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.

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.

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).

Are Banks Failing to Mark Down Toxic Assets?

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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.

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.

When Real Estate Is A Liability: The Movie

I’ve previously posted about how real estate values can fall close to zero here and here, and the importance of completing projects here. This video of new homes being demolished at the direction of the foreclosing bank takes the concept to a whole new level:

This is not as crazy as it appears when you know the bank’s side of the story, available on this post from Vision Victory Manifesto (also the video source). An excerpt:

“Our only option is to either proceed with putting more than a million bucks into the land, which we’ve already taken a huge hit on and lost a lot of money, or, we tear down the houses,” Smith [Guaranty Bank official, Real Estate Officer Dean Smith] said.

He said the builder put up the homes before completing the site improvements and failed to have enough money to finish roads, walls, and other improvements that bring the community into code.

“Everything just fell apart at that point and we can’t sell homes that are not up to code,” Smith said.

He said the city of Victorville fined the bank once because the home are out of code and would have faced daily fines if Guaranty didn’t do something with the vacant houses.

“There are still substantial dollars that need to be put into the land before the city of Victorville will give certificates of occupancy on the houses and the bank isn’t willing to put forward that amount of money,” Smith said.

If the bank was just looking at the cost of finishing the houses, it probably would have made sense to do so. But, when you have to put in roads and other site improvements too, that probably tipped the scales in favor of demolition. Obviously, it’s really bad lending practice to advance funds for house construction and not have enough in the budget to build the roads to the houses.

Another factor was that, in the bank’s view, it would be at least five years before the market recovers to the point the houses would sell. That’s believable, given the market is Victorville. The video mentions other homes being demolished in Temecula, which is also a distant exurb:

More on the problems exurbs are experiencing here, here, here, and here. Neither the video nor post identifies an exact location of the homes being demolished, but here’s an image of the crossroads mentioned:

The combination of exurb market, fringe location, and poor construction loan administration will result in losses in this kind of market.

Economy and Real Estate Post Picks: Week of April 20, 2009

Will the Recession End in a Few Months? Two economic forecasters think so

Can the Economy Function Without Securitization? This post argues restoring  securitization markets should be a top priority.

Commercial Real Estate Values at 2005 Levels: Moody’s Commercial Real Estate Indices indicate gains over the last four years have been reversed.

Which Way Are 10 Year Treasury Rates Headed? Two opposing views

What Will be the Shape of this Recession? V, L, or D?

Maturity Kills: Operating Statement Defaults Versus Balance Sheet Defaults

No question CRE rents are falling and vacancy rates are rising, and these trends are getting a lot of attention (see, for example, Calculated Risk posts here, here, and here, and Zero Hedge posts here, and here). However, this threat is minor compared to what’s happening on the balance sheet side of the business.

There are two ways a CRE loan defaults; an operating statement default, or a balance sheet default. Here is a typical CRE deal illustrating an operating statement default:

The assumptions are an initial interest rate of LIBOR+2.25% with a 30 year amortization, no changes in interest rates or cap rates, but a 25% decline in NOI. This results in negative cash flow, which could lead to a default (one would hope on a $10,000,000 deal the sponsor could cover a shortfall this small, but that capability is not something CRE lenders focused on). The takeaway point is, even with a major decline in NOI the shortfall is not huge, and because there is equity on the balance sheet the problem can be solved with a sale of the property.

Here is an example of a balance sheet default with the same structure, but a smaller decline in NOI coupled with an increase in cap rates:

Note that the operating statement side of the equation is fine; the borrower can still make the payments. However, the increase in cap rates has wiped out the equity in the property, and if the loan matures the borrower can’t repay it. The takeaway here is that cap rate changes have a much bigger impact than operating statement changes (for a more thorough analysis of this point, here’s a link to Philip Conner’s and Youguo Liang’s Income and Cap Rate Effects on Property Appreciation).

Here is what things are actually looking like for 2010 – a substantial decline in NOI and an increase in cap rates, combined with a substantial decline in interest rates:

Note that the operating statement is fine; the decline in interest rates more than offsets the decline in NOI, and cash flow has actually improved since origination. However, the decline in NOI combined with the increase in cap rates creates a huge balance sheet problem, and if the loan matures the problem can’t be solved with a refinance or sale of the property.

This is why there is so much concern over upcoming loan maturities. Here’s a link to a Deutsche Bank CRE presentation which goes into more depth (the maturity discussion begins on page 25).

Value, Cash Investments, Equity, Cash Out Refinances, Anchoring, and Sunk Costs

When I’m talking to a borrower about a loan workout, there is often a major disconnect between the reality they see and the reality I see. One of the disconnects almost always relates to the equity in the property.

Let’s say Bill Ant buys a property in 2005 for $10,000,000, and I make him a 75% LTV loan. Here are the numbers:

Bill’s equity is the difference between the value and the debt, and is equal to his cash investment.

Now, let’s roll forward to 2007. Values have increased 20%:

The cash investment remains the same, but Bill’s equity has increased 80% (the magic of leverage).

Now it’s 2010, and values have decreased 50% (think that can’t happen? Here’s my post, “Commercial Property Values Down 50%?”):

Here is when the disconnect occurs. When you talk to Bill Ant, he will refer to his $4,500,000 or $2,500,000 of equity in the property. Borrowers tend to anchor on their equity at peak value of the property, or on their cash investment in the property, instead of the equity based on the current value. Bill doesn’t have equity in the property any more – all he has is a sad story.

But, he does have $2,500,000 in sunk cost on the deal. Is that worth anything when it comes to his decision to continue to make the payments in a workout context?

Let’s say Tom Grasshopper did the same deal in 2005, and refinanced in 2007, pulling out all his cash investment with a new loan based on 75% of the higher value, and spent the proceeds on a big house and a boat. Here are the numbers:

Now, it’s 2010. I’ve put Ant’s and Grasshopper’s situations side by side for comparison purposes:

Some people think borrowers who have done cash out refinances are less committed to the property and less likely to support the loan than people who never pulled their cash out. After all, Grasshopper no longer has a sunk cost, and he can walk away and keep his house and boat, while Ant has nothing.

This makes sense in theory, but I can tell you with absolute certainty that in practice both of these borrowers are equally focused on their loss from the peak value, and are equally angry, in denial, willing to bargain, and depressed (depending on what stage of the process they’re at). Grasshopper is more likely to default and is likely to default earlier than Ant, but that’s because he owes more relative to the current value of the property, not because he has less commitment to the property.

To recap, borrowers anchor on what they had to start out with or at the peak of the market, measure their losses from those points, and are not much influenced by any gains they made along the way if they end up underwater.

Land Values at Zero?

Land loans are generally regarded as the riskiest type of real estate lending. Here are the FDICIA regulatory maximums for the various types of construction and development loans:

Why? Because land values evaporate in a severe downturn. From an interview with Bob Voit, a legendary Southern California real estate investor posted on Lansner on Real Estate:

Bob: …You could build a case that many real estate assets have zero value today that were worth millions a couple of years ago.

Us: Why?

Bob: It’s because, let’s say you have a beautiful site to build a high-rise office building on in downtown wherever. The combination of market forces, which would include construction costs, lack of availability of financing and the lack of available tenants that support your rental rate. What makes the development of an office structure economically unfeasible. If it’s unfeasible, nobody wants to buy it. Whoever may want to buy it can’t get the money.

Us: You’re talking basically of a collapse.

Bob: A relative collapse in temporary values. The same thing happened 20 years ago. Then market forces readjust, and off we go again.

An example shows how this is possible. Here is a breakeven analysis on a development project:

Now let’s suppose, for the reasons Bob talked about, the completed asset is worth 10% less. Here are the new numbers:

There goes the equity, the lender is now at 100% LTV. Same example, but suppose the completed asset is worth 28.6% less:

The land value is now $0. How likely is it asset values will fall 28.6%? Very possible, as discussed here.

But, of course, you don’t see many signs offering land for free. The reason the land value is zero is because the construction cost equals the end asset value. Build it for less, or find an end use worth more, and there’s still value there. Unfortunately, although construction costs are down, they’re not down that much, and the end values of all types of real estate tend to move down together. So, as Bob says, you wait for the market to readjust. Here are a couple of alternative uses for the land in the meantime:

Information Asymmetry, The Market For Lemons, and Pricing Toxic Mortgage Assets

A number of commentators have noted that the secondary market for mortgage assets suffers from a “Market for Lemons” problem:

There are good used cars and defective used cars ("lemons"), but because of asymmetric information about the car (the seller knows much more about the problems of the car than the buyer), the buyer of a car does not know beforehand whether it is a good car or a lemon. So the buyer's best guess for a given car is that the car is of average quality; accordingly, he/she will be willing to pay for it only the price of a car of known average quality. This means that the owner of a good used car will be unable to get a high enough price to make selling that car worthwhile. Therefore, owners of good cars will not place their cars on the used car market. This is sometimes summarized as "the bad drive out the good" in the market.

Sandro Brusco applies this problem to the secondary mortgage market in “Mechanism Design and the Bailout”:

If the market starts to suspect that some of those Mortgage Backed Assets (MBAs) are more toxic than others and that the managers of the banks know the ones that are more dangerous, then the markets can easily collapse. This is the standard ''market for lemons'' problem, which is by now well understood: investors don't want to buy MBAs at a price equal to their average value, because they are afraid that what they get is not the average but the worse, i.e. they suspect that the banks will first try to unload the most toxic securities. Lowering the price in this case does not work, since it only convinces even more the investors that the securities are truly toxic. The market essentially freezes. Investors will only buy at very low prices, the ones corresponding to the most pessimistic expectations on the assets. But this must mean that on average the MBAs are worth more than the market prices and therefore the sellers will be unwilling to sell.

Leigh Caldwell in “Lemons and Toxic Assets” and Mark Thoma both outline the case for government intervention to get the market working again.

This view starts with the premise there is asymmetric information between sellers and buyers – that sellers know which assets are toxic, and buyers don’t. Is that true in this case? I don’t think so - to a large extent, banks don’t know which assets are toxic and how toxic they are. I’m not just talking about ignorance of their own portfolio (although there’s plenty of that). Real estate is relatively illiquid, highly leveraged, and values are driven by comparable sales that are mostly distressed these days. As I’ve outlined in a previous post, this creates a downward spiral effect as assets are liquidated, and what looks like a good asset now  could easily be a bad asset a year from now.

William Buiter draws this distinction:

• Toxic assets are assets whose fair value cannot be determined with any degree of accuracy.
• Clean assets are assets whose fair value can easily be determined.

In this environment, there are not many real estate assets whose fair value can be easily determined. You can take a snapshot value using current income and comparable sales and decide if the mortgage secured by that asset is a good risk today. But, the snapshot only captures the present, and experienced real estate investors know we are in a nasty feedback loop which will drive down values further. The problem is not information asymmetry; the problem is no ones knows at what level the market which reach an equilibrium.

CRE Loans and the Death Spiral of Doom

When CRE markets start to decline, they can spiral downward dramatically over time. Let’s start out by looking at the underwriting for loans on two identical adjacent apartment projects in Los Angeles in 1989:

The two projects are identical, but the lenders underwrote differently – the Bad Lender used a 3% vacancy factor, but more importantly leveraged the deal to the breakeven point. This was very typical of the market then, and was usually accomplished either by underwriting on the pro forma appraisal income instead of the actual operations and/or by underwriting to a 1.25 DSC on a teaser start rate on a variable rate loan and a 1.00 DSC on the fully indexed rate. The theory was the borrower would refinance when the reset occurred (does this all sound familiar)? The consequence of this approach is the bad lender loan about 80% of the asset value, while the Good Lender loaned 64% LTV.

Let’s go forward to 1991. There have been huge employment losses in the market, and rents have decreased while vacancy has increased. Perceived risk has also increased so cap rates are up too. Here are the numbers (the 1989 Bad Lender underwriting is included for comparison purposes):

Rents are down 5% and the vacancy rate has increased to 15%, creating substantial negative cash flow for the Bad Lender borrower. He defaults, and the combination of lower net operating income and higher cap rate results in the Bad Lender takes a 24% loss. The cash flow for the Good Lender borrower has also taken a hit, but because her deal was not leveraged as highly to begin with, she does not default.

Things start to get interesting when the Bad Lender sells the REO property:

The REO buyer bases their purchase on a higher cap (it’s REO, after all) and suffers an additional loss bringing the overall loss to 33%. The Bad Lender finances the sale at 80% LTV. Note that since cap rates have risen relative to interest rates this level of leverage now has substantial debt service coverage.

By 1992 the REO buyer has dropped his rents 10% in order to capture the best quality tenants and reduce his vacancy factor – the result is his cash flow remains about the same and he has a better quality tenant base. The effect on the neighboring building is profound – this borrower already had negative cash flow and can’t match the rent decrease, so her vacancy goes up. The negative cash flow is too great, she defaults, and the Good Lender takes a 33% loss based on the market cap rate established by the first REO sale. When the Good Lender sells (at a higher cap rate, because it’s REO), their total loss is 40%.

REO Buyer 2 now has a much lower cost structure than REO Buyer 1, and can afford to drop rents below REO Buyer 1’s levels to recapture tenants. Do you see how this cycle reinforces itself? I foreclosed on some buildings 3 times over a five year period as the market spiraled down.

The market will eventually reach an equilibrium again – in LA this occurred when job growth finally returned and virtually all the highly leveraged buildings had been foreclosed upon. But, until an equilibrium is reached it’s impossible for anyone to predict the stabilization level. Those who talk about setting a new price level in CRE don’t seem to grasp that it’s a dynamic, multi-step process and not a one-time mark.

Also, note that the conservative lender actually took a larger loss in the example above, because their default occurred at a point further down the spiral. This is why many lenders consider their first loss to be their best loss, and are reluctant to modify loans.

Will FASB Mark-to-Market Relief Help Income Property Borrowers?

The short answer is I think not – the relief does not appear to affect the accounting treatment of individual loans.

In general, when a borrower defaults on an income property loan and the lender does not expect to recover full contractual principal and interest, FASB 114 requires the lender to write the loan down to the fair market value of the collateral, including a further discount for the cost to sell the collateral. If a lender follows the rules it might as well foreclose and sell the property and avoid the risk of further declines.

In a distressed market like today’s, when it is very difficult to obtain financing for almost any income property project, the fair market value can be difficult to determine. The proposed FASB changes, summarized in this Housing Wire article, provide additional discretion and guidance for determining value other than relying on current distressed trades.

This changes how securities might be valued, but it doesn’t change how real estate collateral is valued in a distressed market. The mechanism for that is an appraisal, and appraisal guidelines already provide for adjusting values to non-distressed levels. From FDIC Laws, Regulations, Related Acts 2000 – Rules and Regulations Part 323 – Appraisals:

Market value means the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
    (1)  Buyer and seller are typically motivated;
    (2)  Both parties are well informed or well advised, and acting in what they consider their own best interests;
    (3)  A reasonable time is allowed for exposure in the open market;
    (4)  Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
    (5)  The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

Of course, without non-distressed comparable sales it’s difficult for appraisers to figure out what the correct market value is. But, that’s already their call; the FASB changes won’t help them.

Here are links to some other posts on the FASB changes:

Zero Hedge: “Brutalizing the FASB’s Attempts at Piglipsticking”

The Big Picture: “What Does the FASB Proposal Mean for Financials?

Economic and Real Estate Post Picks: Week of March 16, 2009

Post Recession Employment Trends: How long does it take for employment to recovery after a recession ends?

Cap Rate Closing/Asking Gap: The spread between asking and closing cap rates is widening.

Maturing Loans Are Coming Home to Roost: The looming problem of maturing income property loans with no exit strategy

Reflation: The risk of deflation has diminished.

Has the Economy Hit Bottom Yet? Probably not, but the rate of decline is slowing.

Your First Loss Is Your Best Loss

Jim Cramer’s reputation as a source of investment wisdom is not at its peak right now, but in the environment today his second commandment of trading is good advice. From a 2005 article on TheStreet.com:

Good trading, no matter what it's based on, technicals, fundamentals, the stars, the news, requires a level of discipline that goes against human nature. We are taught in life to be patient, to let things work out, not to be hasty, yet none of that works when it comes to trading. You have to be willing to cut and run, to use that "flight," not fight, instinct that we supposedly are born with but suppress wholeheartedly when we are grown up.

That's what the second commandment of trading is about, and that's why it is the second commandment of trading:

“Your first loss is your best loss.”

I genuinely believe that most trades need to work almost immediately for them to be right.

John Reeder over at Real Property Alpha has an excellent post making the case that this is true for CRE today, complete with a great example (Lennar’s role in the Newhall ranch development). As John notes, I’ve made the opposite argument –selling in this environment reinforces a downward spiral in values which is hard to stop, with unfortunate consequences for all. It is a classic Prisoner’s Dilemma / Tragedy of the Commons problem, and unfortunately the best individual bank strategy makes the problem worse in the long run. We have met the enemy…and he is us.

A Snake Swallowing Its Own Tail: Mark to Market and Real Estate Values

I’ve previously posted on the illiquidity of the real estate markets and the difficulty and consequences of valuing real estate using distressed sales (see here, here, and here).

Via Newmark's Door, National Review Online has a good summary of the impact of mark to market rules on banks. An excerpt:

Mark-to-market rules damage banks in two ways. The first is that banks have to treat losses on paper as though they were real economic losses, accepting fire-sale valuations of securities that they may not intend to sell. The second is that, because mark-to-market rules are used in assessing banks’ capital requirements, those paper losses can quickly become real losses when banks are forced to sell assets, often at an enormous loss, to raise enough capital to keep the regulators satisfied. Those pressured sales, in addition to locking in losses, tend to drive down the prices of similar assets, creating a vicious cycle of wealth destruction. The market becomes a snake swallowing its own tail.

When Real Estate is a Liability

We are used to thinking of real estate as something of value. This is not always the case.

The first appraisal I saw with a negative value was for a 10 story office building in downtown Minneapolis back in the early 1990’s. I couldn’t find any errors in the analysis, but I felt I had to be missing something – a major office building just couldn’t be worthless. I made a trip to Minneapolis to take a look, and it still felt wrong. Sure, it was old (1920’s), but it was by no means falling down, it had tenants, and it was tied in to the skybridge system. It had to be worth something to somebody.

The issues on the building were all the usual suspects – rents and occupancy had fallen, utility costs had increased, and capitalization rates had climbed, all of which combined to hammer the value (I’ve posted here showing how relatively small changes in these variables can  combine to create a 50%+ loss of value). This building had three additional problems; there was major friable asbestos problem that was missed in the initial due diligence, we had not escrowed for real estate taxes and the borrower didn’t pay them (real estate taxes are very high in Minnesota), and there were mandatory fire code upgrades (primarily sprinklers) imposed after the loan closed which had to be completed. The cost of curing these three items exceeded the value of the building. We ended up releasing our debt ($7M) for a $200K payment from the borrower.

This kind of problem is increasingly common. NPR has a story about lenders refusing to complete foreclosures, and there is an abundance of stories on the median home sale price in Detroit (around $7,000, see here and here) and $1 bargains available (see here and here). This 5 bedroom, 3.5 bath home was available for $8,995:

And it’s not just Detroit.

The combination of low fundamental values, cost to restore the homes to habitability and cure code violations, and real estate taxes are the reasons these “bargains” exist.