Vegas Fontainebleau hotel, pictured at left, is currently shut down as a result of the construction lenders’ unwillingness to advance funds. The borrower is in bankruptcy and and all parties are litigating (more on the story at the Zero Hedge post  Fontainebleu Fiasco Soon To Get Epic). However, big projects are just the tip of the iceberg; for every big project there are ten smaller ones in trouble.

Here’s a list of the way construction loans can go wrong. Some of these are “normal” risks in getting a development done, while others are cyclical. I’ve put the cyclical issues which are currently in play in italics.

Jurisdiction Approval Issues. This category of issues creates delays or cost overruns which put the property in jeopardy.

• Failure to obtain necessary jurisdiction approvals. These could be big, obvious approvals (e.g. a building permit) or an obscure approval which wasn’t obvious at closing (for example, an approval for an off-site bridge over a stream for an access road to get to the project).
• Change in infrastructure requirements or fees post closing with no grandfathering
• Change in code requirements post closing with no grandfathering

Construction Issues

• Costs underestimated in the initial project budget
• Unanticipated site conditions (for example, soils problems) leading to delays and/or cost overruns
• Exceptionally bad weather leading to delays and/or cost overruns
• Labor or material cost increases post closing (e.g., the price of plywood goes up after the budget is set)
• Labor strikes or unavailability leading to delays
• Material unavailability leading to delays
• Failure of the contractor or major subcontractor(s) due to financial problems unrelated to the project (this often creates delays or cost overruns which puts a property in jeopardy)
• Construction or design defects (for example, water infiltration) which must be cured, leading to delays and/or cost overruns

Leasing Issues

• Decline in rents from the original pro forma
• Slower than anticipated lease up
• Higher than anticipated tenant improvement costs (in a soft leasing market, developers have to offer more tenant improvements to get tenants to sign up)
• Deteriorating financials or bankruptcy of a major tenant

Construction Loan Issues

• Increase in interest rates resulting in early depletion of the interest reserve
• Insolvency of or regulatory restrictions on the construction lender

Permanent Financing Issues (these issues may prevent the construction loan from being refinanced before it matures)

• Increase in interest rates
• Increase in operating expenses compare to the original pro forma (for example, real estate taxes assessed at a higher rate than anticipated)
• Increase in cap rates (resulting in a value decrease such that a permanent loan can’t be obtained)
• Tightening of underwriting standards
• Deteriorating financial condition or credit of the sponsor unrelated to the project (for example, foreclosures on other projects)

This list is not complete, but it gives you a sense of how unpleasant it is to be a construction lender (or borrower) these days.

Moody’s Commercial Property Price Indices are Meaningless

The latest bad news on CRE prices, from Zero Hedge:

Moody's has released its April Moody's/REAL Commercial Property Price Indices (CPPI) update and it is a doozy: -8.6%, after what many had expected was a shooting green reading of just -1.7% in March. The problem that many don't grasp, that even Moody's has finally caught on, is that once capitulation in CRE sets in, the bottom will be torn out.

Calculated Risk’s take on the same story:

Prices in the CRE market are not as sticky as the residential market, so prices fall much quicker. We've seen plenty of half off sales for distressed CRE, and this report suggests the average decline is about 25% over the last year.

Econompic’s headline for the story: tttiiiiimmmmmbbbeeeerrrr

From the actual Moody’s report:

To put this in perspective, the total estimated value of direct commercial real estate in the United States is $5.3 trillion. The value of the properties Moody’s based its index on is 0.000113 of the total. Given the non-existent market, how can anyone say with a straight face that these 67 transactions are indicative of anything?

CR mistakes the volatility on the CRE market for a lack of price stickiness, when the reality is it’s just a very thinly traded market compared to single family residential (which is a thinly traded market itself, more on that here).

Putting out reports like this is not a way for a rating agency to reestablish its credibility. Is it so hard to just say, “We don’t have enough data to report something meaningful?” Think how many problems would have been avoided if the rating agencies had admitted they didn’t have the data needed to forecast default and loss rates when residential underwriting standards loosened at the start of the residential bubble.

Pain and Cheating

These are two entirely separate topics which are both covered in an excellent talk by Dan Ariely on TED (which I found through this post on Geary Behavioral Economics).

Some teaser questions answered in the video:

• Which is better, intense pain for a shorter period, or less intense pain for longer? Short answer: less intense pain over a longer period, ideally with some breaks in between painful intervals. There’s probably a lesson to be learned on investment and loan losses…
• Given an opportunity to cheat, how many people do it, to what extent, and under what conditions? Short answer: many people cheat a little, especially if they perceive peers doing it. I think Ariely’s answers definitely apply to mortgage fraud…

I can read faster than I can listen, so I don’t have much patience for learning by video. However, TED has some terrific material, and this talk is a great example.

Valuing Note Purchases

There is a common misconception that lenders know the value of their CRE loans. For example, here’s an excerpt from a Naked Capitalism post (Yves is talking about the PPIP Legacy Loan program):

The problem isn't, contrary to PR designed to mislead the public, that the assets are hard to value. That holds only for an itty bitty percentage of the total. The real problem is that the banks are carrying them at above market values, and above any reasonable long term value too (their protests to the contrary). The problem is not the saleabilty of said assets, it's that they don't like the prices.

I can tell you with absolute certainty that lenders do not know the value of the CRE debt they are holding – there is just too much uncertainty around the key variables. Here are some of the problems:

Uncertainty around the current value of the underlying collateral. CRE is always a thinly traded market, and that is especially true now (more on this topic at Why There Are Very Few CRE Sales). To state the obvious, when there are few sales it’s difficult to establish values.

Uncertainty around the future value of the underlying collateral. Legacy debt service is a big component of the cost structure of existing CRE. When CRE is foreclosed and sold, the debt burden of the new owner will be much lighter, enabling them to cut rents and attract the best tenants (think Detroit automakers with huge pension obligations trying to compete with manufacturers that don’t have this burden). When this happens more of the old deals default and are sold as REO, which creates additional rent reductions, and so on in a vicious spiral down (more on this at CRE Loans and the Death Spiral of Doom). Even if you think you have a good handle on the current collateral value, there is no way to predict how far down this spiral will drive values.

Uncertainty over borrower actions. Apart from the collateral value issues, there is the fact that until you own the real estate the current borrower is still a factor to be dealt with. Depending on the jurisdiction, it can literally take years to get control of a property. And, given today’s low interest rate environment there is unprecedented risk that the debt will be restructured in bankruptcy at a very low interest rate (more on that at Getting Tilled: How a $6,425 Truck Loan May Decide the Fate of General Growth Properties).

All these are uncertainties affecting the current lender. Now imagine the position of the note buyer. REIT Wrecks describes the note purchase due diligence process in “What Hypocrisy? FDIC Loan Sales are a Total Black Hole”. An excerpt:

So what happens when you bid on one of these loans? The FDIC does not allow property inspections of any sort. Buyers are afforded the opportunity to review the original loan files, which contain such helpful information as the original, hopelessly out of date appraisal. Assuming you have enough local market knowledge to formulate a bid and "win", you'll have just 7 days to close. There is no futzing around with surveys, title reports and good standing opinions - we're talking an all-cash close on a 7-day fuse.

Arguably non-FDIC note sales afford better due diligence opportunities. However, I can tell you from experience it is very difficult to pick up an unfamiliar loan file and figure out the deal and it’s current status in the best of circumstances. Imagine trying to do that for a pool of deals, with limited due diligence time, no access to the borrower, and probably only partial access to the files.

It’s no wonder there are few note sales going on given the difficulties of establishing value.

Workout Strategies: “The Boss has Lost It!”

Suppose you were the only wealthy member of a very large extended family. A kidnapper takes a niece – would you pay the ransom? Of course you would. The next week the kidnapper takes a nephew, and you pay again. The third week a cousin is taken, and you realize as wealthy as you are, you can’t pay for everyone’s return. How do you break this cycle?

For lenders, loan modifications are like this. If you go strictly by the numbers, a lender will almost always lose more from foreclosing on a property than by modifying the loan. Going strictly by the numbers, however, is a slippery slope for lenders, because if borrowers believe you will always modify, you will end up modifying every loan. How do you deter the threat of default if borrowers believe you will always modify the loan to avoid a default?

One strategy is to act crazy. Ethan Bronner believes this was the strategy Israel adopted in it’s assault on targets in Gaza in December, 2008 and January, 2009. From his January 18, 2009 New York Times article, “Parsing Gains of Gaza War”:

The Israeli theory of what it tried to do here is summed up in a Hebrew phrase heard across Israel and throughout the military in the past weeks: “baal habayit hishtageya,” or “the boss has lost it.” It evokes the image of a madman who cannot be controlled.

“This phrase means that if our civilians are attacked by you, we are not going to respond in proportion but will use all means we have to cause you such damage that you will think twice in the future,” said Giora Eiland, a former national security adviser.

I would be surprised if any lender had an explicit policy to file irrational foreclosures or seeks deficiency judgments solely as a deterrent to other borrowers. But, modifications are generally the exception and not the rule, and the signal an action sends to other borrowers is always a consideration.

Leverage and Return on Investment

Last week Barry Ritholtz at The Big Picture had a good post on  interest only CRE mortgages. In the comments I talked about why borrowers wanted IO (to goose the initial cash on cash return numbers), and in response one of the commenters made the point:

Maximizing leverage implies boosting ROI.

No, no, no. If anyone should have learned anything in the last two years, it’s that maximizing leverage does not always boost ROI. For leverage to boost ROI, income has to go up. When income goes down, leverage destroys you.

There are a couple more subtle cases where leverage doesn’t help you. Even if income goes up, leverage doesn’t help you much until you exit the investment, because debt service sucks up a lot of cash flow. And, there’s no guaranty cap rates won’t go up and/or financing will be unavailable when your leverage is due (again, a lesson that should be painfully obvious today).

Finally, leverage hurts you when equity is cheaper than debt (i.e., cap rates are lower than interest rates). This doesn’t happen often, because since equity takes the first loss it typically has a higher return than debt. But, it does happen. The usual case is in an inflationary environment when interest rates are up and equity is relatively cheap because investors believe rent boosts will provide additional return.

Below are some examples of how the numbers work. The first set of examples are high, normal, and no leverage scenarios when cap rates are lower than interest rates. The cash on cash returns are towards the bottom, and show what happens when net operating income (NOI) goes up a little, a lot, and down. Note NOI has to increase 38% to get the same return as a non-leveraged deal:

 

A small decline in NOI eliminates cash flow on a highly leveraged deal, but has a minimal impact on an unleveraged project.

The next example shows what happens when cap rates are higher than interest rates:

The next time someone extolling the virtues of leverage, you can send them to this post.

Willingness to Pay, and Crescent Resources

Generally, borrowers pay until they can’t (a theory I discuss in more detail in “Does Recourse Matter on Income Property Loans?"). There are exceptions, of course; a recent example is Crescent Resources, LLC, which (along with more than a hundred subsidiaries involved in separate developments) filed bankruptcy last week. From Pensions & Investments:

Crescent Resources LLC, a joint venture between Morgan Stanley Real Estate Fund V U.S. and Duke Energy Corp., filed for Chapter 11 bankruptcy protection to reduce the debt level and improve the capital structure. Investors in Fund V include the $40 billion Pennsylvania Public School Employees' Retirement System, $119 billion California State Teachers' Retirement System and $6.2 billion San Bernardino County (Calif.) Employees' Retirement Association.

Although Morgan Stanley and Duke Energy (as well as their pension fund partners) are down, they’re certainly not out, and if they chose too they have the ability to write whatever checks were necessary to pay their debts as agreed.

The lesson is, although ability to pay is a necessary condition for a good CRE loan, it’s not a sufficient condition.

Why Are CMBS Multifamily Delinquency Rates So High?

The 60 day delinquency rate for multifamily CMBS loans is skyrocketing. From a Fitch release:

Declining performance, particularly in oversupplied markets, as well as in secondary and tertiary markets, has pushed the multifamily delinquency rate to 4.55%, the highest of all property types. Multifamily properties have been highly susceptible to default in CMBS during the current economic downturn.

Fitch seems to suggest the problem is the asset class, but there’s something else at work – delinquency rates on Fannie and Freddie multifamily loans are less than a tenth of the CMBS figure. From an MBA release on June 2:

Fannie Mae: 0.34 percent (60 or more days delinquent)
Freddie Mac: 0.09 percent (90 or more days delinquent)

Why are the agency loans performing so much better? I think there are several factors at work, but the main reason is the originators of Fannie Mae and Freddie Mac loans had much to lose by selling bad loans to the agencies.

Most of Fannie’s multifamily business has been originated through their Delegated Underwriting and Servicing program. Fannie agreed to buy multifamily loans which were within their underwriting parameters without prior review. The originating lenders retained the top 5% loss exposure, and shared losses after that to a maximum of 20%. A very limited number of lenders were allowed to participate (never more than 30 nationwide). Sell a bad multifamily loan to Fannie under the DUS program, and you not only shared in the loss, you risked losing a valuable franchise.

Freddie took a different approach. They didn’t require originating lenders to share in the loss, but the ability to sell to Freddie was if anything even more tightly controlled, with a limited number of lenders restricted to specific geographic areas (see current list here). Again, sell a bad loan to Freddie, and you risk losing your franchise.

By contrast, CMBS origination was wide open. But, that may be changing. The lead story in yesterday’s Financial Times:

Treasury plans strict rules for securitisation

The US Treasury is planning a sweeping overhaul of securitisation markets with tough new rules designed to restore confidence by reducing the incentive for lenders to originate bad loans and flip them on to investors…

The Treasury plans to force lenders to retain at least 5 per cent of the credit risk of loans that are securitised, ensuring that they have what investors call “skin in the game”. The 5 per cent rule – which looks set to be applied in Europe as well – is less draconian than some bankers feared.

Would such a rule have prevented bad CMBS loans? Probably not; I believe the risk of franchise loss was a much more important determinant of lender behavior. But, it’s a start.

Crescent Resources’ Bankruptcy and the Single Asset Entity Put Option

Lenders’ plans to isolate their loans from borrowers’ problems on other properties are devolving to a borrower put option.

The first big case testing the sanctity of single asset entities was General Growth Properties, which placed 166 of its malls in bankruptcy along with the parent company (see Todd Sullivan’s Valueplays for a nice summary of the status of this case).

Now, Crescent Resources has jumped on the bandwagon. SAEs seem to have turned into a “heads we win, tails you lose” proposition for borrowers. Heads, if the asset is performing well and the borrower wants to use it to prop up less successful projects, the borrower includes it in the bankruptcy filing; tails, if the asset securing the loan is a hopeless loser, the borrower doesn’t include it in the filing and gives it back to the lender.

From Crescent Resources’ bankruptcy web site:

Morgan Stanley Real Estate Group: The Problem With Partners II

Morgan Stanley’s real estate partners are not happy.  Excerpts from Pensions & Investments:

Two investors — the $60.5 billion New Jersey State Investment Council and the $3.86 billion Contra Costa County Employees Retirement Association — backed out of their commitments to its latest closed-end fund, the approximately $5 billion Morgan Stanley Real Estate Fund VII. Contra Costa had committed $75 million; New Jersey, $150 million. (Fund VII is closed to further commitments but is technically open to tie up loose ends, according to sources close to Morgan Stanley.)

•Its $5 billion open-end core real estate fund, the Morgan Stanley Prime Property Fund, has a line of investors asking for a total of more than $500 million in redemptions as of year-end 2008. The fund returned -19.8% for the 12 months ended March 31, underperforming the NCREIF Property index but outperforming the NCREIF Open-End Diversified Core Equity index, according to fund information provided to investors.

This is not just a Morgan Stanley problem, of course; general partners in all types of private equity funds are worried about their limited partners performing on cash calls. From the Wall Street Journal:

How worried are private-equity-fund managers that their investors might not be able to meet capital calls? Very, if the results of a new survey by Private Equity Analyst are any indication.

The Sources of Capital survey asked fund managers, also known as general partners, to rank how important a variety of characteristics of investors, or limited Partners, are to them. Of respondents, 84.8% listed an ability to meet capital calls as extremely or very important, second only to their desire that investors be long-time participants in the asset class, at 88%.

The rapidity with which the inability to meet capital calls has emerged as a problem has been stunning. It wouldn’t even have occurred to us to ask this question a year ago. Now, as the response to the survey shows, there are fears that this is going to become a widespread phenomenon.

It’s almost inevitable that when one partner provides expertise and the other partners provide most of the money, there is going to be a falling out when performance declines (see my related post, The Problem with Partners).

Loan Paydowns from the Borrower’s Perspective

I previously posted comparing CRE underwriting in 2006 and today (bottom line, even if your project income is unchanged, loans are 15-20% smaller, mostly because cap rates have increased). Suppose you have one of those 2006 loans and it’s maturing. What should you do? A look at the numbers reveals borrowers are much better off if they can negotiate an extension.

Here’s an example drawn from an actual deal done in 2006. The original underwriting and today’s underwriting is summarized in the table below:

Key points to note:

• The value of the property is a little less than the current loan as a result of the NOI decrease and the higher cap rate. In other words, the original $2.2M cash invested is gone.
• The property now supports a loan of only $4.5M. In other words, to refinance the current loan, the borrower will have to put in an additional $1,551,328. The new debt and borrower cash investment total $8.2M on a property worth $6M.

Now, 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). We know these biases exist, and their existence helps explain why borrowers continue to perform on loans when it makes economic sense to walk away. However, when it comes to writing seven figure checks, people get rational in a hurry. We are not going to see many people contributing large amounts of money to refinance properties which do not have equity.

So, what are the borrower’s options? One is to walk away from the original $2.2M investment and default on the loan. That would make sense if the borrower sees no possibility of a value recovery on the horizon. However, almost all borrowers do foresee a recovery, want to stay in the game, and will request an extension of the loan. The most common requests are an extension at the existing contract rate, or an extension at the current market rate. The table below summarizes the economics of those scenarios, plus a third option:

Note that although nothing solves the value problem (it takes higher NOI and/or lower cap rates to do that), there is cash flow under each scenario which is a reason for the borrower to stay with the game. To make an extension more attractive to the lender, the borrower could offer to apply some or all of that cash flow to pay down the loan, or sweep it into a reserve account as a hedge against further declines in NOI.

The third scenario (Till) represents how the loan could be restructured in a bankruptcy (for more on Till, Lee, et ux. v. SCS Credit Corp, see my post Getting Tilled: How a $6,425 Truck Loan May Decide the Fate of General Growth Properties). Since this is clearly the worst case for the lender, you might think lenders would avoid the risk and extend loans without a lot of argument. I identify some of the reasons lenders may fight it out in the post What Should Lenders Do With Maturing CRE Loans?

CRE Interest Only Revisited

Barry Ritholtz at The Big Picture has a good post today on  interest only CRE mortgages (although I think he got one thing wrong, as discussed below). Interest only structures were very common during the boom. Sometimes loans were IO for the full term, but more often the loan was IO for a two, three, or five year period, so many loans made at the peak are seeing 15% –20% increases in payments now as the IO period ends. From Barry’s post:

“Investors in bonds that packaged $62 billion of debt for U.S. offices, hotels and shopping malls are bracing for more loan defaults through 2010 as Bank of America Merrill Lynch says landlords’ monthly payments may jump 20 percent or more.

Principal is coming due on the so-called partial interest- only loans as an 18-month-old recession saps demand for commercial real estate. About $179 billion of such loans were written between 2005 and 2007 and bundled into bonds, according to data from Bank of America Merrill Lynch.

With soaring vacancies and falling rents, some cash- strapped borrowers will fail to cover the higher costs, said Andy Day, a commercial mortgage-backed securities analyst at Morgan Stanley in New York. About 87 percent of mortgages sold as securities in 2007 allowed owners to put off paying principal for several years or until maturity, compared with 48 percent in 2004, Morgan Stanley data show.”

I think this is where Barry goes wrong:

Almost by definition, when a borrower users I/O financing, it suggests they cannot afford to make the actual purchase, and were unable to arrange other forms of financing.  Otherwise, the buyer would have arranged for to a less risky structure that is not dependent upon subsequent credit availability.

IO in CRE was not about maximizing affordability or leverage – although the actual payment was interest only, loans were still underwritten assuming amortization, so the loan amount was the same for IO and amortizing structures. Partial term IO structures were about boosting cash on cash returns in the early years of the deal. Here’s an example:

Most of us think of amortization as a small piece of the payment, but when rates are very low (like today) amortization is a very big expense component:

By deferring this expense for a few years a spreadsheet jockey could show a much better return in the early years. Combine that with rosy income projections in later years, and buying CRE at a 5% cap rate starts to look like a good idea.

I discussed IO in much more detail in my post “The Problem with Interest Only” last December. I don’t see a lot of defaults triggered solely by amortization kicking in on these deals – the easiest modification in the world is to extend the IO period, and I think we will see a lot of that going on. The underlying deterioration in cash flow and values is the much larger issue.

Home Court Advantage in Real Estate

Home court advantage is a huge factor in sports; for example, historically the home team in deciding games has won 78 of 97 games up until the second round of the 2007 NBA Playoffs. There is a comparable effect in commercial real estate.

I learned about real estate home court advantage from Gus Williams, the Seattle-based basketball star that led the Sonics to their 1979 championship. Somehow Gus ended up as the primary investor in a strip retail center in Selma, California. Selma is a town about 20 miles south of Fresno on Highway 99. You’re probably heard of tertiary markets – Selma is a quaternary, or maybe even a quinary market. I’m not sure how Gus’s money got into the deal, but I can tell you it never got out, because the Los Angeles lender I worked for foreclosed on the center in the early 1990’s.

It’s not noteworthy when a professional athlete loses money in real estate. What distinguished this piece of REO was that fact that absolutely no one would buy it. Months passed, the listing price was reduced again and again, but nothing. Finally, the local businessman who sold the property to Gus came forward and put us out of our misery with an offer which was a small fraction of what he got from Gus five years before. We (and Gus) were the away team, and the home team blew us out.

Local investors are starting to step up this time around too. From Zero Hedge:

The Buffalo News reports that REIT Developers Diversified Realty is selling back 11 upstate New York shopping malls to the entity it originally purchased them from, Benderson Development Co., at a 30% discount to their 2004 purchase price…“It’s good that the ownership is going in the direction that it is,” said Michael C. Clark, director of retail tenant services at CB Richard Ellis in Buffalo. “There’s going to be a lot of markets in other parts of the country where they have portfolios for sale by different REITs and they don’t have someone like Benderson to step up.
“We’re pretty fortunate in terms of the market, in regard to that. How much better can you get than the folks that developed them and are intimately familiar with them and live and breathe here? They certainly know what they’re doing,” Clark said.

The Zero Hedge spin is that CRE values have fallen, but that misses the real point of the story – a REIT based in Ohio is not going to do a good job pricing and operating malls in upstate New York.

Another example is from the Portland Oregonian, via Portland Housing Blog:

Portland condo king Homer Williams is pursuing a surprising new business.

With the residential real estate market struggling, Williams has turned to a newly hot commodity: failed bank loans.

Williams confirmed that he's the man behind BCC Fund I Limited Partnership, which the FDIC identified this week as the successful bidder for two packages of loans from the defunct Bank of Clark County.

The FDIC auctioned the loans last month from the Vancouver bank that failed in January.

Williams declined further comment. But according to the FDIC, BCC Fund 1 paid just more than $2 million for one bunch of loans with an outstanding balance of $6.1 million. BCC also successfully bid $3.3 million for a group of 53 other loans with an outstanding balance of $10.3 million.

That means BCC paid about a third of the outstanding balance of the loans.

Buying a loan from the FDIC is buying a pig in a poke (REIT Wrecks has a great post on that here), but I have to believe a Portland developer buying loans from a failed Portland bank is going to do better than a hedge fund out of New York.

Moral of the stories: keep the home court advantage.

Getting Tilled: How a $6,425 Truck Loan May Decide the Fate of General Growth Properties

General Growth Properties, the bankrupt mall owner, has $27,700,000,000 in debt outstanding. The fate of the company will depend on the restructured terms of that debt. Those terms will probably be set according to a Supreme Court precedent which restructured a subprime truck loan.

Lee Till filed Chapter 13 bankruptcy and attempted to get the interest rate reduced on the loan secured by his 1991 truck. SCS, the lender, thought the rate should be 21%, because that was the going rate for loans to subprime borrowers secured by old trucks. The Supreme Court thought differently, and ruled the rate should be the Prime interest rate + 1.5%. The essence of the Court’s ruling is that in bankruptcy you start with Prime as a base rate and add a risk premium of 1-3%. You can find a summary of the case (Till, Lee, et ux. v. SCS Credit Corp., 2004) here and the syllabus which goes into more detail here.

If you’re a CRE lender, you might think that this doesn’t have anything to do with you. I know I felt that way, the first time I ran into Till a few months after the court ruled. How could the $12M fixed rate Fannie Fannie loan we serviced be repriced at Prime+1%? What about our yield maintenance provision? Why use Prime as a base rate? How could a large loan secured by a nice apartment project end up priced like a $6K loan on a 13 year old truck? When the borrower’s plan was confirmed, it seemed like a bad dream.

What’s even more surreal is this precedent will probably be used as the basis to reprice at least some of GGP’s $27B in debt. That’s what Bill Ackman of Pershing Square Capital Management is betting with his 7.5% stake in GGP’s outstanding common stock. Valueplays has a link to Pershing’s analysis of GGP’s value here. The discussion of the Till precedent starts on page 41. The bottom line is Ackman believes both that GGP’s debt will be extended, and the overall interest rate on their debt will be reduced.

Prime today is 3.25%, so a borrower in bankruptcy has a realistic shot at getting his loan restructured at a rate below 5%. That rate will allow a lot of partially leased income properties limp along. The risk of getting stuck with a low interest rate restructured loan is also keeping a lot of note buyers on the sidelines.

Craigslist Unglues Apartment Rents

After reading John Reeder’s post over on Real Property Alpha about fundamental changes in the CRE market, I started listing some of the changes I’ve been seeing. The first on my list is the effect better information is having on the stickiness of rents.

In the good old days when the market softened you might need to drop your rents and/or offer concessions to rent a vacant unit, but you could rely on maintaining rent levels for existing tenants. Rents were “sticky”; once you got a tenant into a unit the rent level stuck. However, those days seem to be gone, and I think we have the internet in general and Craiglist in particular to thank.

It is now incredibly easy to obtain rental rate information in minutes at no cost. For example, here’s a partial screenshot of the 102 new listings in Seattle posted on Craiglist yesterday renting for between $1,500 -$1,200:

This is obviously a great tool for potential tenants. However, it’s not so great for the owner of the house I rent for me to know there are three comparables houses within a mile renting for $500 to $700 less than I’m paying.

Lack of information used to be a market stabilizer. Now, in 15 minutes anyone can get a handle on a submarket. Renegotiating a lease rate has never been easier.

General Growth Properties and Distressed Sales

Pre-bankruptcy, General Growth Properties refused to sell properties at discounted prices. From an April 27, 2009 Bloomberg story:

Simon Property Group Inc., the largest U.S. shopping-mall owner by stock-market value, tried to buy real estate from rival General Growth Properties Inc. before it filed for bankruptcy, Chief Executive David E. Simon said.

“They didn’t realize they were a distressed seller,” Simon said in a panel discussion at the Milken Institute Global Conference today in Beverly Hills, California. Few commercial real estate sales are being completed because sellers aren’t willing to take losses on their investments, Simon said.

Is this likely to change now that GGP is in bankruptcy? It seems not. From a May 20, 2009 Bloomberg story:

General Growth Properties Inc., the mall owner that filed the biggest real-estate bankruptcy in U.S. history, may not have to sell any malls at discounted prices, said the head of rival Taubman Centers Inc.

“Even with a distressed owner of a good quality regional mall asset, you rarely, rarely see distressed pricing of those assets,” Chairman and Chief Executive Officer Robert S. Taubman said in a telephone interview. “If you’ve got a great one, no one’s going to want to sell an asset like that at a distressed price.”

…Taubman, whose Bloomfield Hills, Michigan-based company has 24 regional malls, said the court likely will support a plan by General Growth management to keep the company’s portfolio together and emerge from bankruptcy without selling off a large number of properties.

As I discussed in my post “Is General Growth Properties in Denial?”, the GGP bankruptcy was not about fundamentals, it was about maturing debt. That’s a problem that is relatively easy to solve in bankruptcy court without liquidating assets.

The Geography of Job Losses

There’s an extremely cool animation of job gains and losses since 2004 at Tip Strategies. Here’s a couple of screen shots:

The animated version is amazing. This reminded me of Jim Hamilton’s powerpoint which shows the regional propagation by quarter of recessions between 1969 and 2004, saved here. Did you know that the recession starting in 1990 actually began in Arizona in the fourth quarter of 1988?

You have to click through the slides yourself; the action starts on slide 14.

These are both good reminders that there are huge variations in a recession’s impact among metro areas.

Full Recovery of the CRE Market in 2-1/2 Years? The Global Economy

Robert Sanchez thinks a full CRE recovery could take as long as 2-1/2 years.  From The Saint Report (hat tip The Dirt Lawyer's Blog):

During a panel discussion for Pepperdine MBA alumni in downtown Los Angeles last month, Robert Chavez, former CEO and founder of Staubach LA and current president and CEO of Guardian Commercial Realty, said that a full recovery in the commercial real estate market could take 2 ½  years.

I previously posted on why I think this is unlikely given the current state of employment (post here). Another reason I think a recovery is unlikely to happen that fast is the state of the global economy. Now, I’m not much of a globalist (all real estate is local, right?), but there is no escaping the fact that this meltdown is everywhere, and that the world is more interconnected than ever. VoxEU has an extremely sobering post comparing current trends with those in 1929. Here are a couple of charts:

Before a recovery can start, things have to stop getting worse. There is nothing in current economic news to suggest we’ve reached a turning point.

Don’t Blame Loan Officers for Poor Loan Performance

The Obama Administration thinks loan officer pay should be tied to the quality of their loans. From the Wall Street Journal:

The Obama administration has begun serious talks about how it can change compensation practices across the financial-services industry, including at companies that did not receive federal bailout money, according to people familiar with the matter…Among ideas being discussed are Fed rules that would curb banks' ability to pay employees in a way that would threaten the "safety and soundness" of the bank -- such as paying loan officers for the volume of business they do, not the quality.

This idea reflects a fundamental misunderstanding of how loan origination works. Loan officers do not approve their own loans; there is always some kind of credit approval structure with people other than the originator signing off. I’m not saying that system doesn’t break down (for example, see my post, “Why Did WAMU Abandon Underwriting Standards?”). However, if a lender does a lot of bad loans, it means senior management made bad decisions and/or looked the other way.

VoxEU addresses the issue in their article, “Bonus Incensed”:

Until the 1970s, the predominant institutional form for risk taking in financial institutions specialising in speculative trading was partnerships, with partners’ unlimited liability a central element.

Employees were entitled to bonuses, but entirely at the discretion of the partnership. Employee traders producing significant profits were very well paid; those generating losses did not get bonuses, were often dismissed, and even blacklisted. The partners had a highly developed sense of risk and their asymmetric exposure to it, in no small part because failure could also mean personal bankruptcy.

Partnerships have disappeared over time, and the predominant institutional structure in the financial industry is now the limited liability corporation. This transformation is a key reason for the emergence of the bonus culture, because it substantially reduces the incentive of senior management to monitor risk taking. Any financial institution engaged in speculated trading faces the inherent danger of individual traders taking so much risk that it threatens the firm. It is the role of the senior management to prevent that.

Their solution:

Financial institutions should adapt elements of partnership structures to the limited liability financial institutions of today. Senior management (the partners of old) need to have a substantial part of their compensation deferred over a long period of time, with the amount of compensation directly related to the long run fortunes of the firm. Any senior manager in an institution receiving public assistance should lose all of their deferred compensation. By contrast, the supervisors should not mandate deferral of trader bonuses or regulate junior employee compensation. This provides management with an incentive to check for gaming.

When I’ve been in a credit position, I’ve always been impressed with how effectively experienced loan officers triage their loan applicants. Spending time on a loan application which is not going to be approved is a waste of time, and good loan officers can’t afford to waste time. In my experience, applications for bad loans are almost invariably taken by inexperienced loan officers who don’t know a good loan from a bad one and/or who are desperate to establish a client base. Changing their compensation structure is not going to solve that problem – you need good credit people willing to say no to bad deals and senior management willing to back them up.

To the extent bad loans are originated, the problem lies with the lender’s credit people and senior management, not the loan officer.

CRE Miniperm Underwriting Today and Yesterday

Deal Junkie suggests in this post that although the CMBS market is frozen, balance sheet lenders continue to lend on CRE. Traffic Court counters here that, although balance sheet lenders are making loans, the underwriting is much more conservative.

I took the current loan terms and underwriting parameters from one of the banks mentioned in the Deal Junkie post and compared them to the terms and underwriting on an actual deal done in 2006. The loan is a 5 year term with the first 3 years fixed. The bottom line, 17% fewer loan dollars. Here are the numbers:

Why There Are Very Few CRE Sales

According to Sam Zell, the lack of CRE sales is a result of a combination of falling values and low interest rates. An excerpt of a post from Todd Sullivan’s Valueplays (reporting on a Bloomberg interview with Zell):

“Well, there’s been a lot of speculation and a lot of journalists have written about the impending demise of commercial real estate,” he said. “First of all, I think that the fact that interest rates are as low as they are means that even if people are under water in commercial real estate, they still can carry it. And if you’re under water and you can carry it, the last thing you’re going to do is sell it, because you don’t get anything.”
“So therefore, that’s why we have no transactions,” he said. “And I think it’s going to take two or three years before we start seeing that happen.”

This does not hold true, obviously, if the CRE is not generating income (i.e., land, condos, new construction with no leasing). As you would expect, it’s these types of assets which are experiencing foreclosures, note sales, etc. For the rest, I agree with Zell that we’re looking at a prolonged reset to normal transaction volume.

Lender Groupthink

Here’s an excerpt from Michael Skapinker’s opinion piece in the Financial Times, “Diversity Fails to End Boardroom Groupthink”:

Disagreeing with the company’s direction is hard enough. Doing so when an entire industry is going in the same direction is harder still. It is not just boards that suffer from groupthink; entire sectors do. The banking industry did.

Any investment banking chief executive who had listened to a director’s warning that complex financial instruments spelt trouble would have been in trouble himself. As Peter Hahn, a fellow at Cass Business School, told the Treasury committee: “If one of those banks in 2005 decided to be more conservative and hold back in their activity, they more than likely would have had their CEO and board replaced in 2006 for failing to take advantage of the opportunities.”

The implication is that we should heed the advice of dissidents, but real life is not so simple. In the 1980’s a lender I worked for had losses in Las Vegas, and as a result of that experience and my general distrust of low constraint markets, I believed Las Vegas was a dangerous place to lend. Today, I’m right – lenders who made loans in Las Vegas after 2005 are going to take losses. But, I was wrong for 20 years. 12 month change in employment growth is a good proxy for the health of CRE in a market, and the chart below shows went went on in Vegas:

CRE loans in general went through an extended period of virtually no losses, and the lenders making speculative land development, condo, and aggressively underwritten loans enjoyed an extended run of success. In at least some cases more conservative lenders decided to join the party at the end, and are now paying the price.

I discuss how difficult it is for credit officers to go against the flow in the post below:

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