CREDIT SUISSE IS THE VICTIM

Posted on January 4, 2010 by admin

The following article appeared in the news on January 4, 2010.

“Property owners at four struggling and bankrupt resorts in Idaho, Montana, Nevada and the Bahamas have filed a $24 billion federal lawsuit against Credit Suisse, saying the bank gave predatory loans to the resorts’ investors as part of a scheme to take over the properties.
Property owners at Idaho’s Tamarack Resort, the Yellowstone Club in Montana, Nevada’s Lake Las Vegas resort and the Gin Sur Mer Resort in the Bahamas filed the lawsuit Sunday. They are seeking class-action status.
The property owners say Credit Suisse set up a branch in the Cayman Islands to skirt U.S. federal banking regulations and appraised the resorts at artificially inflated values as part of a plan to foreclose.”

$24 Billion – Now that is not your run of the mill, little homeowner who claims being duped into taking on a mortgage that he or she couldn’t possible service. If the borrowers hadn’t borrowed the money there would have been no foreclosure. Claims that the lender over-appraised the properties as part of a scheme to foreclose just fly in the face of reason. The last thing a lender wants is to take over a financially failing property and try to work it out to recover 100% of its investment. If the property value, at the time of foreclosure, will not support the servicing of the debt, then it is axiomatic that the lender will take a loss if it must sell the property or will suffer a financial drain if it must continue to fund operations until the value of the property is restored.
If the borrowers believed that the lender had over-appraised the properties at the time of granting the loan, then they participated in that over valuation by accepting the funding of a loan predicated on that value. If the borrowers had just applied or a loan based on an appraised value that they believed to be reasonable, then the amount they borrowed would have been substantially less.

In this case, the lender Credit Suisse would appear to be the victim and not the borrowers. Credit Suisse did not cause the real estate market to crash. In the current market all kinds of developers have found themselves with loans that they are unable to service. The lenders do not set out with a strategy to foreclose. That is the last thing they want and to claim otherwise is very disingenuous. If all commercial property borrowers could sue and prevail against their lenders when they became unable to service their debts, then the real estate financing market will never be the same. We will go back to the old days when borrowers were required to have a substantial cash investment of their own in the property and achieve pre-sales or pre-leasing targets as a condition of the loan. Maybe that wouldn’t be such a bad idea as it would certainly curtail the type of speculation that contributed to the present economic malaise.

Hopefully, our judicial system will see through this type of lawsuit and not cause lenders to waste incalculable sums of money on legal fees in an attempt to defend their position. This type of lawsuit is like going to the casino and losing a vast sum of money and then suing the casino for allowing you to play. Borrowers must take responsibility for their own actions.

January 6, 2010 –

More news stories have appeared relative to the $24 billion suit against Credit Suisse. Based on the stories it would appear that the plaintiffs in the suit are not the people who borrowed the money from Credit Suisse but rather were investors, through homeownership or otherwise, in the projects financed by Credit Suisse. This makes the suits all the more interesting and bizarre. If the news portrayal of the suit is correct, it is very difficult to see how Credit Suisse had any direct relationship to the plaintiffs. It does not appear that the actual borrowers are the plaintiffs in the suit but, for better or worse, it was the actual borrowers who applied for, negotiated the terms of and accepted the funding of the loans. The loans were made at a time when the real estate market was overly exuberant and the bankruptcy of the financed projects resulted from a very negative real estate market not because of any scheme by Credit Suisse to be able to foreclose and acquire the projects on the cheap. That is just a delusional notion. The news stories also indicate that Cushman & Wakefield were complicit because they provided the Credit Suisse real estate appraisals, which implies that Cushman & Wakefield knowingly over-valued the properties to facilitate the schemes of Credit Suisse. That too is a delusional conspiracy theory. Cushman & Wakefield are one of the most respected real estate companies in the world with a gigantic revenue stream. They would have absolutely no incentive to risk their reputation and net worth in return for an appraisal fee that is “the size of a flea on an elephants behind” in relation to the revenue of the enterprise.

The bottom line is that the borrowers knowingly applied for and took the funding of the loans and now are unable to repay according to the loan terms. The lenders recourse is to foreclose. There can be little doubt that those directly involved in the loan, namely borrower and lender, had extreme optimism that everything would work out profitably. Those who became investors must have shared that optimism at the time of making the investment. Yes, the adverse market destroyed the euphoria of the developers and investors alike but to seek recovery against Credit Suisse is an attempt to hold someone else responsible for a bad investment decision. Such suit are akin to an investor who bought a financial stock in 2007 and lost 50% of their investment in the crash of 2008 bringing suit against the investment banks whose involvement in the mortgage backed securities causes the collapse.

Hopefully, the judicial system will see through this charade and will look only to the documentation signed by borrower and lender for any decisions and not to the wishful thinking and twisted logic of litigators.

Posted in Property Developemnt, Real Estate Economy, Real Estate Appraisal, Real Estate Investment, Real Estate Lending | Leave a comment

THE REAL ESTATE BUBBLE

Posted on November 27, 2009 by admin

By now, if someone doesn’t know that real estate has declined in value, by a substantial amount, from its highs in 2007, they have just awoken from a three year sleep. There is no doubt that there was a real estate “bubble” and that the “bubble” has burst. That is not the question. Rather, the question is one of why did the “bubble” occur in the first place and why did it burst when there are so many supposedly brilliant, highly paid, bankers and investment advisors out there who should have seen it coming?

There is a vast difference between single family residential property and commercial or investment real estate yet, the root of the collapse would appear to emanate from a single cause. The market was being driven by “other people’s money”.

In the case of single family housing, the home buyer was chasing the illusion that values would continue to increase forever. This illusion was fed by irrational competition between lenders eager to push money (mortgage investor’s money and not their own) out the door and earn a fee for doing it. The mortgage brokers, eager to earn a fee, helped the lenders by supplying new and re-financings at a rapid clip. In some cases they helped unqualified borrowers to “qualify” through providing false financial information. But, none of their own money was at risk. The lenders relaxed their “due diligence” processes because they were going to package the loans and sell them to investors through investment banks as mortgage backed securities. Thus, in theory, they would have none of their own money invested in the mortgage. The investment banks, also eager to earn fees, sold mortgage backed securities to their investors and, theoretically, would have passed the risk on to those investors. To facilitate the sale of mortgage backed securities, the investment banks hired rating agencies to rate the securities. The rating agencies, eager to earn fees for this service, overlooked the risky practices taking place but, then, they had none of their own money invested in the product. The home borrower, in many instances, had very little of their own money invested in the home either by virtue of very low down payment requirements or by virtue of successive re-financings, as prices increased, to a point that more than 100% of what they initially invested had been taken back out. Thus, the foreclosed homeowner had no material investment in the property and it was the owner of the mortgage who suffered the financial hit. The market also evidenced a substantial amount of speculative activity from people who purchased many properties with the goal of a quick, profitable re-sale. Had it not been for the easy availability of credit, minimal financial qualifications and the lack of any real risk assumed by the home buyer/owner, would there have been a wild escalation in prices (bubble) leading to a collapse?

Supposedly experienced financial people should have seen the handwriting on the wall at least two years before the collapse occurred, as all of the signs were there. Low or no down payments, abundant availability of funds to loan, very relaxed borrower qualifications, ease of selling mortgage backed securities and a surge of speculative home buying taken in the aggregate were a prescription for disaster. But the fact that the bankers didn’t see the handwriting on the wall shows that, possibly, they were blinded by the substantial fees they were earning and that they succumbed to the competitive pressure of not wanting to “miss out” on a very profitable business opportunity. The fact that investment banks (led by people earning multi-million dollar bonuses) ended up with mortgage backed securities in their own portfolios only shows how they began to believe their own propaganda. Firms like Bear Stearns and Lehman are no longer with us because of the collapse of the mortgage backed securities market. Goldman, a brilliant survivor obviously saw it all coming and made billions shorting the mortgage market (while at the same time continuing to sell mortgage backed securities to investors).

The bottom line seems to be that the pressure of “other peoples money” drove the residential real estate market since the investors who purchased mortgage backed securities, theoretically at least, ended up with all of the risk while all others in the process earned fees but were left with no risk (unless they retained the mortgage securities in their portfolios). There was a time, earlier in the market history, where home buyers needed a relatively substantial down payment and were subjected to very demanding financial standards to assure that the buyer had the ability to service the loan. It is doubtful that the collapse would have occurred if more rigorous standards had been applied but, more importantly, things might have been different if the institution that originated the loan had been required to “age” the loan before selling it in a package of mortgage backed securities.

In the commercial/investment market easy financing was also available with the ability to highly leverage properties through the sale of commercial mortgage backed securities. However, that was only a fraction of the cause of problems in the commercial markets. Major players in the commercial markets are institutions (pension funds), investment funds marketed by investment banks and real estate investment trusts. In each of these vehicles the investment decisions appear to be made by people who are not the end investor.

Pension funds hire investment advisors who are paid substantial fees for vetting investments and guiding their clients into “suitable” investments. The advisor has only one risk – loss of the confidence of their client with a loss of the client. But, the advisors work under an unseen pressure, one that is not anticipated or factored in by the client. If the advisor does not produce “suitable” investments or turns down investments that are ultimately announced by a peer pension fund, the advisor may find that the client moves to another advisor. So, there is a pressure to produce results. And that pressure can, and most probably does color recommendations. This is especially true when there is fierce competition for real estate investments with little or few qualified offerings. The risks to the pension funds are great as seen by the Calpers (California Public Employees) purchase of two major apartment complexes in New York with an estimated loss of $500 million and CALSTERS (California State Teachers) estimated loss of $970 Million in a land development investment in California. Probably, no problems would have occurred if the properties had been acquired at the beginning of the real estate cycle but they were bought at the height of the cycle. Investment advisors should be able to recognize when cycles are nearing their highs but, competitive pressures may serve a blinders.

Investment funds put together by investment banks have the same root problem. They put together a large fund based on the investors’ expectation that they will be able to successfully invest and leverage those funds. Failure to put the money to work creates investor unrest leading to an unseen pressure to show some progress. That pressure often leads to “stretching” the analysis to make the numbers work. A major investor once remarked “even when I lie to myself with the numbers, the deal doesn’t work”. The difference there was the investor was investing his own money where in the case of funds, the purchaser is investing “other people’s money” and that decision does not seem to carry the same risk pressure. Once in a while an investment bank will acquire a property using a high degree of leverage anticipating the easy ability to easily raise the money later. Again, the decision is not made with the expectation that the investment bank will hold the property in its own portfolio other than very temporarily. When it works out as planned, no problem. However a major investment bank lost a substantial cash investment when investors did not buy the fund and ultimately lost the projects to the lender.

Again, it appears here that “other people’s money” drove the investment decisions. Institutions fall prey to the same competitive pressures as lenders. The pressure is the fear that someone else will end up with the deal to their embarrassment.

Real Estate Investment Trusts (REITs) are public corporations investing in real estate and are most often traded on a major stock exchange. Growth in the value of REIT shares comes about by any one of several routes or a combination thereof. Increasing cash available for distribution through increasing rents or decreasing expenses is the most obvious. This route is management driven. Expanding the portfolio by use of leverage and acquisition of properties where the acquisition would be accretive to earnings is another means of share value growth. Finally, a competitive reduction in the rate of return on properties (the capitalization rate) raises portfolio value. The latter is something over which REIT management has no control since it is completely market dominated.

The first avenue to value growth is strictly in the province of property management or operating management skills, but, comes into play by financial managers and the REIT board when making a purchase decision as part of a forward looking financial analysis. However, the ability to raise rents is strictly a function of the market. It is interesting that almost no analysts provide any commentary on the quality of property operations yet that is a very important aspect of growth.

Growth by acquisition comes about through the raising of new capital or leveraging the existing portfolio. Many of the current REIT problems are the result of over-leveraged portfolios in the face of declining rents. Here, again, the acquisition decisions are too often competitively driven with the decision made easy by the fact that it is the investors’ money being put at risk. The decision makers usually do not invest their own money in the acquisition. Competition between REITs places the same unseen pressures on the decision makers as in other vehicles using other people’s money.

There seems to be an inescapable conclusion that the decision makers risking other people’s money do not tend to view risks in the same light as an investor risking their own money. The investor investing his or her own money faces no competitive pressure or embarrassment for failing to make an offered investment and is only concerned with the probability of success of that single investment.

There is also another seemingly inescapable conclusion that the investment models utilized by investment managers (REIT, Investment Banks and Pension Fund Advisors) were most probably flawed by a failure to build in a sufficient downside risk factor. Many analysts utilize discounted cash flow models (DCFs) to determine investment suitability. The models usually forecast only future increases in rents and an increase in value at the time of sale. The models usually did not capture the potential competitive impact of new projects coming on stream and did not consider the possibility of negative economic factors causing vacancies and reducing rents over time. The models made it possible to easily manipulate the results to justify a favorable recommendation.

With all of this one might conclude that over optimism and naive beliefs, by money managers that things go up forever became “blinders” to risk. That attitude seemed to be fueled by continued rising prices and rents and an easy supply of money.

What happened in the recent past relative to commercial properties is reminiscent of the syndication explosion of several years ago. In that era, before public securitization of real estate via REITs, syndicators purchased a property and then sold it in the form of limited partnership shares at an aggregate price substantially above the acquisition cost. This type of market activity gave rise to a theory that the value of real estate was not its value to a single purchaser but rather was its value after being sold off in limited partnership interests. There is no question that tax benefits were a strong inducement to limited partnership investors. However, the pace of syndication activity and the ease of attracting limited partnership investors gave a strong push to the activity in the market and the market fed on itself. If it had not been for the ease of bringing in limited partners, the activity in the market would have been substantially less and prices would not have climbed so quickly.

One thing is certain; whatever has happened in the past will be repeated in the future, although probably in a different form. Those who earn their livings “creating” investment opportunities are very resilient and can be counted on to be able to “invent” a new theory demonstrating that a new type of investment vehicle or investment is bound to be successful even where reason and logic might dictate otherwise. Caveat Emptor!

December 16, 2009 – Recent discussions by some analysts regarding the pending financial regulation legislation have attempted to deflect blame from the banks and Wall Street by focusing on the role of Freddie and Fanny. While it is true that these quasi governmental corporations helped create the problem, the fact remains that without the ability to securitize the mortgage the problem would not have occured. They may have been facilitators but the greed of m mortgage brokers, loan originators, Wall Street, the rating agencies and, last but not least, the homeowners, the problems would not have taken on the magnitude they did.

Much has been said about the “poor homeowner” being forclosed out of their homes. What remains unsaid is that many home buyers knew they were providing false financial information to lenders in an attempt to get their loans because they were anxious to participate in the never ending real estate boom. In many cases they had little or no equity in their homes long before the collapse of the market. So, they are really not all big losers in a forclosure action. Little is said about the homeowners who had built up substantial equity in their homes over the years and then began to use that equity, thorugh succssive re-financings, to spend themselves into prosperity. By the time the forclosure notice arrived many of these people had little or no cash investment remaining in their homes. Finally, what remains unsaid is the part speculation played in the collapse. People caught up in the boom psychology began buying homes on speculation intending to sell them quickly at a profit. That worked for a while but it too came to an end. The only peoplefor whom tears should be shed are the hard working, “straight arrow” people who had built up a good equity in their homes, carrying a manageable mortgage, and then found themselves unemployed and unable to service their loans. These are the people who deserve a “bail out”.

January 26, 2010

The “bubble” mentality and force of “other peoples money” is very well demonstrated by the news that Tishman Speyer are giving Stuyversant Town to the lenders. Tishman, with other investors, acquired the property in 2006, at a market high, of $5.48 Billion. According to news releases Tishman invested $112 million of its own money in the deal. CalPers, through investment advisors reportedly invested $500 million and the Government of Singapore was reportedly in there too. The news release estimated the current value of the project at $1.8 Billion. In addition to the cash investors, the big losers are the primary and mezzanine debt holders. Reportedly, a cornerstone of the deal was the belief that the applicable rent controls could be modified.

One must assume that some pretty smart real estate, investment and finance people did a substantial amount of due diligence before entering into the transaction. So – what went wrong? Reading between the lines, the price of $5.48 Billion was probably not supported by the rents in place at the time of acquisition and to make the numbers work required relief from the rent control laws. One would also assume that the rent control issue was well vetted by a team of lawyers. It obviously was not a “slam dunk”. Those kinds of things never are. This leads to the conclusion that the euphoria of the day blinded all participants to the risks inherent in the deal and most of all, since the bulk of money was coming from investors and lenders, Tishman had a very high reward-risk potential if it all worked out. In 2006 who would have believed that the dynamic commercial real estate market would ever cease increasing rents and values. But, when it is “other peoples money” being risked the people behind the transaction rarely build the proper element of risk into the investment model and the lenders willingly buy into the story line. CalPers were put into the deal by an investment advisor but the investment advisor did not take the risk. Enough said.

UPDATE OF OCTOBER 7, 2011

Anyone interested in reading, in great detail, about the causes of the “bubble burst” must read Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon
Gretchen Morgenson (Author), Joshua Rosner (Author).
This is an excellent, very well written book, detailing all background of the collapse.

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DEVELOPERS WIN-PRIVATE OWNERS LOSE

Posted on November 25, 2009 by admin

On November 24, 2009 the New York Court of Appeals ruled 6-1 that it is lawful for the State to seize private property for use by private developers. This case involves taking, though eminent domain, private property to turn over to a private developer for the development of a sports arena complex including office buildings and rental apartment blocks. Apparently, a cornerstone of the use of eminent domain was the designation of the area in Brooklyn, known as Atlantic Yards as “blighted”. Yet, some of the property to be condemned includes condominium residential units valued at over $500,000. The claims of blight reportedly refer to the appearance of graffiti and the growth of weeds. It is possible that the definition of “blight” used for these purposes is much too broad. However, that is not something the Court can address. The Court, in its ruling, probably depended on the decision of the U. S. Supreme Court in the case of Kelo v. City of New London where private property was taken and turned over to the private development of a campus for Pfizer. In that case it would seem that the “public benefit” was an economic benefit to the community where, in the Atlantic case the “public benefit” appears to be removal of blight and the development of s sports arena.

Both the Atlantic and Kelo cases should create fear in the minds of all property owning citizens of the U. S. If private developers, through the use of lawyers capable of performing gold medal winning legal gymnastics can get the right to use eminent domain to take property for the benefit of those developers, then no one is safe anymore. Logic dictates that when the concept of permitting the State to take private property for a public benefit, no one involved in creating that legal right ever contemplated that eminent domain would be used for other than public projects such as governmental buildings, fire houses, police stations, public transit projects, hospitals, military installations and the like. It is understandable that Cities needed the right to re-develop areas that had become truly blighted. But, blight in this instance usually meant a substantial amount of dilapidated and/or vacant property where social as well as physical blight was present. However – an area with $500,000 condominiums – give me a break!

In the wake of the Kelo decision, many States enacted laws to make it much more difficult to use eminent domain to take private property. However, it was by no means universal. What is needed now is for the U S Congress to revisit the law and write a new law, covering Federal as well as State property takings so that eminent domain is confined to a true public purpose and not a trumped up one as in the case of Atlantic Yards and Kelo, which in the mind of this writer was one of the most poorly reasoned decisions of the Court, where the minority opinion should have been the law..

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NET LEASED PROPERTIES

Posted on November 20, 2009 by admin

NET LEASED PROPERTIES
©2009 Lloyd D. Hanford, Jr., MAI

Long term, net leased properties have long been the darlings of the real estate investment world, particularly among the smaller investors. However, years of observing that market suggests that these investments are not well understood by the investors particularly with regard to the risks involved.

For years, the primary focus of investors has been on the capitalization rate or yield with “credit tenants” commanding the lowest capitalization rates. Emphasis on credit has been misplaced as clearly demonstrated by virtue of different factors. First, a high credit company may be “bought out” via a leveraged buy out that encumbers the company with a mountain of debt that may ultimately eliminate any creditworthiness and may lead to bankruptcy. Secondly, adverse economic times can quickly erode both the capital of a company and lead to a substantial decline in revenues that further jeopardize credit standing. As has been clearly shown in the recent months, many businesses have failed and rejected some or all leases in bankruptcy proceedings. Financial institutions, once believed to be substantial tenants, have failed and closed their doors. Retailers have gone out of business. Businesses in bankruptcy have been able to re-negotiate leases at a substantially lower rent under the implied threat of lease rejection if unable to do so. The bottom line here is that the credit of the tenant may not be as important in the investment decision process as once believed and may not warrant significantly lower capitalization rates than those available from lesser credits.

Fast food outlets like KFC, drug chains like Walgreens, Rite-Aid and CVS, as well as bank branches have been very popular with investors with historic capitalization rates being among the lowest in the market. The market activity in the past suggested that all were treated somewhat alike in that the investment focus was on the income. However, each property type has its own unique characteristics that should be analyzed by investors to a greater degree than has been exhibited to date.

A characteristic of many fast food outlets is a relatively special purpose building that frequently represents an under-improvement of the land because of the necessary parking. Thus, any analysis of these properties, in addition to location, should focus on land value and its potential growth over time as well as potential alternative uses of the improvements. If the improvements have limited alternative uses, then investors should focus on land value as the justification for making the investment. If the improvements have alternative uses then focus should be on the market rent for the property and the value that may be implied by that rent. In many cases, where the improvements are small in relation to land size, the contract rent, on a square foot basis, may well exceed any measure of market rent for alternative purposes. This result should place more attention on the value of the underlying land.

Single tenant retail properties are usually just “boxes” with no limited specialized interior improvements. In addition to location, the relationship of contract rent to market rent is an essential analysis. Often, rental being paid exceeds the indicated market rent. As in the fast food properties, it is important to identify the demand that would exist for the property if it were to be vacated and the rent that would be probable from an alternative user.

A common element of most single tenant commercial properties is an initial long term lease at a fixed rent. The fixed rent acts as an inhibitor to value growth as value growth is dependent on income growth. Also, many long term commercial leases contain renewal options at either the same rent or a very slightly increased rent. This type of provision also limits value growth and, historically, has resulted in rent, over the long term, falling far behind market rent. When this occurs, the tenant builds a substantial leasehold interest which does not revert to the benefit of the property owner until the lease ends.

Single tenant office properties present different problems. There are basically three types of single tenant office properties: general office, high tech office and medical office (includes doctors offices, surgical centers and specialized medical centers like radiology ets). In general offices, tenant improvements are usually fairly standard and, in many instances, can be re-used by a successor tenant with minor modifications. However, in the other types of office, highly specialized tenant improvements and configurations of space are the norm. The tenant improvements are often priced into the rent being paid and are usually far more costly than standard office improvements. Thus, when a tenant vacates these specialized facilities, it is probable that the interior improvements will either be outmoded or will not meet the needs of alternative tenants. In either case extensive new tenant improvements would be needed. More importantly, the market rental value of the space without the specialized improvements is at risk of being substantially reduced. This caveat applies to most special use, single tenant properties but usually not to the same extent as in high-tech,scientific or medical facilities.

Larger net leased properties, such as major office buildings, “big box” retailers or super-markets like Costco and Safeway are not discussed because they are more commonly purchased by very high net worth investors and/or institutions. However, these larger properties, in addition to location, require analysis of the relationship of contract rent to market rent as well as an analysis of alternative uses and demand if the single tenant vacates.

Regardless of the type of property, before committing a purchase, investors should have a firm understanding of the market rent for the property and the alternative use possibilities as well as having an exit strategy firmly in mind. The exit strategy should consider when the property might be sold, the type of purchaser that would buy it and the price it might fetch (a measure of profit) with comfort that this exit would meet investment objectives.

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REAL ESTATE INVESTMENT TRUSTS (REIT’s) – THE NEXT PROBLEM AREA?

Posted on October 8, 2009 by admin

Real Estate Investment Trusts (REIT’s) appear to have come to life and some shares are again selling at prices at or above net asset value. Are the current valuations reasonable on a risk-reward basis? It is suggested that the answer is most probably NO.

Historically, REIT shares have been priced based on anticpated “total returns” which are composed of both dividends and share appreciation. This raises the question as to whether either dividends or share values will grow in the forseeable future?

There should be little question that the investment real estate market is in a down cycle. Vacancies in all property classes appear to be increasing and rents appear to be declining. Neither of these results bode well for dividend increases or future appreciation in the values of the underlying properties. If one accepts this thesis, then investments in REIT’s should be viewed as having a relatively high exposure to a risk of declining share values.

When vacancies rise and rent levels fall, there is a very real risk that cash flow will be insufficient to sustain the level of dividends reflected and the dividends become subject to reduction. Thie reduction of income, in and of itself, can cause a decline in asset value. When these kinds of things happen, total returns will decline

There are other problems for REIT investors. First, in the present market environment it is very difficult, if not impossible, for an investor to calculate the net asset value of a REIT portfolio because there are too many unknowns. Analysts do not focus on the operational management of the properties and, accordingly probably don’t know about vacancy exposure unless specific anticipated vacancies have been publically disclosed.

A second problem is that when cash flow declines the priority is to service the debt first which may force postponment of necessary maintenance or capital improvements and may limit cash availability to make necessary tenant improvements. When this happens, the maintenance problems are pushed off into the future and may negatively impact values.

A third problem arises when individual properties in the portfolio are not producing enough net revenue to support the historic values and, if major vacancies occur individual property values can fall below their outstanding debt.

Boards of Directors of REIT’s should be expected to have all of the information necessary to evaluate whether or not these kinds of problems exist but, the way things often work results in the information not being timely enough to direct defensive actions. For example, when a major tenant goes bankrupt and rejects its lease, that information usually comes too late to be useful. Some, but not all REIT’s have a “lead director” who is independent from management and that “lead director”, at least, should personally inspect each of the owned properties in order to verify the type of management job being performed as well as to view the condition of the properties. Many Annual Reports do not disclose the degree to which any director or directors have personally inspected the properties.

Unquestionably, Annual Reports (10 K’s) provide all required financial disclosures but they do not ordinarily discuss specific concerns such as increases in deferred maintenance, value declines that may be leading to debt being in excess of value. Nor do these Repors generally discuss declining rental markets and their anticipated impact on the particular portfolio.

These concerns suggest that REIT shares could come under downward pressure in those instances where share prices are at a premium to real net asset values. The near term does not look favorable for investment real estate and, as values decline, investors may be incentivized to dispose of assets with the result that the market will become an even stronger “buyers market” There is nothing in the current market to give rise to optimism that the real estate market will grow strong in the immediately forseeable future and ownership of property assets may have a much higher degree of risk attached to them than the market may reflect.

This is just the opiniion of one observer but does suggest caution, if nothing else.

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Tough Rules For Condos

Posted on August 5, 2009 by admin

Tougher rules for condo loans could put blocks on condo purchases. FHA, Fannie & Freddie appear to have increased the percentage of pre-sales required before they will lend on condo purchases and may be screening out projeccts where more than a small percentage of homeowners are delinquent on their HOA dues.

On the surface, these increased underwriting restrictions could make it much more difficult for developers and purchasers alike to transact sales unless the developer steps up and provides the financing. Rep. Barney Frank, who in the past, appears to have been willing to overlook risky mortgage practices, is again telling the lenders to relax restrictions.

Are these restrictions bad? And is Barney Frank wrong? The answer really depends on how one wants to look at the problem. From a buyers standpoint, condo projects with a high percentage of unsold units present some risks. First, the project remains pretty much under the developers control which may not work out to be in the homeowners best interests. But, more importantly, where there is a relatively high percentage of unsold units there is a major risk that the developer will reduce prices to sell the remaining units, whiich step would devalue the units already purchased or, forclosure of the unsold units could result in highly discounted prices as the lender reduces prices to liquidate the properties taken over. Either way, the original group of homeowners could see the immediate value of their units fall.

From the viewpoint of the a developer or seller, these restrictions could be very difficult to deal with as they could, in effect, make it impossible to sell except to someone with 100% equity since any other buyer could not obtain financing. Developers may be able to work around this by providing the financing or the construction lender may provide short term financing until the critical point is reached where sales are sufficient to permit conventional financing. Also, developers of horizontal projects may be able to use the technique of building in phases so that the number of units required to be sold is less than if the entire project were built out at once. But, that definately would not work in high rise projects.

In projects with a relatively high delinquency rate on HOA (Association) dues, there is a real risk that the property will not have adequate funds to provide the services and maintenance that the HOA is required to provide which would work to the great disadvantage of the homeowners and could, under certain circumstances, result in a special assessment.

On balance, the new restrictions may be a convenient way for a lender to turn down loans during periods where there is an excess supply of unsold units in any project as well as protecting borrowers from buying into a troubled projec by just not making financing available.

No matter how one may view the situation, Rep. Barney Frank should absolutely stop putting pressure on lenders and attempting to set underwriting standards. It appears that he didn’t learn anything from his previous application of substantial pressure on the lenders that may, in the last analysis, have contributed to the meltdown of the single family mortgages. It should be very clear to Rep. Frank that the key to reducing the kind of lender risks that caused the current problems is enhanced underwriting standards (much tougher scruitiny of loan applications).

Posted in Condominiums | Leave a comment

REAL ESTATE APPRAISAL RULES

Posted on August 3, 2009 by admin

New rules have been adopted governing residential mortgage loan appraisals.  These rules are intended to assure the independence of appraisers from the lending institution by requiring appraisers to be selected by an independent appraisal management entity.

The problem that this is designed to solve is lender pressure on appraisers to reach a desired number.  This type of requirement was caused by the perception that  appraisals were somehow responsible for the excesses of the sub-prime loans that brought about the collapse of the residential mortage market. Undoubtedly, there were some incompetent or dishonest appraisals.  However, these appraisals most probably did not occur in a significant percentage of the appraisals involved in failed mortgages.  There were many other problems that most probably had a far greater impact.

There are many complaints that these new rules just increase the cost of the trnsaction and negatively impact the borrower.  The complaints seem to have merit.

Legislators and regulators must be mindful of the fact that lax underwriting standards, low down payments, low interest rate adjustable mortgages, excess speculation and the fact that the originator (lending institution) did not plan to hold the loan for its investment.  Rather, the loans were to be packaged and sold off in mortgage based securities so that 100% of the risk in the loan was transferred to the buyer of those secirities. If underwriters had been diligent in qualifying borrowers to make sure that the borrower could service the debt and retained the risk if they couldn’t, then much of the pain in the mortgage market might have been avoided.

What lenders and regulators must remember is that there has never been any assurance that a given property will hold its value or increase in value over time.  Usually, due to the passage of time, values may change either upward or downward and it is the downward shift that causes the problem.  Unfortunately everyone believed that real estate values could only go up and thus weren’t too concerned about value related defaults.  But, the fact is that when values decline, for whatever reason, there is a very hig risk of defaults particularly impacting the most recent buyers who acquired at a market top. When a default occurs it really doesn’t matter whther the property was valued at the price paid on acquisition.  So, the origination appraisal really does not provide much safety for the lender in a default situation.

The less equity that a person has in the property, the greater the default risk in a down market. Where downpayment requirements are 10% or less it really doesn’t take a major downturn to put debtors under water.  The real support for a mortgage loan should be the amount of equity held by the borrower and the borrowers proven ability to repay.  If lenders were making loans for their own investment portfolio, the degree of underwriting due diligence would most probably be greatly enhanced but when the created loans can be packaged and sold off as mortgage backed securities, no one in the process bears any of the liability.  The liability is transferred to the purchased of the securities.

The regulators and lawmakers should focus on the entire process and not just on the appraisal portion of underwriting.  But, knee jerk reactions and laws seem to be the order of the day.

Posted in Real Estate Appraisal | Leave a comment