Monday, March 30, 2009

Every Rose Has Its Thorn

I want to kill myself for incorporating anything written by Bret Michaels or recorded by rock band Poison into this blog, however, the 80s hair band's biggest hit is simply the perfect analogy for the year that investing's biggest hit, Warren Buffet, just had.

Earlier this month, Buffett, the head of Berkshire Hathaway since 1965, addressed shareholders in his annual letter with not the greatest of news. Like almost every other investor, Berkshire Hathaway lost a considerable amount of money for its shareholders. Berkshire in 2008 lost 9.6% in book value per share, a common metric Berkshire uses to track performance. That marks the biggest decline since Mr. Buffett took over almost 45 years ago.

Berkshire shares fell nearly as much as the rest of the market last year, indicating that investors are worried about the company's ability to keep growing. In 2008, Berkshire's Class A stock fell 32%. This year, the shares are down nearly 19%, only slightly better than the Dow Jones Industrial Average.

Buffett, the proverbial investment rose, surely and self-admittedly did some pretty stupid things. He bought a significant number of shares in oil giant ConocoPhillips when the price of oil was near its record high, only to see the price of a barrel of sweet crude tumble almost $100 dollars a barrel, and Conoco's share prices tumble right along with them. He also invested almost a quarter billion dollars in a pair of Irish banks that hit subprime trouble, which resulted in an 89% loss.

Some wondered if the investment guru's run was over, with his inability to stave off steep losses like the rest of the market. Yet while Buffett certainly has had his thorns the last 18 months, he is still a rose.

He took a $400 million dollar loss when he pushed General Re, his big insurance company acquisition in 1998, to disentangle itself from over 23,000 derivatives contracts it had on its books at the time. Buffett was notorious for claiming in 2002 that derivatives were "financial weapons of mass destruction." He has always thought they were unnecessarily complicated risks, not worthy of taking. While on the surface, a $400 million dollar loss is no prize, first consider what the exposure could have been now had he not begun to take action to unburden General Re of them almost a decade ago. $400 million could have ballooned into a double digit number with a "B" on the end of it rather than an "M." How many other investment managers do you know who had the foresight to avert such a monumental disaster? Buffet knew when to cut his losses, and in this environment, losing less than the next guy is actually perceived as winning.

Which brings Buffett to his next (not so) rosy outlook. Losses have been so endemic and persistent across all investment strategies over the past year, that an incredible phenomenon began to occur in the U.S. Treasuries market. People became so scared of investing, that the mass flock to the security of U.S. Treasury Bonds pushed their yield to zero, and even into negative territory, and yet people continued to invest. It turns out that people would rather take a minor, but guaranteed loss, than risk a much bigger loss in the market, trying to make a gain. Or as Buffett specifically noted himself, "the investment world has gone from underpricing risk to overpricing it," which he said is reflected by investor appetite for Treasury bonds. Future historians will comment on the Internet bubble of the 1990s and the housing bubble of the early 2000s, he said, but "the U.S. Treasury-bond bubble of late 2008 may be regarded as almost equally extraordinary."

Possibly the biggest thing that makes Buffett smell rosy through all of this turmoil is all the work he had done prior to this mess to be able not only to weather the storm, but comeback with ferocity. We all know that in this environment, cash is king. Buffett has $24.3 billion in cash that can be used to find bargains in a distressed market. How much do you have?

Friday, March 27, 2009

Drawing a Line in the Wet Concrete

Drawing a Line in the Sand...a phrase everybody knows, yet nobody knows where it comes from. Some say it stems from the Alamo, when William Barret Travis drew a line in the sand with his sword, urging those who were willing to stay and defend the fort to step across it. Many historians suggest that it stems from the Roman Empire, when one of the Macedonian kings, a bit short of cash, decided to invade Egypt, then a Roman protectorate. His army was met at the border by a lone Roman senator named Popillius Laenas, who ordered the king to withdraw. The king began to stall for time, so Popillius Laenas drew a circle in the sand around the king and demanded that the king agree to withdraw his army before he stepped out of the circle. The king, apparently impressed by the senator's nerve (or, more likely, by the Roman Empire in general), withdrew.

Why the history lesson? Because as our parents and teachers have told us time and time again, "those who don't learn from the mistakes of history are doomed to repeat them," or something like that. And when it comes to the credit crisis, and the possible nationalization of the U.S. banking system, there is a lot of history to learn from. As this article from New York Times writer Alan Blinder suggests, nobody is really talking about nationalizing the entire US banking system (although I'm sure Rush Limbaugh is accusing Barack Obama of that desire as I write this).

As Blinder points out, the success that Sweden had in nationalizing banks in the 1990s stemmed not necessarily from the process of nationalization, but rather the efficiency with which they were able to carry it out. Sweden only had a handful of banks to deal with. The United States has over 8,300. Now even though most would not need nationalization, because not all are in financial turmoil, the question arises, "where do you draw the line?" If you only elect to nationalize the 5 sickest banks, what happens when the sixth sickest bank comes calling? Do you let it fail? Surely market speculators would sell its stock to the point where it would fail if if they knew you weren't going to come to its rescue. And so then if you save number 6, what about when numbers seven and eight come calling for the same reasons?

This would essentially be like drawing a line in the sand, only to revise that line at some arbitrary point in time. Not only that, but the government would essentially be doing the same thing as what they are doing with the homeowner bailout....rewarding those who were most irresponsible at the expense of those who were responsible.

If we are really to learn from history, we should know that drawing a line in the sand itself is part of the problem. All we have to do is look back to the actions of Hank Paulson and Tim Geithner. As we discussed in a recent blog post, their misdirection and/or seemingly constant changes of heart in what to do and who and how to help with bailouts made the economy, and the financial markets, even more shaky than they already were by their own doing. For you see, drawing a line in the sand is as fleeting as the wind that can wipe those same lines away. They can be fudged, revised, redrawn and forgotten almost as soon as they are drawn. Suffice it to say, that is simply the antithesis of stability, which is what we really need in the long run, be it for better or worse in the short run. We don't need a line drawn in the sand, we need a line drawn in wet concrete; One that isn't so reversible after a few hours time. Study history, contemplate the likely response/fallout of each choice, and then make the best decision possible. Oh, and then stick to it.

Wednesday, March 25, 2009

Hotel Development No Game of Monopoly

So you own Boardwalk and Park Place (or the best respective site for a hotel in your particular locale). And thanks to the credit crisis, interest rates are at rock bottom lows, the cost of materials used in construction have shrunk, architects can turn around designs more rapidly with fewer projects on their plate, and construction companies are bidding each other down for the same reason. All is good in the world of a hotel developer, right?

Um, not so fast. First there is an issue of scale. Regardless of product type, larger transactions are harder to finance these days. Many of the large market players that financed these transactions in the past are out of the game entirely. Most others are choking on their bad debts, and even the better capitalized sources continue to sit on the sidelines playing the waiting game...that is waiting for the economy to hit bottom. There is a universal aversion, both amongst most developers, and certainly among most sources of capital, of being the first one to gamble in terms of purchasing or developing in this market. Why risk buying now if prices will continue to slide? Why risk construction starts when bidding out the project in 6 months might yield cheaper options? And so we wait.

Yet, at least on the hotel development side, many major market players are finding that their smaller projects are actually getting financed, even in today's challenging environment. Projects that require between $10-20M are getting the green light. For example, Concord Hospitality Enterprises recently secured a $13.4 million loan to build a 124-room Courtyard by Marriott in Pittsburgh, a great flag in not the greatest market. So it is possible....

Unless of course you don;t have sufficient equity. Most lenders are looking at LTV's between 55-65% for ground up hotel construction, and that's assuming you have a stellar reputation, track record, project, strong financial statements, and of course high barriers to entry. If the sponsor needs to raise equity to meet these stringent requirements, they can more or less forget about their project for the time being, regardless of project size.

Sightings of private equity for ground up hotel development in the last few months (or foreseeable future for that matter) has been about as rare as a Loch Ness Monster sighting. Private equity firms simply aren't buying into the notion of ground up development when, despite a drop off in construction costs, you can still buy existing product for less than replacement cost. Returns would have to be approaching a ridiculous 50% for firms to start considering a change in this philosophy.

Who would have guessed buying Mediterranean and Baltic was your best bet after all.

Monday, March 23, 2009

A Diamond in the Rough

Oh the irony of it all. Consumer spending is way down, and so the retail sector has been hit hard. Unemployment is at 8.1% and climbing by the day on its way to 10%, and so the office sector is hurting. People are traveling less, and have less discretionary income, so the hotel sector has been battered. Portfolios of industrial property that would have traded sub-7 CAPs 18 months ago are now trading at double digit CAP rates. Even multi-family, a sector success by way of comparison, has felt the impact of tenants looking to double up, rent growth beginning to flatten, and has yet to see, in some markets, a wave of supply from condo projects-gone-bust mess with occupancy rates.

The one niche sector that hasn't been touched? Data Centers. That's right, the same sector that fueled the mini recession earlier this decade and is lovingly referred to as the dot-bomb era is currently partying like its 1999. How is that possible, you ask? Several factors are at play.

1. Demand is Different

Back at the turn of the millennium, data center demand was bursting at the seems from seemingly every start up company on Earth. Of course, the ability to grow was fueled mostly by venture capital, and every start up needed, or wanted, data center space. When these low revenue/ridiculously highly leveraged companies failed, data centers emptied out and were sold at bargain basement prices.

Now, instead of poorly capitalized start ups driving demand, heavy hitter companies are leading the charge. There are several reasons for this. First, since 9/11, major corporations are legally required to have backup sites for information to protect against the threat of a terror attack on their main infrastructure. These have to be off site, and since most major corporations are located in urban centers, that means these sites are often in suburban areas at least an hour away from headquarters. Secondly, we have seen the rise in bandwidth sucking websites like Facebook, You Tube and MySpace. These types of social networking sites demand a huge amount of electricity that only data center space can provide.

2. Supply is Constrained

When the data center stock was sold after the fallout, many of the suburban buildings were adaptively reused for other purposes. This constrained supply naturally. Furthermore, as construction costs soared a few years ago, nobody built much of anything on spec, let alone a data center whose bad taste was still in every developer's mouth from 2001.

Furthermore, many of these powerful electricity-sucking facilities need to be strategically located close to a major power source like a substation, or a fiber conduit. Locating further away from these sources makes it more expensive to gain access to the necessary power, which isn't conducive to keeping costs down for landlords or tenants. This is especially the case in urban environments, which makes adaptive reuse of old vacant office buildings or warehouses much more challenging if they aren't in the ideal location.
3. Growth is Organic, not Economic

Unlike most other sectors whose growth is usually tied to economic factors like jobs, consumer spending and housing prices, data centers are not. Demand is outstripping supply by a healthy margin, and demand for this type of space is projected to grow substantially over the next 5 years. One only need to look at the newspaper industry to see why. Newspapers are failing across the country because more people are choosing to get their news either via the television or online. As society as a whole becomes more comfortable with doing things online, and as generations who grew up with computers become the majority of the workforce, it is only logical that more and more of our lives will be connected via the computer. As this happens, there will be ever swelling waves of data that need to be stored somewhere, and data centers are where that will likely be. Corporations will move their file rooms to online servers. Warehouse and stock room inventories will be tracked and managed online. It is a natural progression of the way we will work, and live.

Don't believe the hype? Digital Realty Trust, the biggest REIT of data center space, has an 11-million-square-foot operating portfolio that is 95% leased. Demand appears high and new average rents are three-times higher than expiring rents. Hence its strong fourth quarter earnings report a few weeks ago, which included a 43.4% jump in FFO to $68.9 million ($0.76 per share). For the year, FFO was $230.3 million ($2.62 per share), up 27.8% from 2007, and adjusted FFO was $2.48 per share, a 21.0% jump from 2007.

As Baird analyst Will Marks points out, “We believe that many corporations are likely to look for ways to cut costs in 2009 and one way to cut costs is to outsource data center operations.” “This trend should benefit DLR.”

While there are industries and niches that run cyclical with, and counter cyclical to the economy, the data center market, unlike all of the rest, seems to know no valley no matter what the economy is doing.

Friday, March 20, 2009

The Matrix

The Matrix, the hugely popular movie featuring Keanu Reaves, conceptualized an alternate world disguised as the real world, so that average humans would go on, thinking they are living their lives without drastic change, as machines acted as puppet masters behind the scenes, using us all for our energy in order to survive.

When you think about it, that concept isn't all that dissimilar from what is happening currently in Washington with all of the bailouts. The politicians are the machines, US citizens are the unassuming, comfortable humans, and only a rare few of us are actually "awake" living in the true real world.

Let me enlighten you. I am certain at some point over the last few months, you have heard some variation of a statistic suggesting how much all of these bailouts are costing each man woman and child in the United States. Last time I check, it was approaching a few grand. While to most people that is still a significant sum of money, when you rationalize it that way, it still doesn't seem like its that much.

So I took the time to create a matrix of my own (Microsoft Excel spreadsheet) depicting the twenty-five largest cities in America, their populations, and their average household incomes in order to come up with the annual average income of the cities themselves. Note: Unfortunately due to formatting issues, I am unable to paste the table into this blog, but just trust me...

The real purpose of this exercise was to determine how much each bailout costs an entire city population. That is, I wanted to show how much the bailouts cost U.S. taxpayers as a function of everybody in a major U.S. city forking over every penny they've earned over the course of an entire year. I was hoping my efforts would put some perspective on these bailouts, and the results are astounding. Time for some fun facts.

- If everybody in the city of Philadelphia handed over every penny they earned last year, it would cover the cost of Citigroup's bailouts.

- If everybody in Miami AND Pittsburgh handed over they're paychecks for all of last year, it WOULDN'T be enough to cover just the INITIAL auto bailout.

- To cover the initial auto bailout, AND the subsequent requests to maintain solvency, it would take the dollars and cents of everyone in Miami, Dallas & Seattle.

- Think bailing out AIG was a necessary evil? Ask everybody in Chicago if they'd be willing to spend everything they earned last year to make it happen.

- The cost of bailing out, or to be politically correct, placing in conservatorship, Fannie and Freddie? That would be the entire incomes of Los Angeles, Boston & Phoenix.

- And saving the best for last, what was the total cost of the Bush bailout? Only the equivalent of asking every taxpayer in the three largest American cities (New York, LA, & Chicago) to hand every penny over that they made last year. Oh, and guess what....that STILL would have come up a little short.

When we put it in this context, do you think there is a chance in hell Congress would have approved ANY of these bailouts? A few, maybe, but all of them, certainly not. And at least that would have been one fewer emergency tracheotomy resulting in our economic death.

Wednesday, March 18, 2009

The Three Kings

On Monday we discussed the game of three card monte. So what are the three cards acting as culprits in this mess? Let's examine:

The King of Spades - Natural Excess of the Cyclical Economy

In every recession, there always seems to be some sector/product of excess, that creates a bubble, or a run up or oversupply of/in that particular sector/product. When demand can't catch up, the recession hits, as there is no longer a need for that sector/product. To briefly explain why oversupply can cause or lead to a recession, we need to understand relationships in the economy. When oversupply occurs of a major economically impacting product, and demand is far behind supply, supply temporarily stops because there is no need for it. This causes roughly a 3% decline in GDP (gross domestic product). Every time there is a 3% decline in GDP, it roughly translates into $2 million lost jobs.

Naturally, over time, the excess is burned off, because production stops, the population continues to grow, and eventually, demand catches up to a healthier balance with supply. When the tech bubble burst, tech startups stopped, datacenters stopped being produced and were converted into alternative uses, and eventually, we recovered. The housing bubble (which was the main culprit for this recession) is, and will be no different. Construction of single family homes has dwindled, but over time the population will continue to grow, demand will catch up with supply, pricing will stabilize, and we will recover.

The King of Diamonds (aka the King of the Middle East) - Gas Prices

This is probably the card that fools everybody. For months, all anybody wanted to talk about as the culprit for all this mess was the housing bubble. While it certainly was a major culprit, as we analyzed above, it certainly was not the only one. From mid 2006 to the fourth quarter of 2007, the price of a barrel of oil rose $100 per barrel. This was a $100 RISE in oil prices, after the price of a barrel of oil had only previously topped $100 per barrel for four months in the history of commodities trading. Suffice it to say this was unprecedented. The massively booming rise of the populations, and economies, of India and China were a significant cause of demand for oil, which helped push the price up, up more, and up higher still.

Yet, nobody talked about that as a cause of potential recession. No matter how you slice it, every one of us paying more at the pump led to one of two things. Either we spent less as consumers, or we saved/invested less of our money. Both of these have a negative impact on the economy. In fact, this phenomenon alone also caused about a 3% decline in GDP, or another $2 million jobs lost. The good news here is that since then, as the global economy crashed, oil prices have gone DOWN by about $100 per barrel, which should help lead us out of a recession over time. That is of course, if it weren't for card number three...

The King of Hearts - Emergency Tracheotomies

In the notoriously awful film Anaconda, featuring J. Lo and Ice Cube, Eric Stoltz gets a nasty bug lodged in his throat while swimming in the dangerous Amazon River. Jon Voight, who plays a shifty snake hunter (and also has one of the worst accents of any actor trying to portray an indigenous foreign national ever) sees he can no longer breathe. So Voight's character, trying to help, stabs a pen in his trachea, below the blockage, and puts a plastic stint in it, creating another passageway for oxygen to reach his lungs, thus saving his life. We are led to believe Voight's character has done this before, and is somewhat of an expert at Amazon first aid.

Well this is precisely what Secretaries of the Treasury Paulson and Geither have done to the asphyxiating US economy (in the form of ridiculously expensive and often unnecessary bailouts), only they don't have the medical training, and are more likely to kill the patient (the economy) than save its life.

On Friday, we will examine the impact of these bailouts, and what they really mean. Stay tuned.

Monday, March 16, 2009

Three Card Monte

The game of three card monte, is a confidence game in which the victim, or mark, is tricked into betting a sum of money that they can find the money card, for example the king of hearts, among three face-down playing cards.

In a bastardization of the traditional game, say I were to give 3 players a card, and if they won, I'd give them five more cards, and if they won that, I'd give them double the amount of money they bet. Then I asked each how much they wanted to bet. Suppose the first player elects to bet $100, the second player elects to bet $50, and the third player elects to bet $0. Traditionally, logic might tell you the guy betting zero cannot possibly win because he didn't bet anything, and as any avid poker player knows, you can't win what you don't put in the middle. However, we would argue the opposite, because how could anyone ever possibly win a game in which the rules are not clear AND they change as you go?

Of course that question is rhetorical, but its exactly the situation U.S. citizens, and investors alike, find themselves currently in. The U.S. government, both under the Bush & Obama administrations, or to be more direct, under Treasury Secretaries Paulson and Geithner, are the hustlers and we, the public, are the collective "mark." How else can you explain the hilariously sad hearings for the big three auto companies a few months ago? After weeks of hearings in which executives were ridiculed for asking for billions in bailout funds while travelling in corporate jets to the meetings, Congress all but denied Ford, Chrysler and GM their request...until Paulson changed the rules 12 hours later. This blog will not speculate as to the photos Mr. Paulson may or may not have of Harry Reid and Nancy Pelosi, or whether he passed them on as a rite of passage to Tim Geithner.

That being said, the supposed bailout monies have changed intended recipients more times than Sarah Palin has shot moose from a helicopter with a high powered rifle (a lot). First, it was supposed to go to the failing investment banks, then to AIG, then to commercial banks with regulations, then to commercial banks with little regulation, then to the auto industry, then to homeowners (even though nobody has identified which homeowners), and now maybe back to the auto industry again. Its dizzying.

The effect? Investors don't know the rules of the game, and so money continues to sit on the sidelines and wait. Have you put money in an S&P index fund lately? Didn't think so. Point proven. In fact the only people investing these days seem to be hedge funds, and thats only because they have to do something by their very nature. They are the equivalent of a gamble-a-holic in this sheisty casino we are all in.

But if we are all playing a game of three card monte, exactly what are the three cards being used against us?

On Wednesday, we will examine what the three cards being used in this game are in detail. Stay tuned...

Friday, March 13, 2009

Dis-Qualified Intermediaries

When I was a young commercial investment sales broker, I wasn't quite sure how 1031 Exchange Qualified Intermediaries made money, and didn't really care so long as they helped me make money. All I knew was that the IRS required these "qualified" intermediaries to handle the proceeds from an investment sale until a like-kind property was identified by the seller to buy, lest their capital gains on the sale of their property be subject to the tax code. The purpose was to prevent the individual sellers from making money on proceeds from the sale without paying taxes on them (even thought these intermediaries generally paid investors between 0.5-1% in exchange for holding the money).

As it turns out, I wasn't the only one who didn't get it. In the last several months, some of the biggest 1031 intermediaries were either sued, or filed for bankruptcy, placing investors who used them to facilitate their 1031 exchanges in a very precarious position.

Now, before we delve into this mess, let us first step back to the broader picture. 1031 exchanges are facilitated of course by the velocity of sales transactions of property. Simply put, if there are fewer properties being sold, there are going to be fewer 1031 exchanges. Almost a self fulfilling prophecy, the reason velocity is down contributes to an entirely different, but substantial reason for the decline in 1031 exchanges. With property values plummeting, even those property owners who have found a legitimate reason to sell are finding that the "gain" on their property has dwindled to a point where doing a tax-deferred exchange is seemingly pointless, because there isn't a ton of increased value (if any), from the time they bought the asset, to protect from the IRS. I digress....

Back in 2006 during the heyday of the boom in commercial real estate, there were 1031 exchanges happening left and right. The irony of the term "Qualified Intermediary" is that there is nothing "qualified" about them. They are not regulated in any way, nor are the ways in which they invest their clients' funds in the interim until it is time to fund the new property they are buying. No licenses are required, and Nevada (of all states, given whats legal there) is the only state that imposes any regulations.

Intermediaries make money in several ways. Most charge transaction fees, while others earn the spreads between interest they gain on investors' proceeds and the interest paid out to investors.

In 2007, three big intermediaries were charged federally with misappropriating clients funds. One ran a Ponzi scheme (Southwest Exchange, Inc. and Qualified Exchange Services), and another (1031 Tax Group) used monies to fund private real estate transactions, of all things.

One would think investors would have wised up and only invested their funds with bank or securities related intermediaries, or those that are part of the Federation of Exchange Accomodators, a trade organization that performs background checks of all its members looking for previous illegal or fraudulent activity.

Unfortunately, even those "safe" intermediaries investing appropriately, and in some cases, only in securities considered very liquid, were not immune from losing their investors money.

The most public of which was Land America, at the time the third largest title insurance company in the nation, as well as a busy 1031 exchange qualified intermediary. The investors, from retirees to a public company, had $400 million on deposit with the LandAmerica subsidiary, who has sold their title insurance company to competitor Fidelity National Title Insurance Co., and will likely be liquidation their 1031 Exchange arm.

In the filing, the company said it had put much of the money it was holding for real-estate investors into commingled accounts that invested in auction-rate securities that have become illiquid. LandAmerica had guaranteed the money. The auction-rate securities market seized earlier in 2008.

Investors, who thought their exchange and their money were safe, have been put in the precarious position of having to sit through bankruptcy proceedings just in order to get their money back. The biggest problem, again due to lack of regulation, is that there was no transparency for investors to see how these intermediaries were investing their money.

While this isn't necessarily an instance of robbing Peter to pay Paul, rest assured that Jesus was consulted by furious investors on more than one occasion.

Wednesday, March 11, 2009

Government Programs You Don't Know

We've all heard about the TARP program. It stands for "Troubled Asset Relief Program." Of course, the only problem with it, was that it didn't really provide the help it intended to. Because of the time sensitive nature of rolling out this program, there were not enough regulations put in place to dictate what banks could and could not do with these funds. As a result, the government, and unfortunately, the taxpayers, now look stupid.

Recently, the Treasury Department launched TALF, which stands for "Term Asset-backed-securities Loan Facility." Introduced by the Bush Administration last year and since refined under Secretary Geithner, TALF will immediately support purchases of consumer loan-backed asset securities and then be expanded to include commercial and residential backed mortgages. All together it has the potential to generate up to $1 trillion of lending, according to Treasury.

Will this program also become a failure? Time will tell, but in the mean time, we here at Llenrock believe in calling it like we see it, telling it like it is, and/or whatever other tired cliche you would like to use. For that reason, we have come up with some of our own "government programs" that don't just pretend to help clean up the mess we've created using clever acronyms, but rather terms things very, very plainly. We hope to show the U.S. government the inherent stupidity of just being clever on the surface. And so we bring you:

ACRONYM - A Colorful, Realistic Opinion Not Yet Meaningful

1. President Obama several weeks ago vowed to support homeowners directly with aid to help them pay their mortgages to stave off foreclosure. This was hoped to have provided a fewer number of foreclosures, making banks healthier, increasing consumer spending, and encouraging banks to lend more. But where was the fancy acronym? We dub this government initiative:

Mortgages Undertaking Substantial Help

2. There has been a lot of talk about the slide in the stock market. The Dow recently sailed below 7,000 points on news that AIG posted the biggest quarterly loss of any U.S. corporation in history. The stock market, more closely resembling a coop of chickens with no heads than a stable financial market, tanked. Many pundits have said the cause of the financial turmoil, and the lack of confidence it has inspired in the public, has been caused by the mark-to-market effect. Created as a way to ensure corporations had more financial transparency for investors, they were required to periodically reprice assets to current market values. What if this were to happen universally in the world of commercial real estate? Of course, when the current market is in total chaos, how does anyone realistically know what these assets are worth anyways? We give you a new governmental agency formed to figure it out:

Commercial Realty Asset Pricing

3. Back in the late 1980s after the savings and loan crisis, the RTC was created as an entity to hold troubled commercial assets, and efficiently sell them off. This resulted in massive discounts for liquid buyers, often able to scoop up properties for pennies on the dollar. Can we really have another RTC program? Why not, if we can create private/public partnerships to reap some of the benefits! We give you:

Federal Assets in Real Trouble

4. Surely by now, you have heard all the buzz about vulture funds. These funds have been, or are in the process of being formed to scoop up distressed assets over the next few years as owners fail to make mortgage payments due to their assets not being worth the loans currently outstanding on them. Don't know which one to invest in after the Bernie Madoff scandal? Well they all have one thing in common. They are all private equity funds. You can't trust any of them. Instead, we nominate a few brilliant minds to head up a government sponsored vulture fund to buy the real bargains from the banks they loaned billions of dollars to (seems kinda fair, right?) in an effort to actually turn the properties around and make the taxpayers some of their money back. Most citizens don't take pity on the rich guys losing their shirts in the commercial game anyways. May we suggest:

Pilfering Of Other's Property

If you are as clever as we hope you are, you might have noticed a theme with our government programs and the acronyms they might publicly go by. So why the low brow humor on a high brow site? Cause these days, between scandals, failed banks, failed insurance giants, failed automakers, and failed government programs, you just never can tell whose full of it.

Monday, March 9, 2009

Calling a Bluff: Lease Renegotiations

For the purpose of leisurely analogy, tenants looking to renegotiate their leases with landlords isn't too dissimilar from the functionality of baseball contracts. Unlike in other sports like football, baseball player contracts are guaranteed for the life of the contract. Owners cannot renegotiate them if a player gets injured, or fails to live up to their previous performance. On the flip side, if a player "outperforms" his contract, he can attempt to renegotiate an extension for more dollars/year or threaten to leave via free agency or demand a trade.

Of course, the economic climate, job loss reports, earnings reports, and major bankruptcy filings like those of Linens 'N Things and Circuit City make it easy for tenants to argue their case. Some landlords are quick to help, figuring that blending and extending their leases gives them more assurance of income over a longer period of time, even if the rental rate has to drop as a result.

So what level of recourse do landlords have when all of their tenants come crying, asking to renegotiate (see: lower) their rent at the same time, giving the threat of bankruptcy (and therefore zero rent payment) if the landlord doesn't choose to work with them?

There are several things to consider before caving:

1. Know Thy Tenant - The best thing that landlords can do to ensure successful lease renegotiations is to remain knowledgeable about their tenants' businesses. This process begins with the original lease negotiation. Including, monitoring, and enforcing lease covenants that require tenants periodically to provide financial statements or profit-and-loss reports keep landlords informed.

2. Know Thy Market - If large blocks of space are becoming available for sublease in the surrounding area or new space is being completed, tenants that are willing to move can exert some leverage on their current landlords. The best protection against this is knowing what it would cost a tenant in terms of time, money, and disruption to uproot its business and employees to a different location.

3. Know Thy Options - Since the original lease was signed, rents in surrounding areas either have risen or fallen. If space is tight and replacement tenants are available, decreasing a specific tenant's rent may not be necessary. Conversely, if new tenants don't appear readily available, renegotiating the rate might prevent the space from becoming vacant. An alternative option to lowering base rent would be renegotiating CAM reimbursements. In exchange for lowering reimbursement requirements, a landlord could negotiate a new lower base year, usually defined as the amount the landlord spends per square foot to maintain the building in a certain year, in exchange for a higher escalator or higher base year for a lower escalator.

4. Know Thy Assurance - Convincing a tenant to add or strengthen a guaranty can be difficult. However, gaining such a concession is valuable if the tenant fails but its owner retains significant assets. If a tenant's financial condition is precarious, its owner may close the business rather than personally guarantee the obligations of a shaky enterprise. Conversely, if a tenant has a strong financial statement, negotiating a guaranty might be a sufficient exchange for allowing the tenant to remain in the space at a decreased lease rate.

5. Know Thy Loan Terms - Landlords who have taken out a loan to acquire or develop a property should consult their loan agreement prior to renegotiating any lease. Financial covenants may restrict a landlord's ability to renegotiate leases.

Know Thy Space Requirements - A tenant reducing the size of its workforce also may want to decrease the amount of space it occupies. By doing so, the tenant hopes to limit its rent payments as well as decrease its pro-rata share of the building's expenses. This potentially presents a landlord with two complementary opportunities. A tenant with sufficient assets but foreseeing a need for less space may be willing to buy out part of its lease. After receiving a discounted payoff from the reduced tenant, the landlord could try to lease the space to a new tenant.

7. Know Thy Co-Tenants -
Co-tenancy clauses also can hinder renegotiation attempts. A co-tenancy clause states that a tenant may close its store or reduce its rent if another tenant or group of tenants does not occupy space at a retail project or if the occupancy rate of the project falls below a certain level. If this is the case, the landlord is stuck and may lose other tenants because of a co-tenancy clause violation caused by the renegotiation. To avoid this, landlords should understand and monitor the parameters of these clauses so they don't breach their leases with other tenants in an attempt to preserve a troubled tenant.

In addition to these seven commandments, its also wise tor remember one other thing. Odds are that a tenant's prospective bankruptcy is going to hurt them a lot more than it will hurt the landlord, and often its a case of absolute last resort. Giving the appearance of helping a tenant is usually enough, and in the process, you can garner many of the advantages, or at least offset a decline in rental income, by taking some of the approaches listed above.

Friday, March 6, 2009

The Price is Right

Where is Bob Barker when you need him? Aside from telling us to have our pets spayed or neutered, or getting in a fist fight with Adam Sandler, we could really use his pricing prowess to settle a little real estate discrepancy going on right now.

In the Obama Administration's new Homeowners Stability Plan, it suggests that home prices be valued via BPO (broker pricing opinion) or AVM (automated valuation models) when restructuring home loans. Current bank agencies guidelines require new appraisals in restructuring loans when a material change in market conditions exists, but in some states do not specify rules dictating how or who is to determine such values.

The nation’s four largest organizations of professional real estate appraisers-the Appraisal Institute, American Society of Appraisers, American Society of Farm Managers and Rural Appraisers, and National Association of Independent Fee Appraisers-recently delivered the second of two letters to Treasury Secretary Timothy Geithner urging the Administration to protect homeowners and taxpayers by requiring that the market values of homes under President’s Obama’s Homeowners Stability Program be determined by professional appraisers who are state certified and licensed.

To ensure that all parties have accurate and reliable information when restructuring loans, the letter cautions against the use of real estate sales people to provide broker price opinions. These individuals have no valuation training, do not observe uniform valuation standards, are accountable to no one for their estimates of home prices and may sometimes have an economic interest in whether loans are modified or defaults occur requiring a resale of the property to another buyer. By contrast, all 50 states license, certify and supervise the work of appraisers; and 23 states specifically prohibit realtors from valuing properties for any mortgage related purpose, including loan modifications.

Of course, this is all a giant game of finger-pointing, and both appraisers and real estate brokers have a conflict of interest, standing to gain or lose business to the other. Similar to the residential market, in the commercial real estate market, appraisers are important mostly from a financing perspective. If the property doesn't appraise at the value it is being sold for, the buyer's return would either dwindle, or they will walk away from the deal because the bank will not give them the financing they seek to make the deal work. It is for this reason most real estate brokers, and some buyers, don't particularly like appraisers, because they only stand to get in the way of their potential transaction if their valuation comes in too low.

Appraisers are mostly using comparable sales (a total rear-view mirror approach, and an inefficient one in a rapidly changing market) in addition to the income approach to get their values. But every transaction is different, and there can be a considerable amount of legwork, that most appraisers don't bother to do, that explains why a particular property traded at a certain value. Real estate brokers have better access to this information, and to the parties involved in these transactions to uncover this information, than do most appraisers who are largely relying on parties to be both be honest and detailed in answering their cold calls.

The residential housing market and commercial real estate market are still very similar in one regard. Whether its trying to figure out how much properties have depreciated in the last 12 months on the residential side, or how much CAP rates have risen on the income-producing property side, determining value boils down to one, simple idiom. At the end of the day, something is only worth what someone else is willing to pay for it, regardless of past, present or speculative future "value." It shouldn't matter whether a broker prices a home at $400,000 or an appraiser prices it at $300,000. If a ready, willing and able buyer offers $350,000 for it, and can close, then that's what its worth.

Bankers use appraisals as a safety net just in case they make a bad loan, and we all see how well that safety net has worked over the last 12 months as the housing market has collapsed. As brokers are fond of saying, "it only takes one buyer to get a deal done," and on every deal, that buyer will have to live with the fact that the reason they bought the property is because they were willing to pay more than anybody else. C'est la vie.

Wednesday, March 4, 2009

The Nationalization of Our National Pastime

How is it that one of baseball's best new rivalries could soon mirror one of America's oldest? The credit crisis, that's how. As if this global disaster hasn't caused enough pain, reaching across geographical boundaries, socioeconomic boundaries and pretty much every other boundary one could contemplate, it has finally reached baseball.

I am talking specifically about the rivalry between the New York Mets and Philadelphia Phillies. For those still unsure where I'm going with this, just remember what site your are that lives in the world of finance and real estate. Citizens Bank paid an extraordinary sum of money to the Phillies' brass back in late 2003 for the naming rights to the then new stadium now known as Citizens Bank Park. Similarly, last year, Citigroup paid an even more exorbitant sum to Mets owner (and real estate developer) Fred Wilpon for the naming rights to the newly constructed home of the Metropolitans, dubbing it Citi Field. Something to the tune of $400 million dollars.

But where, you ask, would troubled Citigroup get the money for that, given the fiscal turmoil they find themselves in, especially amid rumors that they, even post bailout, may still be financially insolvent? Check your wallet. Feel lighter?

As recently reported in the media, the U.S. Government, (see: taxpayers) could increase their ownership stake in the company to 40% in the form of common stock. Of course, knowing that Citigroup, even under recent pressure to relinquish their naming rights to cut costs, is forging ahead anyways, has many citizens up in arms. And rightly so. We just witnessed huge public backlash towards many of the bailed out firms continuing to spend lavishly on things like corporate jets and trips to Las Vegas. The difference here is that those companies finally caved in to the public pressure. Citigroup? Not so much. Perhaps they wanted to remain affiliated with the team current World Series MVP Cole Hamels referred to publicly as "choke artists." After all, Citigroup, a New York based firm, has been the commercial banking equivalent of the term. They just choked away your savings account for two consecutive years rather than two 162 game seasons.

90 miles down the turnpike, Citizens Bank isn't faring much better. In fact, their parent, the Royal Bank of Scotland, is doing even worse. In a story that emerged last week, RBS posted the worst loss ever for a British corporation. They lost $41B in 2008. $41 BILLION! As a result, the Edinburgh-based bank has struck a deal in which the government of the United Kingdom will raise its stake in RBS from 58 to 70 percent.

So let's see here. While the fan bases of these two respective teams will remain in New York and Philadelphia, the actual names of the stadiums in which they play will be rooted more in a rivalry throwback to 1776. US citizens versus British citizens. The team colors are even historically accurate. The Mets are wearing revolutionary blue, and the Phils sport the British-based redcoats. What, I ask you, is more American than that?

Monday, March 2, 2009

Mezz: The New Four Letter Word

George Carlin was famous for developing the seven dirty words you can't say on TV. Five of those seven were four letter words, and if you aren't familiar with them, you've probably uttered most of them each morning when opening the business section of your morning newspaper of choice, or late each afternoon when visiting to check on the market.

In commercial real estate, there are several four letter words that have become tantamount to the taboo four letter words to which we are accustomed, among them are "deal," "math," and "jobs." All of these are relative terms whose perceived impact on individuals has been negative. Well, time to add a more specific four letter word to the list...MEZZ.

Mezz, short for mezzanine debt, was all the rage in the waning years of the commercial real estate boom. Firms made an estimated $50 billion to $75 billion in mezzanine loans, debt that fills the gap between the borrower's equity and the first mortgage. Billions of dollars already have been lost and the figure is likely to balloon as the steep downturn in the commercial-property market deepens.

For borrowers, it was a convenient way to additionally leverage their deal, given the cost of mezz was usually still cheaper than the cost of equity. The spread between the two provided extra internal yield to the borrower, and thus, became an all too comfortable trend of overleveraging. The attraction of mezz debt to investors/providers was twofold: the rate of return on such debt, once levered up, was in the teens if the borrower kept current, and if the borrower defaulted, the investor in the debt would have the right to take over the property. All they would have to do is continue to pay the first mortgage debt service. Sure, their yield would be lower, but they would become owners of great theory. And therein lies the problem mezz has today.

Real estate values have dropped off the face of the map, to a point where, in some cases, values are lower than the amounts owed on the senior debt.

The biggest and best example, among many, is the largest private transaction in commercial real estate history, the 5.4B purchase of the Peter Cooper Village and Stuyvesant Town apartment complex in Manhattan. This deal had $1.4 billion in mezz financing provided to a venture of developer Tishman Speyer Properties and BlackRock Realty Advisors. As the weakening New York economy hinders the venture's ability to boost the rental income of the complex, the project is running the risk of defaulting on the mammoth debt unless the venture is able to persuade its investors to pony up more capital.

Recently, borrowers have begun to default on mezz loans, forcing the mezz investors to try to foreclose. But this isn't easy even in cases in which the mezzanine holders believe their position is even worth something. Often the mezz debt is broken up into slices with different degrees of risk and claims on the property.

No wonder investors want to scream out #$%&! when they realize they're great investments are knee deep in $*@#. And if you are one of the borrowers, please try to keep things civil and refrain from telling your creditors to go "mezz" themselves.