Unprecedented

Unprecedented. Watching the financial markets is watching history in action, I told my sons that they will study this point in time when they are in college ten years from now. It is good to hear politician’s like McCain encourage the people, we all need it, the fundamentals of the U.S. economy are strong. No, this isn’t referring to actual fundamentals such as housing prices, employment trends, and GDP growth, it is referring to the “get it done”, “go for the gold”, “where’s the opportunity” mentality of the American worker and businessman. This crisis will get worse before it gets better, we are experiencing an unprecedented deleveraging of the economy and the bottom line truth in the process is there are losses that need to be taken, wealth lost. As the smoke clears in 2009-2010 what will the financial landscape look like? I would suppose that it will look a lot like a forest after a raging fire storm. There will be few trees standing, those that are will have been the strongest with the firmest root systems, roots that spread out far and wide. Those anchored by few roots (less diversification/significant risk concentrations) or that were rooted in shallow soil (built on leverage) will be no longer. Credit will be tighter and harder to get, renting will become more accepted because while a individual might have the cash flow to service debt they will also need cash for a down payment, think 20% down payment as standard. Operating companies, real estate developers, and others will need real equity, and lots of it, to fund new ventures. An economy built on a firmer foundation but one, as least for a while, that will grow at a slower pace.

Liquidity...going going gone

Over the last 10-15 years commercial real estate has moved from a predominately local/private to an international/market enterprise due almost exclusively to the maturing capital markets for real estate backed paper, specifically CMBS. Likewise residential real estate also changed from a local to an international business because of RMBS. The subprime meltdown has caused significant, but not irreparable, harm to the industry. The result of this crisis will be a decline in real estate values, not just residential, but commercial. It seems to me this issue goes back to the fundamentals that we learn in economics of supply and demand. Inherent in the supply and demand model is the assumption of liquidity, an agreeable currency to facilitate the trade. That currency in real estate is bonds. Investors in CMBS have left the house which has disrupted trade between buyers and sellers of CRE (just as it has hammered buyers and sellers of residential real estate). Cheap, easy credit made the world go-a-round, it drove up values, which drove up returns, which brought more buyers to the dance, which in turn drove up values. Now the credit is gone, the music has stopped, and many have gone home. The potential recession aside the underlying supply and demand fundamentals for CRE have not changed significantly over the last two years the difference this time around is that liquidity drives the market and with $200 billion of the table in 2008 (the ballpark reduction in CMBS issuances from 2007) it impacts all participants.

What I see from my vantage point are developers for whom the world has changed, users (e.g. drug stores) who continue to price deals like they did in 2006, traditional lenders who have taken a couple of big steps backward, and a non-functioning CMBS arena. Where is this going? I suspect that the CMBS market will return, those with a vested interest say it has to, but probably in a different format and running on lower horsepower. Deleveraging continues, developers will get used to this though the pain is significant now. Gap players will become more important, mezz, hard money, bridge, private equity sources will all have a place at the table where prior to the crash 75% to 85% senior positions were common, sometimes even higher if there was a value play (and lenders bought into pro forma numbers). It will take more creativity and work to build the capital stack for even the typical deal. Developers will probably start to use more early stage funding as commercial banks will be less willing to go too far out on the risk curve. With more players in the capital stack the cost of capital will increase which will force up costs for new projects and create an inflationary environment in CRE over the longer term. For the short term, higher capital costs mean that investors will have to pay less to generate the returns the same returns.

Consider a Walgreens purchased in 2006 for a 6.00% cap with $375,000 NOI, the purchase price would have been $6,250,000. The ROE (EBTDA/Equity) on this asset with an 80% LTV at a 5.79% interest rate is 6.84%. Today the same asset would be valued at $5,393,355 with a 70% LTV and a 7.00% interest rate to generate the same 6.84% ROE.


This is to say, that for the same asset between 2006 and 2008 the value has declined $856,645, a 95 BPS increase in the cap rate. Why, higher interest rates and lower leverage require a lower asset value to generate the SAME return on equity. Are market participants willing to take a lower ROE than they were in 2006? Probably not as the risk in the market has increased significantly, arguably they would demand a higher ROE which would push prices down further. Buckle your seatbelt, it will be a bumpy ride…

The Joys of Development

Real estate development is one of the most challenging entrepreneurial endeavors I can imagine and certainly that I have experienced. The idea of spending bombastic amounts of money with no assurance of a return is unnerving, though of course with real estate you always have the land so maybe it’s not as bad as some nebulous start up. Though, every new project is a start up, even if you’re replicating a proven model. On paper things always work, or can be made to work, but the devil is in the details. Also, most everyone on the “team” is not taking risk more than their next invoice so you’re alone, really. Having worked with large development companies with deep pockets this on the edge feeling is less evident but still real, after all money is money and losing it doesn’t feel good no matter who you are. However, bootstrapping real estate development is really hard. All the stars have to align: costs, demand, design, capitalization, and timing. If one of these items is out of whack you get your head handed to you, less the design fees. That said, not having the right team who can help you design, plan, and finance your project is a greater risk and can lead to greater loss of money and time, I know I have lived this…more to come.

Beware of the control period...

On the interesting news front the WSJ had an article today about the Portofino condo project in Tampa where the developer (Providence Management Corp. based in Chicago) plans to terminate the condo association and convert the project back into a rental community forcing, as provided in the termination language, owners who don’t want to sell to have to sell at the fair market value of their unit, a price today which is less than their original purchase price. Talk about being rolled (by the way the developer only owns 30 units in the 396
unit complex but must still be in his control period as he controls 92% of the association votes).

(http://online.wsj.com/article/SB121132415516908607-email.html note this link will die after 7 days)

The Condo Market

In economic bubbles signs that a collapse is coming can generally be identified well before the music stops. For me I was at a golf tournament in North Carolina when I overheard two very elderly ladies discussing their strategies for securing multiple condo units in a pre sale auction process. Two ladies, two different projects and apparently they had bought previously in other projects. Now this is not a sexist or ageist comment but on appearances their speculative activities did seem to be out of the norm. Similarly during the tech bubble the WSJ had regular articles discussing what stock the barber was buying and who didn’t have a friend that gave up his day job to take up day trading…We are now dealing with the aftermath of the speculative bubble in real estate. When I was underwriting condo financing in Florida in the nineties we insured that:

1. 100-120% of the loan amount was covered by pre sales and…

2. We limited the speculative investors in the project by limiting multiple purchases to a single buyer and restricting investor units (as opposed to primary or secondary home buyers).
These disciplines fell away in the heat of the market after 2001 but are sure to return as the market heals. Sometimes these types of restrictions are good not only for the lender but also serve to place a governor on an overly ambitious developer which benefits both parties when the “buyers” disappear.

The time may soon be at hand...

It's a tough time to be in real estate. Financing is difficult to secure with a CMBS market that has locked up, cherry picking life companies, and increasingly risk adverse commercial banks as a result of increased regulatory scrutiny. The drone of the mainstream press is continually negative. What to do? It may soon be a great time to be investing in real estate. Prices have moderated with increasing cap rates, many industry participants expect to see price declines of 5 to 10% in 2008. So far it appears that sellers are holding the line and this has caused a marked slowdown in sales activity, but at some point soon the new realities may make sellers more willing to negotiate then they have been in many years. We all know one should buy low and sell high but investor psyche often dictates the opposite, they buy high and end up selling low in a panic or being forced due to deal economics. For those with access to capital (and despite the increased challenge securing financing it is still available), now may be the time to be hunting deals.

As way of background...

After spending 17 years in real estate finance with Wachovia Bank and Bank of America I decided to launch my own firm with the goal of helping real estate investors and developers make their efforts more profitable. Over my years in banking I saw many investors and developers who had amazing vision and drive but who failed to fully count the cost, that is, identify, underwrite, and manage the risks inherent in their investments.