Borrower Risk, Net Worth, and Liquidity

You are considering making a $10,000,000 loan to one of two borrowers. Both borrowers have a $10,000,000 net worth and $1,000,000 in cash. Your astrologer has told you one borrower will default and the other won’t, but she can’t tell you which one. You are allowed to ask each borrower three questions. What do you ask?

Here are my questions:

What are your total liabilities (contingent and non-contingent)? A borrower with $10,000,000 in net worth with $20,000,000 in assets, $10,000,000 in liabilities and $1,000,000 in cash is a great risk. A borrower with the same net worth and liquidity comprised of $100,000,000 in assets and $90,000,000 in liabilities is toast in a significant downturn.

How did you make your money? If the answer is investing in the same market and kind of real estate as the loan you are considering (for example, multifamily in Dallas), the borrower is a good risk. Any other answer (selling a software company, dentistry, UPS driver, playing poker, aerospace engineer) is a problem. I know this from personal experience because I’ve approved and subsequently regretted making loans to borrowers with these former occupations. Each time I thought we had mitigated the risk – I now believe you can’t mitigate inexperience.

What was the value of CRE assets you owned in 2001? The answer should be at least $2,000,000 – enough to tell you they had some holdings in the last downturn. If the answer is less than that it means they made all their money in easy times. Ideally, a borrower would have been through the 1989-1994 trough, but those guys all have a net worth a lot bigger than $10,000,000.

I believe the answer to these three questions tells you pretty much everything you need to know about a borrower.

Commercial Real Estate Market Stability and Government Centers

Last week I posted on the merits of college town markets (although I glossed over the reasons – Chris Rodriguez goes into more detail in his post “Commercial Real Estate in College Towns – Recession Proof”). Markets with heavy concentrations of government employees also weather the storm better.

The charts below show the 12 month percent change in employment for the largest market in the state, and that state’s capitol. Starting with the state that’s always the worst:

Employment losses in Lansing are half those of Detroit. Next, Washington:

Employment loss in Olympia is a quarter of that in Seattle. On to Texas:

Austin is one of the few places that hasn’t lost jobs at all.

No discussion of government centers is complete without looking at Washington DC. Job losses there are half what they are in the nearest major market (Baltimore):

Government centers don’t always outperform; Sacramento and Albany performance is about the same as Los Angeles and New York respectively. But, as a general rule the relative stability of government jobs provides a safety net for their markets.

All data from this BLS site.

Retail CRE: Which Deals Get Renegotiated?

One answer: new, incremental deals in outlying areas. Calculated Risk put up this post a few days ago:

“We’re dumbfounded. We’ve been working on this deal for four-and-a-half years. I don’t know how, all of a sudden, the numbers don’t work.” JMW Development Principal Mark Johnson

From the Minneapolis / St. Paul Business Journal: SuperTarget planned for Woodbury now on hold (ht Arnold)

“Target recently informed JMW that it would not proceed with the project unless it receives “a pretty significant discount” from its previously negotiated deal, JMW Principal Mark Johnson said.
“We’re dumbfounded,” Johnson said, noting that Target officials had told him as recently as June 24 that the project was on track.”

Maybe Target has lowered their retail sales estimates for the store? Just saying ...

Woodbury is an outlying Minneapolis-St. Paul suburb, and already has a Target (“B” on the map below) which is eight minutes from the site of the proposed new store (“A”).

When it negotiated the deal for the new store Target was anticipating new residential growth in Woodbury which is now not going to happen. Without growth the new store won’t hit its numbers, and will cannibalize sales from the older store.

Preserving Favorable Financing in Bankruptcy

Section 1124 of the Bankruptcy Code allows borrowers to reinstate debt under certain conditions. Via Zero Hedge, an excerpt from a letter from Watchell Lipton reporting a settlement in the Spectrum Brands bankruptcy case:

Section 1124 of the Bankruptcy Code provides that if, pursuant to its Chapter 11 plan, a debtor cures all nonbankruptcy defaults under a debt instrument and does not alter the rights of the debtholders, the reorganized company can “reinstate” the debt on its original terms, without the consent of the debtholders. Thus, the success of a “reinstatement” strategy depends on the debtor’s ability to craft a feasible plan that does not violate the terms of the relevant loan documents and allows the debtor to remain in compliance with the loan’s terms post-bankruptcy. Because many secured credit agreements negotiated over the last several years have favorable interest rates and contain so-called “covenant lite” provisions (few or no financial covenants and permissive negative covenants), such companies have a strong incentive to try to take advantage of reinstatement.

Although I’ve not heard of the section being applied in a real estate case, this would seem to be a mechanism a borrower could use to restructure junior or mezzanine debt while leaving favorable first lien debt in place.

The complete Watchell Lipton letter can be found at the Zero Hedge post.

REITs Positioning to Take on CRE Debt

As banks pull back from CRE debt and the CMBS market lies dormant, REITs are raising capital to step in. From REIT Wrecks:

In addition to LRCF, Alliance Bernstein, Angelo Gordon, Apollo Global Management, Colony Capital, Starwood Capital and Western Asset Management have all registered to raise equity for their own Mortgage REITs…

The filings make for great reading. Ladder said there is now an “unprecedented market opportunity" to originate well-priced loans. Colony said that the the credit crisis was causing an "over-correction" in commercial real estate debt and that there would be a "protracted opportunity" originate attractive loans. Alliance's new REIT, Foursquare Capital, said that the "current distressed condition in the financial markets" would allow it to buy mortgage assets at "significantly depressed trading prices and higher yields." As for Barry Sternlicht and Starwood, their filings were even more emphatic: "the next five years will be one of the most attractive real estate investment periods in the past 50 years."

For more on the logic of this move, see my post, “Why Now is a Great Time to be a CRE Lender.”

Commercial Real Estate Market Stability and College Towns

If you’re looking for CRE markets that are insulated from downturns, college towns are a good place to start. The Creative Class post “Where Unemployment Is Worse Than Expected” analyzes the performance of various metro areas in this recession. Here’s one of their graphs:

Low and to the left is good (Iowa City), high and to the right is bad (Detroit, Kokomo and Elkhart). An excerpt from the post:

College towns number among the best performers, doing much better than predicted: Champaign-Urbana, Illinois, home to University of Illinois (-2.2); Iowa City, University of Iowa (-1.81); Manhattan Kansas, Kansas State University (-1.82); College Station, Texas, Texas A&M (-1.74); New Haven, Connecticut, Yale University (-1.54); State College, Pennsylvania, Penn State University (-1.47); Boulder, Colorado, University of Colorado (-.93); Austin, Texas, University of Texas (-1.0); Ann Arbor, Michigan, University of Michigan (-.94); and Ithaca, New York, Cornell University (-.97), among others.

The correlation isn’t perfect; for example, the metros with the major Oregon universities (Eugene and Corvallis) have both underperformed. However, the relatively stable employment base and demand for services created by large universities tend to buffer these markets. And, since employment is the most important determinant of CRE performance, CRE in these markets tend to do better.

Picking the Right Distressed Asset Broker

If you’re selling in this market, almost by definition you, your asset, or both are distressed. It’s also pretty likely that unless you were selling assets back in the early 1990’s you’ve not been a seller in a market like this. What to do?

The short answer is to find someone who is successful at moving similar product in your market. For example, if I were the unfortunate owner of undeveloped land in Hesperia, California, I would call John Reeder at Sperry Van Ness, because John recently brokered the sale of this 55 acre parcel there:

There certainly is a lot of vacant land in Hesperia, isn’t there? SVN’s Dealbreaker site also has information on lots John brokered in Victorville. The guy who can sell land in a market made famous by a lender demolishing mostly completed homes is the guy I would want selling my asset.

Brokers who are successful in this market are not necessarily the brokers who were successful in happier times – the skill set and often the buyers are different. From Lansner on Real Estate’s post “Big Money Now in Selling Foreclosed Homes”:

Power has shifted away from the traditional model of real estate agents representing homeowners to agents specializing in selling foreclosed homes, new data show…

Most traditional agents haven’t been able to adapt to those changing circumstances because selling foreclosures requires different skills: the ability to deal with evictions, making repairs, managing large numbers of vacant properties, plus paying out large sums of your own money, then pursuing reimbursements.

In tough times, you need an expert - for example, Leo Nordine, the Los Angeles REO broker the New Yorker profiled in their April 6, 2009 issue (abstract here).