Archive for August, 2009

Banking Industry Woes to Strengthen Some While Others Vanish

If you are a regular reader of StreetWise, you know that in New York City the community and regional banks have been the main driver of financing activity which has kept the sales market out of the morgue, especially for small to mid-sized assets. Ironically, these are the very types of banks which are suffering the most around the country, threatening our economic recovery. Banks are failing at an alarming rate and, as real estate professionals, it is important to be familiar with the status of this critical industry.

Last Friday, Bradford Bank in Maryland and Mainstreet Bank in Minnesota were closed by regulators marking the 82nd and 83rd US bank failures in 2009. This figure is greater than that seen in any year since 1992 and, what is most troubling, almost half of these have occured since July 1st. In 2008, 25 banks failed bringing the total during this recession to 108. It is expected that this number will grow to as many as 1,000 over the next 18 months before the smoke clears. The FDIC seizes banks on Friday afternoons and the banks are reconstituted over the weekend to open as part of the acquiring bank on monday morning. During the Savings and Loan Crisis, 853 banks failed and today’s conditions are widely considered to be far worse than the conditions we saw in the early 1990s.  The problems this time around will result in hundreds of failures with some of the stronger banks growing stronger as they emerge from this cycle.

The FDIC insures deposits at 8,246 banks and keeps a “watchlist” of banks which are candidates for insolvency. This figure comes out periodically and at the end of March it was 305. Last Thursday, the FDIC said the number had grown to 416 which is the highest number since 1994. In 1988 this number was a record 2,165. Given the relative comparision, the watchlist level is expected to soar during the next year or two.

Stronger and larger banks, in addition to receiveing TARP funds, have been able to raise $48.3 billion recently through a combination of strong earnings, dividend cuts, asset sales and equity raising. Unfortunately, it is estimated that $275 billion is needed to stabilize the industry. How did the industry get into this position? It did because far too many banks tripled-down on real estate investments. Here is the triple-down scenario:

First, and most obviously, banks made loans on residential real estate, commercial real estate and development projects. Unfortunately, the present speed of deterioration in loan performance is unprecedented – even relative to the early 1990s. Particularly, some banks deployed over 100% of their risk-based capital into development projects. Many of those banks no longer exist.

Second, we must look at how some banks handled their investment portfolios. Thousands of banks and thrifts purchased securities tied to the housing market. Banks bought $2.21 trillion of these securities which represents 16% of the industry’s total assets of about $13.5 trillion. 1,400 banks purchased “private label” securities which are those not issued by Fannie Mae or Freddie Mac. It has been estimated that small and regional banks presently own $37.2 billion of these private issuer securities.

Third, the industry has been battered by $50 billion of “Trust Preferred Securities”. These are financial instruments issued by banks which are a hybrid between debt and equity. Between 2003 and 2008, 1,500 banks issued these products. Wall Street purchased these securities, created CDOs, and sold the resultant securities back to the same pool of banks! As market conditions weakened, the performance of these banks and of these securities weakened. In the first half of 2009, 119 of these banks deferred dividend payments on these securities and 26 banks defaulted altogether. The consequences of these stresses are cascading down to the buyers of the securities (the banks).

This tripling-down effect has created the difficulties in the banking sector. As the sector weakens and more banks fail, tremendous stresses are being exerted on the FDIC and its insurance fund which takes a hit each time a bank is seized. As the FDIC seizes banks, it prefers to have a buyer in hand prior to the seizure so that a conversion can be implemented over the weekend. Unfortunatley, buyers, particularly for larger institutions, have not been plentiful in supply.

Two weeks ago, Colonial Bank, with $25 billion in assets, was seized and sold but there were surprisingly few bidders engaged in the process. When Guaranty Bank in Texas was sold, the FDIC, for the first time in history, sold the assets to a foreign bank. Banco Bilbao Vizcaya Argentaria, a Spanish bank, was the buyer.

The FDIC’s most important consideration is to limit the cost to its insurance fund, which covers losses from a failed bank’s troubled loans. In order to achieve this objective, having as many bidders as possible is in their best interest. Expanding the arena of foreign banks is part of this strategy and several have expressed interest including TD Bank (Toronto-Dominion Bank), Bank of the West (BNP Paribas), UnionBanCal (Bank of Tokyo-Mitsubishi UFJ) and Rabobank (Rabobank Group).

This past week, the FDIC also made it a bit easier for private-equity firms to purchase failed banks. Existing bank holding companies need a Tier 1 capital ratio of 5% to be a qualified purchaser while new banks require 8%. Private-equity firms were required to have a Tier 1 capital ratio of 15%. This has been reduced to 10%. By attracting private capital to buy these failed banks, the FDIC can reduce the number of liquidations and thus reduce the potential losses to taxpayers. The impulse to demand a higher capital cushion as proof of ownership commitment and staying power is exactly correct. The same goes for the requirement for non-bank holding companies to hold onto the bank for at least 3 years before it can be resold and the requirement that the buyer act as a financial backstop. The weak US banking system doesn’t need investors looking mainly for a quick spinoff that could leave a bank in poorer hands within a year or two.

Sheila Bair, the Chairman of the FDIC, has been one of the most on-point players in our financial markets during this cycle. She had the foresight to ask congress to provide access to a $500 billion Treasury line of credit several months ago. While she is reluctant to tap the line (for obvious reasons) it is good that the facility is in place.

We keep hearing from the Treasury and Congress that the US needs more and tougher bank regulation, even though regulators failed miserably to detect problems within the system. Yet the FDIC is being roughed up, by these same proponents of more regulation, for demanding capital and other standards from nonbank investors who won’t have to meet current bank holding company rules. This position is not the way to restore confidence in the banking system.

We need a healthy banking system to provide financing to our industry. There is a recycling process that it will have to go through but we remain hopeful that a stronger system will emerge from the rubble.


Isn’t Anyone in Washington Paying Attention?

We are all, by now, well aware of the $400 billion travesty created by subprime lending and the fundamental structure of Fannie Mae and Freddie Mac.  A platform which includes private profits and public liabilities should have been conceptualized in a different fashion. In the 1980’s, the government thought an increase in the homeownership rate from 64% to 75% would be positive for the country and incentives were given to these government sponsored enterprises to help achieve that objective. They loosened their standards, expanded their platforms and supported riskier loans (over 20 years later the homeownership rate has only increased 3.4% to its present level of 67.3%).  Subprime lending was a central catalyst for the difficulties faced by Fannie and Freddie as loans were made to people who did not qualify for them. A bubble was created and spectacularly burst when we discovered that housing prices could not keep going up forever. Lesson learned, right? Think again.

Enter the Government National Mortgage Association, aka Ginnie Mae. Ginnie’s mission is to bundle, guarantee and sell mortgages issued by the Federal Housing Administration. The FHA is the government’s in-house mortgage operation which, given the difficulties in the housing and related markets, has grown spectacularly as it filled a void. As the FHA has grown, so has Ginnie Mae. FHA/Ginnie now guarantee $680 billion of mortgage securities, a 400% increase since 2006.

In June alone, Ginnie had issued $43 billion in mortgage backed securities. By the end of next year, it is expected that Ginnie’s mortgage exposure will eclipse the $1 trillion mark. With the activity of late, Ginnie has now swaped positions with Fannie Mae in terms of loan volume.

Here is what is troubling: the government has eased FHA’s already loose underwriting standards while every other lender on the planet has tightened them. FHA’s program and oversight are notoriously lax. It accepts very low downpayments (3.5% generally) and will make loans to borrowers with below average to poor credit ratings. They also have other policies which, among other things, allow borrowers to finance closing costs which can reduce the downpayment to a mere 2%. Given the tremendous growth of the operation, it is even more likely than before that fraud protection mechanisms will be ineffective. This is called subprime lending and Washington is running the show.

Additionally, FHA has been the recipient of a Congressional blessing to assist with the refinancing of hundreds of thousands of subprime and other exotic loans extended to borrowers who can’t (or wont) make their mortgage payments. Through the Home Affordable Modification Program, the FHA will refinance these troubled loans by reducing the balances of the loans by as much as 30%. The stated purpose is to reduce foreclosures but someone has to pick up the tab. Guess who? Right, the US taxpayer.

Fannie Mae and Freddie Mac carried “implicit” government guarantees. (These are off balance sheet liabilities for Uncle Sam which, if reported properly (no one believes the government wont stand behind them), would increase our national debt by 75% to about $12.7 trillion and a more than 90% debt-to-GDP ratio, but questioning the integrity of the National balance sheet is another topic for another post). FHA and Ginnie carry “explicit” guarantees of the government.

HUD’s Inspector General issued a report recently indicating that FHA’s default rate has risen to 7% which is more than double the level considered tollerable for lenders. Moreover, the report found that 13% of the loans were delinquent by more than 30 days. Because of these facts, the FHA’s reserve fund has been reduced by more than 50%,  going from 6.4% to about 3%. Why is a 33 to 1 leverage ratio ringing a bell to me? The report went on to say that, “FHA may need a Congressional appropriation intervention to make up the shortfall.”  It sounds as if yet another bailout is on the horizon.

Doesn’t Congress have a responsibility to the US taxpayer to secure the soundness and safety of FHA? Common sense reforms would show that attention was being paid to the extraordinary things that have occurred recently. Why not increase the downpayment requirement to a level where the borrower has something to lose by defaulting? This would be the best protection against default and foreclosure. Why not participate in the upside of the home’s value given the generous terms upon which loans are made. The “participation” could protect the taxpayer from inevitable losses.  This would allow those who benefit directly from the program to help support the program.

I know that the function of the FHA and Ginnie Mae are fundamentally well intended and necessary. The government needs to provide an overly reasonable path to the “American Dream” for those who need a helping hand. The point is that we were just afforded the opportunity to learn a VERY costly lesson about the dangers of subprime lending. It is a big concern that the lesson has seemingly been missed by those on Capitol Hill and the government is now explictly running the biggest subprime lending operation in the world.

REIT Power Likely to Increase in 2010

Real Estate Investment Trusts (REITs) are a form of ownership which have been around for quite a while but really began going public in earnest to delever their balance sheets in the early 1990s. And thrive they did in the mid to late 1990s. However, their dominance was somewhat muted in our most recent bull market in the mid- 2000s. I would like to share a perspective with you that I think is very interesting. REITs have the potential to become an even more dominant force in our investment sales market beyond where they are today. Let’s take a look at why this could be the case.

Let’s consider current market conditions. The speed of deterioration in loan performance is unprecedented, even relative to what was experienced during the Savings & Loan crisis in the early 1990s. The total delinquency rate has reached 4.1% recently which reflects an increase of over 350% from the rate at the end of 2008. Deliquency rates are likely to increase substantially over the next two to three years as billions of dollars of pro-forma loans that never reached stabilization mature. Loans which have interest-only periods expiring or interest reserves burning off will fall into this category as well. Additionally, numerous properties are hanging on by a hair only because the mortgage rates are floating over LIBOR, which is minscule today.

In New York City, we had $106 billion of investment property sales in 2005, 2006 and 2007. Based upon loan-to-value ratios available during these years and the reductions in value that we have seen, an extrapolation would indicate that approximately $80 billion of this total or about 6,000 properties have negative equity today. Clearly not all of these properties (or the notes on them) will come to the market as distressed assets as many owners have the ability to service the debt and want to own the assets for the long term. Notwithstanding this fact, a substantial percentage of these properties will come to the market needing to be sold.

Refinancing requirements will add to stresses in the market and will prove challenging, particularly for larger loans which are not generally available from community banks and regional banks due to their magnitude.  They will also be challenging due to reductions in value and more conservative LTVs which will exacerbate the massive deleveraging that the market must go through. It has been projected that well over $2 trillion in commercial mortgages will be maturing between now and 2013.  Much of this financing was delivered to the market by banks, life companies and CMBS intermediaries.

The CMBS market has evaporated. In 2007, there were $230 billion of issuance and in 2008, this number dwindled to just $12 billion (all of which was in the first half of the year). Since July of 2008, there have been no new issuances. A disturbing fact is that even if the banking and insurance industries were operating at full throttle, they do not have the capacity to meet the refinancing demand. Access to public capital is crucial. Enter the REITs.

Not surprisingly, REITs have been negatively affected by current market fundamentals, as all sectors have.  The Dow Jones Equity and REIT Total Return Index, which tracks 113 stocks, had posted a negative return of approximately 68% from its peak in February of 2007. While the Index has improved, it is still well below peak levels and REIT stocks are trading at double digit percentages below net asset value (net asset value was nearly impossible to determine 8 months ago and, while it is not much easier today, there are some data points from which to form a reasonable estimate). By contrast, REITs traded at a 25% premium to NAV between 2004 and 2007. Presently, the REIT dividend yield spread to the 10-year Treasury note is approximately 260 basis points, well above the long term average of 118 basis points. They are also trading at approximately 325 basis points below their long-term average FFO multiple of 12.8x. These facts should help REITs facilitate capital raising efforts.

REITs own a significant portion of the better quality properties in the United States. They currently have access to over $30 billion in credit lines and have generated in excess of $5 billion of liquidity since mid-2008 via dozens of dividend reductions, eliminations and in-kind payments. Most importantly, REITs have access to the public capital which was regularly accessed via the CMBS market. Several well capitalized REITs have successfully raised capital recently, an extremely positive sign in a market sorely missing them.

Fortunately for the sector, relative to other professional commercial real estate investors, REITs were among the least active buyers as cap rates declined significantly between 2005 and 2007. REITs were the purchasers of only about 11% of investment properties during these years. During this same period, private equity funds and private owners acquired in excess of 55% of the investment properties sold. Therefore, a number of REITs should be well positioned to acquire assets from these entities at significantly more attractive prices as these over-leveraged properties and owners become distressed. Surely, some REITs will face challenging times and may need to be folded into other entities. The well capitalized players should be in great shape.

Access to public capital and large stockpiles of dry powder should make REITs even more powerful as we try to manuever our way out of current market conditions. We clearly have a long way to go to get through this cycle. As we emerge, look for the well capitalized REITs to lead the way, particularly if CMBS fails to make a tangible comeback.

2Q09 NYC Investment Sales Better but Still Weak

The investment property sales market in New York City was slightly improved in the second quarter of 2009 (2Q09) versus the first quarter of the year. That being said, it couldn’t possibly have been worse than 1Q09 during which we saw the paralysis of 4Q08 manifest itself in a 1st quarter volume which we needed a microscope to see. However, even with an improved 2nd quarter, the first half of 2009 (1H09) was still a major disappointment for those of us relying on transaction volume for a living.

The total dollar volume of sales in NYC for 1 H09 was approximately $2.8 billion. This figure was down 81% from the 1H08 total of $14.47 billion and down a whopping 92% from the peak half year of 1H07 during which we had $35.8 billion in sales.

With regard to the number of transactions,  in 1H09 we had 562 closed transactions. This figure was down 65.7% from 1H08 and down 75.3% from the peak half year of 1H07 during which we had 2279 sales closed.

Because some transactions involved multiple properties, we also track the number of individual properties which have been sold.  In 1H09, 670 properties were sold.  This figure is down 64.5% from 1H08 and down 75.5% from the peak half year of 1H07 during which we had 2738 properties change hands.

To put these sales figures into perspective, we must look at historical averages and milestones. Since 1984, we have tracked a statistical sample of investment properties in New York that constists of 125,000 properties. Over a 25 year period, the average turnover rate has been 2.6% with the all-time low level being 1.6%. The 1.6% level was hit in 1992 and again in 2003. Both of these were years at the end of recessionary periods and were also years during which unemployment  reached cyclical peaks. We always assumed that this 1.6% turnover level was a “base line” which consisted only of people who were forced to sell because of death, divorce, taxes, insolvency, partnership disputes, etc. If we annualize the activity during 1H09, the turnover percentage is running at 1.07%!! We anticipate that activity will pick up slightly during 2H09 but that we will still hit a new record low of 1.2%-1.4% for the year.

Values are also taking a hit as office and retail properties have seen cap rates increase 200 to 250 basis points above their lows. The multifamily sector has held up the best with cap rates only about 100 basis points above their lows. In fact, in the Manhattan market (south of 96th street on the eastside and south of 110th street on the westside) during 1H09, walk-up buildings saw average cap rates of 4.58% with the elevatored average hitting 4.08%. Upward pressure on cap rates is present in every sector of the market.

In general, the New York City building sales market has seen a reduction in activity and value. The trend has certainly been towards smaller transactions, for which there is plentiful debt available from community and regional banks. We have also seen a resurgence of high net worth individuals and old-line families who had been overpowered by operators backed by institutional calpital for the past several years. We anticipate the volume of sales increasing slightly as we move into the second half of the year. Based upon current market activity , we expect volume to increase as prices drop due to eroding fundamentals caused by increasing unemployment.

(For a copy of the 25 year study or to recieve borough by borough building sales reports for the first half of 2009, please feel free to email me and I will be happy to send them to you)