This is not my headline, but I wish I had written it. It comes from REBusinessOnline which recently published a story about Ethan Penner and his perspective on the commercial real estate market. Penner’s comments are consistent with my view that the stampede into primary markets and core assets is overdone, just like the stampede into the Sunbelt was overdone in 2007. To be sure, San Francisco (where I live) is seeing strong rent growth across the four major food groups, but some investors are paying up for Daly City and Santa Rosa as if they were Pacific Heights and Telegraph Hill.

The article, which you can read here, follows:

Today’s extremely low interest rates pose a danger to commercial real estate investors, particularly those with billions of dollars to deploy such as pension funds and sovereign wealth funds, warns Ethan Penner, founder and president of CBRE Capital Partners. In order to receive a reasonable rate of return, these investors are being “crowded out” of low-risk investments and forced into high-risk investments.

The 10-year Treasury yield, a benchmark for commercial real estate finance, currently is hovering around 2 percent, not far from its record low.

“There is almost no way to invest large amounts of money in today’s market — specifically in today’s real estate market — and not be set up for a major disappointment sometime soon,” remarked Penner during his keynote address at the Commercial Real Estate Investment & Finance 2012 conference. Law firm Morris, Manning & Martin along with France Media’s InterFace Conference Group hosted the day-long event at the Grand Hyatt in Atlanta.

“The major disappointment may take the form of economic non-recovery, it might take the form of very, very high interest rates, which will render your returns very, very inadequate,” explained Penner. “I don’t know what [factor] it is going to be, but I can tell you the byproduct of investing money today for most investors is going to be a lot of crying going forward.”

A disconnect among investors only compounds the problem. Some fund investors, for example, seek low-risk properties that generate double-digit returns. But those returns are more representative of value-add or opportunistic deals.

Penner, a pioneer in the commercial mortgage-backed securities industry who served as CEO of the Capital Company of America/Nomura Capital from 1993 to 1998, said the federal government has engaged in a misguided effort the last few years to bail out the banking system. In his view, government has acted on the belief that in an overleveraged world saving creditors is important.

“Obviously they are wrong. [The government] should have been saving the debtors, not the creditors,” argued Penner. “If we had taken the couple trillion dollars that we wasted trying to prop up the creditors and deleveraged the debtors, we’d already be in a recovery. It’s so obvious that it’s kind of amazing that nobody figured it out.”

Penner supports the idea of providing mortgage debt relief for homeowners. “That could be something that catalyzes a recovery because it’s obvious that it’s needed.”

Who is paying the bill for the efforts to prop up the banking system through low interest rates? The most obvious group is savers, explained Penner, “because people who are older, who are retired, and who were expecting to be able to invest their hard-saved money at a very low-risk investment at a certain rate of return to live a certain way of life are screwed beyond belief.”

San Francisco, once considered one of the strongest commercial real estate markets in the country, had one of the largest increases in overall CMBS default rates in the second quarter of 2009, up 444 basis points to 5.15% (and yes, this was even worse than Miami). Detroit was still the worst performing market, with an overall CMBS default rate of 5.62%, up 562 basis points from Q1. However, San Francisco’s multi-family sector now has a CMBS default rate of 21.7%, which is almost double the 12.93% multi-family delinquency rate in Detroit.

The amazingly high default rate in multi-family is being driven by one just one buyer and a lot of brokers in nice suits. Well known for not only paying top dollar (over 20 times gross rents) but also for pursuing, shall we say, aggressive retenanting programs, this buyer actually pocketed 75% of all San Francisco apartment properties that traded in 2007. And who is surprised? At 20 times gross rent, anybody who wasn’t selling was living under a rock. About $1.2 billion was “invested” from 2003 through early 2008, financed primarily with two year, interest-only, cross collateralized debt complete with personal guarantees who’s your daddy now?

The answer is UBS, which has already taken back about 1,500 units, and CIM, which bought the senior debt on 24 properties from Credit Suisse. This is only the tip of the iceberg though, and so far only about 700 units have actually been sold to new buyers. San Francisco apartment brokers, who were only too happy to cheer 20 GRMs on the way up, are now complaining publicly about comps that are “artificially low”. Predictably, the view on that side of the fence is not that this guy overpaid, but that he simply over-levered! That aside, I’ll give you one guess where prices in San Francisco are heading:

Despite the mess in San Francisco now, the S&P/Case-Shiller Index for Bay Area multi-family prices shows a 10.83 percent growth rate from the year of its inception (1995) through 2002. Growth in prices was strongly influenced by the Bay Area’s healthy population growth, and as a result growth in Bay Area multi-family prices far outstripped the S&P/Case-Shiller Index for the top 10 metropolitan areas over the same period.

Unlike some cities in the Lone Star state, for example, where increased supply typically rises to the occasion, Bay Area multi-family prices have been influenced by a fundamental supply and demand imbalance even before the credit/real estate hysteria of 2003 through 2006. Between 1987 and 2002, the Bay Area population increased by 18 percent. The growth was fairly evenly spread over nine Bay Area counties, with Solano County having a growth rate of 28 percent, which was the highest growth rate in the area. The largest population growth in terms of total residents occurred in Santa Clara County, which added 301,000 people, followed by Alameda County and Contra Costa County, both of which added approximately 250,000 people. Combine that with natural and political barriers to unfettered new development, and Northern California doesn’t look so awful even in you’re a Bears fan.

Granted, the current San Francisco foreclosure saga is far more interesting than plodding through Bay Area demographic statistics. But when all those “artificially low” comps get set, is there any place you’d rather be with your money?

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If you are investing in REITs right now, life is good. The US MSCI REIT index has doubled since hitting its lows in March, and in the second quarter Mid America (MAA) generated $.05/share in earnings from the sale of just one asset, a 36 year old, 96 unit apartment building in Grenada, Mississipi. Indeed, gambling on a little property in Grenada, Mississipi looks like a much safer bet right now than rolling the dice in Las Vegas, the gambling capital of the world.

Las Vegas is so volatile that 2009 transaction volume has dropped almost to zero, and prices prices appear to have declined by at least 60% from the peak. However, with virtually no sales taking place, it’s hard to know what the market is. Amazingly, sales by dollar volume in Las Vegas have plunged by 99%, from almost $2.5 billion in 2005 to just $25 million for all of 2009:

The buyer, a San Diego socialite, was somehow convinced to pay a 5.5% cap rate on trailing-three-month NOI and a 6.1% cap on a trailing 12-month NOI. Even more incredibly, because the property was only 65% occupied by the time the sale closed, no lender would touch it, and the purchase had to be an all-cash deal. Can you say no competition?

Given the crummy fundamentals in Las Vegas, this sale is yet more evidence that the distress in commercial real estate may be cushioned by patient capital much more so than some currently expect.

Apartment values in New York City have declined at least as much as in Las Vegas. As I wrote earlier this year, the yawning gap between cap rates and GRMs means that New York City apartment values are heading in but one direction: Staten Island.

The Riverton, a massive 1232 unit behemoth of bricks that was purchased in 2006 for $340 million, is a great example. The buyers purchased the property using a first mortgage with day one debt coverage of .39x, which meant that the loan had absolutely no hope of being paid through existing cash flow.

Of course, the CMBS loan promptly became delinquent and the property is now in the hands of its special servicer, appraised at $108 million barely three years after Deutsche Bank wrote a check for its $225 million first mortgage. And the REIT goes on!

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It’s summertime and the living is easy, but if you’re a distressed debt broker, this is no time to be mixing Cuba Libres at the beach. There have been 72 bank failures in the first eight months of 2009, compared with 26 in all of 2008 and just 3 in 2007. So it should be no surprise that distressed debt offerings are taking off like a teenager after a paternity test, and distressed debt traders are definitely going to have their day in the sun, whether it be by hook or by crook.

Last week, $487 million of bad commercial real estate loans were offered for sale, and $235 million of it was on behalf of just one seller. The collateral was literally all over the map: Arizona, Illinois, Wisconsin, Tennessee, Indiana, Kansas, Florida, Nevada, California, Texas, North Carolina, Missouri, Minnesota, Ohio, New Mexico and Arkansas. And this week, the Wall Street Journal chronicled the mess at Maguire, which will soon let loose another $1 billion in bad debt on the market, with collateral concentrated in Southern California.

What’s happening is no mystery. These loans are succumbing to conditions that can’t be contemplated if your stock in trade is acquiring property with OPM using interest-only debt at 90% LTV, and this is just the tip of the iceberg. While many 2005 and 2006 borrowers are still alive, the hold your breath and hope strategy they have adopted will come to an end in 2010 and 2011. And just like the mid-market loan barons at CIT, these commercial real estate contessas are pressing for an assist from Uncle Sam. However, aside from TALF and PPIP, and just like the situation at CIT, additional government assistance is unlikely to materialize.

The reason is that the magnitude of the problem is being overstated. One could produce a graph showing all commercial loan maturities through 2013, and if one were to do that, it would show that there are $1.4 trillion in commercial loan maturities through 2013, and it would also show that the majority of those loans, over $1 trillion worth, are held by banks and thrifts. With bank failures increasing at an exponential rate, these the figures are the ones that the Real Estate Roundtable would use to bully congress into smothering the grenade with tax dollars:

However, the data on commercial real estate loans held by banks and thrifts comes from the FDIC, and the FDIC does not publicly release data that is granular enough to analyze the collateral backing these loans. It’s true that all of these loans are secured by commercial real estate, but many of them are actually business loans in which real estate happens to be just one small component of a much larger collateral package. Accordingly, the data does not distinguish a $5 million loan for an office building in Topeka from a company in Topeka that obtained a $5 million line of credit secured by an office building, accounts receivable and inventory.

Notably, this chart also shows that commercial real estate loan maturities climb relentlessly through 2010 and 2011, ascending to a peak in 2012, but it’s also notable that billions of dollars have been raised in anticipation of this eventuality.

As of the end of June, REITs had raised almost $15 billion in 45 public offerings, and even the beleaguered Mortgage REITs managed to scratch together $4 billion. HCP, a Healthcare REIT, closed yesterday on a $441 million stock offering, and Starwood Capital, Barry Sternlich’s new Mortgage REIT, just announced that it was increasing the size of its IPO to $800 million, which would make it the largest IPO of the entire year.

Raising money in the private market has been less productive, perhaps another $5 billion has been coaxed from the coffers of private equity investors. However, the market is nevertheless working as it should: bad debt is being recycled into equity, and amazingly enough, prices have not dropped as much as one would expect. Should the government get even further involved, using our ever-more scarce tax dollars, when private capital already seems to be doing the job?

If the real estate exposure is overstated in the bank and thrift world, where will all this new money find a home? One place where the turkeys are definitely coming home to roost is in the CMBS market, where 2005 and 2006 vintage loans with five year maturities will have very little hope of being refinanced without additional borrower equity. Opportunities for new investments in pear-shaped CMBS deals will be especially abundant in 2010 through 2012:

So, if you’re looking for deals in commercial real estate, you’ll need to look even harder than everybody else. Barry Sternlicht is no dummy, and he’s definitely not alone. The truth is out there, and it congregates here!

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Last week, Zero Hedge attempted to make a tortuous connection between the sales prices of “performing” commercial real estate loans being sold by the FDIC and the book value of performing CRE loans held by healthy financial firms – presumably the likes of JP Morgan Chase, Goldman Sachs, Morgan Stanley and others. Aside from creating a new platform from which to bellow about “very startling” and “very hypocritical” dealings in the financial world, I failed to understand the purpose.

My Own Experience With FDIC Loan Sales

Having bid on performing and non-performing CRE loans with real money (my own), and having worked directly with two of the intermediaries that the FDIC has hired to dispose of these loans, my real world, practical view is that there is absolutely no connection to be made.

“No floor floaters” would be really interesting if they were part of a hip hop performance, but not if they are real estate loans at LIBOR plus 150. “No floor” simply means that there is no floor on the loan’s benchmark rate. In the case of a no floor floater at L+150, the new owner of that loan would get a coupon of about 1.85%. In today’s market, that’s a zombie loan. Add in a crooked borrower with bad collateral, and I’ll show you a loan on blocks sitting forever unsold on Indy Mac’s front yard.

One of the other revelations in the post was that even performing CRE loans were being sold quick, call the SEC! at an average of 51 cents on the dollar. But whether a loan is “performing” or “non-performing” is really not relevant: it is simply a bureaucratic classification for the current payment status of the loans.

If it Sounds to Good to be True…

In the real world, many of these “performing” loans are doomed. They were promoted by borrowers and mortgage brokers on the basis of NOI assumptions that can no longer be achieved, underwritten by loan officers who had no idea what they were doing, and ultimately sold to investors whose profit motive (in many cases) was collecting management fees, not interest income. In that case, why not lever yourself silly and buy all you can?

A couple of the loans I looked at had unpaid principle balances that were completely disconnected from the true value of the collateral. The reason: underwriting that seemed to be done by a kindergartner, and probably was.

One of the loans, against a 1960’s vintage 164 unit apartment building, assumed that operating expenses would be almost 30% below the national average. Nevermind that launching the Apollo program would be cheaper and easier than fixing the leaks constantly springing from this property’s creaky 45 year old plumbing system. Effective gross income also showed red against the original underwriting – something about renters unwilling to pay a premium for kitchens that hadn’t been updated since Jack Ruby gave Lee Harvey Oswald a new address.

Another was a Fannie Mae DUS deal in which the borrower had racked up negative retained equity of $2MM in just 4 years. In the most recent year, the borrower lost $250,000 just from trying to meet the property’s monthly nut. That loan is current and matures in 2012, so it is classified as “performing”. Neverthelesss, there’s no way it will get refinanced at par, assuming the borrrower makes it that far, because the property is worth much less than par. How could the loan be worth anything more?

If you think the sole province of bad underwriting is multi-family originations, you should think again and again.

So, You Want to Bid on an FDIC Loan Sale? Look Before You Leap…

So what happens when you bid on one of these loans? The FDIC does not allow property inspections of any sort. Buyers are afforded the opportunity to review the original loan files, which contain such helpful information as the original, hopelessly out of date appraisal. Assuming you have enough local market knowledge to formulate a bid and “win”, you’ll have just 7 days to close. There is no futzing around with surveys, title reports and good standing opinions – we’re talking an all-cash close on a 7-day fuse.

Once you own the loan, you’ll eventually need to foreclose. Quantifying the risks around that is practically impossible. Convincing the borrower to enter into a deed-in-lieu of foreclosure is about the best outcome you could hope for. Assuming the borrower does not declare bankruptcy, in which case you are totally screwed, expenses on a “clean” foreclosure will run you at least 4-5% of the face amount of the loan.

Then you finally get the deed, but it won’t be the normal “general warranty” deed that you want. It will be a “limited warranty” deed, meaning the seller (the FDIC) will not vouch for the deed’s marketability. This is ideal, as everybody Vladimir Putin and Caesar Chavez likes limited marketability.

After that happens, the town/county/governing authority comes in and wants to authenticate the Certificate of Occupancy. In the case of the 164 unit building above, the county condemned 32 units right off the bat yes we can! So now the purchaser, a small private equity fund in Connecticut, is suddenly 20% vacant just for the privilege of a handshake with the local building inspector. Meanwhile, they’re stuck paying property taxes based on some inflated value from 2006. But that’s OK – they have unfathomably deep pockets and lots of spare time, and according my friends at Zero Hedge, they’re a co-conspirator! Shameless Plug: Chris Germain San Francisco

Update: This post received over 30 intelligent, knowledgeable comments, but when I updated my software and moved to a new location on the server, they did not automatically port over to the new location. I have republished them in bulk below, under my name. I added a few line breaks for legibility, but they are otherwise unedited. Cheers, REIT Wrecks
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