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

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

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

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

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

Trust and Workout Negotiations

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Complexity, Predictability, and Cascade Effects

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

Some excerpts:

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

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

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

Are Banks Failing to Mark Down Toxic Assets?

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

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

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

Why Lenders Don’t Do Principal Writedowns

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Debacle at 250 Montgomery Street: Other People’s Money

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

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

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

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

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