Archive for June, 2009

Where Are All of the Distressed Assets?

Our economy has been in recession for more than 18 months now and for the past year our real estate fundamentals have been adversly affected. Investors are constantly asking me to show them all of the distressed properties that we are handling for sale. The fact is that everyone is looking for these assets but there is really not much of this product presently on the market.  

A major reason why sales volume is down by as much as it is, is due to supply constraint as discretionary sellers feel that it is unwise to sell into this market. But, What about the sellers that have no choice but to sell? Many lenders fall into this category as the need for cash has left many of them seeking conversion of bad loans into capital. Stress has been evident in the market for quite a while so investors assume that distressed properties should be coming on the market to a significant degree. They have not yet and I will try to explain why this is the case.

As real estate fundamentals have eroded, defaults have been increasing and many lenders have had to put themselves in a position to deal with nonpayments. Many of these lenders have been very busy dealing with balance sheet issues, dealing with regulators and dealing with the government’s TARP initiatives. These issues, while very important, had “distracted”  lenders from addressing their defaulted loan issues.  

It has only been for the past few months that lenders have been figuring out what their exposures are and have been analyzing all of their troubled loans. Workout divisions within the banks have been staffed up and there have been significant enhancements to personnel infrastructure to deal with ever increasing piles of loan files that need attention. These “distressed” assets have been accumulating in a huge pipeline which is chock full of distressed properties and until now, these assets have only been trickling into the market.

We have brokered the sale of a few loans thus far in the cycle but are keenly aware of the potential supply which should reach the market in one fashion or another. Within the past 7 months we have provided lenders with valuations of several hundred nonperfoming loans and their corresponding underlying collateral. Our agents have identified several hundred additional properties which we believe are likely to go into default based upon the prices that were paid for them over the last few years and the amount of leverage that was placed on them. We are watching those asset very carefully.

Many funds have been established to purchased distressed assets, whether these assets are notes or properties,  and the funds have not been all that active due to the lack of supply that exists. These funds are patiently waiting for their opportunities and these opportunities will come.

We have seen distressed assets slowly coming onto the market in greater numbers and feel that the massive pipeline of these asssets will really start to open up during the third quarter of this year. We know that billions of dollars of these assets are in the pipeline and they will present a buying opportunity unlike anything we have seen since the early 1990s.

In addition to the funds that have been formed, we have seen a resurgence of high net worth individuals and the old line New York families that have not been as active as invesstors backed by institutional capital during the past several years. These were the same buyers who made fortunes buying properties during the early 90s. We have also seen a resurgence of foreign interest on an individual investor basis. These foreign high net worth investors are coming into the market in numbers not seen since the mid 1980s. We believe this is due to the perception that prices are low and good values can be obtained today.

Distressed assets exist because of prices that were too high and leverage that was too available in great abundance and real estate fundamentals have deteriorated.  These assets will consequently be a significant component of our marketplace for years to come as some of the distress will be caused by mortgage maturities which are spread over time. As these assets hit the market, investors will find opportunities and we will see market dynamics in which lenders and investors both end up winning. Lenders will be able to convert nonperforming assets to cash and investors will beef up their portfolios with great long term assets.


How Unemployment and Inflation Could Affect Commercial Real Estate Values

The most common question I am asked these days is, “When will the good times return to the commercial real estate market?” That question is impossible to answer with accuracy as we are in unprecedented times with unprecedented government intervention and an unprecedented global recession. Below is a scenario that I think could be possible and may even be probable based upon what we are presently seeing in the market.

I have read many reports recently stating that “experts” are seeing a turnaround in several segments of both the commercial and residential real estate markets. Intuitively, it is difficult to put any credence in these reports due to one very important fact. There is no other metric that is more closely tied to the fundamentals of real estate than employment and there is no indication that we are close to seeing a peak in unemployment. We are presently at a rate of 9.4% nationally and economists’ estimates have risen from a peak of 9%-10% to as much as 11% before the trend reverses. The implication for real estate value is acute.

As unemployment rises, people who have either lost their job or fear losing their job do not move to a larger rental apartment and do not move from a rental unit to purchase a residence whether it is a single family home, co-operative apartment or a condominium. As unemployment rises, companies do not increase their need for office space and may shed excess space adding to the vacancy and availability rates. It is easy to see how the fundamentals of real estate are most stressed when unemployment reaches its peak.

The most optimistic economists predict that the economy will begin to turn during the third quarter of 2009 (the most pessimistic see the turnaround sometime during the first half of 2010). Unfortunately for the real estate market, unemployment is a lagging indicator and it is likely that unemployment will peak three to six months after the economy turns. That would place the peak at the end of 2009 or the beginning of 2010 in the best case scenario.  This is the point at which the fundamentals of our market will be suffering the most and this is the point at which value will hit a bottom.

The question then becomes, when will value start to climb? In order to answer that, we must consider the potential impact of inflation. Will we have above trend inflation? It is hard to imagine that inflation will not be well above trend as the amount of government spending we have seen, coupled with the overtime the printing presses at the Treasury have been putting in, is creating a very likely potential for excessive inflation.

If this inflation kicks in, what are the ramifications for real estate values? There are two impacts, one positive and one negative.  In an inflationary environment, a flight to hard assets is prudent as cash in the bank loses purchasing power each day. Commercial real estate is a great hard asset to own so demand for the asset class should increase. But with inflation comes intervention from the Fed in the form of increasing interest rates. The Fed’s comfort zone on inflation has been in the 1%-2% range on an annual basis so anything over this range will prompt the Fed to tighten monetary policy ie, raise interest rates. Currently in the 6% range, mortgage rates could climb to 8%-9%

If interest rates rise, mortgage rates will rise. Given economic conditions, we are likely to see an extended period of positive leverage again as we did throughout most of the 1990s after the S&L crisis of the early 1990s left lenders underwriting in a very disciplined manner for the balance of the decade as the “sting” of the crisis was still fresh in their memories. If we see positive leverage, we could see cap rates rise into the high single digits to low double digits range. This dynamic will have a negative impact on real estate values.

Rising interest rates will be only one of a two part wallop to the market. The other is the impact of a deleveraging process which will play out over a multiyear period as it is based as much on mortgage maturity as a deterioration in fundamentals.

After value hits its low point, it is likley that value will simply bounce along this bottom for a period of years as the dynamics mentioned above play out and distressed sellers consistently add to the available supply of properties for sale.  It might be 2012 or 2013 before any meaningful appreication is seen in the market. If this happens, why should an investor buy now not waiting for value to clearly hit a bottom? There is a good reason.

Calling an absolute bottom of a cycle is nearly impossible and if you want to buy a hard asset as an inflation hedge, you want to buy that asset at a time before interest rates start to meaningfully rise. Buying an investment property today will give the investor the ability to lock in fixed rate financing at today’s low rates. The asset will have steady debt service payments while inflation increases rents and the value of the asset over time.

This is only one of a number of scenarios that might play out in the coming years. No one knows for sure what will happen but if I was a betting man, my bet would be on the analysis presented above.

Has Capitalism Failed?

If you look in a dictionary, the definition of capitalism goes something like this: “An economic system in which investment in and ownership of the means of production, distribution, and exchange of wealth is made and maintained chiefly by private individuals or corporations operating in a free market, especially as contrasted to cooperatively or state-owned means of wealth. The creation of ideas and taking advantage of conditions to provide services or supply goods to the free market via privately controlled production and consumption, the success of which is dependent upon the accumulation of profits gained in and reinvested in a free market”.

“Capitalism has failed” is a popular outcry today but those who believe this have misread the causes of our current economic conditions. If we consider our position today from a macro perspective, it is quite apparent that our economic distress has been caused by a failure of our regulatory framework, not the failure of capitalism.

There are several blatant examples of these regulatory failures: 1) the failure of the SEC to investigate Bernard Madoff after several acusations of his operation being a ponzi scheme over a 15 year period, 2) the failure of bank regulators to understand the risk position of the institutions they were charged with overseeing, 3) the Fed’s ruinous interest rate policy under Alan Greenspan during 2002-2005 during which interest rates were kept too low for too long, 4) a failure to regulate the credit default swap market, the ramifications of which are still unknown to most on The Street and off The Street, and most importantly and outrageously, 5) the absolute collapse of economic policies in favor of ad hoc “deals” which are more politically influenced than economically influenced.

Let’s be clear, government non-performance is the reason for our current economic circumstances, not the failure of capitalism. We should not be surprised by this as history has shown us the US has a long tradition of regulatory failure under all administrations.

In the fall of 2008, the Treasury and the Federal Reserve were empowered to take actions which threw out longstanding rules of economic behavior. As the US transitioned from longstanding policy to ad hoc decision making, predictability and transparency disappeared in a matter of weeks. Decisions were made in a matter of hours regarding the fate of companies. Moreover, these decisions were made with limited and poor information.

The result was that the politically blessed received billions but these actions have produced disasterous results. Hundreds of billions of taxpayer dollars were wasted, trillions of wealth were destroyed and 4 million jobs have been lost…… far.

Ad hoc decision making is not how things should be. In the US economy, winners and losers should be determined based upon the old fashioned principles of 1) satisfying customers, 2) controlling costs and 3) constantly adjusting to changing markets. Today, we have devolved into a nation similar to Russia or Venezuela where your success is predicated upon your political connections rather than your economic ability.

In order to have a prosperous economic system, we must have certainty, transparency and people must win or lose based upon economic ability not political ability. When we saw rules replace by fiat, we saw investors and consumers move to the sidelines in droves.

To say that we have witnessed, since the fall of 2008 (which encompases both Republican and Democratic administrations), the most abysmal economic leadership since the 1970s era of wage and price controls is not an overstatement. Economic analysis has been thrown out the window because the government has replaced the precepts of economics with government mandate.

There is, however, a reason to be somewhat optimistic. While Hank Paulson was an ad hoc deal junkie, Larry Summers and Paul Volker, two of the present administration’s key economic advisors, are policy oriented. whether we love or hate the policies, we must remember that policies are better than deals.

Capitalism has not failed, our elected decision makers have.