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.”

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).

Why Now Is a Great Time to Become a CRE Lender

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

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

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

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

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

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

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

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

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

Five Underwriting Issues Which Kill CRE Deals

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

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

The link may take you to a free registration page…

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.

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.

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.

What Should Lenders Do With Maturing CRE Loans?

We’ve had some conversation in the comment thread on this post about what lenders should do with maturing loans. Today I will attempt to address that question in more detail, starting out with what I would do if it were my money, and moving on to some of the reasons lenders adopt different strategies.

Foreclose on properties the borrower is driving into the ground. At this point in the cycle there is no point in giving an extension or modification to a borrower who is taking actions (or inaction) which is hurting the value of the collateral. A recovery is not imminent, and if a borrower is deferring maintenance or is ineffective at leasing the property, an extension will just result in a bigger loss down the road. This situation can come about for a variety of reasons, and often  the borrower is not the villain. Usually, it’s because a borrower is under severe financial pressure on other deals, or lacks the experience to deal with difficult market conditions.

Foreclose on properties when the submarket is in a downward spiral. No matter how good a borrower is at property operations, it is very, very difficult to compete when you owe $100,000 a unit on a property and the building next door has gone through a foreclosure and the owner next door only owes $50,000 a unit, because the new owner can substantially undercut your rents and still get a good return. For an example with numbers that shows how this works, see my post CRE Loans and the Death Spiral of Doom. If your property is in a submarket with multiple foreclosures in process you will probably minimize your loss by foreclosing too.

Extend loans which have experienced, solvent borrowers in relatively stable submarkets when the property can pay a reasonable interest rate. You want an experienced borrower who is not tapped out because fundamentals will probably get worse before they get better, and you want someone who can make the right decisions and kick in some cash if necessary. You don’t want to be in a downward spiral submarket for the reasons discussed in the paragraph above. To keep the borrower motivated, you need to offer an extension long enough to get through this part of the cycle (2 years minimum, 3 or 4 more likely). A reasonable interest rate is hard to define in this market, but I think the best structure is a floating rate deal around 3% over your cost of funds, which, if you’re a bank, will probably result in a rate of 4% to 5%. I would keep the structure interest only, but require 50% of any excess cash flow to go into a reserve account to cover operating deficits, capital costs, and perhaps pay down principal if the reserve account reaches a threshold level (maybe 5% of the loan amount). This structure gives you a reasonable return, gives the borrower an incentive to maximize cash flow, and gives you both a piggybank to draw from if conditions continue to deteriorate.

These are the strategies which I think would give you the best recovery on individual deals. However, not all banks and investors pursue them, for a variety of reasons.

The lender or investor wants out of the asset class. Right now banks and institutional investors pay a price in their market value and ability to attract new investors if they have heavy CRE exposure. There is a lot of value created if you can say a problem is behind you. To create this value, the lender sells notes or forecloses on deals for less than they might realize with a hold strategy.

Regulatory Direction. Many banks are under pressure to reduce their CRE exposure. An REO may create a loss, but at least the asset is gone. A modified loan, on the other hand, will be reviewed by examiners every time.

Your First Loss is Your Best Loss. Many lenders follow this strategy on all loans until it is clear a recovery is underway (more detail here).

Avoiding Second-Guessing. Many modifications don’t work out (see this post on single family modification failures; in my experience the CRE modification failure rate is even higher). If you modify the loan and end up taking the property back anyway it’s probably because conditions have continue to deteriorate and you will recover less than you would have if you had foreclosed to begin with. It’s easy to quantify that loss, and it looks like poor judgment. On the other hand, if you foreclose, no one will quantify how much you could have saved by modifying the loan.

Pooling and Servicing Agreement constraints. If the loan is a CMBS loan, the servicing of the loan is governed by a Pooling and Servicing Agreement. Generally, in a maturity default the special servicer is charged with maximizing recovery for all investors. Although this could mean doing a long term extension at a lower interest rate, given that there’s an excellent chance the investors that actually own the loan may want out of the asset class or believe in the “first loss is the best loss” strategy, a special servicer is vulnerable to second guessing. Foreclosure is a safer strategy. Thompson Hine has a good summary of CMBS modification and extension procedures here.

Dual Track Costs. Many lenders will not begin negotiation until there is an actual or imminent default. This may be a function of a Pooling and Servicing Agreement, or the lender could just be hoping the borrower will find a way to pay the loan off. Once a default happens, many lenders will start the foreclosure while negotiating an extension so no time is lost if an agreement is not reached. This adds costs, and frequently at least some payments are not made because the borrower is also not sure an agreement will be reached. As a result, to close the extension frequently a substantial amount of money needs to be paid, and borrowers sometimes decide to walk at that point.

Workload. Modifications are enormously time consuming. The deal needs to be negotiated, approved, and documented, and frequently multiple rounds occur. A complex deal can be a full time job for an asset manager for months. It is much simpler from an asset manager point of view to foreclose. If the justification for a modification looks marginal or the borrower is difficult, this factor can swing the recommendation to foreclosure.

Given all these hurdles, it’s not surprising few long term extensions are done. If an extension is offered, it’s usually short term (90 to 180 days) and predicated on progress being made towards marketing or refinancing the property.

CRE Problems: Rate Structure, Maturity, and Vintage

Zero Hedge’s post, “The Special Servicing Problem,” talks about the ballooning transfers to Special Servicing status. The post includes a table of large CMBS loans which have been transferred, which I think gives a nice snapshot of the types of loans which are in trouble:

(Click on image for a larger version in a new window)

Rate Structure. The only floating rate loans in this group are loans which have matured. Given the very low floating rates today, we are not going to see many payment defaults, but given the decline in values, tightening of underwriting standards, and lack of financing available for CRE deals, many floating rate loans can’t be refinanced or sold for the outstanding loan balance at maturity.

Maturity. There are four loans in the group which are five years or older (i.e. originated before 2005). All of these loans have matured. There are not many old loans in the table because many older loans were successfully refinanced during the boom years. The remainder were underwritten conservatively enough that they have been able to make their payments, but in the current environment they can’t be refinanced or sold without a loss.

Vintage. The vast majority of the loans in the table are fixed rate loans underwritten in 2005-2007, at the peak of the market and when underwriting standards were weak. With the decline in fundamentals these loans are having trouble making their payments, and can’t be refinanced or sold.

It may be possible to work out the first two groups with term extensions. The only hope for the last group would be a drastic reduction in the interest rate (for example, switching to a floating structure).

Lender Conspiracy to Destroy Competition?

The developers of the Fontainebleau casino and hotel development in Las Vegas believe Deutsche Bank is out to get them. From Zero Hedge:

In a stunner of a development, Las Vegas casino operator Fontainebleau has amended its ongoing lawsuit against a set of banks, and has alleged that Deutsche Bank is now "seeking to destroy the Fontainebleau in order to minimize competition" with the Cosmopolitan Resort and Casino, which was acquired by Deutsche Bank in a foreclosure auction in September 2008 for $1 billion, after the casino had defaulted on a $760 million loan. Allegedly, DB is doing this by pulling Fontainebleau's revolver, making it impossible for the development-stage casino to survive…

As both the Fontainebleau and DB's Cosmopolitan developments are in their final stages of development, their "successful" opening would result in yet another flood of hotel rooms in the already oversupplied Las Vegas market. The Fontainebleau casino would provide 3,800 brand new rooms and condo units, while the Cosmopolitan would supply yet another 3,000 rooms and condos.

How plausible is this argument? This plan would require monumental stupidity at Deutsche Bank. Shutting down the Fontainebleau development would ultimately lead to a new owner who would acquire the development at a much lower basis than the current owner. This would allow the new owner to substantially undercut the Cosmopolitan, pulling that project down too. I’ve discussed this downward spiral effect in more detail in my post CRE Loans and the Death Spiral of Doom.

If you view an income property submarket as an ecosystem, the whole system does best when all the competing properties have similar cost structures. When a predator property with a much lower cost basis enters the system (as a result of a greatly discounted purchase out of a foreclosure or note purchase, for example) it can offer much lower rents, which in turn can destabilize other properties. Eventually a new equilibrium is established, but at a much lower level than before the system was destabilized.

If Deutsche Bank is really trying to shut down Fontainebleau to benefit Cosmopolitan, it’s shooting itself in the foot.

Why Are Performing CRE Loans Selling for 50 Cents on the Dollar?

Zero Hedge and Real Property Alpha have picked up on the results of recent FDIC auctions of CRE loans (Zero Hedge posts here and here, Real Property Alpha posts here and here). A graph from Real Property Alpha shows performing CRE loans are being sold at roughly 50% discounts:

You might think the sales price on the performing loans indicates the collateral backing the loan is worth only half the loan amount, but that’s not the case. This is about a change in investor yield requirements, not CRE fundamentals.

Let’s say you have a well secured, performing $10,000,000 CRE loan paying a 6% interest rate:

Now, let’s say you are taken over by the FDIC, and the FDIC wants to sell the loan. You might think that since the loan is well secured you could sell it for the full principal amount, but you would be wrong; note buyers want a 12% yield on their investment (actually, they want more – I get two or three calls a day from people wanting to buy notes, and return requirements are 12% to 25%). To get a 12% yield on a loan paying 6% interest, you need to buy it at a 50% discount:

You might question why the FDIC would sell – 6% is not a bad yield when 5 year Treasuries are at 2%. If the answer is the same as when I worked there in the late 1980’s, it’s because their job is to liquidate assets at the best price they can get for them. But, most banks would be content to collect 6%, and that explains why you don’t see many banks selling performing CRE notes.

The Commercial Real Estate Risk Culture at Deutsche Bank

Zero Hedge has published a letter from a former risk manager at Deutsche Bank which speaks to the difficulties of being a risk manager in a lending institution. Some excerpts:

For more than two years, I have been working internally to improve the inadequate governance structures and lax internal controls within Deutsche Bank. I joined the firm in 2006 in one of its foreign subsidiaries, and my due diligence revealed management failures as well as inconsistencies between our internal actions and our external statements.
Beginning in late 2006, my conclusions were disseminated internally on a number of occasions, and while not always eloquently stated, my concerns were honest. Unfortunately, raising concerns internally is like trying to clap with one hand. The firm retaliated, and this raises the question: Is it possible to question management’s performance without being marginalized, even when this marginalization might be a violation of law? Two years later, our mounting losses are gaining attention, and I offer my experiences and my thoughts in the hopes of contributing to the shareholder and public policy debate…

I joined Deutsche Bank in 2006 to build an investment business within its commercial real estate lending operation, and I was generally surprised by the aggressive sales culture within our firm. While many people consider the banking sector’s problems to be caused by residential lending, I witnessed multibillion-dollar loan proposals for commercial property.
With funds provided at more than 90 percent loan-to-value, these loans were “priced to perfection” and assumed that property prices and rental rates would continue to rise. For perspective, a single billion-dollar commercial real estate loan is equivalent to 2,000 residential loans of $500,000.
In general, my colleagues are hard-working, decent people, but the system of incentives encourages people to take risks. I have seen honest, high-integrity people lose themselves in this cowboy culture, because more risk-taking generally means better pay. Bizarrely, this risk comes with virtually no liability, and this system of O.P.M. (Other People’s Money) insures that the firm absorbs any losses from bad trades…

There’s much more at this follow up Zero Hedge post.

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

Indications of a Credit Bubble

From Socializing Finance’s post Flashback: The Quality of Credit in Booms and Depressions, some commentary from 53 years ago:

In the past few years important new historical evidence has been developed on the cumulating deterioration in the quality of credit during the period of prosperity that precedes severe depression. […] With respect to the current situation we must concern ourselves with the fact that some, at least, of the economic conditions are in evidence today. What are these conditions? First and foremost is a rapid increase in the volume of credit or debt. Second, a rapid, speculative increase in the prices of the assets that are brought with the rapidly increasing credit, such as real estate, common stocks, or commodity inventories. Third, vigorous competition among leaders for new business. Fourth, relaxation of credit terms and lending standards. Fifth, a reduction in the risk premiums sought or obtained by lenders.” – Moore, G.H. (1956). The Quality of Credit in Booms and Depressions. Journal of Finance 11, 288-300.

How accurately did these conditions predict the current CRE bubble, and where are we today?

1. Rapid Increase in the Volume of Credit or Debt. This clearly occurred during the bubble. As of today, the amount of debt outstanding hasn’t really declined, because few assets have retraded at reduced value levels.

2. Rapid, Speculative Increase in the Price of Assets. Again, this obviously happened. Some distressed sales are starting to occur, but for the most part values have not been marked to market yet.

3. Vigorous Competition for New Business Among Lenders. That clearly went on. Today, there is very little competition occurring; the few lenders that are making loans can pick and choose.

4. Relaxation of Credit Terms and Lending Standards. Terms and lending standards were clearly relaxed during the bubble (Loan to Value, Debt Service Coverage, Interest Only payment structures, etc.). For the most part these standards have tightened, although arguably LTVs are still based on cap rates which are too low, and DSCs calculated on historically low interest rates may not be high enough to ensure an exit if rates return to historical averages.

5. Reduction in Risk Premiums. Again, this obviously occurred during the bubble, with spreads over Treasuries in the 100bp to 200bp range. Today, spreads are much wider, but again maybe not enough in light of the historically low Treasury rates.

So, it appears lenders in 2006 were not attuned to the risks publicized by this article 50 years earlier. And, it appears we are only part way to establishing a normal lending environment.

Abandoned Projects Everywhere

Calculated Risk has a post featuring a video of an abandoned condo project in Irvine, CA:

Yesterday, the Wall Street Journal had a story on abandoned construction projects. An excerpt:

No one tracks precisely how many construction projects nationally have been stopped by developers midstream. But an indication of the scale comes from New York-based Real Capital Analytics Inc., which estimates that there were 3,929 distressed commercial properties across the U.S. as of March 31 -- a 55% jump since Dec. 31, 2008. Roughly a quarter of the properties involve developments, unfinished, Real Capital said.

The story mentions a website, UnfinishedConstrution.com, which specializes in liquidating such sites. Here are some photos of featured properties:

The site also features an alligator farm for sale:

That seems entirely appropriate given the difficulties of jump starting a project which has been shut down.

Related Posts: Roads Before Roofs, Roofs Before Retail, When Real Estate is a Liability: The Movie, and Workouts 101: Complete the Project!

Economy and Real Estate Post Picks: Week of May 3, 2009

Wholesale Sales Continue to Slide: Commodities are the hardest hit

The Latest Employment Report: Not as bad as previous months, but still not good

Does a Decline in Initial Jobless Claims Signal the Recessions End? A discussion of the impact of initial, continuing, and net jobless change

Regional Disparity in Unemployment Rates: The West Coast is faring poorly in this recession

CMBS Loan Performance: Transfers to Special Servicing are up sharply

Successful, Until You Aren’t

Lansner on Real Estate reports Pacific Property Assets has defaulted on the interest payment due on $90,000,000 in notes held by its investors. PPA has a 2,400 unit multifamily portfolio in Southern California and Arizona. Some excerpts:

Company CEO Michael Stewart said interest payments on about $90 million in notes would be suspended for an undetermined period, adding that he’s hoping investors will bear with the firm to give it “breathing room…”

“We’ve never missed a payment in over 10 years. It’s probably the toughest decision (we’ve made),” Stewart told the Register.

The fact that no payments were missed for ten years doesn’t mean much. I was Chief Credit Officer at ARCS Commercial Mortgage from 1997 to 2006, during which time we originated about $2B a year in multifamily loans with virtually no delinquencies, foreclosures, or losses. I would love to believe that was a result of my stellar judgment, and maybe it was. But, I’ll never know for sure, because during the time I was there any bad decisions I made were bailed out by declining interest and cap rates. Periodically, someone would complain we should do a risky deal I had turned down, because the fact we had no defaults indicated we weren’t taking enough risk. My response was that if the average CRE default rate was 2%, that was arrived at by 9 years of no defaults and one year of 20% defaults.

Commercial real estate performance, to paraphrase the quotes about airline travel and war, is years of boredom punctuated by periods of terror. If you’re a CRE investor who never missed a payment between 1995 and 2008, that puts you in the same class as 99% of all CRE investors. If you never missed a payment between 1979 and 1982 or between 1990 and 1994, I’m impressed. I expect 2009 to 2012 will be another period where never missing a payment will be something to brag about.

One of my grandmother’s sayings was “You don’t know if your roof leaks until it rains.” It hasn’t rained hard in the CRE world since the early 1990’s, and many lenders and owners (like Mr. Stewart) have assumed that, because they weren’t getting wet, they had a good roof.

Here’s a link to another story about Mr. Stewart during happier days just 8 months ago, in which he explains PPA’s decision to diversify into the Phoenix market (oops!), and how risks were lower in October 2008 than when he started PPA in 1999.