Sam Zell: 'Very Few CRE Financings from 2003-2007 Are Above Water'

Following up on the theme Zero Hedge discussed that the vast majority of commercial real estate backed loans have negative equity, real estate tycoon Sam Zell yesterday, in a presentation to the Milken Institute, said that "you have a scenario today where you have very few '03 to '07 financings that are above water. You have more debt than you have value." As owners of these properties have more debt than value, sales of properties over the next two to three years will be minimal as none of them would result in a deleveraging. Instead Sam Zell says "investors will buy distressed debt as these properties go into foreclosure."

Sam Zell's observation was in response to the disclosure by David Simon, CEO of SPG, that the REIT had attempted to purchase real estate from bankrupt rival General Growth Properties shortly before it filed for chapter 11. Per a Bloomberg article:

“They didn’t realize they were a distressed seller,” Simon said in a panel discussion at the Milken Institute Global Conference today in Beverly Hills, California. Few commercial real estate sales are being completed because sellers aren’t willing to take losses on their investments, Simon said.

This goes to the heart of the CRE problem: as no owners of negative equity properties are motivated to sell (why contribute equity to force a sale), existing properties will merely see continuing declining cash flows with no underlying property ownership exchanges, until either the loan defaults or the borrower (REIT xyz) files for bankruptcy as interest costs overwhelm cashflows. The last fact is the reason why Scott Minerd, CEO of Guggenheim partners said "Equity players have every reason to keep playing for time." That explains all the recent REIT dilution actions, who, together with any investors who "dollar cost average down" on their REIT positions, are merely hoping the U.S. government will be successful in reinflating the housing and rent bubbles yet again and property values rise above loan values, resulting in at least nominal equity value. For investors who like betting on those kinds of odds, Craps or even Black Jacks may be a better expression of risk appetite.

Comments

[Tricky:]

I can corroborate this at the regional level, where some of my family members are substantial players. Even though there is considerable money in distressed purchase funds ready to pounce, the property owners are refusing to budge and are indeed playing for time. Depending on the property, they've got <1 to 4 years of time. No guesses on when the real pain starts to become visible to the investing public.

Apr 28 10:23 AM

[Carlos Lam:]

Question: Let's assume that Sam Zell is right. Will debtholders force the REITs into bankruptcy or foreclose and push for a sheriff sale or auction? I think they would not. They know that as the quantity of CRE on the market increases, the price they'll get at sheriff sale or auction decreases. Not only are the property owners playing for time; I'd wager that the debtholders are too.

Apr 28 11:54 AM

[Tricky:]

^ it's a good point Carlos. My aforementioned family members are telling me that banks and debtholders are trying to do very quiet restructures and forebearances rather than pressing the issue. Of course it can't last forever, but it will delay the visibility of the problem somewhat.

Apr 28 12:03 PM

[CautiousInv...:]

Tyler and ZH have been all over the some of the peculiar disconnects in the related worlds of commercial lending, CRE lending and REIT's.

In general, these groups share problems of being underwater, increasing default rates and the need to rollover typically short maturity financing. The financing must be done with the former in mind and against the backdrop of tighter bank lending.

The numbers are big and ugly.

Apr 28 01:18 PM

[bricki:]

Delay also creates the possibility that an improving economy might increase cash flows and lessen the pain a little.

In any case it is going to be big ugly. Just a matter of how big and how ugly.

Apr 28 02:22 PM

[William Kab...:]

The old saying "your first loss is your least loss" isn't a new concept. Anyone, except for this generation of lenders, who has financed deals knows it is true with rare exceptions. To be that exception you better have a borrower with very, very deep pockets and not many competing obligations. The first guy out usually looks pretty smart with hindsight.

Apr 28 03:15 PM

[babajay:]

Question for everyone or anyone...... Cant the borrowers just keep issuing equity (ala KIMCO) to get out of this mess...? $100 million in equity will pay a lot of interest. The investment banks are starving for business... so secondaries or converts(at the right terms) will be welcome business for them and hedge fund clients. Doesnt this stave off the grim reaper..?

Apr 28 07:10 PM

[2houndz:]

William - your comment is absolutely correct, but in this case, nearly ALL recently leveraged properties are screwed. They could not ALL rush for the door and be the first one out.

The tragedy to me is expressed in David Simon's comment about GGP: “They didn’t realize they were a distressed seller...". Didn't even know the value of their assets. This is typical in the shopping center industry. I'm repeating myself from another post, but there has been more easy money than talent. They weren't just pissing investor's money away, they were pissing LEVERAGED money away. Instead of giving a child a handgun and telling him to go play, they were given M-16's.

For a good example of the really smart money getting out early (and with a handsome profit), see privately owned North American Properties (Ohio). Those people actually understand the shopping center development business instead of just understanding fashion merchandising and pretending to be developers.

Babajay - I suppose they can issue new equity as long as people keep buying watered-down offerings. I like Kimco, and God bless em for being able to pull it off, but I want no part of it.

Apr 28 09:41 PM

[2houndz:]

Babajay - Joe Weisenthal over at Clusterstock had this to say this morning. As usual, he expresses himself better than me, but we are in agreement:

"As Zero Hedge has been pointing out, a number of REITs have been busily trying to raise capital in order to buffer up during the mini boom happening in the stock market right now. It looks like a classic case of the smart money knowing when to sell shares to, well, the less smart money."

Apr 29 09:06 AM

[Emerald:]

Not really. Many new equity issues note that they are repaying their lines of credit, i.e. the underwriter seels the sticok that repays its own line. Hence, the debt is destroyed and no meaningful equity is created. It's a swap of interests with a dilution of the shareholder as a result. Keep your eye on the moving ball!


On Apr 28 07:10 PM babajay wrote:

> Question for everyone or anyone...... Cant the borrowers just keep
> issuing equity (ala KIMCO) to get out of this mess...? $100 million
> in equity will pay a lot of interest. The investment banks are starving
> for business... so secondaries or converts(at the right terms) will
> be welcome business for them and hedge fund clients. Doesnt this
> stave off the grim reaper..?

Apr 29 10:43 AM

[nukldrager:]

"When your outgo gets ahead of your income, your upkeep becomes your downfall" ... unknown

Apr 29 10:53 AM

[Allan Frain:]

Tyler's description of the CRE market in 2009 sounds eerily similar to the Residential RE market in 2007. Everyone is underwater and it will take very little to set off an autocatalytic unwind.

Apr 29 12:30 PM

[MLKlein:]

In the CRE world lenders and owners are moving from the denial to the fear stage. Bank lenders will have to reappraise at maturity and that is when the real panic will set in. Appraisers will, to protect their ass(et)s, take very hard looks at vacancy, absorption and concessions and will take very conservative approaches to cash flow and the resulting value. This will trigger appraisal shortfalls and loan classification. Classified assets will increase rapidly over the next twelve months and will put increased demands on already overburdened capital structures. The Banks will have to capitulate and realize the truth; many properties will require that their capital be restructured through write downs or foreclosure. The smart banks are doing this now but there are very few banks with bankers that have the experience to remember the good advise given earlier which is to get out early and move on.

Apr 29 01:33 PM

[Alok Swain:]

a) I consider it a little presumptuous that the saga that got played out in the Residential sector would also get played out in the Commercial sector.

b) There are various reasons why this may not come to pass. But I would agree if it does, then it could get quite ugly.

c) I will like to enumerate a few of those reasons why they maynot.

d) Now commercial real estate (CRE) is a business, unlike residential real estate (RRE), which was speculation! Remember there is a cap rate in CRE but in RRE there was negative equity :-)) Think about it, there is no cap rate when in came to RRE. Thats a big difference there, in CRE you get paid to hold real-estate but in RRE you pay to hold real-estate. But for some reason middle-brow, middle-class folks who buy RRE don't think of themselves as speculators but investors, but in reality, CRE folks are the only true investors. Anyways.

e) There is the thing about incentive. Remember in banking they say, if you borrow $10,000 dollars from the bank and can't pay, its your problem, but you borrow $100MM from the bank, its bank's problem. The same thing applies here. Unlike the RRE market participants who are small borrowers the CRE borrowers are big. The banks have a strong interest in negotiating. Look at all the earnings transcripts of the REITs, every one of them says we have good relations with our bankers and are negotiating. How many times have you heard about individual RRE investors talking about negotiating with their bankers and having good relations with them.

f) The case with RRE market is that there is a big secondary market. The big secondary market players such as Fannie, Freddie have absolutely distorted the RRE markets. The banks were able to turn around and sell their loans in the secondary market, unlike the CRE markets where many of the loans can't be easily offloaded as CRMBS. Many banks in CRE case hold the loans themselves. It has always been difficult to get the necessary diversification necessary to create the CRMBS in CRE, hence the banks have a strong incentive to be careful and be watchful like LTV of 70-80%, DSCR of 1.2+ etc. So the credit quality is nowhere near as bad in the CRE case as it was in RRE case where we had subprime mortgage, low-doc loans etc etc.

g) There are many other reasons that I could extend to contend that its possible CRE implosion (if it happens) maynot be as bad as RRE implosion.

h) Of course, I could be wrong :-) and may end up losing a bunch.

Disclosure: Long (PEI, AIV, BDN, CDR, GGP, RAS, IRC, HPT)

Apr 29 11:13 PM

[Westcoaster:]

Sam Zell is full of shit.

He and his company clogged the capital markets when he got out of his overvalued overbuilt office buildings. Now, he's mad he can't be a newspaper guy. He should have bought KIMCO instead. They are over there printing money. People are still buying groceries. Not all CRE is the same. Many of these loans were done at 60% LTV with a good 1.3 or greater DCR. Now why would a regional bank today with close to a trillion in TARP capital not want to lend on something like this. Yes, the capital markets are gone, and yes the terms (the price for capital) should go up but to say that all CRE is underwater is a joke. There is value and then there is cash flow, the two are very different items. Banks still like cash flow, they are benefiting today by picking up more and more business. He and his distressed sharks need to put their money into the next bubble that is coming, electricity.

Apr 30 02:41 PM