HFF, Inc. (NYSE:HF)
Q3 2008 Earnings Call
November 7, 2008 8:30 am ET
Myra Moren – Director of IR
John Pelusi – CEO
Greg Conley – CFO
Nancy Goodson – COO
Will Marks – JMP Securities
Vance Edelson – Morgan Stanley
Sloan Bohlen – Goldman Sachs
Welcome to HFF, Inc. third quarter 2008 conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session with instructions being given at that time.
I would now like to turn the call over to your host, Myra Moren, Director of Investor Relations. Please go ahead.
Thank you and welcome to HFF, Inc.’s earnings conference call to review the company’s third quarter 2008 results. Last night, we issued a press release announcing our financial results for the third quarter of 2008. This release is available on our Investor Relations Web site at www.hfflp.com. This conference call is being web cast live and is being recorded. Also available on our Web site is a related capital markets and commercial real estate presentation which you may use to follow along with our prepared remarks. A PDF version of the presentation along with the transcript of this call will be archived on our web site.
Before we start, let me let me offer the cautionary note that this call contains forward-looking statements within the meaning of the Federal Securities laws. Statements about our beliefs and expectations and statements containing the words may, could, would, should, believe, expect, anticipate, plan, estimate, target, project, intend and similar expressions constitute forward-looking statements. Forward-looking statements involve known and unknown risks, uncertainties and other factors which could cause actual results that differ materially from those contained in any forward-looking statement.
For a more detailed discussion of these risks and other factors that could cause results to differ, please refer to our third quarter 2008 earnings release dated November 6, 2008 and filed on Form 8K, and our most recent annual report on Form 10K, all of which are filed with the SEC and available at the SEC Web site at www.sec.gov.
Investors, potential investors and other readers are urged to consider these factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. Except as required by applicable law, including the Securities laws of the United States and the rules and regulations of the SEC, we are under no obligation to publicly update or revise any forward-looking statements after the date of this conference call. We may make certain statements during today's call which will refer to certain non-GAAP financial measures and we have provided reconciliations of these measures to GAAP figures in our earnings release.
With that in mind, I will introduce our senior management team. Conducting the call today will be John Pelusi, Chief Executive Officer; Greg Conley, Chief Financial Officer and Nancy Goodson, Chief Operating Officer.
I will now turn the call over to our CEO, John Pelusi.
Thank you and good morning everyone. Our third quarter and year-to-date results were clearly impacted by the continuing adverse and unprecedented conditions in the global and domestic capital markets which have seen a continuing increase in the level of write off’s and loan loss reserves by both domestic and international financial institutions as well as a global intervention by many world governments to support and prop up the financial institutions in their respective countries.
These conditions in the capital markets coupled with the continued weakening in the global economy, especially the U.S. economy at the consumer level, are now impacting parts of the U.S. economy and will likely continue well into 2009 and possibly into 2010. These conditions continue to erode the already tepid investor confidence in nearly every aspect above the fixed income, debt markets and equity markets, resulting in further negative pressures on the pre-pricing of debt and equity lists.
These conditions have caused a number of capital sources to cease or significantly curtail their investment in many of their lines of business, especially their lending and direct equity investments in the U.S. commercial real estate markets which had a significant adverse impact on the company’s production volume, revenues, net income and EBITDA for the third quarter 2008 and for the first nine months.
Despite these extremely volatile and unprecedented financial and economic conditions, we believe the company with its solid balance sheet and fully integrated capital market service platform is well positioned and fully prepared to weather through this continuing storm. We remain fully focused on our clients, our business and our excellent relationships with our capital sources as well as our people to navigate through these uncharted waters.
During today’s call we are going to focus on the following topics; Reporting third quarter and first nine months results. The second topic will be a brief assessment on the credit and liquidity issues in the capital markets and its impact on all asset classes followed by more in-depth analysis of the U.S. commercial real estate capital and real estate markets. I want to apologize in advance for the length of this presentation but we believe it is warranted since the number one question we get from both our clients and our investors alike and unfortunately the frequency of these inquiries has grown due to the unprecedented events that have recently transpired. The third topic we will focus on is the depth and experience of our senior management team and our senior professionals. All of our senior management team are transaction professionals who have been through a number of difficult times before which we believe is key in surviving and prospering even in today’s challenging environment through the aggressive management of the business. The fourth topic will be our pay for performance business model at the transaction level, management level and ownership level which we believe is a total alignment of our interests with our shareholders and will lead to future earnings growth and shareholder value whenever these unprecedented conditions pass.
Following these presentations we will then open the call to answer any questions. Before turning the call over to Greg and Nancy I would like to express our appreciation to our clients who have continued to show their confidence in our ability to perform value added services for the commercial real estate and capital needs as evidenced by the $16.5 billion in consummated transaction volume during the first nine months in these very challenging and demanding times. We would also like to thank each of our associates who have consistently demonstrated their ability to quickly adapt to a challenging environment by sharing their collective knowledge from each transaction with their fellow associates to provide superior value added service to our clients.
I would now like to turn the call over to Greg and Nancy who will report on our financial and operational results in the face of these challenging times which we believe started back in late February 2007 as we reported on each of our previous earnings calls during 2007 and 2008.
I will now ask Greg to discuss the third quarter and nine month results in more detail.
Thank you John and good morning everybody. I would like to go through our third quarter 2008 results. I want to highlight again that the financial results presented in the earnings release reflect a consolidated position and results of operations of holiday GP, HFF Partnership Holdings, the operating partnerships and HFF Inc. for all periods presented. The minority interest line item included in the financial statements relates to the ownership interests of HFF Holdings in the operating partnerships following the offering which approximates 55%. HFF Inc.’s consolidated offering results and balance sheet for all periods presented give effect to the reorganization transactions made in connection with this initial public offering.
Revenue for the third quarter 2008 was $31 million compared to $68 million in the third quarter of 2007 representing a decrease of $37 million or 54.4% from the third quarter last year. This decrease was due to the conditions briefly described earlier by John.
For the first nine months of 2008 revenue was $106.8 million as compared to $203.4 million for the first nine months of 2007. This represents a year-over-year decrease for the first nine months of $96.6 million or 47.5%. The company had an operating loss of approximately $100,000 for the third quarter of 2008 compared to operating income of $13.6 million in the comparable period in 2007 representing a decrease of $13.7 million. For the first nine months of 2008, operating income was $1.8 million as compared to $40.7 million for the first nine months of 2007 representing a year-over-year decrease of $38.9 million or 95.6%.
The decrease in the third quarter and year-to-date operating income is attributable to the decrease in production volumes and the related revenue from the prior year in a majority of the company’s capital market services platforms. Offsetting this decrease in revenue is a reduction in total operating expenses of $23.3 million in the third quarter 2008 and $57.7 million for the first nine months of 2008 as compared to the first nine months of the prior year. This reduction in operating expenses is the result of decreases in cost of services and other operating costs which are primarily due to decreases in commissions, incentive compensation and other performance based accruals.
The largest portion of our expenses is cost of services. The majority of the costs in this category are the commissions paid to transaction professionals and the salary and commission bonuses paid to analysts to support transaction professionals in executing transactions. As we have discussed numerous times in prior calls, a significant portion of this cost category is variable. There are, however, fluctuations in this category quarter-to-quarter depending on the reported revenue amounts, the timing of certain payroll and other benefit costs as well as fluctuations that occur from time to time in the fixed cost portion of this category. As such, a longer-term comparison such as a year-over-year basis of this category is the most representative measure and it evidenced in part when comparing the third quarter 2008 results to the results for the third quarter 2007.
Cost of services for the third quarter 2008 decreased $19.2 million or 48.9% from the third quarter 2007. As previously stated, this decrease is primarily attributable to the decrease in commissions and other incentive compensation directly related to the lower capital market services revenues. However, third quarter cost of services as a percentage of revenue increased from 57.6% in 2007 to 64.5% in 2008. This increase in the cost as a percentage of revenue is attributable in part to a year-over-year increase in the fixed cost component of this category which is primarily related to salaries of the production support personnel and other payroll related items. This year-over-year percentage increase was further impacted in the third quarter 2008 as a result of the increased fixed cost amounts spread over a lower revenue base than in the third quarter of 2007.
Operating, administrative and other expenses decreased $4.3 million from $14.3 million in the third quarter 2007 to $10 million in the third quarter 2008. These costs also decreased approximately $10 million from $42.9 million in the first nine months of 2007 to $33 million in the first nine months of 2008. These year-over-year decreases can be primarily attributable to a reduction in service-based accruals and other operating expenses as a result of the decrease in capital market services revenue. These decreases were partially offset by certain normal increases in other operating expenses and increased costs associated with the increase in personnel. Total headcount as of September 30, 2008 was 490 compared to 462 at September 30, 2007.
Income tax expense for the nine months ended September 30, 2008 was $4.8 million compared to $7.8 million in income tax expense for the same period in 2007. This decrease is primarily attributable to a lower pre-tax book income which was partially offset by the effective changes in the rates used to measure the deferred tax asset. The largest component of the deferred tax assets that are on our balance sheet relates to the tax basis step up resulting from the reorganization transactions completed in 2007 in connection with the company’s initial public offering.
The effective changes in the rates used to measure the deferred tax assets resulted in an increase in income tax expense of $4.6 million. This tax expense and its impact on net income were partially offset by an increase in other income of $3.9 million which is related to the corresponding decrease in the payables to HFF Holding under the tax receivable agreement. The effective changes in the rates used to measure the deferred tax assets and the corresponding effect of the related re-measurement of the payables under the tax receivable agreement resulted in an overall net decrease to net income of approximately $700,000 or an estimated $0.04 per share on a fully diluted basis.
The company’s net income reported for the third quarter 2008 was $300,000. This compares to third quarter 2007 net income of $4 million. Net income for the first nine months of 2008 was $400,000 compared to $10.4 million for the first nine months of 2007. Net income attributable to the class A common stock holders for the third quarter 2008 was $0.02 per diluted share as compared to $0.24 per diluted share for the same period 2007. Net income attributable to class A common stock holders for the first nine months of 2008 was $0.03 per diluted share as compared to $0.72 per diluted share for the same period 2007. Again, the effective changes in the rates used to measure the deferred tax assets and the corresponding effect of the related re-measure in the payable under the tax receivable agreement resulted in an overall net decrease to net income of $700,000 or an estimated $0.04 per diluted share on the first nine months of 2008.
EBITDA for the third quarter 2008 was $3.1 million which is a decrease of $13.6 million or 81.2% compared to the same period last year. EBITDA for the first nine months of 2008 was $12 million, a decrease of $35.7 million or 74.8% as compared to the first nine months of 2007. These decreases are primarily attributable to the decrease in our operating income as discussed previously.
I would now like to make some comments concerning our liquidity as well as certain balance sheet items. Our cash and short-term investment balance at September 30, 2008 was $37 million which was $7.1 million less than the balance at December 31, 2007. The company’s use of cash is typically related to the limited working capital needs during the year and payment of taxes. The company has limited capital expenditures and virtually no debt to service.
I’d like to make a couple of key points regarding our use of cash during the first nine months of 2008. The company purchased a six-month United States Treasury Bill during the second quarter 2008 for approximately $10 million. This is included in investments on the consolidated balance sheet and is identified as a purchased investment on our cash flow statement. The company had a net use of cash of $6.7 million from operating activities during the first nine months of the year. Important to point out, included in this amount is a payment to HFF Holdings under the tax receivable agreement of $5.3 million. Additionally, we made payments of certain performance and other incentive based compensation relating to 2007 performance in the first quarter of 2008. This is reflected on the balance sheet in the accrued compensation accounts payable and other current liabilities account. This account was reduced from $17.4 million as of December 31, 2007 to $11.8 million as of September 30, 2008 for a total reduction in that balance of $5.6 million.
As such, when adjusting for the payment of the 2007 performance based compensation and the payment to HFF Holdings under the tax receivable agreement, the company generated cash in the first nine months of 2008 from 2008 operating activities. As of September 30, 2008 we had no outstanding borrowings on our $40 million line of credit facility nor have we borrowed on the line of credit at any point since its inception in February 2007.
We had $103.3 million of outstanding borrowings under our warehouse credit facility to support our Freddie Mac multi-family business and we also had a corresponding asset recorded for the related mortgage notes receivable from Freddie Mac which is now under conservatorship in control of the U.S. government. The September 30, 2008 balance sheet includes a net deferred tax asset amount of $124.2 million. This balance reflects the decrease associated with the re-measurement associated with the deferred tax assets due to the change in rates as previously discussed.
Additionally, the balance sheet includes the corresponding payable to HFF Holdings under the tax receivable agreement of $108.3 million. This balance decreased by $9.1 million during the first nine months ending September 30, 2008 as a result of the $5.3 million payment to Holdings under the tax receivable agreement and the $3.8 million reduction due to the re-measurement of the deferred tax assets as previously mentioned.
The balance sheet also reflects a minority interest balance of $25.9 million which represents HFF Holdings approximate 55% ownership interest in the operating partnerships.
Now I’ll turn the call over to Nancy Goodson to discuss our production volume and loan servicing business. Nancy?
Thanks Greg. Good morning everyone. I’d like to review our production volume by platform services and our loan servicing business for the third quarter and the first nine months of 2008 and compare these results to the third quarter and first nine months of 2007. In the face of the continuing difficult and challenging conditions mentioned earlier by John, the company’s production volume for the third quarter 2008 totaled approximately $5 billion on 167 transactions compared to the third quarter 2007 production volume of approximately $11.9 billion on 301 transactions. This represents a 58.2% decrease in production volume and a decrease of 45.5% in the number of transactions.
The average transaction size for the third quarter 2008 was approximately $29.8 million or 24.7% lower than the comparable figures in the third quarter 2007 of $39.6 million. It should be noted that portions of this 58.2% decrease in production volume was due to an extraordinarily large portfolio transaction that closed during the third quarter 2007. If this large transaction was excluded our third quarter 2008 production volume would have decreased by approximately 46.6%. In addition, our adjusted average deal size for the third quarter 2007 would have been approximately $30.9 million compared to $29.8 million for the third quarter of 2008 resulting in a decrease of $1.1 million or 3.7%.
Debt placement production volume was approximately $3.2 billion in the third quarter of 2008 representing a 42.9% decrease from the third quarter 2007 volume of approximately $5.6 billion. Investment sales production volume was approximately $1.1 billion in the third quarter 2008 representing a 79.9% decrease from third quarter 2007 volume of approximately $5.5 billion. Structured finance production volume was approximately $275.8 million in the third quarter of 2008 representing a 48.7% decrease from the third quarter 2007 volume of approximately $537.2 million.
Net sales and net sale advisory production volume was approximately $374.3 million for the third quarter of 2008 representing an increase of 82.9% from the third quarter 2007 volume of approximately $204.6 million. The amount of active, private equity discretionary fund transactions at the end of the third quarter 2008 on which HFF securities has been engaged and may recognize additional future revenue is approximately $1.9 billion compared to approximately $2.2 billion at the end of the third quarter 2007 representing a 12.3% decrease. The principle balance of HFF loan servicing portfolio increased 11.9% to approximately $24.3 billion at the end of the third quarter 2008 from approximately $21.8 billion at the end of the third quarter 2007.
Production volumes for the nine months ended September 30, 2008 totaled more than $16.5 billion on 525 transactions representing a 54.6% decrease in production volume and a 46.5% decrease in the number of transactions when compared to the production volume of approximately $36.3 billion on 981 transactions for the comparable period in 2007. The average transaction size for the nine months ended September 30, 2008 was approximately $31.4 million representing a 15.1% decrease from the comparable figure of approximately $37 million for the first nine months of 2007. It should be noted a portion of this decrease in production volume was due to four large investment sales portfolio transactions which closed during the nine months which ended September 30, 2007. If these large transactions were excluded our production volume would have decreased by approximately 43%.
In addition, our average transaction size for the nine months ended September 30, 2007 would have been approximately $29.5 million compared to $31.4 million for the first nine months of 2008 resulting in an increase of $1.9 million or 6.4%.
As for headcount in the third quarter, HFF’s total employment was 490 as of September 30, 2008 which is a 6.1% net increase from the third quarter 2007 employment level of 462. However, total employment has remained essentially flat since the end of the first quarter 2008 when the company had 487 employees.
I will now turn the call back over to John for his presentation on capital markets.
As I have emphasized in the past, HFF is in the intermediary transaction business. We do not make equity investments and/or loans on commercial real estate. We do not own commercial real estate nor to we manage or lease commercial real estate. While the economy and the state of the capital markets clearly impacts our business as we have reported in this quarter and the previous two quarters, we continue to transact business in good times as well as times such as these as the only way to invest is through a trade or a transaction and the only way for an investor to get his money out of an investment is through a trade or transaction.
I’d like to refer you to the PowerPoint presentation we made available to you prior to the call. I would like to begin on page four of the presentation.
One of the hardest parts about today’s call is deciding what significant events we should touch on relative to their impact on the global capital markets and economies, especially those in the U.S. and the resulting impact on asset values. There have been so many events, any one of which would have been a significant story in its own right, and each event would have dominated the news for weeks or months.
Let me just touch on a few of the more significant issues the global economy and world governments especially here in the U.S. that we have witnessed since the collapse of Bear Stearns in the middle of March of this year. I will attempt to review some of the more major events as quickly as I can.
Please refer to slides four through nine.
Beginning on slides four and five, we will attempt to summarize the write down’s taken by the global financial institutions as well as the investments or outright ownership world governments have taken to shore up their respective financial institutions.
In March of this year 45 of the world’s biggest banks and security firms had taken $181 billion in asset write-downs and credit losses and had raised $105 billion in capital in an effort to shore up their balance sheet as reported by Bloomberg. Please refer to slide nine. As this was not enough bad news, since that time on slide four the $181 billion of losses has grown to $680 billion, a mere $500 billion in seven short months and the capital raised has grown a similar $500 billion to $611 billion.
Frankly, the totals are probably much higher as governments such as Australia, Britain, France, Germany, Spain and the U.S. have had to make investments in most of the major banking and financial institutions in their respective countries. These investments have amounted in 2-5% of the respective GDP’s as reported by Bloomberg on October 13. Please look at slide five for details.
I wish I could report that this was the end, but unfortunately this was not the end as most recently the Netherlands purchased $10 billion Euro’s of preferred ING. South Korea is guaranteeing $100 billion of bank debts and injecting $30 billion to lenders to stabilize its markets. China announced it was pumping $19 billion into the Agricultural Bank of China and Russia has stepped up to bail out Iceland who stepped in to take over its financial institutions.
The $700 billion U.S. TARP program which represents approximately 4.9% of the U.S. GDP is unprecedented. TARP, in addition to the following investments, were direct ownership in Bear Stearns for $29 billion, $200 billion each for Freddie and Fannie, $123 billion for ING, $100 billion for FHA and recently $40 billion per month for Freddie and Fannie to begin purchasing alt A and sub-prime mortgages from banks. The U.S. government’s TARP equity program of $250 billion for a direct preferred equity investment in U.S. banks I think provides some real insight as to how long the Federal Reserve and U.S. treasury anticipate it will take the credit markets to stabilize, as the interest rate goes from 5% to 9% after five years on a preferred.
Also in the 30 years I have been doing this business, I have been through a number of downturns and recessions. At no time can I remember that the Fed Fund target rate was at 1% at the start of a recession assuming one has begun as no one has called it yet and I’m not really sure what they are waiting for. This is on top of the massive injection of liquidity into the system. I know this has been an over-used statement but we are not clearly in uncharted waters in an unprecedented time.
An example of exactly what this means can be found on slide six as reported by Bloomberg. In the month of October alone we have seen the following: The S&P has tumbled 42% from its October 9, 2000 record and the Dow has lost 39% from its peak the same day. The MSCI world index of equities in 23 developed countries slipped 20% this week, the most since records began in 1970. Equities around the world tumbled this month, wiping out more than $12 trillion dollars of market value. All 48 of the developed and emerging markets as tracked by MSCI have declined in 2008 with 20 losing at least half.
Hedge funds are aggravating the worst market sell off in 50 years as they dump assets to meet investor redemptions and keep lenders at bay and the average hedge fund is down 18% this year as measured by HFRX global index. Home prices in 20 U.S. cities fell 16.6% in August from a year earlier and have dropped every month since January 2007. The Institute for Supply Management in Chicago said its business index decreased to 37.8 this month, the lowest level since the 2001 recession from 56.7 beginning in September.
The monthly drop is the biggest since the index started in 1968. The economy suffered its biggest decline since 2001 in the third quarter, ushering in what may be the worst recession in a quarter century. Consumer spending dropped at 3.1% annual pace, the first decline since 1991 and the biggest since 1980. The 6.4% rate of decline in spending on non-durable goods like clothing and food was the biggest since 1950. Unemployment is at a five-year high at 6.1% and the steep drop in the stock market so far this quarter has wiped out $2.8 trillion from investor’s portfolios.
Borrowing by U.S. consumers fell $7.9 billion in August, the biggest drop since the Federal Reserve began tracking figures in 1943. According to Moody’s the credit card industry default rates all but surpassed post-recession peaks reached in 2003. Confidence by Americans fell the most on record in single family housing starts hit a 26-year low posing an increasing threat to consumer spending that accounts for more than 2/3 of the economy.
The Reuters University of Michigan Preliminary Index of Consumer Sentiment fell to 57.5 this month from 70.3 in September. This measure averaged 85.6 last year and it is a gauge of current conditions which reflects American’s perception of the financial situation and whether it is a good time to buy big-ticket items like cars. It went to 58.9, the lowest level ever from ’75.
What about the rest of the world? Let’s go to slide eight. Ukraine, Hungary, Belarus, Pakistan are all seeking aid from the International Monetary Fund and Argentina’s markets are in turmoil after its government tried to take over the Private Pension funds. European banks lent $3.5 trillion to these economies compared to just $500 billion from the U.S. and $200 billion from Japan according to estimates. Russia has pledged more than $200 billion to stem its worst banking crisis since 1998. China is slowing after expanding more than 10% in five years. At the same time, U.K. Prime Minister Gordon Brown said the IMF is running out of cash and China and the Persian Gulf oil producing nations should pay into a new fund to help Eastern Europe. His quote was, “The IMF only has $250 billion available and this may not be enough.”
Also, the Korean Development Bank was approved by the Federal Reserve to sell as much as $830 billion of commercial paper to the U.S. central banks. Kookmin Bank, South Korea’s largest, was also deemed eligible to sell commercial paper to the Fed. Based on the above there can be no dispute that 2008 will clearly be labeled the unprecedented year of all time.
Let us look quickly at what the above means for U.S. delinquencies as measured by the Fed on slide ten. Admittedly, while backward looking, the U.S. lending delinquency chart should be much worse given that housing is about to enter its fourth year of a downturn. That is right, it started down in 2006. Just as an aside, the up tick in commercial real estate I think is misstated to the Fed category as it includes not only income producing real estate assets but also residential development including construction loans for residential development on vacant lots. Thus, the recent spike upward. We will not touch on this now but the CMBS and ACLI commercial delinquency rates shown on slides eleven and twelve bear this out.
Part of the reason this is not worse might be the Fed began to attempt to get in front of this train wreck over a year ago with a series of rate cuts and liquidity injections as shown on slide thirteen. While this partly might explain why delinquency rates are not significantly higher it does little to explain why the rate cuts in the Federal Reserve target rate from 5.25% to 1% in a little over a year as well as tremendous liquidity injections not only by the Fed but by other global central banks have not relieved the stress in the financial system.
Slides 14 through seventeen graphically demonstrate the stress in the credit markets and also show similar stress ratios when looking back at the same keyed rates back to 1998 and examining what happened in periods of stress. Please review these slides as I provide some technical commentary over the brief period of October 28 through October 31. When comparing these Bloomberg key rates to the 10/31/08 to the same on 10/28/08 the five year AAA and ten-year AAA absolute gross rates of 7.32% and 8.79% respectively are as high as they have ever been for the past eight years. The respective spreads relative to the Federal Reserve target rate is equally as wide. What is equally troubling is the spread between the Fed Reserve target rate and the one-month and three month Libor is 158 basis points and 203 basis points versus 21 basis points and 49 basis points from this period one year ago.
Recent norms in 2005 to mid 2007 period were in the 11 basis point and 25 basis point range respectively. If you look at this from six months ago, the spread between the one-month and three month Libor versus the Federal Reserve target rate was 80 and 85 basis points respectively. If you look at this from only three months ago the spread between the one month and three month Libor versus the Federal Reserve target rate was 46 and 79 basis points respectively.
Even going back just one month ago and taking into account the massive rate reductions by the Federal Reserve and the start of global rate cuts by other central banks and the massive liquidity injected into the global banking systems by the U.S. Federal Reserve and other global central banks, the spread between one month Libor and three month Libor versus the Fed Fund Reserve target rate was 193 and 205 basis points respectively which shows some progress on the one month Libor spread but little to no improvement in the three month Libor spread relative to the U.S. Federal Reserve target rate.
I quickly checked these same rates yesterday and there has been some additional improvement with the one-month and three-month Libor spreads to the Fed Fund Target rate which are down 77 and 177 basis points respectively. We have also seen the five-year and 10-year AAA banking and finance rates come in to absolute rates of 6.44% and 7.98% respectively. All good news but still a long way to go to get back to the more normal levels of credit risk.
The above, in my opinion, still have very negative implications for all asset values regardless of asset class as shown on slides eighteen and nineteen. There is still massive global de-leveraging underway at both the asset level and in the financial institutions. Unfortunately, we have a way to go. There are more losses to come and balance sheets are in need of additional equity just to keep the doors open. Hopefully if financial institutions complete the de-leveraging by mid-2010, however at the add-it level it may take until 2014. U.S. residential markets will be a problem through 2009 and possibly into mid 2010. The U.S. residential markets need to bottom out before a recovery in financials can begin.
We think that credit cards and car loans are the next shoe to drop as well. The lack of liquidity remains an issue for all types of debt regardless of asset class. The denominator effect in defined benefit plan funding on equity, pension funds and endowment means less equity for investment. With the declines in the global and domestic equity markets and if annual pension fund returns are less than 8-10% companies will have to contribute additional earnings to meet future pension fund implications. There will be a drag on earnings.
The debt and equity risk have been and continues to be re-priced, especially the debt. We are clearly in a lender friendly environment. He who has the gold makes the rules. Recession and job losses and possible deflation, the U.S. is slowing and is likely in a recession and so is the rest of the world. Prices are dropping. That said, inflation still remains a concern. Energy and commodity prices are lower but commodity prices will likely rise steadily when the global economies recover. With massive global financial intervention by world governments and the increased liquidity being injected, inflation is likely to be a key problem.
Higher taxes: In the U.S. taxes at the federal, state and local level are likely to be on the rise especially on high net worth individuals and businesses. Interest rates are headed up. When the U.S. economy recovers it is likely that the base rate indexes will be moving up. The 5-10 year treasury will likely be moving up regardless with more than $1.5 trillion in new debt that has just been added to the U.S. balance sheet how can they not go higher? We have not even yet started to deal with social security, Medicare, Medicaid and infrastructure needs. The above are all negatives for most asset valuations. Multiple compression in the near term, the next 3-5 years.
That said, cash flows are king. Assets with solid and increasing cash flow earnings will be stand out and attract investment dollars, likely at a higher cost. While it appears we are in uncharted waters, we need to keep this in perspective and there are some positives as shown on slides twenty through twenty-three.
If you thought rates were low last year the Fed Fund and Prime rate are down 350 basis points. One month and three month Libor are down approximately 250 basis points and 186 basis points respectively. The two-year treasury is down 238 basis points and the five-year is down 136 basis points. The ten-year is down nearly 48 basis points and is near a 47 year low.
Finally, there are large pools of capital ready to be deployed albeit maybe a little bit less today including Sovereign Wealth Funds. This now brings us to the U.S. commercial real estate markets.
Turning to slide twenty-five you can see that the U.S. institutional commercial real estate market is very large. $5.1 trillion with underwriting and due diligence. There are numerous on-book lenders that hold risk for their own account. There are underwriting standards. There is the buyer, due diligence. There is income. There are generally tenants with their own credit and there is always loan documentation. It is not residential. We do not do no-doc loans and sponsorship is important. The industry tries to lend money to people who will pay them back on hard assets which is an appropriate check and balances for over supply issues that have beset the residential markets but not the commercial markets. This is graphically readily apparent when you look at slides twenty-seven through twenty-nine.
The current Mercer Real Estate fundamentals are relatively healthy. Although the risk of s allowing economy or recession does have negative implications. For example, current delinquencies are near record lows as show on slides thirty and thirty-one. Despite heading into the fourth year of a downturn in the residential markets, CMBS delinquencies are at 0.6% as reported by Trepp and the delinquency rate reported by ACLI for the life industry is only 0.03%, both hardly worth reporting. That said, we believe increases are looming due to the projected maturity defaults as well as the global credit liquidity crisis we are faced with. We think defaults will primarily be on the short-term floating rate deals that were originated over the past 12-18 months, approximately $140 billion that will start to mature in the next 6-18 months and possibly on the longer term maturities that are set to expire in 2009 and 2010 as loans mature from prior long-term financings from approximately 10 years ago, if the CMBS market or some replacement debt market does not materialize relatively soon.
As show by PPR’s on slide thirty-two, recent property performance has been generally healthy with growth in rent and NOI. That said, recent issues discussed earlier in the call, PPR projects projected property performance is projected to trend down as shown on slide thirty-three. With a recession looming this may cause property level mortgage defaults depending on the length and depth of the recession.
Another plus is show on slides thirty-four and thirty-five is the projected supplies in NCIEF and the projects entering the underweight state are near 2003 levels. While PPR and construction data on slide thirty-six indicates there is an up tick we think the current credit market conditions will table most of the projected development.
Another positive development is the high reproduction and replacement costs as show on slide thirty-seven. Even with the drop in commodity prices, reproduction costs and current rents do not support new development even if credit conditions improve. Clearly a looming recession and projected job losses will create vacancy which is always a concern and projected property performance is projected to slow due to the slowing economy which will affect otherwise good fundamentals.
That said, unlike previous downturns we just don’t have the supply of new space coming on line as we have in past downturns so that we believe any decreases will likely be somewhat muted and any declines will be found with a very strong base. Riding these strong fundamentals and strong fund flows into the sector, commercial real estate has been a strong performer relative to the other asset classes as shown on slide forty-four and equity invested in this asset class has continued to grow recent years as shown on slides thirty-eight through forty.
Prior to the recent downturn in all international domestic equities which has already affected funds flowing into commercial real estate as show on slide forty-one, commercial real estate was still under allocated as reported by Kingley Associates on slide forty-two. Earlier this year several announcements by several pensions funds as show on slide forty-three would support that view.
Given recent low interest rate environments from 2004 through mid 2007 fueled by the leverage-squared phenomenon, yields on stable core assets dropped below the overall 8.5-10% returns needed by pension funds and endowments. So the money started to chase yield as evidenced by slide forty-five and forty-six. This was clearly enhanced by the leverage-squared phenomenon with both GAAP and equity risks clearly mis-priced as evidenced by the current situation faced by all asset classes in the debt markets. In my opinion, one of the biggest issues facing this sector as well as other sectors is the marked trend in downward end in debt and equity funds flows as shown on slide forty-eight. This is especially acute in the debt markets which become very evident as we view the next section of slides.
As reported by the Federal Reserve and others as shown on slides forty-seven through fifty, the debt market has expanded fairly rapidly especially from 2003 to 2007. The largest holders of commercial real estate debt are depository institutions followed by the purchases of CMBS paper and then the whole loan portfolio lenders such as life insurance companies and pension funds. The massive de-leverage is causing significant net outflows in the debt markets shown on slides fifty-one and fifty-two based on data from the Federal Reserve, the MBA and commercial mortgage alert albeit from very high levels from a historical standpoint.
In retrospect, the funds flowed into this sector from 2003 to 2007 were unsustainable from a historical standpoint especially in the CMBS and agency markets which were fueled by the leverage squared phenomenon as well as the massive public and private deals that were done from 2004 to 2007. This has been especially acute in the CMBS markets as shown on slide fifty-three. We do not believe the CMBS market has to give back $200 billion as it was in 2006 and 2007 as we think much of this was driven in large part by the public/private phenomenon. In retrospect, this market should not have been at $230 billion in 2007, $203 billion in 2006 or even $169 billion in 2005. This market is virtually nonexistent today but from 1997 through 2002 CMBS issuance ranged from $37 to $74 billion. We do not believe the CMBS market has to get back the $200 billion as it was in 2006 and 2007 as we think much of this was driven in large part by the public and private phenomenon. There appears to be a $50-75 billion shortfall CMBS does not come back in order to provide the necessary liquidity to support a normal market on a go forward basis or some other form of debt capital needs to be created to step into this void.
Given the current situation of the global capital markets we do not see CMBS coming back in any meaningful way in 2009 and the market quickly needs to uncover a way to fund the level of debt. As shown on slide fifty-four the life company commitments grew from 2003 to 2007 as well. However, their rating growth while higher than normal was substantially below the growth of the CMBS markets. Life company flows in 2000 were $20 billion to $33 billion range from 1997 to 2003, but 2003 was the only year above $30 billion. From 1997 to 2002 flows were only $20-27 billion.
Additionally, the life industry has not been immune to the global credit and liquidity issues as reported by Bloomberg. The largest insurers in the U.S. and Bermuda posted more than $93 billion in write down’s and unrealized losses on holdings tied to the collapse of the U.S. sub-prime market since the beginning of 2007. Recently there has been talk that the insurance industry is going to petition Congress and the Treasury for access to TARP funds. Given the current global, credit and liquidity issues it is likely the life insurance industry will return to the $20-30 billion level and will only want to do business with the best borrowers on the best properties.
As shown on slide fifty-five, Freddie and Fannie remain active lenders but they are now under conservatorship. The agencies can quickly continue to provide the needed liquidity to the multi-family markets, but again they cannot fill the void left by the CMBS market. There are some questions regarding the long-term prospects for the agencies as the agencies are required to reduce their portfolios by 10% beginning in 2010 and it is not clear what the long-term funding future holds for agencies relative to multi-family. That said, for the foreseeable future we expect agencies to have a run rate in the $55-60 billion range as it is unlikely there will be much public to private activity or private to public activity until the credit crisis is resolved.
As discussed in our previous calls and as clearly illustrated on slides fifty-six and fifty-seven, the period from 2004 through the first quarter 2007 saw dramatic increases in fund flows, increasing leverage that when coupled with a healthy economy, strong property performance and limited supply created the perfect storm for steadily increasing valuations for commercial real estate and for frankly most all asset valuations. These conditions drove sales volumes and CMBS volumes until mid 2007. This brings us back to the very same issues we discussed on slide eighteen when we discussed the global capital markets.
Commercial real estate, despite its strong fundamentals, is faced with the same issues. If it sounds familiar it is. The [inaudible] debt to this sector have been dramatic as shown by slides fifty-nine through sixty-six. As shown on slide fifty-nine, based on a recent Federal Reserve survey lenders have become very wary. Given the current credit and liquidity issues lenders do not have the capacity to lend as they did in the previous five years yet borrowers are still seeking funds to support current developments that are in the pipeline as well as to refinance existing short and long-term debt. When supply and demand get way out of balance coupled with significant credit and economic issues, spreads go up dramatically as shown on slide sixty which is from the same Fed Fund survey mentioned above.
Slides sixty-one through sixty-six really point out the significant stress in the commercial real estate debt markets and the impact of the massive de-leveraging at the asset level as well as at the financial institutions. The impact of financials no longer being able to utilize leverage squared is being dramatically felt by borrowers big and small alike. The data from slides sixty-one and sixty-two show what happens when credit concerns, de-leveraging effects income investors are all merged. It is not pretty if you are a borrower who needs to refinance a loan in 2008 and will likely be the same in 2009.
Slide sixty-three based on data from Citi shows the time it took for the CMBS market to recover from past crises in 1998, which was long-term credit capital and in 2000 which was 9/11. Disruptions in the two most recent downturns last only three to six months and while spreads spiked they were nowhere near the levels we are seeing today. We are well over a year without any significant issuance and at this point we do not see the CMBS market returning any time soon in 2009 unless there is a dramatic turnaround.
Additionally, if it does come back, Bear Stearns, Lehman, Merrill Lynch, Wachovia and Wamu no longer exist and Goldman and Morgan Stanley have had to significantly de-leverage their respective balance sheets so there will be significantly less competition when the markets return.
As we have shown on slide sixty-four through sixty-six, portfolio and other lenders have picked up some of the slack but have done so on their own terms. Though not near enough to make up the deficit from the nonexistent CMBS market. In all cases, lenders who are making loans are doing so on vastly different terms and conditions than they were in 2006 and 2007. Again, giving new meaning to the phrase, “He who has the gold makes the rules.”
Shown on slide sixty-five, many lenders are saying why make a new loan when you can get such high yields on AAA CMBS paper. These portfolio lenders have to justify making whole loans on a relative value basis which is difficult to do when you can buy AAA paper at higher spreads. However, many lenders will not touch the nearly $500 billion of vintage loans made between 2005 and 2007 and the recent write down’s on securitized paper has questioned the wisdom of these past investments as evidenced by the more than $93 billion in write down’s taken by some of the largest insurers in the U.S.
The new rules are that spreads are dramatically wider. Loan valuations are dramatically lower. Interest only loans that once littered the landscape are a thing of the past. 25-30 year amortization schedules are back in vogue and cash outs are a thing of the past and recourse has become more prevalent.
As show on slide sixty-nine, when combined the all-in cost of debt capital, the constant of a loan to value of 50-65%, now ranges from 7.8% to 8.5% depending on the asset, sponsorship, market and specifics of the property as well as its size. The real question will be when things return to equilibrium. Remember the old adage, be careful what you ask for. You may get it.
When we went back and looked at our famous 47-year history of the 10-year Treasury as shown on slide sixty-seven you will note that the 47-year average for the 10-year Treasury is 6.9% based on the data available from the department of Treasury. The data in the box at the left gives some perspective on where these yields have been over the past 50 years. If you throw out the highs and lows the data would suggest the majority of the time the 10-year risk free treasury ranged from 6.5-7.5% for a significant portion of the time.
As for private commercial mortgage spreads, the data from Gilberto Levy is on slide sixty-eight. It only covers the period from 1988 through 2008. This data is interesting as it shows the average spread was 185 basis points from the period 1990 to 2000 and was 169 basis points from 1998 through the second quarter of 2008. While this data is not perfect, it is all that is available other than our own personal recollection from being in the business for 30+ years.
Going back to slide sixty-nine if you take the average 10-year treasury and combine it with the average spreads it will produce an all-in coupon of 8.5-8.75% and loan constants of 9.3% to 9.9% utilizing 25-30 year amortizations. Clearly the loan to value will likely be in the 70-75% range to fairly match up with comparison which will provide 20-25% more leverage today albeit at a higher all-in rate. While this data is not perfect it is all that is available. The impact of this question that we should not have asked is it will have a negative impact on values if debt costs go up. Cap rates usually follow and debt usually makes up 65-75% of the capital stack in normal times. Today while cap rates are up on a historical basis, they are still attractive as shown on slide seventy based on NCRIEF and PPR.
If the previous described analysis has any merit it would appear that cap rates are headed even higher. Based on PPR’s projections, see slide seventy-one and seventy-two, they are projecting cap rates to increase in the near-term to 12 which would indicate values will fall further unless cash flows can be increased to match the expected increase in cap rate which is not likely with a looming recession which would frankly imply even lower cash flows with the stress in the economy.
We elected to take PPR’s historical data and look at cap rates for office, retail, multi-family and industrial for 1984 through the third quarter 2008. As shown on slides seventy-three to seventy-six there are some very interesting historical data points that owners and potential investors should consider especially since many are asking the $64,000 question, “I’m not sure what this is worth today. How are you determining value?” Remember the old adage, be careful what you ask for you may get it.
The average median cap rate for these property types is as follows for the period from 1984 through the third quarter 2008. Office average cap rate was 7.8%. Retail was 7.9%. Multi-family was 6.8%. Industrial was 7.6%. If you eliminate the period from 2005 through the third quarter 2008 the leverage squared period numbers are as follows: Office 8%, retail 8%, multi-family 7% and industrial was 7.8%.
If you only look at the data from the period from 2005 through the third quarter of 2008, the leverage squared period, the numbers are as follows: Office 6.8%, retail 6.6%, multi-family 5.4% and industrial 6.6%. I know a number of owners that would do deals at the above cap rates in a New York minute. Do you believe leverage squared caused cap rate compression or did it come from the growth in NOS during this period or was it a combination of both? My guess is history will call it the leverage squared cap rate compression era.
The above is somewhat like the recent elections we just had. Regardless of whether your candidate won or lost we are still faced with the current conditions we discussed at the beginning of the presentation. We are in uncharted waters and faced with unprecedented conditions in the capital markets coupled with a looming recession. What does it mean for commercial real estate? See slide seventy-seven.
Commercial real estate fundamentals are as strong as they have been in the past 25 years. Maturity faults and an economic slow down or recession will impact fundamentals but we think any decline will be from a position of strength. We expect improving the debt markets however new CMBS originations may not start to really recover until mid 2009 and the way we are going it could be mid 2010. The global domestic credit markets for all asset classes will be the determining factor as well as the improvement in the U.S. residential markets.
This could be a serious issue if CMBS market or a replacement market does not materialize. Today size, structure, leverage and sponsorship matter. There has been a re-pricing of risk, all in coupons while still attractive on a historical basis appear to be headed higher. The re-pricing of equity risk remains attractive on a historical relative basis but as we just went through cap rates appear to be heading higher. There is still plenty of raised equity looking for a home, although with the recent downturn in all the equity markets it may be a little less. Values will be driven in the future by solid and growing cash flows. Cap rate compression is history. It is a hard asset and strong fundamentals we believe attractive relative value play versus other alternatives especially in this environment.
In the short run the impact to commercial real estate transaction market has been significant and has lasted longer than any previous downturn I have been involved with. I believe this really started in the second quarter of 2007 and is lasting much longer than anyone predicted when they said we were in the eighth inning at the end of the third quarter in 2007.
Slides seventy-eight through eighty-one really highlight the dramatic and stunning impact of the transaction market. As show on slide seventy-eight, and has been previous stated, 2008 CMBS issuance supply through September 30, 2008 totaled $12.1 billion. Unchanged since June 30, 2008 and down 94% from the $197 billion during the same period in 2007. It is virtually nonexistent. According to commercial real estate direct property sale database report on the U.S. Office Industrial Retail Apartment markets through September 30, 2008 sales are down 75% year-over-year and cap rates are up almost across the board. It is also interesting to note that sales volumes from 2001 through 2003 ranged from $83 billion to $122 billion in the nonpublic and private market era and is still very healthy but it is significantly below the heyday period or should we say the leverage-squared period from 2004 to 2007.
Which brings us full circle back to the same positions we discussed at the beginning when we talked about the global capital markets. While it appears we are in uncharted waters we do need to keep this in perspective and there are some positives as were shown on slides twenty through twenty-three. I’m not going to repeat this as you can look back on those slides although I will mention another positive which is the U.S. is ranked as the country providing the most skilled and secure real estate investment climate by [AFIRE] in its 2007 year-end study. While all of the above is interesting we think it is important to remind everyone that HFF is in the transition business and not in the principle business as previously discussed. Please refer to slides eighty through eighty-four through eighty-six.
Remember that in the face of the most difficult capital markets we have seen in over 25 years we have in fact consummated more than $16 billion worth of equity transactions in the first nine months of 2008.
As we have stated in the past, slide eighty-four is probably the most important slide in our presentation. It is our mission and vision statement. Covering less than a page this important message clearly articulates our approach to clients, our vision for the business and the high value we place on our people and exemplifies our pay for performance philosophy and clearly articulates why our interests are aligned with shareholders.
From a competitive standpoint we believe on an overall percentage basis we are a small part of the U.S. capital markets, maybe 5-6% market share, and continue to have plenty of outside opportunity to increase this market share regardless of current market conditions. That said, from an institutional standpoint we believe we are clearly one of a select handful of commercial real estate intermediaries in the U.S. Our integrated capital market service platform puts us in a unique position as an independent, objective advisor to provide value add to our clients particularly in volatile capital market environments such as we are in now and we have demonstrated in the periods covering 1998 through 1999 and 2001 through 2002.
We think it is also important to keep the following in mind when you look at our business and our people. Please look at slides eighty-five and eighty-six. We have significant depth and experience within our transaction professional and senior management ranks which we believe is key in today’s challenging environment. The top 25 transaction professionals by initial leads have average tenure with HFF and its predecessors of 13.4 years. In 2008 56% of the initial leads by revenues were generated by owner transaction professionals. It is also noteworthy that 24% of our transaction professionals are also owners.
All of our transaction professionals for the most part do not make money unless they are consummating transactions. We also believe our pay for performance business model better aligns us with our shareholders. It is important to note that nearly 80% of our managers are owners and only three of our most senior managers are not transaction professionals; Greg Conley, our CFO; Nancy Goodson, our COO and David [Crossberry] who runs our servicing platform. But all three have some form of ownership in the company and therefore they too have a vested interest in the performance of the firm.
We call it our managers for the most part our transaction professionals and make the majority of their compensation as transaction professionals. They also participate in our profit participation pool provided they hit a 14.5% profit margin they get 15% of the net for their office or line of business which we believe properly aligns them with ownership even if they are not currently owners. Recall there are more than 40 transaction professionals who also own approximately 55% of the market value of the firm and are on equal footing with our shareholders in all investments and profits and losses resulting there from.
This group has a fiduciary responsibility to our outside shareholders and currently invest $0.55 of every $1.00 to strategic investments we are making which we believe will lead to future earnings growth and shareholder value and the issues and concerns facing the current capital markets and current economic conditions in the U.S. and other parts of the world from the unprecedented hits they have taken. We believe the above correctly aligns our interests with those of our shareholders and we do not believe there are many other public companies that are so structured and aligned.
While these are certainly trying times in terms of attempting to strategically navigate through them, one thing I am confident of; these times will pass and those companies that remain focused on their business plans who continue to retain and hire the best people will be uniquely positioned to take advantage of the many opportunities that will present themselves during this period of uncertainty as well as the numerous opportunities that will abound when these markets recover. I believe that HFF is uniquely positioned to take advantage of the present opportunities as well as those that will present themselves in the future.
We have a strong balance sheet and have been able to maintain it during the first three quarters of 2008. Our fully integrated, diverse capital markets platform allows us to compete in the debt and structured finance markets, the performing and distressed debt markets, the private equity and investment sales market as well as performing the necessary loan monitoring functions carried out by our servicing group for our lenders that we originate loans for.
Our paper performance structure constant evaluation of our people have allowed us to retain one of the most experienced and longest tenured senior transaction professionals in the business. This talented group of professionals have lived through several periods of tough times before and the fact that current ownership management owns approximately 55% of the enterprise value provides a unique and solid foundation that we believe will allow us to provide superior value added results for our clients in these difficult times and create additional opportunities to build additional market share.
As one of my partners is fond of saying, “Tough times never last but tough people do.” I think HFF is long on tough people who are up for whatever the challenges may be.
Operator, I’d now like to turn this call over to you for questions.
(Operator Instructions) The first question comes from Will Marks – JMP Securities.
Will Marks – JMP Securities
Really simply, you gave a great overview of the economy and real estate conditions. I’m wondering if your business, what could make your business worse than it is right now? It seems like everything that can go wrong has gone wrong except you have a good structured business but in terms of ability to do deals could credit markets tighten further?
I’d like to say I don’t know how they can get worse but I probably would have said the same thing the first quarter 2008 and it just seems like there has been one shoe after another. My own personal opinion is with all the liquidity that has been dumped into this market by the global financial institutions and the steps I think people might be taking in the short-term which might include even making direct side-by-side investments with private groups to create debt funds, I am hopeful that we are going to see a bottom of this some time in 2009 and start to recover. I think your guess relative to those things is probably no better or no worse than mine are.
Will Marks – JMP Securities
Your first few quarters, I think if I recall there was a tough comp particularly in the third quarter. It seems the first three quarters revenues were down almost an equal amount. I know you don’t give guidance but in the fourth quarter I know the environment has gotten tougher but the ability to close transactions or do your type of business has that changed in the fourth quarter and is fourth quarter 2007 an easier comp than third quarter 2007 was?
As you said we don’t give guidance. What I would tell you is it is becoming ever increasingly difficult to get deals done. We are still getting them done. We do issue press releases. That is probably the best form of guidance an investor can pick up from us. That said those only come out on $50 million or above…I’d have to check with Myra. We do issue local press releases as has been our custom in the past. It is just exceedingly difficult. We are going out to more and more capital sources on every deal and a lot of deals now are clubbing people together. We are going to the local and regional banks that do have money. I had a closing dinner last night and I can state this because the client released it but we did a $40 million loan on a regional mall in Morgantown, West Virginia and we were able to piece together 5-6 community banks, the smallest of which was $3 million and the largest of which was $17 million and get that deal done for [Glumsher] Realty Trust who has been a long-term client both pre-public market days and post-public market days. They have engaged us to do additional transactions for them because all of their line lenders are basically full up on not only [Glumsher] credit but also just commercial real estate credit in general, the largest bank of which just raised $115 million out of equity. They are a rising star in the markets. They went on a road show and in less than two days raised $115 million which translates to more than $1 billion in lending capacity and they love the asset class. They are able to do deals they have never been able to do before. So I think the bottom line is there are still people out there doing it. You just have to work harder and look harder to find it.
Will Marks – JMP Securities
I know there was carry over business that closed in the fourth quarter 2007 but is that an easier comp than the third quarter?
I think the best comps are going to be as we move into the first quarter 2009, the second quarter of 2009, the third quarter of 2009. If you recall, we went public at the end of January so all of our numbers are kind of somewhat distorted from that holdover period which we were reporting as a private company as opposed to a public company. I also think the credit conditions while I think they started back in February/March of 2007 I think most people would say it probably didn’t really start until August or September.
I think a better analysis and a better comparison would be first quarter 2009 against first quarter 2008 and go forward. We also had a lot of what I would call [boxstone] portfolio transactions in our numbers in 2007 where we traded out or sold for them a bunch of assets in Chicago, Austin, D.C. and other markets.
Will Marks – JMP Securities
Traditionally has the fourth quarter been your best quarter in terms of cash flow? You have done a great job this year of preserving your cash in this tough environment. Obviously without giving guidance I’m just curious what trends have been in tough environments.
In historical environments where you don’t have world governments basically owning financial institutions, the first quarter has always been our best quarter both in terms of revenues and cash.
The next question comes from Vance Edelson – Morgan Stanley.
Vance Edelson – Morgan Stanley
If you could just comment on regional differences. You have mentioned in the past certain areas such as Texas, Seattle are strong. Now that we are three months further in can you provide any additional color there?
We continue to believe that Texas is still very strong relative to other parts of the economy and if you pick out regional reports cities like Dallas, Houston and Austin are doing very well. Seattle continues to do well but I think the Boeing strike will have some short-term impact but I think that strike has largely been settled. There are pockets in the U.S. that are doing well. Again, from the stuff I read I still haven’t seen anyone say we are officially in a recession so I don’t know how better to answer that question.
Vance Edelson – Morgan Stanley
With your employment level flat this year despite the worsening macro backdrop for activity level and so forth is there any chance it starts to pale off through attrition and so forth which would help you keep costs down beyond the lower commissions?
I think our business because we are a pay for performance pay structure has a tendency to if people aren’t doing well they aren’t going to make money so people will probably leave the business. I think the other side of that question is probably the most appropriate and that is we are still aggressively looking for key people in all of our lines of business in all of our markets. In today’s environment people are also looking at the platforms they are in. We think our platform is second to no one. We think we offer the best capital market solutions to our clients and we think the capital sources we represent are also second to none. We are being pinged on. I would say the activity has significantly increased over the last couple of quarters and as you noted we have a lot of money on the balance sheet. That money was targeted and we have reaffirmed those things with our board to go out and do selective, strategic investments in people. That is both in our own existing people that we grow organically and that is from people from other competitors who are calling us about potentially joining us.
Vance Edelson – Morgan Stanley
Any reason to think the smaller deals that have seen the fast drop off, you mentioned the press releases that you do for the larger transactions, they would seem to paint a relatively healthy picture but the all-in volume numbers for the quarter show a more significant slow down. Is there any difference between large and small transactions you are seeing?
The larger transactions are more difficult to get done simply because no one wants to do a $200 million equity deal or a $200 million loan today. So if you are doing those bigger loans you have to find participants to get those done. Right now, the biggest issue I hear repeatedly on the equity side and there is a lot of money out there relative to people that have money to invest, they just don’t know what values are. All of a sudden people woke up and became stupid and don’t know how to value or price things. I’m not saying I know any better than they do but this business has been ongoing for 100 years. I’ve been in it for 30 years. I’ve never seen a period where you sit down with capital and they say I just don’t know how to price something. Okay, well would you do this deal for a 10% cap rate? I don’t know. Would you do it for 12%? I don’t know. How about 15%? Well yeah maybe you are talking now. So we are somewhere between 12-15%. Would you do the deal and they sit there and go, “Geez, I just don’t know. I don’t want to get a mark to market.”
Because with all this new accounting and FASB regulations people that do deals whether they are debt or equity depending on how they hold them are mark to market every quarter. So if you are sitting here and you have money to invest and you have to report back to either shareholders or investors that are in a fund, who wants to buy something today and 30 days later have to mark it down? I think that and the lack of liquidity in the debt markets, despite the fact the Fed has created this TARP program and they have put $250 billion of preferred equity up to the banks, the banks aren’t lending that money. The banks are using that money because they were under-capitalized to begin with. On one side you have this new TARP investment come in but on the other side you have the OCC regulators and other regulators that are sitting there saying you have poor loan quality, you shouldn’t be doing this loan or that loan and if you can go…PNC Banks acquisition that was just announced of National City they are picking up $95 billion of deposits. They got TARP money I believe like $8 billion. They are also going to get I think about $5 billion of tax incentives for doing the deal and while the $5 billion acquisition for $95 billion in deposits also comes with a $20-25 billion probable hit they are going to take on the Nat City residential portfolio it is still a pretty good trade because at $5 billion plus the $20-25 billion call that a $30 billion investment they are picking up $95 billion and they got $8 billion from the Federal Government and they are going to get $5 billion in tax credits. That is a really good deal.
The problem is when you sit down and look at the combined balance sheet and look at commercial real estate as a percent of total assets it is about 20%. So the regulator is sitting there saying you really shouldn’t be doing any more real estate loans. You just sit here and wonder, and again I think Treasury and the Fed are doing as good a job as they can but I really think what needs to happen here is that somebody has got to start creating some debt funds to actually start doing deals and make a market. No matter how ugly that market is once it is made then others see it and say well somebody just did a 10% interest rate loan. I would have done that for 9%. So the next deal that comes out kind of greases the skids. I was just at a meeting in New York where the Under Secretary of the Treasury was there meeting with a group of industry professionals and that was the kind of thing we were telling them. All this money that you folks have dumped into the system is not getting out to the street to the level it should be or to the level the economy needs.
The next question comes from Sloan Bohlen – Goldman Sachs.
Sloan Bohlen – Goldman Sachs
Along the same lines, how are your clients or you best positioning yourself given what is going on with TARP and how that may play out when the market comes back? No one knows what price…how are you best positioning yourself?
Frankly we are in major discussions with all of our clients and I would tell you I don’t think since I’ve been with this firm since 1998 I don’t think we have been better positioned than we are right now today relative to our clients. Because we are still getting deals done. There is a lot of people that aren’t getting deals done. We think we have a pretty good handle on what can and can’t get done. We are very clear and very black and white and very frank with our clients. We say, here is where we think the market is today this afternoon and if it is 1:00 we say the market might be changed by 4:00 but here is where it is at 1:00 and here is where we think people will underwrite things. Here is how we think we can structure around this. We have done some very, very complicated and innovative kinds of deals because we have great relationships with people. People are always willing to listen to what we have to say and we can structure around whatever the issue is or if we can figure out a way to financial engineer something so the deal works then people will trade. I think more and more people are looking at this thing and believing that it is unlikely the debt markets are going to improve substantially in 2009. They may get better but if they do get better interest rates are probably going up. So the net effect of spreads coming in and interest rates going up is the same absolute coupon and if you think the economy is going to get worse in 2009 or 2010 with the recession if you are thinking you are going to do the debt deal or you are going to sell something between now and 2010 or 2011 you are probably better off trying to execute that trade today than wait.
I think a lot of people are starting to look at that and say I probably come around to that conclusion and on top of that if you owned this asset since the early 1990’s or early 2000’s you are still going to make money and it is redeploying that money in a very attractive environment. Some of the deals that I am seeing getting executed at debt levels and structure with principles involved are unlike anything I’ve seen in the 30 years I’ve been in the business. Some of the deals that are trading they are unlike anything I have seen in my 30 years in the business. So if you have money today I think it is an unbelievable opportunity to be a lender. I think it is an unbelievable opportunity to be a buyer and while that doesn’t mean it is great to be a borrower or a seller depending on what your basis in the property and how long you have owned it pricing is still attractive relative to historical levels.
If you go back and look at those PPR charts I think it is very telling.
Sloan Bohlen – Goldman Sachs
Along those lines can you comment on the investment you made in the treasuries and how that investment will maybe stack up against buying your own stock or how your value is relative to your views on a correction in the credit market going forward?
I think the reason we bought the Treasury had nothing to do with other than prudent cash flow and financial management. That was when Bear Stearns, Freddie, Fannie, Lehman…everywhere you turned you had major financial institutions that had been around for hundreds of years blowing up left and right. We through Greg’s efforts thought that was the best thing to do with that money on a short-term basis. As we have continually said we need probably $20-25 million just to support the enterprise we have. The additional cash that we said at the beginning of the year we were going to invest strategically to grow the company that is what it is for. We think that is probably the best use of that cash. We routinely sit down with our board and discuss that. I think they are of a like mind with us and remember we own 55% of this. So if we were going to buy back stock it would benefit us the same as an outside shareholder and we as 55% owners think the best use of that cash is to strategically grow the business and in today’s environment right now cash is king. We want to not horde cash but we are going to invest strategically but we are also…we don’t think buying stock back and the studies we have seen from Goldman and Morgan Stanley who we have had look at this an analyze it would lead you to believe that is a short-term, 30 day kind of moment and if you look out a year after it happens there has really been no material movement in the stock price related to the buy back of that stock.
I would now like to turn the call back over to management for closing remarks.
Again, we appreciate your time and we apologize for the length of this call but given the issues in the capital markets we felt it was the best way to handle it. If anyone has any questions as always, Greg, myself, Nancy are available to answer any calls and we thank you for your time today.
That concludes today’s conference call. You may now disconnect.
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