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.