Tuesday, May 26, 2009

“Curses are like young chicken, they always come home to roost” And So Has the Debt of Commercial Real Estate

So you thought what we’ve seen so far is bad? New research from Deutsche Bank indicates that there is another financial crisis coming, specifically a “refinancing crisis”. It deals with the large amount of high risk, debt fueled loans which were taken out to finance commercial real estate investments between 2005 and 2007. Now with the value of these properties gravely diminished, it is projected that many people will have no choice but to default.
Starting in 2005 and peaking in 2007, underwriting standards went on a perilous “walk on the wild side”; bloating loans with so much leveraged debt that today they resemble cumbersome humpty dumpty’s teetering atop the crumbling walls of our nation’s financial institutions. A key element of debt (recently forgotten) is that at some point it needs to be repaid; in terms of loans this translates to the maturity date, when the principle on the loan is due. For a while people thought that this judgment day could simply be pushed back with the push of a few magic buttons on our financial calculators. But alas, it seems this time people will either have to pay up or get out of town (literally). However, if you fall into this unfortunate category, be comforted, for you certainly do not travel alone.
Of all the loans which are set to mature in 2009 or thereafter, 68.3% ($601.9 billion) do not qualify for refinancing. Coupled with the fact that commercial real estate prices have dropped 40-50% or more, it becomes obvious that most people will have no choice but to default either at maturity or sooner, translating to massive market upheaval.
However, hidden within all this pessimism there is still opportunity. Unlike previous commercial real estate crashes, such as that of the early 1990’s, this crash has little to do with oversupply. So though many people may default and loose their properties, the properties themselves will still have definitive value. It is better to think of this crisis as a cleansing of the system, a removal of all the risk and debt which plagued us. Concurrent with the outflow of bad money will undoubtedly be an inflow of good money and a sound ground for the future.

Thursday, May 21, 2009

Keynesian vs. Classic: Which approach do you agree with?

By: Joan Pino

As an economics major, the past year as a student has been extremely interesting to say the least. The study of the demand, production, and consumption of goods and services is always at the center of debate during a recession. Different economists, such as Ben Bernanke and Robert Barro, have been interviewed repeatedly since the start of the economic downturn by members of the media trying to make sense of the United States’ current position and what it means for the future. The two major economic schools of thought, Keynesian and Classical, are what policy makers ultimately base their decisions on to drive our complex economy.

Classical economics was pioneered by Adam Smith in his book The Wealth of Nations in 1776. He advocated the concept of the “invisible hand”, which is based on the assumptions that people pursue their own economic self-interests and that prices adjust reasonably quickly to achieve equilibrium throughout the economy. Followers of the Classical school of thought discourage government involvement and policies because of their belief that they will be ineffective in eliminating business cycles (the business cycle: boom, recession, depression, recovery). Classical economists believe that the business cycle is the economy’s natural and best response to market conditions and should be left to reach equilibrium on its own.

In 1936, 160 years after Adam Smith’s The Wealth of Nations, Keynesian economics was developed by John Maynard Keynes in response to the Great Depression and unprecedentedly high rates of unemployment. The “invisible hand” wasn’t doing its job and people wanted an explanation. Keynes satisfied the need for a new economic theory with Keynesianism, which assumes that wages and prices adjust slowly, unlike the Classical model. The slowly adjusting markets account for unemployment because wages and prices don’t adjust fast enough to keep up with the number of people firms want to employ and the number of people who want to work. Therefore, Keynes suggested government intervention with an increase of its purchases of goods and services which would then stimulate demand for output and result in companies hiring more workers to meet the new demand. Thus, Keynesians believe government policies and intervention solve the problem of unemployment faster and more efficiently than the Classical approach of letting the market clear on its own.

Today’s policy makers tend to use some combination of the Classical and Keynesian approaches, although there are certainly several economists who strongly advocate one school of thought over the other. I hope my brief explanation of economic thought and policy helps you to understand our intricate economy a little better and the reasons for things such as stimulus packages and other government policies. Do you think you are a Keynesian, Classic, or somewhere in between?

Friday, May 8, 2009

10MM is the new $100MM; A Recap of Real Share’s Net Lease Conference

Between the regular conversations with industry veterans, reading periodicals and daily press releases, and watching any local or national media, it doesn’t take much analysis to realize we are in the midst of a real estate and economic downturn never before seen. With this in mind, I knew it would be of paramount importance to attend Real Share’s annual Net Lease Conference on April 29th, 2009. This event gathered of 200 of the nations most intelligent and seasoned veterans representing all aspects of the net lease, sale lease back, and 1031 exchange markets, ranging from publicly traded REIT’s, hedge funds, private equity, lenders (yes, they still exist), as well as brokers and a handful of third party service providers. The organizers and moderators were aimed at figuring out where the market is, how we got into this malaise, and what the path to recovery should look like.

The opening remarks featured a quick synopsis of a few key statistics from a recent edition of “The Economist” which talks of the telling signs of General Growth Properties (GGP) recent Chapter 11 bankruptcy filing. As America’s second largest mall owner, GGP’s large debt load created by aggressive acquisitions during the run up of the market, namely the purchase of Rouse Company for $12.6B in 2004, as well as the recessionary environment with lower consumer spending and ailing retail tenants was it’s eventual downfall. Shorter term debt matured during an unprecedented retraction in the global financial markets. With this in mind, it was pointed out that there is $594B of additional commercial mortgages maturing in America between 2009 and 2011 alone, with no financing vehicle currently available to fill that void. While I sat pondering these comments, I mentally prepared myself to listen well and take many notes. Below is a synopsis of all the topics discussed, and what I took away from each panel, I hope it proves insightful…..

Making Sense of the Economic Downturn:

Howard Davidowitz - Chairman of Davidowitz & Associates, Inc.

  • We, as Americans, need pain, “Pain gets things fixed”
  • Living standards for Americans will never be the same as they were over the past 5 years…….EVER
  • In regards to the national stimulus plan and associated budget deficit, we are spending at an unsustainable level.
  • Interest payments on the national debt will constitute 12-14% of the GDP.
  • Retail is the worst hurt sector “All anchor tenants are in the ‘crapper’”
  • There is currently 21 square feet of retail space per every person living in the United States, while the per person demand equates to 13 square feet.
  • (Pessimistic would be an overly optimistic way describing Howard’s outlook on the economy)

Dr. Sam Chandan - President and Chief Economist with Real Estate Economics, LLC

  • America was engaged in a level of spending that was unsustainable
  • US savings rate between 2004-2006 was negative, however we are currently at 4% positive savings rate
  • While a positive savings rate ultimately is a positive movement, in the near term, it will extend the current retail downturn and weakened sales levels.“Wealth Effect” = greater spending when overall perceived wealth increases, while effective personal income does not increase
  • Currently experiencing a “Negative Wealth Effect” where income has decreased by 10%, consumer spending has been pulled back by 20%+
  • This is a different downturn than the early 90’s as there was less excessive and speculative building, limiting the supply side of the equation, however the demand contraction has been greater than previously experienced.
Town Hall meeting

  • Bruce MacDonald – President, Net Lease Capital Advisors
  • Richard Ader – Chairman, U.S. Realty Advisors
  • Peter Budko – Executive Vice-President and Chief Investment Officer, American Realty Capital
  • Gordon DuGan – President and CEO, W.P. Carey & Co.
  • Kyle Gore – Managing Director, Real Estate Net Lease Group, RBS Global Banking & Markets
  • Glen Kunofsky – Senior Director, Marcus & Millichap

Overall sentiments
  • In 2006, a similar panel discussed “what is the hot investment”, with the response of “everything”, while just 3 years later, the exact opposite is true, with no clear product type to pursue aggressively.
  • Opinions were very segregated between the Institutional investors and Private markets.
  • Recourse lending is here to stay – similar to yield maintenance which was instituted during the S&L crisis of the 1990’s.
  • Corporations will increasingly be attracted to Sale Leasebacks as an alternative to raising capital, however many corporations may have missed their opportunity, as either their corporate financials have deteriorated or the necessary capital to facilitate the transaction is simply non-existent.
  • Inflation was addressed as an issue to watch, with the current spending initiatives led by the government, it is not a matter of “if” it will be an issue, but “how bad” it will be.

Institutional investors

  • Most were out of the market for the past 3-4 years, as there was an excessive amount of capital in play, driving terms below where most saw as reasonable.
  • Only willing to pursue Credit Tenant transactions – true Investment grade tenant, signed to a lease of 15 years or greater, on an absolute net basis, with pricing based on the spreads displayed in the corporate bond market.
  • While corporate credit is key, real estate fundamentals must be present – market rents, market pricing for $/sf of building, etc.
  • Collectively mentioned that they were very inactive and overly the stressed that credit is everything in their underwriting.
  • There is a large amount of uncertainty over the implied pricing of a large transaction in today’s market, as funding a deal over $50MM requires an “act of god”

Private Market Comments

  • Investors are underwriting real estate as the primary driver in their decision making process
  • This includes an understanding of market rental rates, reasonable building and land costs, and reasonable re-tenanting for alternative use.
  • The large premium for purchasing a real estate asset that includes an income stream has been largely eroded.
  • The days of purchasing retail bank branches paying $80/sf in rent when market is $20/sf are over.
  • Private market players generally have a depository relationship with a local lender that is still providing relatively aggressive loan terms, although it is full recourse
New Realities of Debt Financing

Gerald Levin – Senior Managing Director of Sale-Leaseback Capital, Mesirow Financial
Barclay Jones – Executive Vice-President of Investments, iStar Financial
Andrew Kroll – Director, Debt Capital Markets, SunTrust Robinson Humphrey
Daniel Own Mee – Executive Director, Tremont Realty Capital
Nicholas Muzychak – Managing Director, Parkland Financial Advisors, LLC
Randy Reiff – Founder, Spartan Capital, LLC

Overall Sentiments

  • The Commercial Mortgage Backed Securities (CMBS) market may never come back, that product is inherently flawed.
  • The world as a whole is over-leveraged
  • Recourse is here to stay for the most part, you will have to pay a significant premium on an “A” product to get non-recourse.
  • Current rates vary between 5% to mid 6% for recourse money, some lenders will do non-recourse at low leverage at 7%+.
  • If CMBS market comes back, syndicating bank will have to remain in the deal, potentially structured as having to hold 20-30% of the paper
  • There is no product that currently exists to fill the void of the CMBS market, however lenders and capital sources are actively working on a solution, but it will be a slow evolution with many victims before a real product exists.

When posed the question of “In today’s market, describe a deal you would pursue”, here is what a representative from the following institutions answered:

  • Mesirow Financial – recently closed a $60MM deal for a “A” rated tenant, but we had to utilize 4 separate lenders to fund the transaction.
  • Suntrust Robinson Humphrey – True Credit Tenant Lease deal on a Sale-Leaseback or Build-to-Suit terms.
  • Spartan Capital – There isn’t a deal worth pursuing at this stage
  • Parkland Financial – Similar to Suntrust’s response – would need to be a true Credit Tenant, with 15+ year NNN lease through either a Build-to-suit or Sale-leaseback transaction.
  • iStar Financial – There are currently no real opportunities worth pursuing
  • Tremont Capital – Strong credit-tenant with strong real estate fundamentals on a basic 70% LTV transaction.
Net Lease Insider:

Paul McDowell – CEO, CapLease, Inc.

  • There is more pain to come on the real estate side of things
  • Public markets and owners have taken their hits (for the most part), but there are still private investors trying to hold on to bad assets.
  • Deal size - “$10MM is the new $100MM”
  • In regards to a lack in confidence in credit ratings as a guideline, “default of an ‘A’ rated company may occur, however it almost always requires many years of bad corporate management, and generally is coincided with downgrades along the way”
  • Real estate investors are like “wildebeests trying to cross a river filled with crocodiles. There is pressure to move forward by the herd, but everyone knows the first to act is in the most danger”
  • 2-3 years ago the outlook was “Everything is good and there is no end in sight”, however today the outlook is “Everything is bad with no end in sight”

Roundtable discussion - Net Lease Opportunities in the Medical Office Sector:

  • This sector has garnered a lot of attention, as a recession resistant product type, however the basic fundamentals of market rental rates must be present
  • Tenant creditworthiness is being overly scrutinized, as the relatively hot properties must be guaranteed by one of the top two health care organizations with the market place
  • While private physicians tend to be good at creating a large amount of cash-flow, they generally lack the ability to build significant net worth when compared to a typical tenant guarantee in other sectors.
  • There are some attractive medical office tenants that fall within the private market for single tenant assets, such as Affordable Care, Fresenius Medical, etc.
  • On-campus medical facilities will fetch 25-75 basis point premium over off-campus facilities.

Underwriting Credit & Tenant Retention Strategies:

Merrie Frankel - VP/Senior Credit Officer, Moody’s
Benjamin Butcher – CEO, STAG Capital Partners
Robert Corry – Managing Director of Real Estate, Gladstone Commercial Corporation
Peter Mavoides – President & CEO, Sovereign Investment Company
David Steinwedell – Managing Partner, AIC Ventures
Gordon Whiting – Founder & Sr. Portfolio Manager, Angelo, Gordon & Co.

  • Experiencing relatively similar actual ratios of defaults, per letter grade, as the early 1990’s recession
  • A signaling event that things are looking better would be “Tenants Paying on Time!”
  • When tenants want rent relief, they better offer up to date audited financials and be willing to have an “open book” relationship between tenant, landlord, and lender (if debt is in place)
  • The Sale Lease Back and Net Lease business should be 15+ years view.
  • Property types to pursue, if not a publicly rated entity, should only be critical assets that are part of their core business in irreplaceable locations.

All in all, after eight hours of discussion covering all aspects of the net lease business, I can truly say that the general sentiments were that of determination to survive and profit on the way out of this mess. The number one issue is DEBT. We need a lot of it, and have none available. Lower leverage is a good thing, and it will take a while to de-leverage, but near-term debt maturities will sink many owners. Most people have realized we are currently at the ID stage, where we have realized the majority of the problems, and now need to focus our efforts on finding a solution. The “blame game” for why we are here can be sorted out later, right now we need to be creative yet conservative to move forward. If you have any questions about items mentioned, or would like to discuss any of the topics in greater detail, Please feel free to contact Patrick Nutt at pnutt@calkain.com or 813-282-6000.

Monday, May 4, 2009

Medical Office Real Estate May Be the Way to Avoid Un-Healthy Investments

By Winston Orzechowski

While many real estate investments are losing value, the Medical Office sector has shown remarkable resilience. The segment is holding up much better than other property types and this trend projects to continue. So who do we have to thank for this bit of good news? Well the Baby Boomers of course. Though a recession can slow many things down, one thing which it cannot alter (although it may seem like it can) is the progression of time. The simple fact is that as more boomers age, they will inevitably have an increased amount of medical issues which subsequently turn into an increased amount of medical costs. This all adds up to relatively inelastic demand for medical services and their pertaining medical office buildings. So if you’re considering investing in today’s market, there may be no firmer investment than our nation’s infirmaries.