Anticipation

Like so many child victims of midcentury American cooking, (assuming you can muster the generosity to consider “ambrosia surprise” cooking,) while growing up I relied heavily on ketchup to make my mother’s featured evening creation something resembling palatable. I put ketchup on everything that had meat in it, and on somethings that didn’t, burgers, hot dogs, chicken, meat loaf, turkey, casseroles, veggies, and of course French fries. Flaubert said, “Pleasure is found first in anticipation, later in memory” and trite as it sounds, memories of my early ketchup dependency and the sense of anticipation–which that glass bottle excruciatingly prolonged—illustrate his words with a resonance that only the pangs of childhood can. Apparently the bourgeois calamity of waiting in agony for the Heinz bottle to give up its contents is universal enough that Heinz has been regularly using Carly Simon’s hit song “Anticipation” in their commercials since the 80’s. Those of us working in commercial real estate know the pains of anticipation all too well. It's the anticipation of making the deal, getting paid, being rewarded for success that is uniquely defining to anyone in the business that only "eats what they kill" but it is also that which sustains us through challenging times.

As eternal optimists, we owners, investors, brokers, and bankers (note that I left out the attorneys who know better than to subscribe to optimism) are always anticipating the “find of a career”, endlessly looking for that pony in the pile. Unfortunately it is unlikely that those investors who think they are going to dine on the misery and misfortune of their peers—who were arguably a bit reckless in their pursuit of ketchup—will be savoring the sweet tomato sop any time soon.

Real estate brokers around the country are busily engaged producing Broker Opinion’s of Value, discovering prices/true values with the intent to provide guidance to their new prospective clients (read: servicers and lenders) on how to monetize non performing loans. But rather than moving this bad product through the system, these BOV’s are being used to "Extend and Mend". For properties with cash flow, we expect this strategy to play out across all property types in all geographical areas, draining the anticipated tsunami before it even happens. Once the Fed starts setting the floor for price discovery with major portfolio sales of notes on broken projects, we expect prices and cap rates to settle back to historical norms.

Here is a look at what is actually happening with these BOV’s behind the closed bank doors. The following is the anatomy of a workout with a "recap map" of what it looks like.

2007:
NOI: $7,800,000
Cap rate: 6.5%
Value: $120,000,000
Equity: $20,000,000
Debt: $100,000,000 (6.0% IO)

2009:
NOI: $6,600,000
Market NOI: $5,900,000
Cap rate: 8.5%
Value (BOV based on market rents): $69,000,000
For equity and debt see work out below:

Recapitalization/Workout Solution:
Borrower writes check for $10,000,000
Lender writes off $10,000,000
Restructured debt of $80,000,000 is priced at 6.5% IO for 3 years
Debt service: $5,200,000
Interest and releasing reserves: $400,000
Return to equity: $800,000
Return to lender (spiff): $200,000

Result for Borrower and Lender:
Lender takes a pari pasu hit for each dollar of equity.
Lender gets a better yield on restructured debt.
Net loss ("investment") to lender is $10,000,000 (10%) vs $30,000,000 (30%) anticipated by the BOV
Loss of original equity is $20,000,000 (which was lost in any scenario)
New equity owns property and starts with a cash on cash return of 8% with ample reserves to release vacant space.
New capitalization gets a new 3 year life to get through the downturn in the economy and liquidity crisis.

This leaves investors waiting on the sidelines anticipating the flow of ketchup hungry, frustrated and in despair.

If you are an investor it's time to wake up and start hunting. If you can write a check you can bag some game, but you have to lock and load and get out there. Don't wait for the bottom. Don't expect to be successful bidding at 50% off the 2007 numbers. Don't expect the game to find you or you will be playing that Carly Simon Anticipation song over and over again in your head while you wait for the ketchup to start flowing. Now is the time to buy and the "Recap Map" is right here.

Here is a musical interlude to help you pass the time while you wait.

(To the tune of "Anticipation")

We can never know about the days to come

But we think about them anyway

And I wonder if I'm really a buyer now

Or just chasing after some finer day.

Anticipation, Anticipation

Is making me late

Is keeping me waiting

And I tell you how easy it is to stress and moan

And how right my numbers seem to me.

But I reworked the math just late last night

When I was thinking about how right this buy might be.

Anticipation, Anticipation

Is making me late

Is keeping me waiting

And tomorrow we might not reach a deal
I'm no prophet, I don't know lenders way

So I'll try to see into your head right now

And stay right here, 'cause this is all I will pay'.

Ecdonomics 101: People Respond to Incentives

What do the technological innovations of the last 10 years mean for commercial real estate? And more importantly how has it changed where young people today can look to find careers? It has been said that the internet and technological innovations that have taken place over the past 20 years have created a fountain of youth for those who have embraced its capacity to do more with less. The opportunity for career advancement predicated on natural turn over that many in the corporate ladder were counting on has been obliterated by the 20+ years of “productive life” that technology has given seasoned executives. Leaving; according to economist Jeff Thredgold and several professors at Harvard Business School, new and evolving industries the new “blue oceans” of opportunity, e.g. Nano-technologies, Transportation, Telecommunications, Financial Services, Energy, Entertainment, Bio-medicine and health care We need jobs to have real substantive recovery according to Professors Bill George, Rob Kaplan, Jay Lorsch, and Arthur Segel (who co-founded TA Associates), during a panel hosted by Harvard Business School last week. Collectively, they shared several interesting new observations:

1. The stimulus package is not creating new jobs. There will be another one focused on jobs in 2010.

2. All net jobs created in the last 10 years came from small businesses; which are now being crushed by the economy and banks’ unwillingness to lend to them.

3. Congress is not “getting it done” and is dysfunctional (lacks focus on the real systemic problems) and too short term oriented (worried about getting re-elected) to be capable of solving either health care or fixing the economy.

4. CRE is just beginning to feel the effects. Actually we’ve been feeling them for a long time, it just has not shown up in the statistics yet, because there has been little transactional activity due to lack of pricing discovery.

5. Inflation is 2-3 years away as worldwide capacity utilization remains low, unemployment remains high and globalization and the transportability of jobs erodes pricing strength and keep inflation in check.

6. Deleveraging is massively deflationary. There is no cure for it, so the government will err on the side of creating inflation, which they can fix rather than let deflation win the battle.

7. We are creating new asset bubbles (oil and gold as the new international currencies) and Treasuries, which the banks are buying with zero financing for risk-free profits.

8. The role for the government is to beef up the rules for liquidity and leverage.

9. Corporate boards need to rethink how they approach strategy and risk.

10. Industries of the future will be where creativity and innovation will provide opportunity to thrive and create jobs. This statement is so abstract it’s meaningless

CRE can be more relevant to the future by capitalizing on creativity and innovation by embracing and perfecting the science of getting more out of less. Better and more efficient warehouses; more specialized and customer-focused retailing with a bifurcation between BIG (priced based) of very small (service based); more livable multi-family units that maximize urban space built ecologically responsibly and are well appointed; and high efficiency "green" offices that maximize capacity, are smaller, wireless, and emphasize mobility. If anything, this market has showed us that building more capacity no longer equals growth. The era of growth as the sole vestige of the investor / developer is over. American does not need another office tower or industrial warehouse or shopping center for the foreseeable future.

We're Turning Japanese

The jointly constructed “Policy Statement on Prudent Commercial Real Estate Loan Workouts” issued on October 30th, 2009 by the FRB along with the FDIC, NCUA, OCC, OTS and the FFIEC , on how banks could / should address problem loans could be the precursor to a decade of the United States entering into a “Japanese Style Recovery.” These guidelines, in which ”renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance”, legitimize the current practice of "extend and pretend" or “delay and pray”. This all but insures that there will be no "tsunami" of bad debt creating the most incredible buying opportunities in a generation, as many investors with cash in their pocket have been anticipating.

It is interesting to note that after the tremendous successes enjoyed in the 1980’s, the Japanese economy had one of the worst recessions in modern history throughout the 1990’s. The very same system that produced so much success, did not allow it to redress and account for its excesses and failures. Failures and recessions are a necessary component of the capitalist system, without it there can be no cleansing and no renewal of excess capacity and inefficiencies. In Japan the 90’s were a “lost decade” that featured near zero interest rates, no jobs, no growth and a stock market that collapsed under the burden of no prospects for future GNP growth stemming from the dearth of jobs. Ultimately it was Japan’s decade long jobless and growthless “recovery” that opened the door for China to become the dominant economy in the east.

Despite the likely consequences of turning the American economic recovery into a 90’s-Japan-style ‘recovery’ with no real economic growth and no jobs, simple arithmetic demonstrates why lenders and servicers will wait long as possible for assets to recover value before offloading them. We can illustrate what we mean with a broad brush look at the numbers. Asset values have dropped by an average of 50% from the peak. 30% of that correction was clearly the “financing bubble”, 10% is attributable to the bad economy and the remaining 10% is due to the lack of liquidity in the market. There will be no price recovery without a debt market that is accretive to value. Assets are still trading in the multi-family sector because there is agency debt at 5.0% with a 70% LTV and a 30 year amortization available. Unless there is a gun to their head, there is not a single lender or servicer who will just hand over assets representing billions of dollars of losses simply because investors are standing in line.


Last week we explained that the recapitalization problem amounts to about $50+/- billion in new equity a year to get through this cycle. By waiting for the economy and capital markets recover, lenders and servicers can possibly recover $10+/- billion (20% of $50 B) in value for each year of recovery waited. While prospective buyers castigate the lenders, servicers and attorneys for not moving quickly like the Fed did with the RTC back in the 1990's, their actions are rational and precise. Hence the process of deleveraging and recapitalization in CRE will be the opposite of a tsunami; the process will move at a glacial pace. It will start with note sales, which we are beginning to see for mostly non-investment grade assets. As this process accelerates and more portfolios are sold a la the Corus Bank portfolio, it will give way to asset sales six to twelve months later.

Unfortunately this means there is little hope for an active commercial real estate transaction business before 2011. 2010 is shaping up to be another terrible year for CRE brokers and salespersons. The sentiments of many investors attending San Francisco’s ULI conference suggested that the only ray of hope is that over the last year the investor hands of The Aggregate Watch has moved from Fear and Despair and most investors are now well into Adaptation and getting ready to buy. But, until the capital markets and economy recover, there will still be a little price alignment and even less transactional volume.

The Good, The Bad and The Ugly

For those of you too young to remember the great spaghetti western with Clint Eastwood, Lee van Cleef and Eli Wallach I encourage you to put it high on your Netflix cue especially to gain some perspective on the economy at the end of Q3 2009. Each character, Blondie, Angel Eyes, and Tuco literally and abstractly embodies the distinctly different position of the hero, the villain and the “jester” respectively.

First, the Good [Eastwood]: Blondie the stock market continues to confound and amaze us all in its relentless drive, surging more than 50% and nearly breaking 10,000 on the Dow for the first time since the March 9th low. But is this forward drive a sustainable reality? How can there be prosperity on Wall Street when there is so much dislocation and turmoil on Main street? Like Blondie, the stock market proved extremely deft and adaptable. Faced with the state of the market, companies quickly shed [jobs] and hoarded cash “under the mattress” to survive. With the “shooting” over and rationality returning to the markets, those who reacted quickly and have the means to take advantage of competitive weaknesses and favorable conditions (governmental policies), are positioned to reap huge profits (Goldman, Morgan Stanley). The Feds are about to make a play with TALF and Wall Street is lining up CMBS 2, so there may be hope soon but it’s still too early to tell.

Second, the Bad: With this economy, like Angel Eyes, you can’t really tell what’s going to happen, but you know it’s just not going to be good. Despite the good efforts of the Blonde there are clearly troublesome issues that portend a long, “bad” recovery. The economic fundamentals (“Angel Eyes”), continues to be the nemesis. Unemployment is approaching 10% (with under employment closer to 17%), the credit markets are still on ice, consumers have adopted a new mindset of doing without, and everyone is waiting to see how $2 trillion of debt is going to be restructured so that banks can start lending again. Most economists predict that the fourth quarter numbers will reflect the economy has begun to expand, but we are a long way away from job growth and normalcy. There is hope for “good” to return, but fear that more “bad” is to come.

Last, Tuco the Ugly: despite his best efforts, Tuco never caught break. In this cine-market-metaphor commercial real estate is Tuco, and it is indeed ugly. The Colliers Q3 greater LA market reports paint a very depressing picture for landlords and investors. Fundamentals continue to erode across all markets in the five county Los Angeles Basin with every product in every submarket showing severe distress. With a base of 1.35 billion square feet of industrial product, there is over 166 million square feet (12.3%) of space available. Office is quickly deteriorating with more than 53.3 million square feet vacant (17.7%) out of a base of 301.8 million square feet. In some markets, e.g. Orange County, office vacancy is over 20%! Retail vacancy rates are skyrocketing as well while rent have dropped by as much as 50% in some markets. For information on any one of the 8 submarkets, please see the attached submarket reports. With unemployment expected to rise, additional stress is anticipated through at least Q2 2010. Meanwhile money is lining up as investors have adapted to the new environment. There is purportedly over $100 billion in equity on the sidelines ready to invest in distressed assets.

Over the past few months Colliers has completed several hundred Broker Opinions of Value ("BOV's") for nearly every major national servicer and lender. We have seen 3rd quarter values coming in 40% to 75% off the 2006/2007 peaks across the board, with some land and development properties as low as 90% off peak; which mean debt is getting hit by 30% to 50%. According to Real Capital Analytics, debt recovery is averaging around 60% with wide variations depending on loan types. The economy's icy grip on real estate values is starting to thaw as a few transactions have moved forward with seller financing widely recognized as the only means to drive value in a market with debt pricing that is not accretive to value.

In the fourth quarter we expect to see lenders and servicers get serious about their loans and start to “resolve” them whether by (i) Selling notes, which is everyone’s preferred solution as it maximizes the value of the debt for banks and bond holders. (ii) Appointing receivers to preserve and utilize the debt in place to assist a new borrower in recapitalizing the property. (iii) Moving forward with foreclosure and disposition in cases that are too far gone to save. Many large institutions like Bank of America, JP Morgan Chase and Wells Fargo that took big hits in the 3rd quarter will continue to do so in the 4th quarter as they clean up their balance sheets while they are making huge profits on their net interest margins.

Looking forward, we expect the continued deterioration in fundamentals across all sectors for at least 3 - 4 more quarters. Tenants will be looking to lock in long term commitments at terrific net effective rents, but will likely be negotiating with lenders rather than landlords. The bid / ask spreads for stabilized properties are coming into alignment as sellers see that the current underwriting is here to stay. The pending arrival of CMBS 2 could help accelerate these transactions. Unstable properties that are incomplete or have high vacancies will have to reconcile with valuations well below 50% off peak pricing and will only change hands through lender disposition.

While we are confident that the Good will triumph over the Bad, it will likely be an Ugly win. We will keep an eye on the market’s struggle between the good and the bad via The Aggregate Watch as it continues to play out.

They're Ba-ack

Finally, CMBS ii is here! Almost two years after the death of the CMBS market, yesterday’s news broke the story that Goldman Sachs (aka the evil empire - see new nexus posting "Man's Gold Sachs") and Morgan Stanley are about ready to launch CMBS ii. Will it be a better model with the risk issues concerning defaults addressed, or will it be computerized prestidigitation? Either way, in order to work, it will have to be different with risk properly carved and allocated and more flexibility built into being able to substitute collateral and dismantle loan pools. Then again, does it matter? When lost in the desert with no water are you going to query the Bedouin is saving your life if he is serving up brackish three week old well water, or Perrier?

If leverage is the fuel that makes the CRE industry work, it must also be assumed that without it there is no stability in pricing, no transactional volume, and no meaningful data points to establish value. Without liquidity in the debt markets real estate cannot perform its function in the capital markets as the hybrid between debt and equity; thereby in effect, there is no real estate market. Wall Street is coming back in the debt market to fill the void left by the banks and agencies and provide debt that is accretive to value. New debt, that is accretive to value will allow anxious early movers to push up pricing.

In just the last few weeks, we have seen a plethora of new buyers contacting us every day pleading for product. There is plenty of money out there and the recapitalization problem is not as large as everyone thinks it is. The equity needed to recapitalize the debt market is only going to be $50+/- Billion a year for the next 6-8 years. Just do the math: Say $2.5T of debt placed in 2004-2007 at an average of 75% LTV off peak values ($3.3T). Say values have dropped 40% to $2.0T. Equity is wiped out. Lenders take a 20% hit ($500B), then re-leverage the remaining $2.0T with 80% LTV (not new originations), and you need $400B of equity over 8 years = $50B a year. Buyers all want distressed assets, but they want them at pricing that is based on leverage that is not accretive to value. Smart buyers will figure this out and lock up properties at 30% to 40% discounts off the peak early in the cycle with seller financing of as much as 80% to 90%. If they cannot get seller financing, they can now call "1-800-darkside" and get some of the new CMBS ii jet fuel.

Preaching to the Corus

Los Angeles may be hot in September, but is it nothing like 95 degrees with 100% humidity that greeted this unsuspecting visitor when stepping out of the cab in downtown Miami last Tuesday. Turns out that as hot as it was, it was nothing compared to the largest bad debt portfolio sale ever completed by the FDIC. Moments after I made it into our Miami office, soaking wet after walking a half a block I was greeted by an e mail from my team in LA that Barry Sternlicht and Starwood Capital, was at it again with a successful bid for the $5 Billion portfolio of debt from Corus bank. I was immediately struck by the report that claimed that his bid was 20% more than the next highest bidder. So, the question was obvious: "Is Barry brilliant or bonkers?"

If you subscribe to Real Capital Analytics, you saw their October 9th story questioning whether or not it was a good deal or a viable pricing benchmark. They cited statistics from the old RTC days, which arguably bear no relevance whatsoever to what is happening today, to make a declaration that the Corus transaction was an anomaly and should not be taken as the new benchmark based on historical information in sales in such times. I will take the contrary view that the pricing is a good barometer for the overall market.

a. The deal was priced at 54% of the outstanding debt ($2.77B on $5.0B). The FDIC agreed to put in another $1B to finish the projects, so that brings the pricing up to 63% of par. Inputting a 25% margin on the original underwriting makes the pricing 50% off the exit pricing originally underwritten ($3.77B / $7.5B). So, betting that pricing is 50% off peak, the FDIC and Barry (along with a lot of other smart people) teamed up. Barry and friends put up a paltry $554M (7.4%) of the original exit value; or 15% of the revised value. In an economy with no debt liquidity, they got a loan at 85% of the purchase price.

b. The FTC in the 1990's gave value away like candy on Halloween. It was effective to get the bad debt cycled out of the S&L's, but a complete give-a-way of value to entities that could access capital and debt. One such transaction, the $2 billion Security Pacific Bank portfolio, which was sold by Bank of America after it purchased Security Pacific, was sold for $500 Million; of which $400 Million was debt and the sponsor only put in about $10 million of the $100M in equity; the rest was outsourced. That debt was processed with a recovery of almost $1.5 billion, providing a 1000% return to the equity. The FDIC has finally realized they can play that game too.

c. Now, if you purchase at 50% off the peak in core markets and you have great (85%) leverage, it only takes a small price recovery, say 3% per year over a three year period, to produce a very strong return on equity; e.g. 10% of $3.77B = $377M; $377M / $554M = 68%. The annualized return, excluding rental income in the interim, would be over 20%.

d. In 1995 Barry took a small paired shared REIT and turned it into Starwood Hotels. His creativity, insight, tenacity and shear guts are legendary. This transaction is no different. Worst case, he gets his money back with say a 6-10% interest. Best case, he makes a 30%+ return that is almost risk free with the backing of the US government. The difference this time is that the government will be riding shotgun and, no doubt, will shared a piece of the profits if the transaction achieves certain hurdle returns.

Conclusion: The Corus transaction is the new normal. The FDIC, banks and servicers are not going to fire sale assets so buyers with cash can make 20% to 30% annualized returns, especially when doing so would deplete their capital reserves and jeopardize their survival. They want in on the game and are going to be participants by providing leverage to facilitate transactions and preserve values. Look for more of the same to come as holders of debt, smarter now and wiser than in the 1990's start to cycle the toxic debt from their balance sheets, and doing what they do best, lending money.

The Aggregate Watch

Take a look at the Aggregate Watch and leave a comment to let us know what in the market time is.