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Tuesday, June 16, 2009

Tough Sledding for the Commercial Real Estate Industry

Below is an article we published in Seeking Alpha on 6/16/09 - link here. Another "post" that is arguably too long for a blog, but we're including for those interested in commercial real estate.

On Friday, we attended Day Two of IMN's 10th Anniversary US Real Estate Opportunity & Private Fund Investing Forum in New York City. The event is oriented toward the real estate fund, developer, and LP communities. We published a brief Day One summary on Seeking Alpha (link here) and expand on key takeaways in this article. Day Two included additional panel discussions that covered many topics related to both challenges and opportunities facing private equity and the commercial real estate industry.

Big Picture Conclusion

On balance, we gathered from conference speakers and conversations with some of the approximate 900 attendees that there are more challenges than opportunities for real estate equity investors and no new private equity money is really being put to work at present. This view is largely consistent with negative media headlines in recent months sounding the alarm about massive amounts of mortgage debt coming due over the next several years. As a result, creditors appear better positioned as property valuations compress and new funding structures gradually – or sometimes forcefully – replace legacy structures that were based on much higher loan-to-value percentages, lower capitalization rates, and higher cash flow forecasts established prior to the recession (e.g. in 2005-07). Finally, negative economic trends across virtually all sectors are hurting real estate fundamentals – please see our blog post here for helpful economic data and trends.

Implication for Public Market Equity Investors

Tread cautiously and, as always, focus on quality of assets, financial condition (i.e. balance sheet strength), and quality of management. The caveat: this strategy hasn’t worked as virtually all REITs, no matter how levered, recovered quickly and smartly from March lows. However, we suspect that quality will increasingly matter as fundamentals remain challenged and new capital is ever more expensive.

Detailed Key Takeaways

(1) Conflicting view that we’re both entering a period of tremendous buying opportunities, yet also a long way from the bottom as mountains of debt come due and can’t be refinanced amidst deteriorating fundamentals;

(2) Government support to financial institutions could be delaying distressed sales and preventing market clearing prices;

(3) Reluctance of note holders (e.g. banks) to take losses (related to point #2);

(4) Property deal flows near all-time lows, although perhaps somewhat better than several months ago;

(5) Not surprisingly, fundraising is difficult and fund structures are changing; and,

(6) Well capitalized REITs may be relatively better positioned to lead the way through the next several years.

Insights/Commentary for Each Point

(1) Conflicting view that we’re both entering a period of tremendous buying opportunities, yet also a long way from the bottom as mountains of debt come due and can’t be refinanced amidst deteriorating fundamentals.
  • The private equity fund business is largely focused on the National Council of Real Estate Investment Fiduciaries (NCREIF) indices (link here), all of which are down meaningfully over the past year.
  • Participants also follow the NAREIT index, which is down 46% over the past year (link here). Given the significant declines, an ad hoc audience poll during a keynote session showed nearly 100% of persons believe we’re entering the “best buying opportunity for real estate in decades”. One potential sign of a bottom: foreign money is very interested and starting to take advantage of US opportunities (example: purchase of AIG headquarters by investment firm partnered with South Korean bank – link here).
  • However, despite the pervasive sense that values are down so much there must be great buying opportunities, reality paints a different story.
  • Real estate runs in long cycles – typically seven years up, seven years down, seven years up…. We seem to be in year two of a down cycle. One conference speaker commented that real estate typically lags GDP by approximately 12 months and, therefore, if US GDP turns the corner in late 2009 or early 2010, a real estate recovery may not materialize until late 2010 or early 2011. The best case scenario relayed by one speaker called for net space absorption in 2011 with rent growth returning in 2012 or later.
  • Fundamentals across sectors – retail, office, industrial, multifamily, hotels – are still deteriorating, making net operating income (NOI) forecasts and corresponding valuations unreliable – buying at 10-12% trailing cap rate today might be a 7-9% cap rate on 2010E NOI.
  • Finally, the real zinger: $1.5 to 2.0 trillion of mortgage debt is coming due over the next four to five years (*figures and timeline vary depending upon source) and new lending remains constrained (or nonexistent). While there are signs of life in the CMBS market for single tranche deals, the securitization channel remains largely closed relative to days gone by when approximately one third of commercial real estate debt was securitized. Legacy CMBS issues may require five to ten years to workout.
  • Thus, when large LP investors were asked at the Forum where they’re investing today, the answer was basically, “we’re not – we’re waiting and watching”. They’re spending most of their time dealing with existing investments.
  • Conclusion: no one wants to miss the bottom, yet veteran real estate investors don’t think the bottom has arrived and are waiting for the other shoe to drop.
(2) Government support to financial institutions could be delaying distressed sales and preventing market clearing prices.
  • Conference presenters implied that government support to large money center banks delayed the day(s) of reckoning with poorly underwritten commercial real estate loans that will likely need to be marked down and restructured.
  • According to speakers, since banks have been holding onto most loans at original, par values – not to mention complex CMBS loan structures – the amount of distressed sales has been less than expected to-date and true asset values are not yet reflected in the marketplace. In addition, some financial firms are waiting to see what else the government brings to the table and what the rules of the game are before committing to a specific course of action. The introduction of the Legacy Securities Public-Private Investment Program (PPIP – information here) on 3/23/09 seemingly created both opportunity and incremental confusion for market participants.
  • But, now that near-term bank capital requirements have been addressed, both federal/state regulators and banks are focusing attention on commercial real estate loans.
  • Conclusion: most investors expect the banks to more aggressively address troubled commercial real estate loans and the pace of distressed sales to accelerate into 2010.
(3) Reluctance of note holders (e.g. banks) to take losses (related to point #2).
  • Given Tier One capital requirements, marking loans to adjusted market values would have a detrimental effect on bank balance sheets.
  • Belief that the economy and real estate market will turn in another two quarters and values may recover somewhat, despite reality that real estate is a lagging asset class and “the reset button” has been hit on valuations.
  • FASB 157, the new framework for measuring fair value, allows for valuing assets based on a “normalized” income stream. Still, for those parties needing to sell assets in the short-term, valuations are likely to be based on current, depressed market comparisons and/or cash flows.
  • In last month or so, some increased realism and willingness of banks to “take keys” with property entering REO (real estate owned by bank).
  • In the new lending environment, underwriting may be 50-60% LTV on new (lower), adjusted values. Example: $100M property in 2007 ($8M NOI at 8% cap rate) with 75% LTV ($75M loan) might now be valued at $78M ($7M NOI at 9% cap rate) with 60% LTV supports a loan of only $47M (requires more equity). Still, several Forum speakers noted that many buildings might be valued at 50c on a 2007 dollar, far less than the 78c in this example and implying credit losses.
  • Conclusion: banks will strive to address loan issues gradually to minimize negative balance sheet impacts.
(4) Property deal flows near all-time lows, although perhaps somewhat better than several months ago.
  • Very few transactions are taking place and bid-ask spreads remain extremely wide given uncertain valuations on declining NOI figures.
  • Related to points (2) and (3), the difference between bank seller “asks” and private market bids is meaningful. Banks may want 80-85c but market clearing price is 50c.
  • Limited access to credit for willing private market participants compounds an already slow transaction environment.
  • Potential buyers “don’t want to look bad” if values decline further and are largely waiting to see forced selling.
  • Conclusion: transaction activity may remain limited, yet ongoing market adjustments and the need to ultimately move assets off balance sheets should lead to more market clearing deals.
(5) Not surprisingly, fundraising is difficult and fund structures are changing.
  • With value often reverting to creditors – and equity holders left with nothing in leveraged funds – pension and endowment funds, as well as high net worth investors, are twice shy about allocating more funds and do not wish to throw good money after bad.
  • One speaker cited a pension fund allocation to real estate of only $300 million in 2009 compared to $16 billion in 2008 (source uncertain).
  • That said, the Forum consensus view was that the fund business won’t go away since large LPs are “not equipped” to invest all of their assets without help from targeted investment funds. Yet, going forward, improved governance is a must, hurdle rates will be higher and fees/promotes lower.
  • Back-to-basics approach: emphasis on owner-operated investment models with proven capabilities rather than financially engineered structures.
  • Conclusion: long track records with real experience kicking the tires are ever more important when selecting real estate private equity fund sponsors/managers.

(6) Well capitalized REITs may be relatively better positioned to lead the way through the next several years.
  • Perception that private side has been slower to address impending debt maturities on expectation that things will get better in 2010-2011.
  • By contrast, REITs have been proactive in several ways to de-lever balance sheets: first cutting dividends, then cutting dividends further and paying stock rather than cash dividends, and, recently, raising equity.
  • Larger scale and liquidity puts many REITs in stronger positions to manage through a period of declining fundamentals.
  • Conclusion: REITs with strong balance sheets may be better able to (1) acquire distressed assets over the medium term relative to private players and (2) pay investors to wait with cash/stock dividends.

Brief commentary for certain property sectors and high level reads across for selected REITs: Office
  • Activity very slow and large elaborate spaces/rents are thing of past for now.
  • New York City rents in free fall. According to one speaker, Class A rents are averaging $65 per square foot compared to $120 previously and Class B rents are averaging $40 per square foot compared to $70 previously.
  • Leases for banks with government money might be viewed as “GSA” leases.
  • Despite negative trends throughout office, central business district (“CBD”) properties are viewed as better positioned for an eventual recovery than suburban office properties. That said, asset quality and location are critical factors whether CBD or suburban.
  • Negative to mixed read across for large central business district (“CBD”) REITs Boston Properties (BXP), SL Green Realty (SLG), Vornado Realty (VNO), and suburban REITs Brandywine Property Trust (BDN) and Mack Cali (CLI).
  • View from speakers that we’ve not seen bottom and, as we expected, landlords are seeing essentially no demand for net new space given plenty of excess supply in most markets. Tenants are hesitant to commit to new space and there is a perception that the US is over-retailed.
  • Pace of decline in monthly same store sales has slowed, but still seeing mid to low double digit declines with many retailers operating under duress. However, the number of retailers seeking rent relief is less than several months ago and landlords are successfully calling bluffs of many large, national tenants hoping to take advantage of weak conditions to work concessions.
  • Impact of rent relief: while all companies will have different sensitivities, one speaker relayed the following for his company: approximately 15% of tenants asked for rent relief in recent months and company granted two thirds of requests with average rents down 35% from prior levels. The change is expected to reduce forward revenue by 3.5-4.0% and forward NOI by 7-8%.
  • On purchasing new properties, “NOI is more likely down than up [over the medium term], which makes buying very difficult.”
  • Grocery anchored community centers seen as more defensive, while “power center” carries a negative cachet at present and Class B malls are at an obvious disadvantage relative to “high-end, fortress” properties.
  • Mixed/negative read across for grocery community center anchored REITs Kimco (KIM), Regency Realty (REG), and Weingarten (WRI). Negative read across for highly levered mall REITs CBL & Associates (CBL), Macerich (MAC), and Pennsylvania REIT (PEI). Mixed read across for relatively better positioned Ramco-Gershenson (RPT) and Simon Property Group (SPG).
  • Prices in the overall residential market are expected to decline into 2010 with lower rents and higher vacancies for multifamily properties for the next two to three years.
  • Key drivers such as family formation and new job growth are expected to remain soft, although view from Forum speakers than multifamily sector is better positioned than other real estate sectors since the US population is still growing and people need a place to live (*true, but may not offset negatives).
  • One speaker noted that, during the boom, the US was adding two million single family housing units per year, well ahead of demographic demand for one million units per year. Now, the excess product is acting as a “shadow supply” drawing persons away from the multifamily market.
  • Most “busted condo deals” don’t work because they were constructed for unit sales prices that don’t work as rental units and fragmented properties (some condos, some apartments) are difficult because institutional owners want consistent cash flow from all units and not uncertain sales revenue from sporadic unit sales to retail buyers.
  • Each market is different, yet Miami/Florida is viewed as the most troubled region with one speaker noting that during the 1970s it took approximately eight years for Miami prices to recover.
  • For newly constructed properties in core markets (e.g. NYC, DC, SF), some institutional buyers are willing to purchase properties at a significant discount to construction cost with the goal of running as breakeven for the next eight years but making two to three times purchase price on exit as values recover (*2-3x sounds good, but long time to wait without current cash income).
  • Negative/mixed read across for large apartment REITs AIMCO (AIM), AvalonBay (AVB), Colonial Properties Trust (CLP), and UDR (UDR).
  • Expectation that buying opportunities may improve in 12 – 18 months.
  • “AIG effect” combined with down economy is major negative: events business down substantially.
  • Brands especially important to drive business.
  • Foreclosures rising: W Hotel San Diego (link here), plus numerous Ritz Carlton Hotels.
  • Casinos just beginning to show problems – example of challenges: one speaker commented that Steve Wynn’s Encore phase two in Las Vegas was built assuming an average room rate of $430/440 per night but that rooms can currently be had for as little as $140 per night (*note that Encore’s Web site is offering $300-400 quotes, yet perhaps specials offers of $140 per night are available through various channels).
  • Negative read across for the hotel sector at large, including REITs Diamondrock Hospitality (DRH), Felcor Lodging (FCH), Host Hotels (HST), and Sunstone Hotels (SHO), as well as for casino companies Las Vegas Sands (LVS), MGM Mirage (MGM), and Wynn Resorts (WYNN). Likewise, negative read for C-corp hotel companies Marriott (MAR), Starwood (HOT), and Wyndham (WYN), although well capitalized companies with revenue streams beyond direct lodging (e.g. management/franchise fees) are clearly better positioned to weather the storm.

We evaluate equities across sectors with an owner-oriented investment approach and are closely tracking real estate because of the sector’s pain. As with all equity investments, asset/franchise quality and fundamentals are what matter over the long-term. While we believe certain well-capitalized REITs offer attractive risk/reward tradeoffs, our takeaways from the IMN's 10th Anniversary US Real Estate Opportunity & Private Fund Investing Forum are largely negative for near-term private and public equity investments in real estate. A contrarian investor might suggest that (1) the bottom is impossible to call and (2) since the primary messages were mostly negative, perhaps we’re at/near a bottom. Nonetheless, lagging real estate trends and debt challenges keep us cautious and inclined to expect the worse when considering any investment in the sector (or elsewhere). Only when we’re confident that (1) assets are both high quality and inexpensive relative to replacement cost, (2) the balance sheet is strong and cash flows are resilient, and (3) management is capable and committed for the long-haul, are we willing to put our capital at risk.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BDN, WRI.

© 2009 Jeffrey Walkenhorst
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1 comment:

  1. If a good real estate agent can help grease the wheels and get your offer in front of a lender, you can get an answer more quickly, and potentially close more deals.


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