Peter Pays Paul

Page C1 of today’s Wall Street Journal is reporting that Blackstone Group, LP and CIM Group are attempting to acquire commercial real estate assets by buying the mortgages for a steep discount.

Private-equity firm CIM Group has teamed up with New York developer Harry Macklowe to help him regain control of what is regarded as one of the most valuable vacant lots in the world, according to people familiar with the matter.

This strategy is being used in a number of transactions. The success of this strategy depends upon the lenders willingness to take a loss on the property. Lenders that are in need of cash or understand that they are underwater on a property are more likely to take a discount.

In the case of the Drake Hotel site, a vacant piece of land doesn’t offer a lender much to work with. When Mr. Macklowe bought the lot it had a hotel on it which is more marketable. A lender is likely going to avoid a situation where they have to develop a piece of land.

The WSJ article also quotes Keith Barket from Angelo, Gordon & Co., a private-equity firm. Mr. Barket believes that the deleveraging of commercial real estate will take 3-5 years to complete.

It will be interesting to see if it does.

“Although troubling times are ahead for many investors, lifetime investment opportunities are forming for the real estate cycle players with cash in hand,” according to the most recent PricewaterhouseCoopers Korpacz Real Estate Investor Survey, which polls major institutional equity investors who invest primarily in institutional-grade property. Investors who are patient, but also daring and selective will acquire high quality assets in markets such as Boston, Washington, D.C., San Francisco, New York and Austin.

2010 Promises More Deleveraging for REITs, Great Buying Opportunities.

Residential real estate had a tremendous run up in value and is severely overbuilt due to the easy access to consumer credit.

Commercial real estate, unlike previous downturns, did not commit the same error of overbuilding for the most part.

However, the macroeconomic factors of a stock market crash, tightened credit market, and a lack of consumer spending negatively impact commercial real estate.

According to CoStar Group’s article This Year, Pain To Replace Gain , 2009 will see a contraction in the demand for office and retail space.

CoStar’s CEO Andrew Florance presented a 2009 State of the Office Market review and reported that as many as 1,200 properties were either delinquent or past maturity. (Past maturity loans are not necessarily a bad thing. While the loans are in technical default, many lenders are happy to accept monthly payments while the borrower seeks to refinance the loan.)

Florance has one of the most poignant quotes from anyone in the midst of the wave of bailouts.

“The market needs to establish a new bottom before a recovery can take hold,” Florance cautioned. “The sooner we reach it, the better off we’ll be. If property values need to fall to X, it’s better to get there in 18 months not five years.”

This quote is filled with wisdom. Artificially inflating real estate values through bailout money or other funds will only prolong the downward movement. A hands off approach would allow the market to reach bottom sooner. We may feel the pinch now, but a prolonged painful slide would be avoided.

The Wall Street Journal reports in Dirt Lawyer is not impressed by this massive number (sic).

An unusually high number of the underlying CMBS loans that are going bad were made and securitized in the past three years. That is a sign that investors overpaid greatly for those properties and that underwriting standards were loose. In many cases banks lent money based on future income assumptions rather than current cash flows, experts say.

Only time will tell how good/bad 2009 will be. The sooner we reach the bottom the better for all involved in commercial real estate.

Photo credit: AdobeMac

I think home prices are coming back to reality.

Despite an increasingly uncertain economy, thousands of homebuyers around San Francisco Bay kept snatching up foreclosed homes last month, dragging down the median home price by 41 percent from a year ago, a real estate tracking firm said Thursday.

The median home price in the nine-county region plunged to $375,000 in October, compared with $631,000 in the year-ago period, according to San Diego-based MDA DataQuick.

Last month’s median price was down 6.3 percent from September and nearly 44 percent from the peak median of $665,000 in the summer of 2007.

NorCal median home price plummets 41 percent – Yahoo Finance.

Imagine that little retail center near your house.You know the one.

It has your favorite coffee shop, the weird home decor shop, a woman’s clothing boutique, the nail shop, and the national auto parts store.

Over the years you’ve seen the stores change. Different shop owners have come and gone. The coffee shop has been there for a while. The woman’s clothing store is only a year old.

As you drive by you notice a “Going Out of Business” sale going on in the home decor shop. You’ve talked with the owner of the woman’s boutique and she is having a rough time making a profit.

If these two stores close their doors, you wonder who is going to fill this space. What is going to happen to the owner of that little retail center? Where will he find tenants?

The Plight of Retail Stores

Americans are spending less money these days. We built our economy upon the model of consumption and borrowed to fuel that consumption.

With the well of cheap financing depleted, spending has come to a screeching halt. Retailers nationwide are taking a hit. The recent headlines have featured the likes of Circuit City, Mervyn’s, Shoe Pavilion, and Linens ‘n Things.

The Pain on Retail Center Owners

When a retail store closes or “goes dark” the landlord will feel the pain of having a vacant store. (Some leases do have a provision that stores can close but while the tenant continues to pay rent.) This means that she does not have as much rental income to pay the bills she faces for owning the property.

How Vacancy and Rental Rates Affect Value

I shared here the most common method to value income producing property. The most important numbers to determine value are Net Operating Income (NOI) and the Capitalization (Cap) Rate.

Rental rates and the assumed vacancy rate will affect the NOI. NOI is then used to calculate the value of the property based on an expected return to the investor, the Cap Rate.

Slight Changes with Devastating Effects

So how would a 10% decrease in rents, a 5% increase in vacancy, and a 1% increase in Cap Rate affect a properties value?

Notice that the value decreases by 26%.

Also notice that the change in the maximum loan amount decreases by $1.08 million. If the borrower needs to refinance under these new assumptions, the borrower will need to come up with over a $1 million to close the loan. The foreclosure process and bankruptcy are not far away.

The Current Credit Crisis

Currently, some institutional lenders have begun to underwrite retail loans along the lines of this scenario. They are forecasting decreasing rents and higher vacancy rates.

Some lenders are incorporating a higher cap rate as well. (One developer I know said that he hasn’t started a retail project unless it underwrote at a 8% cap rate or higher because of historical cap rates, even during the boom times.)

Unless, a retail property absolutely must be refinanced now, the wise real estate investor would be best served to hold off until cooler heads prevail.

The Wall Street Journal is reporting that Calpers, the California Public Employees’ Retirement System, has lost 35% of the value in its land and residential real estate investments.

As of August 31, 2008 the fund had a total of $233.4 Billion under management. Only 10.1% of that amount is allocated to real estate assets. The fund as of June 30, 2008 had lost only 2.4% overall.

The nation’s largest public pension fund, known as Calpers, is paying dearly for its ill-fated decision to become one of the most aggressive real-estate investors among public pensions.

Amid the rapid decline in the housing market, the value of Calpers’s investments in land and housing projects across the country had fallen 35%, to about $6 billion, as of June 30, according to recent performance results released Wednesday by the California Public Employees’; Retirement System.

The losses are likely to be larger now because the values were based on appraisals completed at the end of March. Since then, land values have cratered nationwide, as evidenced by the bankruptcy-protection filing of one high-profile Calpers undertaking, the LandSource land venture in California. An investment vehicle funded by Calpers sank $970 million in that venture, which holds 15,000 acres outside Los Angeles.

Calpers Confronts Huge Housing Losses – WSJ.com.

The NY Times has an interesting article on the California town of Mountain House that sprang up during the housing boom. The first homes were sold in 2003 and according to the article 90% are underwater on their mortgages.

Read the Article

The NY Times also has a map of the locations where homes are worth less than their mortgages.

Interactive Graphic – NYTimes.com.

Paul Kedrosky has an interesting graph from John Mauldin up in the link below that highlights the difference in the GDP if you were to subtract mortgage equity withdrawals.

Paul Kedrosky: Funny Money: U.S. GDP Growth Net of Mortgage Withdrawals.

What does this mean?

Much of the growth in the US economy from 2001 t0 2006 was fueled by money borrowed from our houses.

Now that home equity has disappeared for many homeowners, discretionary spending will decrease.

Companies that depend discretionary spending (retailers) will feel the pinch by the loss of this discretionary spending money.

(HT:Tom Vanderwell

The Wall Street Journal is reporting on the plight of Vallejo, CA today. The Journal reports that Vallejo is already down 20% of its police force since January and could loose another 20% of its force by the years end.

California Cities Cut Police Budgets – WSJ.com.

This is just one of the effects that cities are experiencing due to lost revenue from development fees and property tax revenues. City councils bought into the myth that real estate would continue to go up in value indefinitely and city services would be adequately funded.

An underfunded police force will likely affect real estate values in Vallejo and other municipalities like Vallejo. If crime rises and the perception of safety decreases, real estate values in some areas of Vallejo will likely decrease as neighborhoods become less desirable.

This could be an unending downward spiral for cities as property taxes are assessed on transfer value in California due to Proposition 13. Lower real estate values would generate lower property tax revenue and the city would have to cut more costs from their budget.

This is a key reminder to real estate investors that local government issues can affect long-term real estate values.

Deals in cities with bankrupt or poorly funded city coffers should be given a higher degree of scrutiny and underwriting.

The ULI Blog offers some insights on how to survive your first down market. If you are like me, this is your first downturn in real estate since I began my professional career.

The Ground Floor: How to Survive Your First Down Cycle.