Archive for March, 2009

Geithner’s Plan is a Start, but…

Treasury Secretary, Timothy Geithner, rolled out some of the details of what insiders are referring to as TALF 2.0.  This program has two componets, the Legacy Loan Program and the Legacy Securities Program. These programs are expected to help the commercial real estate industry based upon the premise that loans and securitiees collateralized by real estate are fundamentally undervalued due to a liquidity discount as opposed to drastically reduced cash flow expectation.

The public/private partnership investment program will create a pool of buyers for a market in which there are currently no buyers. For the securities program, the Treasury will oversee the auction process and for the loan program the FDIC will provide the oversight. Buyers will partner 50%/50% with the FDIC or the Treasury and that partnership will borrow money from the government to create purchasing power of up to $1 trillion in the first phase of this program (I am calling it the first phase because there will undoubtedly be additional capital required to address the massive amount of  toxic assets on the balance sheets of institutions). The newly formed entity will borrow on a non-recourse basis and the private sector component of the partnership has losses limited to their initial investment. The substantial incentives and debt guarantees provided by taxpayers to private asset managers should be enough to drive prices to levels satisfactory to sellers.

The questions, however, are several and the primary question of whether the credit supply resumes depends on the true health of banks. Some of the questions revolve around the appetite hedge funds and private equity investors will have for a program controlled by a government that is prone to changing the rules midstream. The recent furor in Congress over executive compensation has been frightening and with the way the White House has tongue lashed Wall Street at every turn, will the Street want to help? Sure they will. Why? Because it is a tremendous money making opportunity and billions will be made by those who can manuver through the system. Another question is whether this can be accomplished without unduly wasting taxpayer money.

Other questions revolve around whether banks will decide to sell their assets through this program. To what level have the assets been written down? What is the expected sale price via the auction? Can the bank set a reserve? How will these assets be valued? Many of these questions have not been answered yet.

To the extent participants do indeed participate, the result will likely be an easing of credit as the capital ratios at banks should be greatly enhanced by these programs. Banks have more cash than they have ever had but capital levels are stressed due to the mark-to-market accounting rules which force banks to mark assets to “market”. But the fact is, when there is no market, you are only guessing at what market is. A few forced transactions do not make a market.

An enormous issue for the commercial real estate market which these programs do not directly address is the status of CMBS loans and how a borrower can deal with maturing loans in a market where there is no replacement financing available and, moreover, there is no one to speak to at “the lender”. A borrower with a performing loan, who is making their monthly payment, which is approaching maturity, will be in technical default if they cannot refinance. Today, it is unlikely they will be able to and the effects of TALF 2.0 will probably not be tangible enough in the short term to address the massive refinancing needs commercial real estate is facing in 2009. A solution to this dynamic is needed quickly as the first performing loan to be held in technical default because of maturity could be the first of many dominos to fall.


When will this Market Turn?

I am asked this question several times every day.  The true answer is that I do not know and no one knows. We are in unprecedented times.

There are so many factors to look at to try to figure out when this market will start to correct but nothing that has happened, thus far, has indicated that we are headed for clear skies in the short term.  There are several things we need to see and several hurdles we need to overcome before we can say that we are headed for recovery.

There is no doubt that many people will be financially disadvantaged and billions will be lost only to provide others with the opportunity to make fortunes. We saw this during in the early 1990s and today the circumstances are much more acute.

Last week the stock market rallied leaving some pundits proclaiming that we are at the bottom and the recovery has begun.  I do not think so and I will try to explain why.

We have said for many quarters that in order to believe that a recovery has begun, we need to track three indicators: 1) a couple of quarters where banks are not compelled to raise capital, 2) leveraged loan spread regulating and 3) credit default swap premiums attaining stabilized levels. Let’s look at each of these indicators.

Bank capital is stressed. Banks currently have more cash than they have ever had but distortions caused by mark-to-market accounting rules have forced banks to write down assets to levels where bank capital levels are marginal. Due to reserve requirements, while banks have huge levels of cash, they are not lending as much as they could because of their capital ratios. Mark-to-market accounting is stifling the appetite for banks to originate new loans.

Leveraged loan spreads are at all time highs. These spreads indicated the willingness of banks to make loans. Based upon these spreads, it would appear that banks are less eager to lend than they should be. Several banks publically state that they are lending and lending more than last year, but who is seeing this liquidity in the market? We could also include TED spreads in this category. This is the spread on bank loans to other banks which has historically been 5 to 10 basis points. In September, this spread hit 470! Today it is around 100.

Lastly, let’s look at credit default swaps. They are indicative of the perception peers have of the credit worthiness of other companies. The premiums that these swaps have been trading at are indicative of a general skeptisism that exists in the equity market today.

Notwithstanding Citigroup and Bank of America recently announcing that they do not require any additional cash injections from the government, banks still need to raise cash and capital. Leveraged loan spreads are still bloated and credit default swap premiums are still far too high. Based upon all of this, the recent bear market rally does not seem to be indicative of  a bottom in the market.

We believe that the housing market needs to bottom out before the economy can bottom.  Can housing bottom before unemployment peaks? Many economists do not think so. Neither do I.

Optimistic economists believe the economy will bottom out in the third quarter of 2009 and the pessimists are projecting a bottom in the second quarter of 2010. Unemployment is a lagging indicator and will, likely, not peak until 3 or 4 months after the economy bottoms. If we assume that the optimists are correct, we should have unemployment peak in the first or second quarter of 2010. This is when the housing market will probably bottom and the big 3 indicators (mentioned above) will start to regulate. This is also the point at which we should start to see improvement in the fundamentals within the commercial real estate market.

Based upon all of the data available today, it would seem that we are looking at about a year before the correction begins. I certaintly hope it happens sooner.

CMBS Needs Some Skin in the Game

There has been virtually no new issuance of CMBS since the summer of last year. The result has been a reduction in the number of investment sales in New York with prices over $100 million of 85% in 2008 versus 2007. Thus far in 2009, there have been only 2 transactions which have exceeded $100 million. Securitizations are used for smaller loans as well, however, the  majority of this sector consists of larger loans.

Various reports have indicated approximately $180 billion to as much as $400 billion of commercial real estate financing maturing in 2009. Most of this financing is CMBS and a significant percentage is collateralized by assets located in New York. The market does not have the ability to refinance this magnitude of capital without access to the public markets. Even performing, low LTV (even using today’s adjusted values) loans with strong sponsorship will find refinancing challenging if the aggregate amount of dollars needed is too large. It is, therefore, critical to get the CMBS market operating again, in one form or another.

The government is trying to stimulate all credit markets including the CMBS market. The TARP includes TALF 1.0 which is geared towards supporting asset backed securities collateralized by credit card debt, student loans and auto loans. It also has an allocation to purchase newly originated AAA traunches of  CMBS. TALF 2.0, which was born out of the “Geithner Plan”, has an interesting component which will attempt to create a pool of buyers of legacy CMBS as well as other toxic assets. Created via the formation of public/private parnerships, this pool of buyers will consist of competitive bidders for these assets. Leverage will be available at a ratio of as much as 10 to 1. Balance sheets of financial firms could be significantly enhanced based upon the extent to which this process is successful.  

How did the CMBS market deteriorate?   Similar to the mechanism which caused problems with RMBS, no one had any skin in the game……. until the end of the process. Along the way, fees were made and exposure was passed on to the next one in line. Loans were orignated and sold to the secondary market. Pools of loans were securitized and divided into traunches. Rating agencies gave their blessing and when the securities went bad, the investors who purchased them were left holding the bag.

The question is, What will convince investors to purchase these securities in the future? Perhaps something like this could help:

The originator of the loan should be required to keep a first loss position of let’s say 20% on their balance sheet and could then sell 80% of the loan to the secondary market. The lender would then be compelled to make prudent decisions about what loans they are making because they will have skin in the game. The secondary market securitizer should have to keep a second loss position of let’s say 10%, which would make them scrutinize the collateral, layering in another slice of due diligence. The securitizer could then sell the balance of the securities to institutional investors. With a 30% loss position in front of  the investors, a rating agency would no longer be necessary to give comfort to the investors. The percentages of loss positions could vary greatly, but the concept is to have market participants put their money where their mouth is rather than merely processing a financial instrument for a fee and then passing all of the risk on to someone else.

The market desperately needs access to massive amounts of capital and a fix to the CMBS market would be a start.

2009 Volume of Investment Sales Could Hit New Low

Opportunistic buyers call me every day looking for “good deals” on “distressed assets”. I have not had much to send them recently. Thus far, we have not seen tremendous buying opportunities with enticing cap rates because of the distress in the market. Why are these opportunities not presenting themselves?

In order to answer that question, let’s take a look at some history. In the early 1990’s, the S & L crisis created buying opportunities but only after banks had gone through a long foreclosure process. The Dow crashed in October of 1987 but the effects were not felt in the real estate market until 1990 when the number of sales started to shrink and prices finally started to drop, and drop they did. As an example, multifamily properties that we sold in 1988 for 14 times the rent for co-op conversion (condos were very rare in NYC at that time) were being sold for 4 times the rent in 1992 and 1993.  As prices started to fall in 1990 and 1991, defaults began and the foreclosure process was initiated by lenders.

This foreclosure process took  12 to 18 months. While the wave started in 1990, properties did not start to hit the market until 1992. Most of these foreclosures came to market in 1993 and 1994.  There were  real opportunities available for cents on the dollar. The reason why these opportunities were so good was that few people had equity, of any substance, that they were willing to invest.

We are once again in troubled times. Thus far, the properties in financial trouble are still working their way through the pipeline and have not found their way to market in substantial numbers. Lenders are still going through the process of determining whether they will sell their notes or go through the forclosure process. The insatiable need that lenders have for cash today is likely to lead them to sell notes to get cash today rather than go through a foreclosure process, which would delay the cash injection which is so desperately needed. 

So, where are we in this cycle of processing these troubled properties? I believe we are at the beginning of the process. We determine turnover, or volume of sales, as the number of properties sold out of the total stock of existing properties. In New York City, we track 125,000 multifamily and mixed-use properties which have had a turnover rate which has been averaging 2.5% annually, of that total stock, over the past 20 years. This volume had hit an all-time low of 1.6% in 1992 and again in 2003. We believed that this 1.6% level of turnover repressented a baseline of turnover consisting of only those sellers who had to sell without discretion. They sold for reasons including death, divorce, taxes, insolvency, partnership disputes, foreclosure, etc. Both of these years ended recessions and had experienced peaks in cyclical unemployment. In 2008, this volume of sales hit 1.9% which was down about 40% from the 3.0% experienced in 2007.

We are projecting a turnover rate of 1.6%, or less, in 2009 as discretionary sellers are not yet capitulating to current market conditions and sellers who will be forced to sell, are still going through the process of determining how they will be going to market and what they will be going to market with, notes or real estate. We expect unemployment to hit its peak in 2009 or 2010 which is when we should see turnover hit its cyclical low point.

We are currently faced with constrained supply and we do not expect this supply to increase, in any meaningful way, until later in 2009 which will result in sales in 2010.

Opportunistic buys are in the marketplace now but only sporadically. Could we hit a volume of sales lower than the all-time low of 1.6% in 2009? Sure we could. We expect a trough in 2009 with volume picking up in 2010. 

A key difference today, as opposed to the early 1990’s, is that there is plenty of equity on the sidelines waiting for opportunities to present themselves. They are starting to appear and will continue to over the next few years as deleveraging progresses.