MLKlein

Commercial Real Estate: Evidence that It's Ready to Come Crashing Down

The longer banks are allowed to "extend and pretend" the longer it will take for there to be price discovery. Banks count on a single appraisal to establish a property's value. These appraisals are currently supported more by opinion than fact and are often flawed by overly optimistic or pessimistic assumptions that are compromised by the shear lack of credible market transactions. Thus for now, we are living in a fairy tale where banks hope that by holding on, values will rebound to bubble levels that were supported by high leverage interest only debt structures that no longer exist in the market.

The basic change of requiring loan amortization and 20% less debt in the capital stack substantially reduces cash flow available to equity and has the predictable effect of substantially decreasing value. The reset in the perception of risk and strained Net Operating Income exacerbates the decline in value.

As a result, almost any loan made at 80% of the capital stack in the late part of the boom is surely 20% underwater today and likely will not service debt if amortization were required.

This will take a long time to workout, especially if "extend and pretend" persists.

Property Values Set to Fall from Bubble Peak to Long-Run Average

I would suggest taking a look at the cost of ownership in relation to incomes over the extended time frame as well as availability of and cost of mortgages. As we witnessed in the bubble years, cheap and easy money resulted in accelerating prices to the point where very few people could actually afford, by conventional measurements, a home.

The chart shows that post WWII the value of homes was higher than prior to the war (ex depression). I believe that this is a result of having a deep market of good (and rational) financing options available to homeowners. So as a suggestion, I would overlay a graph depicting mortgage payment as a percentage of median income. For the payment calculation it would seem to make sense to use a 30 year fixed rate loan at the best available rate in the period. This may give additional clarity on the valuation process as most home buyers and underwriters relate their purchase and loan decision to the amount of monthly payment in relation to income (assuming we are not in a bubble).

Good luck. Thanks for the analysis.

Three Sides to the Housing Story

More to think about. In the Los Angeles and Ventura County markets only about one in five foreclosures are going to auction. That means about 800 of the 1000 or so homes that go to auction each day are finding their way back to an investor's balance sheet or remains in some form of protracted work out. That translates into a fair amount of non-earning or impaired assets.

On the commercial real estate side, values are down about 40% from peak. Some product types and markets are somewhat worse and some are somewhat less impacted. But 40% is quite a Tsunami to overcome. So far banks in our markets, unless forced by their regulators, have not recognized this loss (A loan originated at 75% LTV would have a 20% loss if 40% of the value is deducted). More impaired assets.

It is my belief that until the banks realize their losses and move them off their balance sheets (which will result in a probable loss of 20% or more of the banks), a true recovery is unlikely because lending capacity will remain impaired because human and capital resources will be fully absorbed fighting the lost battle of working against the massive Tsunami of deleveraging.

Commercial Property Woes Reveal Bank Insolvency

Commercial real estate valuations are a function of Net Operating Income and Cap Rates. In Southern California, most commercial properties are under attack on both fronts. Net Operating Income has fallen as tenants down size or renegotiate rental rates to reflect current and anticipated levels of business activity and Cap Rates are adjusting to reflect the pull back in available debt capital. The combination of the movements in these two components of valuation have caused many buildings to have values of half of peak values achieved in 2006-2007.

Loans made on commercial properties during the 2006-2007 heyday are in tatters. While defaults may not yet be apparent as reported, Net Operating Incomes have not yet fully reflected the impacts of renegotiated lease rates and increased space availability. Property owners have been feeding losses and banks have not yet had an interruption in payments which would trigger a default and reappraisal. Eventually, either because of a payment default or a maturity default (most commercial bank loans do not exceed five years) a reappraisal will become necessary and loans will have to be marked to reflect the appraisal which given the above will undoubtedly be lower than the carry value of the loan.

Here are the numbers:

Original Property Value: $1,000,000
Original Loan: $800,000
Max LTV: 80%
Original Net Operating Income: $60,000
Original Cap Rate: 6.0%

Today's Net Operating Income: $48,000
Today's Cap Rate: 8.0%
Max LTV 65%
Valuation @ 8.0% cap and Current NOI: $600,000
Max Loan based on LTV: $390,000
Loan Shortfall based on 100% of value: $200,000 or 25%
Loan Shortfall base on refinance: $410,000 or 51%

Given the above, I am quite concerned that bank reserves hardly reflect the magnitude of the situation.

U.S. Commercial Real Estate 'Showing Signs of Capitulation'

Before this correction is over, it is quite possible that values will fall below the initial level shown in the graph. The following factors contribute to this conclusion:
* More equity is required in every transaction driving up the WAC to levels not seen since the late 1990's.
* Debt is very difficult to obtain.
* Rents are under pressure and virtually every landlord I know is in discussions to modify lease payments downward.
* Concessions are on the rise.
* Vacancy is on the rise.
* Investors have no appetite for negative leverage (WAC exceeding initial CAP rates).

These factors led our team to estimate a 46% drop from peak or an index value of approximately 90.

The Countrywide Charges: Yes, They Could Have Kept Housing from Imploding, But They Weren't the Only Ones

Although it would take an army of auditors to enforce, how about prosecuting defaulting borrowers that lied on their loan application. While this is not an argument to let the loan originators off the hook - they should be held accountable to the full extent of the law - lying on your loan application is bank fraud. Our politicians talk of borrowers as victims, and there definitely are some or many, but not addressing the fraudulent acts of all the conspirators in this mess addresses only half of the problem and is a huge ethical lapse. I have no sympathy for someone that knowingly misstated their income or any other material fact on their loan application and is now losing "their" house (the excuse that the broker filled out the application and I only signed it is awfully weak too).

Who Do You Believe: The FDIC or Hard Facts?

Here is a real story of how the FDIC is looking after your tax dollars. I have now seen two cases where real estate developers had loans with a bank that the FDIC seized. In both cases, the developers were in direct negotiations with the FDIC to purchase their notes back for 70 cents on the dollar. Neither were able to close a deal with the FDIC. Instead the FDIC sold the entire portfolio to investors. Now the developers are buying their notes back for 50 cents on the dollar from the entities that bought the portfolios. Rumor is that the FDIC sold the portfolios for 23 cents on the dollar. The remaining funds that the FDIC has will not last very long making deals like the above.

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

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.

Commercial Real Estate: The Reality Is Not as Bad as It Looks

We recently did our own analysis of where we think real estate values are today relative to the 2007 peak. We believe values are off at least 35%. Below are three major points in our assessment:
1. With lenders pulling back there overall participation in the capital stack from 80% to 60% or so, the weighted average cost of capital has increased approximately 32% without changing the actual cost of capital. This will eventually be seen in cap rates.
2. Vacancy has increased in almost every market, so even without changes in rents, NOI is down.
3. Given greater vacancy and a weak economic outlook, rent rates will be under pressure to fall. If numerous buildings in a sub-market go into default and are sold at distressed prices the new entrants to the market will have lower basis than the other buildings and will be able to offer lower rental rates to attract tenants. This begins a cycle that adjusts all rents down until basis is adjusted through foreclosure or sale.

Unfortunately, there are many deals that were done in 05-07 where the going in margin of cash flow safety (DSCR) was predicated on increasing rents, interest only for the first 2 or 3 years and historically low margins for error.

So as usual, a business weakness t will be exacerbated by a leveraged capital structure that leaves no room for cyclical change.

To Assess Current Treasury Plan, Understand Liquidity

Well done. Thank you.

Why Banking Should Be Boring

Boring used to backed with training. Unfortunately, about 20 years ago most banks abandoned their credit/management training programs for loan officers and traded the programs in for sales training geared to selling "products". So instead of careful examination and structuring of loans to meet a borrower's needs and thereby minimizing the risks of default and non-payment of the loan, loan officers became focused on selling a product. I believe that this change in culture, coupled with legislative changes that have allowed banks to get into all sorts or higher risk activities and poor regulatory oversight has gotten us to where we are now.

So, in addition to changes to focus banks back to their core business or taking deposits and making loans, we should insist that any bank getting FDIC insurance demonstrate that their loan officers and management receive credit training. The training can be in-house or out-sourced, but it must meet a set of standards. At a minimum, it should lead to certification that is similar to the CPA designation.

While this idea will not entirely stop the "greed leads to stupidity" cycle that is human nature, I believe it will make a more stable banking system.

Wells Fargo: John Stumpf's Letter to Shareholders Is a Must-Read

Customer service? Here are two recent examples of "customer service" at WFC in our family:

Daughter number one opens a checking account and gets a debit card. Thinking (incorrectly) that if she is overdrawn the bank will stop authorizing payment on the debit card if she has no money, she processes a series of small debit purchases over a weekend. While this assumption is wildly optimistic and not consistent with dad's advice, it is most probably made by many teens as they learn to manage their finances. End result; $53.07 in charges triggered $689.00 in OD fees. Wells position; close account, report to credit agencies, not budge on fees until dad gets involved and then agree to "settle" for $275 with no guarantee of clearing credit report. Extortion?

Second example: Daughter number two opens a Wells account without discussion with dad. Dad finds out that the "banker" gives daughter free checking. That's great, except that the free checking account is linked to a savings account that automatically pulls money out of the checking account every month. Looks fine until one realizes that daughter is a student with irregular income. Dad queries about what happens if the debit hits and there are insufficient funds in the checking to satisfy the automatic debit. Daughter can not explain what happens and tells dad that she never got a clear answer to this question at the bank. Dad now gets involved and closes the linked accounts.

Solution to both issues: US Bank. USB has a second chance account for daughter #1 and has an appropriate fee free account for daughter #2.

My opinion is that if we are going to support banks with deposit insurance and for the larger ones, the full faith and credit of the USA, it is time that we expect a higher standard of care when it comes to customer service. This starts with training that promotes doing right by the customer first. That requires that the banker actually understands what the customer needs and sells a solution not a product. This shift in the bank's selling paradigm is particularly relevant on the lending side of the bank's business where in most banks, lenders are let loose on customers to sell loan "products" with little or no formal training. Given the this sales attitude, we shouldn't wonder when the asset side of a bank's balance sheet blows up.

Problem Banks in 2008 Are Nowhere Close to 1990-91

It would be of interest to know what the bad bank situation looked like in 1988 since that year marked the beginning of the melt down. By 1990, we were well into the problem. Also, I suspect the numbers include the S&L's. The S&L's should be taken out since that was an industry that, while lumped in with the banks, was run at very low capital levels and made bankrupt by increased capital levels that could never by realized.

I have been told by several bankers after their regulatory exams that the FDIC is projecting a 15 to 20% failure rate in this cycle. Stay tuned.

When Will Housing Bottom?

Unfortunately replacement cost does not prove to be a floor for prices; the ability to service the after tax cost of a mortgage, taxes and insurance and how that compares to rents and income (jobs) is. Homes in several areas of Southern California are now below the cost of replacement when lot development costs and fees are factored into the cost. The ability to exceed replacement cost determines when new inventory will be added to the housing stock.

There is a ray of hope however, in certain markets in the Los Angeles metro area prices have fallen below replacement cost and the after tax cost of ownership is now below rents and as a result sales volumes have picked up and sales are subject to multiple bids.

Keeping a eye on sales volume, job creation (destruction) and the after tax cost of ownership compared to rents are good metrics to try to identify a bottom. In certain markets we may be there except for the uncertainty around the jobs situation.

Are Things About to Turn Around for Housing?

The focus should be on volume not price. Volume fell much earlier than price and was down (way down) for about a year before price started downward. Although real estate remains a local market and national data can be misleading, in many hard hit markets volume is recovering (see Los Angeles). The worst may be over. Of course, all bets are off if our economy falls off the cliff.