Elephant in the Room
I've read plenty of 10-Qs over the past few weeks.  I am beginning to think that many broker / dealers' and analysts' obsession with distribution coverage and Funds From Operations is too myopic.  Don't get me wrong, this is an important area, especially for the non-traded REITs raising significant amounts of investor capital based on high dividends.  Coverage ratios are convenient because they give a clear indication of REIT performance.   I feel that broker / dealers need to expand their analysis and start looking at maturing debt and how this could impact future cash flows.

I am concerned with non-traded REITs that have debt maturing over the next several years, and how these maturities will impact the REITs' balance sheets and future distributions.  I am not going to call out any particular REIT, but have put together the spreadsheet below based on composite data that I feel represents what could happen to a REIT as it goes to refinance its debt:
 

                                                        Original Purchase                   Refinance

Property Leverage		70%		60%
Cap Rate		6.50%		7.50%
Debt Interest Rate		3.50%		6.50%
Annual Debt Svc		$1,225,000		$1,972,052
Purchase Price / Value		$50,000,000		$43,333,333	-13.33%
Leverage		$35,000,000		$26,000,000
Original Equity		$15,000,000		$15,000,000
Required Additional Equity		-		$9,000,000
Total Equity		$15,000,000		$24,000,000
NOI		$3,250,000		$3,250,000
Debt Svc		$1,225,000		$1,972,052	60.98%
Net Cash Flow		$2,025,000		$1,277,948	-36.89%
Cash Return On Equity		13.50%		5.32%		-60.56%

The assumptions are that a property was acquired for $50 million.  I assumed 70% leverage, or $35 million and $15 million of equity.  I assumed the property was acquired at a 6.5% cap rate on net operating income of $3.25 million.  I assumed the original loan was interest-only and had variable rate interest at a rate of 3.5%.  This gave the property a cash return on equity of 13.5%. 

Now this hypothetical property has to refinance this favorable debt.  In my refinance assumption I kept the NOI the same.   Cap rates have increased and leverage ratios have dropped over the past two years.  I used a new valuation cap rate of 7.5% and a 60% leverage ratio.  The property is now valued at $43.3 million (using a 7.5% cap rate on the unchanged NOI), and the amount of a new loan is only $26 million (60% leverage on the new $43.3 million value).  This leaves a $9 million shortfall that the REIT needs to retire the original loan.  So, the original $15 million of equity needs to be increased to $24 million.  Looked at another way, the REIT needs to add an additional $9 million to a property that has lost $6.7 million of value.  I assumed the new loan has a rate of 6.5% and amortizes on a thirty-year schedule.

The end result is that the debt service increases, despite the lower leverage, and the cash flow decreases.  In the example above, the return on equity drops to 5.3%.  The other option is to walk away from the property, but this has its downside, too.  How can a sponsor justify walking away from property with positive operations?

Non-traded REITs that are raising capital may be able to pay down original debt.  REITs that are not raising capital may have to cut distributions to preserve cash to repay debt.  The end result may be long-term lower cash flow, as shown above.

This scenario can get worse if it is expanded to lease renewals.  Lower lease rates would lead to a lower NOI, which leads to a lower valuation, which leads to lower refinance debt amounts, which leads to more REIT cash to repay the exisitng loan, which leads to lower returns on equity.  You get the picture. 

It is not a bold statement to say that REITs struggling to cover their current distributions, and that have significant debt maturing over the next few years, will be hard pressed to maintain their current dividends.  Analysts and broker / dealers need to turn their attention to non-traded REITs maturing debt and be aware of the potential impact on cash levels and distributions.

How Much Does $500,000 Really Cost?
Bloomberg TV just had a segment stating that since the start of the oil spill in the Gulf, British Petroleum has lost $57 billion in market capitalizaton.  Bloomberg estimates that clean-up will cost BP $24 billion.  And who can estimate far ranging legal and settlement costs, which will extend for years.  The oil and gas industry successfully fought regulation that would require the installation of a remote acoustic trigger to shut off oil wells in the event of a blow out.   Acoustic triggers cost $500,000.  There is no guarantee that the trigger would have worked to stop the flow of oil at BP's well, but countries with extensive off shore drilling, like Norway and Brazil, require these devices.  At a price of $70 per barrel of oil, the trigger is the equivalent of 7,150 barrels of oil.  It is estimated that the BP well is leaking 75,000 barrels a day.   The switch would have been two hours and twenty minutes of production.  At this point, I don't think BP will survive this disaster.  I hope other oil companies are looking at this example, and are realizing that $500,000 is cheap.  Here is a link to a Wall Street Journal article discussing the acoustic valves.

Appears Important
This article from Bloomberg about Well Fargo and LNR selling distress loans and real estate strikes me as important.  LNR is the largest special servicer of CMBS loans, which means it is tasked to deal with loans in CMBS that have gone bad.  Hear is what they are looking to sell:

Wells Fargo of San Francisco, the biggest U.S. commercial real estate lender, is taking bids on $500 million to $1 billion of office and hotel mortgages and properties, said four people, who asked not to be identified because the sale is private. LNR, the largest special servicer of commercial mortgage-backed securities, is trying to sell about $1 billion of defaulted loans, two people said. 

And here is what they hold in non-performing assets:

Wells Fargo had $12.9 billion in nonperforming commercial property loans in the first quarter, the firm said, while LNR is the special servicer on $24 billion of delinquent assets, according to data compiled by Bloomberg.

Most of the Wells loans relate to its takeover of Wachoiva.  I would guess that the LNR loans need to be bought and then foreclosed upon, with the proceeds LNR receiving going to CMBS holders.  Not sure but I think this is encouraging news.

Four Dollars and Twenty-Five Freaking Cents
$4.25.  That is the price per share that the Behringer Harvard REIT is now values itself.  The original share price was $10.  I heard rumblings a few weeks ago that a large devaluation was pending.  I have never analyzed this REIT, so I am not sure the valuation is that shocking, but on its face, a 57.5% loss of value is troubling.  Here is a link to the SEC's website where BH posted its document that puts forth the valuation - buried at the bottom of page 26 of a 32 page document. The REIT also cut its distribution to 1%.  The Moody / REAL All Type Property Aggregate Index for commercial real estate shows a 41.8% drop in commercial real estate prices from their peak in August 2007 through February 2010.

Part of the BH document is dedicated to laying out a case that part of its troubles stem from problems in commercial real estate and the greater economy.  There is obviously some truth to this.  But not all real estate firms have lost 57.5% of their value.  Publicly traded Federal Realty Trust (FRT) has gained nearly 19% since the start of 2006.  It pays a quarterly dividend that it has managed to increase from $.56 a share to $.66 a share over the same period.  I know that comparing Behringer Harvard REIT I to FRT is not an apples-to-apples comparison, but I show it to illustrate that while all real estate firms have faced the same economy, using a bad economy and tough real estate market cannot be used to explain away all problems.

Something to Ponder
I can't believe it's been almost a month since my last post.  There are plenty of post coming.  In the meantime, here is a post I saw last week on the blog Marginal Revolution that's worth thinking about:

The challenge

David Leonhardt spells it out clearly:

As a rough estimate, the government will need to find spending cuts and tax increases equal to 7 to 10 percent of G.D.P. The longer we wait, the bigger the cuts will need to be (because of the accumulating interest costs).
Seven percent of G.D.P. is about $1 trillion today. In concrete terms, Medicare’s entire budget is about $450 billion. The combined budgets of the Education, Energy, Homeland Security, Justice, Labor, State, Transportation and Veterans Affairs Departments are less than $600 billion.
This is why fixing the budget through spending cuts alone, as Congressional Republicans say they favor, would be so hard.

Here is related commentary.

The permalink is here, but includes all the comments, many that are inane partisan blather.  Marginal Revolution is a libertarian blog.

CMBS Article
Here is an article (subscription required unless you email it to yourself) from today's Wall Street Journal on the CMBS market.  Commercial mortgage default rates, defined as more than 60 days past due, for mortgages in CMBS are now at 7%, and are expected to reach 11% by year-end.  This article confirms what I have been hearing, in that special servicers, the firms tasked with handling defaulted mortgages, are getting more creative in restructuring mortgages.  Until recently, the special servicers only real options were to extend a mortgage for a short period or give a break on interest rates, as their sole goal was to protect CMBS investors from losses.  This task is getting untenable as the scale of defaults and pending maturities are changing CMBS dynamics.  Here is a long quote from the article:

Servicers have restructured about $13.7 billion of those loans, according to estimates by analysts at Deutsche Bank. Such restructurings, which include extending loan maturities and reducing interest rates, could help bondholders and borrowers avoid bigger losses as the economy recovers. But some borrowers still wind up defaulting.

Such firms—including LNR Property Corp., owned by private-equity firm Cerberus Capital Management LP, and CW Capital, majority-owned by Canadian pension manager Caisse de Dépôt et Placement du Québec—are "going to trot out the entire playbook" used during the real-estate crash of the early 1990s, said Mark Warner, a managing director at BlackRock Inc.

One emerging restructuring strategy involves cutting mortgages into good and bad pieces. For example, Grossman Company Properties was in danger about a year ago of defaulting on the $190 million mortgage for its Arizona Grand Resort in Phoenix, which is suffering from a decline in business and leisure travel.

The loan, originated by Greenwich Capital, was part of the Goldman/Greenwich deal in 2006, which also includes troubled loans on an office complex in downtown Los Angels and six retail stores. Grossman is led by real-estate investor Sam Grossman, who made a name for himself by snapping up distressed assets in the early 1990s. After months of negotiations with CW Capital, Mr. Grossman's company struck a deal allowing it to keep the property in return for a $5.8 million capital infusion.

The original Grossman loan was split into two parts, with the cash flow from the 640-room resort, equipped with two golf courses and a water park, now used only to service the debt on the $100 million part of the loan, Deutsche Bank said. The second slice, totaling $90 million, will get no payments until the loan matures in 2016 and the first part of the loan gets paid off.

The net effect of this restructuring is that it allows the subordinate bondholders to avoid taking a loss before the loan matures while delaying the recoveries for senior bondholders, Deutsche Bank analysts note. Supporters of the restructuring said the move was in the best interest of all bondholders and the borrower because liquidating the property likely would have resulted in large losses.

It is my opinion that this new flexibility will help the real estate market.  I suspect it will also spur more commercial mortgage refinancings, which will also help the real estate market.

More HTA
The table below shows how Healthcare Trust of America funded its distributions in 2009 on a quarter-by-quarter basis.  The table was derived from data in a March 8-K filing by HTA.    The key to me is the second half of the year where operating cash flow is much less than in the first half of the year.

	12/31/09	9/30/09	6/30/09	3/31/09
Total Distributions	$23,900,000	$21,908,000	$18,004,000	$14,247,000
OP Cash Flow	$5,033,000	$1,718,000	$8,355,000	$5,895,000
Offering Proceeds	$18,867,000	$20,190,000	$9,649,000	$8,352,000
Dist as % Op Cash	21.06%	7.84%	46.41%	41.38%
Dist as % of Offering Proceeds	78.94%	92.16%	53.59%	58.62%

Yes, the REIT saw increased equity in the second half of the year, which would contribute to the drop in the operating cash flow-to-distribution coverage ratio discussed in the previous post, but it also saw a drop in operating cash flow over the same period.  The low operating cash flow-to-distribution coverage ratio cannot be fully explained away by problem of raising too much equity.  This ratio bears close attention in the coming quarters, especially since HTA made more than $400 million of acquisitions late in the fourth quarter, which ideally should be accretive to the REIT's current 7.25% distribution.

It'd Be Funny, If it Wasn't Serious
I need to stop reading public non-traded REITs' 10-Ks.  They're not good for my mental health, but reading them is like watching Kate Gosselin on Dancing With The Stars, so bad, yet you can't look away, or stop from snickering.   Healthcare Trust of America's (HTA) 2009 10-K has plenty of gems, and it may take more than this post to point some of them out.  The latest outrageous example of egregiousness is the compensation of HTA's Chief Executive Officer / President / Chairman of the Board.  This executive saw his total compensation jump from $504,753 in 2008 to $2,834,688 in 2009, the same year in which cash distributions as percentage of operating cash flow dropped to 25.5% from 66.3%.   I know HTA carried a large cash balance in 2009 as it dealt with large inflows of investor equity, and I know HTA did not acquire significant properites until late in the fourth quarter, and I have not done an analysis on the extent to which new investors may have increased the distribution pool, but a $2.3 million, or 5.6 times increase in total comp is troubling.

It is important to note that while an increase in investor equity would cause the amount of cash required to pay distributions to increase, it would not have an impact on operating cash flow.  HTA's operating cash flow increased $324,000, or 1.6% in 2009.  The properties bought late in 2009 likely did not show up in cash flow, but the properties acquired in 2008 should have, as they had a full year on the books.  Is that minuscule rise in operating cash flow worth $2.3 million?

I list below a large portion of the compensation discussion that is taken directly from HTA's 10-K:

Base Salary. Base salary provides the fixed portion of compensation for our named executive officers and is intended to reward core competence in their role relative to skill, experience and contributions to us. In connection with entering into the employment agreements, the compensation committee approved the following initial annual base salaries: Mr. Peters, $500,000; Mr. Engstrom, $275,000; and Ms. Pruitt, $180,000.  The compensation committee approved an increase to Mr. Peters’ 2008 base salary in order to more
closely align his base salary with our peers. However, due to the compensation committee’s focus on  performance-based compensation, Mr. Peters’ base salary approximates the lower end of the scale of base salaries provided by our peer companies. To emphasize performance-based compensation, the compensation committee designed Mr. Peters’ compensation package so that the majority of his cash-based compensation may be earned through an annual bonus after the compensation committee’s assessment of his performance during the year.

As discussed above, the initial base salaries for Ms. Pruitt and Mr. Engstrom were negotiated in connection with their joining our company. Also as discussed above, a key priority for us is to attract, retain and motivate a top quality management team. In order to attract a high caliber management team, the compensation packages offered must be competitive within the market, as well as reflective of the executive’s level of skill and expected contributions. These were the guiding principles followed by Mr. Peters and the compensation committee in negotiating the compensation packages with Ms. Pruitt and Mr. Engstrom.

Annual Bonus. Annual bonuses reward and recognize contributions to our financial goals and achievement of individual objectives. In 2009, we did not have a formal bonus program. Each of the named executive officers is eligible to earn an annual performance bonus in an amount determined at the sole discretion of the compensation committee for each year. Pursuant to the terms of their employment agreements, Mr. Peters’ initial maximum bonus is 200% of base salary. Mr. Engstrom’s and Ms. Pruitt’s initial target bonus is 100% and 60%, respectively, of base salary.

The compensation committee, together with Mr. Peters, developed a broad list of goals and objectives for 2009. The compensation committee awarded Mr. Peters the maximum bonus payable to him under his employment agreement based on its assessment of his performance during fiscal year 2009. In reviewing his performance, the compensation committee concluded that Mr. Peters accomplished, and in many cases, exceeded such goals and objectives, which included:

•  effectively leading the expansion of the company, including growing our portfolio through the acquisition of quality, performing assets;  
• successfully negotiating substantial and creative value-added transaction terms and conditions;    
• coordinating successful and competitive refinancing transactions during a time of significant dislocations in the credit markets;
  leading our successful transition to self-management;
• recruiting and effectively supervising our employees;  
• implementing effective risk management at all key levels of the company;
• maintaining a strong and solid balance sheet; 
• coordinating the engagement of new, competitively-priced and performance-driven property management companies for our portfolio; 
• leading the extension of our initial offering for up to 180 days, successfully transitioning the dealer manager for our initial offering to RCS and spearheading the registration of the follow-on offering; 
• establishing and enhancing our relationships with commercial and investment banks; 
• maintaining and actively enhancing our “stockholder first,” performance- driven philosophy; 
• effectively establishing our independent brand name as an asset to our company; and, 
• facilitating an open and effective dialogue with our board.

In addition to the annual bonus available under his employment agreement, after an extensive review of the peer group information and Mr. Peters’ performance in 2009, the compensation committee also awarded Mr. Peters an extraordinary bonus of $200,000. The extraordinary bonus recognizes and rewards Mr. Peters for (i) his expanded role and extraordinary efforts in providing demonstrated and effective leadership to our company, and (ii) positioning the company for continued success during recent unprecedented, difficult economic times, and in the future.

I like that extraordinary bonus of $200,000.  I wonder whether it was for ""facilitating an open and effective dialogue with the board," or "leading the extension of the Company's initial offering for up to 180 days."  How is the nearly six times jump in CEO pay putting "stockholder first," unless that stockholder is the CEO.  To me, the bonus targets are too subjective and several sound like normal tasks that are part of any CEO/President/Chairman job duties, and not factors that should be included in a bonus determination.   I examined a few other REITs' executive compensation plans, and all were quantitative in the metrics that their executives needed to achieve, not subjective goals like HTA.

As you read further, the data gets more interesting.  The increase in CEO's total compensation is disturbing, but his termination clause is hard to believe.  I list the description of HTA's senior executive termination clauses listed in the 10-K below:

Termination without Cause; Resignation for Good Reason. If we terminate the executive’s employment without Cause, or he or she resigns for Good Reason (as such terms are defined in the employment agreement), the executive will be entitled to the following benefits:

 • in the case of Mr. Peters, a lump sum severance payment equal to (a) the sum of (1) three times his then-current base salary plus (2) an amount equal to the average of the annual bonuses earned prior to the termination date (if termination occurs in the first year, the bonus will be calculated at $1,000,000), multiplied by (b) (1) if the date of termination occurs during the initial term, the greater of one, or the number of full calendar months remaining in the initial term, divided by 12, or (2) if the date of
termination occurs during a renewal term after December 31, 2013, 1; provided that in no event may the severance benefit be less than $3,000,000; 
• in the case of Mr. Engstrom and Ms. Pruitt, a lump sum severance payment equal to two times his or her then-current base salary;
• continued health care coverage under COBRA for 18 months, in the case of Mr. Peters, or six months, in the case of Mr. Engstrom and Ms. Pruitt, with all premiums paid by us; and
• immediate vesting of Mr. Peters’ shares of restricted stock and restricted cash award(s) and Mr. Engstrom’s and Ms. Pruitt’s restricted stock units.

“Cause,” as defined in the employment agreements, generally means: (i) the executive’s conviction of or entering into a plea of guilty or no contest to a felony or a crime involving moral turpitude or the intentional commission of any other act or omission involving dishonesty or fraud that is materially injurious to us; (ii) the executive’s substantial and repeated failure to perform his or her duties; (iii) with respect to Ms. Pruitt and Mr. Engstrom, gross negligence or willful misconduct in the performance of the executive’s duties which materially injures us or our reputation; or (iv) with respect to Ms. Pruitt and Mr. Engstrom, the executive’s willful breach of the material covenants of his or her employment agreement.

“Good Reason,” as defined in Mr. Peters’ employment agreement generally means, in the absence of his written consent: (i) a material diminution in his authority, duties or responsibilities; (ii) a material diminution in the his base salary; (iii) relocation more than 35 miles from Scottsdale, Arizona; or (iv) a material diminution in the authority, duties, or responsibilities of the supervisor to whom he is required to report, including a requirement that he report to a corporate officer or employee instead of reporting directly to the Board. “Good Reason” as defined in Ms. Pruitt’s and Mr. Engstrom’s employment agreements, generally means, in the absence of a written consent of the executive: (i) except for executive nonperformance, a material diminution in the executive’s authority, duties or responsibilities (provided that this provision will not apply if executive’s then-current base salary is kept in place) or (ii) except in connection with a material decrease in our business, a diminution in the executive’s base salary in excess of 30%.

I like the "Good Reason" clause that states that if HTA's offices are moved more than thirty-five miles from Scottsdale it is reason enough to trigger the CEO's termination clause.   HTA's 10-K states that the termination amount at the end of 2009 for the CEO / President/ Chairman of the board would have been $11,037,118.   If moving the office more than thirty-five miles is worth $11million, what's it worth if the printer runs out of toner?  $500,000?  What a crazy clause.  This REIT's board needs to get its act together and straighten out this compensation.  If the CEO saw a nearly six times leap in salary for lackluster financial performance, it's hard to imagine what's he going to want in compensation if performance improves for real.

Can't Fix Stupid
AIG looks to sue Goldman Sachs over losses in mortgage-backed securities that AIG insured, and then on which AIG had to pay claims when the insured securities failed.  (I think the taxpayers, via AIG's bailout, played a large role in paying AIG's claims).  AIG reminds me of a fat guy trying to hustle Michael Jordan in a game of H-O-R-S-E because he has one trick shot, and then claiming Jordan cheated after he gets beat and loses all his money.  Goldman, other Wall Street firms and hedge funds took advantage of AIG's dimwitted, short-term thinking, where AIG collected premiums for insurance it did not reserve against because it was unregulated (and therefore AIG was under no legal obligation to reserve against it), and that it never expected it'd have to honor.   The explosion in credit default swap demand should have alerted AIG to the huge problems in the mortgage market, but AIG thought it had created a new way to mint money.  The guys from State College should not play financial H-O-R-S-E with the guys from Harvard and Stanford.

Smoking Gun?
Here is an article from yesterday's New York Times about the involvement of Goldman Sach's senior management in decisions relating to the mortgage market.  I don't see a smoking gun here, I read just the opposite, that Goldman's senior management was actively engaged in what the firm's mortgage traders were doing.  This is the type of engagement that shareholders should expect from top management, especially in a line of business that had seen dramatic growth in a relatively short period of time.  It's the type of engagement that taxpayers would have liked to have seen at AIG, as a once small division (Financial Products) became huge in very short time writing un-reserved insurance policies against newly created securities that never been exposed to a full market cycle.

The article details Goldman Sach's internal debate over the housing market and how the bears prevailed in late 2006.  This was before the early-2007 collapse of the two Bear Stearns' funds that started the subprime mortgage implosion.  Goldman made a lot of money when the crap mortgage securities began to decline in value.  Here is a long quote from the article:

Goldman’s top ranks changed its stance on housing in December 2006. In a meeting in a windowless conference room on the executive floor, Mr. Viniar, the chief financial officer, and Mr. Cohn, the president, gathered about 10 executives for a briefing. Mr. Sparks, the head of the mortgage unit, walked them through the numbers. The group was unanimous: Goldman had to reduce its exposure to the increasingly troubled mortgage market

A few months later, in February 2007, senior executives began turning up on the trading floor. The message, one former employee said, was clear: management was watching.

“They basically said, ‘What does this department do? Tell us everything about mortgages,’ ” this person said.
The executives told Mr. Sparks to tell his traders to sell Goldman’s positive bets on housing. The traders’ short positions — that is, negative bets, mostly used to hedge other investments — were placed in a central trading account.

Not everyone was happy about it. One trader leaving the firm wrote the mortgage unit a one-word e-mail message: “goodbye.”

Goldman turned over all these negative positions to Mr. Swenson and Mr. Birnbaum, the traders who had previously been positive on the market. Along with Mr. Sparks, they have been credited for managing the short position that yielded a $4 billion profit for Goldman in 2007. Mr. Sparks retired in 2008. Mr. Birnbaum also left in 2008, to start his own hedge fund.

But former Goldman employees said those traders benefited from the short positions that were given to them. And their trading was tightly overseen by senior executives.

At one point in the summer of 2007, for instance, Mr. Birnbaum made a case to Mr. Cohn that some mortgage assets were cheap and that Goldman should let him add $10 billion in positive bets. Mr. Cohn said no.

Goldman / Paulson's Magnetar Trade

My last post linked to an article that detailed how a hedge fund helped create CDOs and then bet against those CDOs.  Today, the SEC charged Goldman Sachs with doing nearly the same thing.  Goldman, according to the civil suit filed today, allowed hedge fund manager Paulson & Co to select mortgages for inclusion into CDOs.  Paulson selected the mortgages it felt had the most default risk.  Goldman then sold the CDO to institutional investors while Paulson bought a credit default swap (insurance) that paid off when the CDO defaulted.  Here is an explanation from the New York Times:

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst. 

Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds. 

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

I like this paragraph near the end of the article.  Our old friends at AIG, of course, provided the insurance through the credit default swaps that made Paulson so much money:

In seven of Goldman’s Abacus deals, the bank went to the American International Group for insurance on the bonds. Those deals have led to billions of dollars in losses at A.I.G., which was the subject of an $180 billion taxpayer rescue. The Abacus deal in the S.E.C. complaint was not one of them.

Must Read
Here is a link to an incredible article about the financial crisis.  It details how one hedge fund helped prolong the credit boom.  Cracks in the system began to show in 2005 when spreads on securitized loans (CDOs) began to expand, as Wall Street became nervous about the quality of the securitized offerings.  In stepped a new hedge fund, Magnetar, which aggressively sought the riskiest pieces of new CDOs called the "equity" tranche.  Magnetar's willingness to acquire the small portion of equity, in the range of $10 million, and typically the hardest part of a CDO to sell, allowed investment banks to create CDOs in the range of $1.5 billion or more.  Magnetar even had a hand in developing the CDOs, picking actual securities that would comprise a CDO's holdings.  Magnetar wanted the riskiest loans available in the CDOs where it bought the equity.  While Magnetar was buying the equity and loading up the CDOs with as much risk as possible,  it was also buying credit default swaps, betting that its CDOs would default.  Defaults was where it made huge profits, more than offsetting the loss of the equity portion.  At one point, Magnetar was even able to package and sell some of its CDO equity portions.

Magnetar's willingness to buy high risk CDO equity sparked a resurgence in the CDO market, and therefore mortgage lending, leading to record underwriting of CDOs in 2006 and into 2007, until the whole market collapsed in the summer of 2007.  Magnetar posted huge profits in 2007 as its bets against its CDOs paid off.  This article debunks the thought that no one saw the credit crisis coming.  As early as 2005 the warning signs were apparent, but the availability of money, especially equity, caused investment banks to overlook the obvious.

Employment Figures
The economy added 162,000 net new jobs in March.  I think this is good news, even if about a quarter of the jobs are temporary Census hires.  I like the look of the chart below, stolen from FiveThirtyEight.com:

It shows employment trending in the right direction.  The unemployment rate stayed at 9.7%, reflecting in part more people who'd been out of the work force coming back looking for work.  The link above to FiveThirtyEight has more in depth analysis of today's report.

More on Non-Traded REITs 
I mentioned at the end of the last post that I'd have more to write on Behringer Harvard Multifamily REIT I (BHMF).  I think it is important that broker / dealers and investors read its 10-K.  It's complicated, but will give you a good picture of what the REIT owns.  It may surprise some broker / dealers to know that the REIT's strategy has been to acquire apartment complexes via development, and more specifically through mezzanine loans to apartment developers.  The mezzanine loans are junior to construction loans and the mezzanine loans will convert to equity when the developments are complete.  Many of the REIT's recent acquisitions have been newly constructed apartment complexes (or properties originally build as condos that are now being rented as apartment communities) that need to be leased. 

I don't have a problem with BHMF's investment strategy.  It's a perfectly fine, legitimate method of acquiring real estate.  Broker / dealers need to understand that BHMF is not simply buying cash flowing garden style apartment complexes.   BHFM's investment strategy will not allow it to pay distributions from operating cash in the near term because its properties are either under construction or in lease up.  Given the strategy, the negative Funds From Operation is not shocking or even unexpected, but it's eye-opening when you see that the REIT paid a 7% distribution to investors.   I don't have a guess when operations will fully cover the REIT's distribution, but I wouldn't expect it to cover in 2010.  Note that the BHMF had actual rental revenue in the fourth quarter.

Investors need to be compensated for the extra risk of development and acquiring properites in their lease-up phase.  This is simple investment risk/reward, where a risky investment should pay a higher return than a less risky investment.  Obviously, an investment that develops its properties should generate a higher return to its investors than an investment that acquires existing properties with established, stable income.

Sponsors of non-traded REITs get pulled by competing forces.  Broker/dealers want high distributions, but they want those distributions to be stable, low-risk and covered from operations immediately.  BHMF raised more than $40 million a month for the first two months of 2010.  I wonder how much this REIT would raise if it told broker/dealers it would only pay distributions generated from operating cash?  I don't think it would be $40 million a month.  You can't single out BHMF for "buying" its equity capital with the 7% distribution, because it is not alone in this practice, far from it.

Broker / dealers should analyze specific acquisitions made by their approved non-traded REITs that are in capital raising mode.  This eliminates the influence of excess cash waiting to be invested, and determines whether acquisitions are accretive to the REITs' expected or current distributions.  (A specific property's cash return to a REIT, based on the  REIT's investment in the property, should generate sufficient cash to support a REIT's distribution.)  If a REIT is acquiring non-accretive properites, broker / dealers better ask why, because REITs that are acquiring properties that are not accretive to their current distributions will eventually have to cut their distributions.  Broker / dealers should not feign surprise when distribution rates get cut.

Never Ceased to be Amazed
I am reading Behringer Harvard Multifamily REIT I's  2009 10-K, which was released today.  In 2009, it had Funds From Operations of -$700K.  That's right, a negative FFO.  Its operating cash flow was a measly $244K, which was at least positive.  These robust cash returns allowed the REIT declare distributions of $22.7 million.   Well, at least this REIT's mortgage debt was only $51 million on $525 million of total assets. Ahh, but not so fast.  You need to read those pesky footnotes.  The actual amount of debt is higher, much higher.  This additional debt, of which $247 million is the REIT's portion, is off-balance sheet financing and attributable to a joint venture and property-level operating entities that the REIT owns or has ownership in.   I will leave my findings at these gems, because I need to eat dinner soon and for some reason have lost my appetite.

In all seriousness, and the above snarky post is serious, I encourage you to download and read this 10-K.  I only read snippets of this massive document to pull out the teasers above, so I am sure a wider, more comprehensive reading will reveal more material passages.

Today's Housing Figures
The reaction to today's release of the monthly S&P / Case-Shiller index of twenty metropolitan markets has been mixed.  I for one think the news is good.  The index, which was up .3%, showed that the housing market was improving without the Government's tax credit for first time homebuyers.  Yes, the credit is still available, but from what I have read, its impact on the most recent numbers is much less than last fall when buyers rushed to take advantage of the tax credit that was initially set to expire at the end of November.  California was a big beneficiary of the increases with some markets up 1% or more.  

Here is a quote from a naysayer in the LA Times:

"If you look at the last two big real estate bubbles in the late 80s and 70s, you didn't see the market rebound for five years," said Christopher Thornberg, principal of Beacon Economics. "It's amazing to me that people can look at a rebounding market after the largest bubble ever and possibly think this could be sustainable."

He is right of course, but the key is when the bubble peaked.  In California, and other areas like Las Vegas and Phoenix, the bubble peaked much earlier than other parts of the country.  The bubble's peak was not marked by by the subprime explosion in mid-2007, but when values stopped increasing, which lead to the prime and subprime borrowers not being able to continue their cycle of endless refinance.  I reckon that California peaked in the summer of 2005, not the summer of 2007, so we are approaching the magical fifth year. 

Don't Look Now...
Piedmont Office Realty Trust (PDM), formerly named Wells Real Estate Investment Trust, crossed $20 per share this morning.  It had its IPO in mid-February, began trading near $15 per share, and has been creeping up ever since.  As part of its listing process, PDM had a three-for-one reverse split, so to figure an investor's breakeven share price, you need to adjust for the split.  The breakeven share price reflecting the split is $25.14 per share.   The current price of $20 is therefore about 20% under its breakeven.  It is worth considering that PDM raised most of its equity capital and acquired the bulk of its portfolio in the late 1990s and early 2000s, and as noted in a post yesterday, Moody's states that commercial real estate prices are now at 2003 levels.

Commercial Real Estate Prices
I have read several articles over the past few weeks stating that Commercial Real Estate (CRE) prices are increasing, so I figure it's now time to start commenting.  Here is a link to a Calculated Risk post (scroll down) about a Moody's report that CRE prices increased 1% in January.  Overall, CRE prices are 40% off their 2007 high, and near 2003 levels.  I have not seen this article yet, but am waiting for the article equating the increase in CRE prices to an increase in available financing.  Commercial Mortgage Backed Securities (CMBS) are staging a slow comeback that will make for more non-distressed transactions.  Real estate always has and always will be a finance game - if affordable debt is available, there will be buyers and sellers.  Low interest rates and an improving economy are also signaling that a bottom has passed in CRE prices. 

In Praise of Cash Flow
Over the past few weeks I have looked through numerous public non-traded REIT 10-Ks and supplemental financial filings.  All present Funds from Operations (FFO) and Modified (or Adjusted) Funds from Operations (MFFO).  FFO used to be a fairly simple calculation:  Net Operating Income plus depreciation and amortization, and less any cash from property sales.  But over the years, this non-GAAP number appears to have become bastardized, and in my opinion, less reliable.  Non-traded REIT sponsors used to shun this number, but with the rise of MFFO, they are embracing the figure as it has the impact of making distribution coverage look better.  MFFO figures now include items from investing - acquisition fees - and from financing - interest hedging gains and losses - which may or may not be actual cash figures, and are not operational figures.

That is why I am spending more time looking at cash flow from operations, which is a GAAP number and that is adjusted for non-cash items like depreciation, and discounting MFFO figures.  I review all three figures to the amount of total distributions (cash and reinvested) the non-traded REITs have paid during the year.  The more the REIT covers from operating cash and FFO the better.  Lack of operational cash flow coverage is a harbinger of potential future distribution cuts.

Condo Link
Here is a link to a Calculated Risk post on vacant condos in South Florida.  One 32-story high rise condo in Fort Meyers has only one owner living in the building.  The lone owner is fighting the condo developer The Related Group to get out of his condo.  Good luck with that.  Condo developments that only sell portion of their units are a mess because the whole complex is then subject to the condo association, which makes conversion to an apartment rental property difficult.

Non-Starter
I did a cursory review of a tenant in common deal yesterday (yes there are still some available).  This deal acquired the property last summer and is still raising equity.  The property's underlying operations have deteriorated over the past year.  The deal's sponsor felt it had a great buy, which may have been true when the property was acquired, but based on current operations I am figuring a cap rate to TIC investors of less than 5%.  Most of the distribution is being paid from reserves.   Why? Why? WHY? 

This deal has legacy economics (low cap rate, negative leverage (cap rate less than mortgage rate) and supplemented distribution) in a non-legacy world.   Paying the taxes makes sense over investing in this deal.

There are other tenant in common deals raising equity that acquired their properties before September 2008.  Talk about legacy deals.

Financial Times Profiles Stuyvesant Town and Peter Cooper Village
Last Saturday the Financial Times profiled the poster child of real estate excess - Blackrock's and Tishman Speyer's 2006 acquisition of Stuyvesant Town and Peter Cooper Village (STPC).  The $5.4 billion transaction was eye-opening even in an era of wild deals.  Earlier this year the 11,200-unit apartment complex, which started construction in 1943, defaulted on its debt and is now with its special servicer.  Prominent real estate investors are looking at the huge property, and the drama is sure to drag on for a long time.  The estimated value for STPC is $1.8 billion.

One party that gets no press in the whole STPC discussion is Met Life Insurance.  Met Life developed and owned STPC since its inception.  Met Life sold it at the top of the market for a huge price.  Met Life sold other real estate in around New York, including its landmark headquarters.  I'm not sure what Met Life did with the proceeds (hopefully it did not load up on subprime mortgage bonds) but its divestiture strategy was prescient. 

Blackstone Betting On Retail Real Estate
Here is a Bloomberg article stating that Blackstone may assist Simon Property in its attempt to acquire regional mall owner General Growth.  The article also states that Blackstone is forming a joint venture with Glimcher Realty Trust for malls in Portland, OR and Tampa, FL.   Retail real estate was hard hit in the real estate downturn and it looks like investors are staring to return.

General Growth Rejects Simon
General Growth rejected Simon's $10 per share offer and articles here and here are expecting bidding wars.  I'd like to see an analysis showing the implied cap rate of the deal and what it signifies for General Growth's real estate assets.

National Debt
Here is a good article from the New York Times on the national debt and partisan politics.  It has some good quotes, including this one:

“I used to think it would take a global financial crisis to get both parties to the table, but we just had one,” said G. William Hoagland, who was a fiscal policy adviser to Senate Republican leaders and a witness to past bipartisan budget summits. “These days I wonder if this country is even governable.”

And this one:

“There isn’t a single sitting member of Congress — not one — that doesn’t know exactly where we’re headed,” Mr. Simpson said in a telephone interview Tuesday just before word of his role got out. “And to use the politics of fear and division and hate on each other — we are at a point right now where it doesn’t make a damn whether you’re a Democrat or a Republican if you’ve forgotten you’re an American.”

I think two of the biggest potential economic problems facing the country are spending and the debt.  These two issues too easily get caught in partisan politics, and hard decisions get put off.   The impression is that Democrats want to boost spending and tax the rich, while Republicans want tax cuts.  Republicans have further backed themselves into a corner by pledging not to change Medicare.

Not dealing with these two issues in a serious manner will to higher interest rates and eventually weigh on the national credit rating.   A drop in the national credit rating will really push up interest rates and the economic consequences of this are hard to imagine.

The Slow Return of CMBS
Here is a Bloomberg article on the first potential multi-borrower CMBS since 2008.  The lead lender is Goldman Sachs and it looks to package loans from other lenders.  This is another encouraging sign for commercial real estate.  The Goldman loan will be to Glimcher Realty Trust owned shopping center in Tennessee.  Glimcher owns neighborhood and community shopping centers.  A loan on retail real estate is also an encouraging development.  The Bloomberg article states that there are $28 billion of loans in CMBS that mature in 2010, so I expect to see more lending activity.

Simon's Offer For General Growth
Simon Property Group's offer (Bloomberg link) for General Growth is all over the news this morning.  Simon is offering General Growth shareholders $9 per share, of which $6 is in cash.  Simon's total offer is more than $10 billion.  General Growth's unsecured creditors would be repaid at 100% on the dollar.  Both firms have portfolios of regional malls, and I am guessing the transaction would be a boost for retail real estate.

PDM Stumble
The price of the Piedmont REIT increased today.  (Don't worry, this blog is not going to post daily price updates.)  I think that part of the reason the price is holding up is that the original shares are not yet able to trade.  These shares were sold as a direct investment, and therefore were not in brokerage accounts.  The newly listed shares need a securities number and have to be put in brokerage account before they can be sold.  If you listen closely, you can here the howls of frustration rising from brokerage firms across the country that are fielding questions from anxious investors.  I suspect the shares will start arriving in tradeable form in brokerage accounts late next week.  We'll see how the price holds up then.  Remember, only 25% of the existing share were made liquid on the initial IPO.

Ritz Carlton's Lake Las Vegas Sinks
Ritz Carlton is closing its Lake Las Vegas property on May 2, 2010.  It is part of the larger Lake Las Vegas development, which was built around a man-made lake in a hilly area near Henderson, Nevada.  It is about twenty miles from the Vegas Strip, but the drive feels longer than twenty miles.  I am posting this because I went to a meeting there a couple of years ago before the financial world began to implode.  The area around the hotel was a ghost town then, it must be awful now.  The hotel and development have been in trouble for years.  Vegas is the Strip with its gambling, shows and restaurants, not an isolated, quiet hotel.  Building a resort, however nice, that far from downtown was a risky move at best.  What the heck do you do with an empty resort?   An affiliate of the lender, Deutsche Bank, now owns the property.  It's another example of an unsound deal financed with easy money.

Piedmont Trades
Piedmont Office Realty Trust began trading this morning under the symbol PDM.  Last night the REIT priced 12 million shares at $14.50 per share and raised $174 million. The REIT originally had planned to issue 18 million shares at an expected price of $16 to $18 per share.  Piedmont, in early trading this morning, is approaching $15.50 per share, an increase of over 6%.  Piedmont did a one for three reverse stock split before the listing and so $15.50 equates to an price of $5.17 per share based on the original share level.  Investors have a basis of $8.38 without reflecting the reverse split, so the current price reflects a discount of 38%.  The REIT has positive Fund From Operations (FFO).  The yield based on this FFO and the current price approximates 8.5% and an FFO Multiple of 11.75.

Retail Cap Rates Over 9%
I saw that cap rates for retail space are over 9% on the Calculated Risk blog.  The chart accompanying the post is amazing, it looks like a snowboarding half-pipe.  Calculated Risk got the information from CB Richard Ellis.  Retail cap rates dropped from over 8.50% in 2003 to almost 7.0% in mid-2007, and is now over 9.00%.  The CB Richard Ellis reports states that strip mall vacancies are at the highest rate since CBRE started tracking vacancies in 1991, and that rent rates are dropping. 

Special Service Surge
Here is an article announcing that the amount of CMBS loans in special servicing is now 10%.  Special servicers are the entities that deal with loans that are late on their payments. 

Consolidate Now
Yesterday's Wall Street Journal had an article on a failed TIC deal.  It is an interesting read.  I read the article as a blanket indictment of the TIC and CMBS structure.  In the mid-2000s CMBS was pretty much the only game in town as the major banks competed to finance every real estate transaction, and most loans were underwritten to fit into a CMBS.  The competition between lenders and the availability of easy money spurred the TIC business and pretty much all real estate transactions of any meaningful size. 

TIC investors were sold a packaged product where a sponsor acquired the property and arranged the financing (almost always debt headed for inclusion in a CMBS).  TIC deals are a direct real estate investment for tax purposes, but are in all actuality a security.  TIC investors have no say in the management of the underlying property, even though they are owners. 

The article strikes to the heart of the TIC problem. Many TIC investors were small investors who had sold properties and then invested the sale proceeds into a TIC transaction to defer capital gains taxes.  The deals were not structured to have significant reserves for unknown leasing events.  The article highlights a property had only one tenant, which has now vacated the building, and the lender will only extend the loan if investors contribute an additional $2 million.  I would guess that most TIC deals don't have enough investors, in aggregate, that can contribute this level of cash.  It is likely that the property will be returned to the lender.

TIC deals need to be consolidated into real estate investment trusts (REITs).  This is the only way to stave off a long process where properties are returned to lenders one at a time.  The REIT structure, via a 721 exchange, will allow investors to keep their tax deferral.  It will also allow their investment to be spread over a larger number of properties.  The REIT can access additional capital for improvements and leasing expenses.  A REIT would also have the collective leverage to renegotiate CMBS debt, rather than a series of stand alone negotiations that quickly hit dead ends.

In a consolidation and 721 exchange, while investors maintain their tax deferral, they lose their ability to exchange to another property.  In essence, the REIT (via ownership in an operating partnership), is the final real estate exchange.  I do not see this a major impediment, because realistically, how many TIC investors were ever going to acquire another property.  It is my opinion that the TIC investment was the last stop for most investors, so why not consolidate into a larger fund to provide diversification and, possibly, a more reliable stream of income.  It is my opinion that consolidation into a REIT would be better for most TIC investors for several reasons:

• Investors have a diversified investment rather than one property
• The REIT has easier access to capital for leasing and improvements
• The REIT has an ability to acquire additional properties at today's valuations
• Ability to use the size of the REIT to get better financing terms
• For estate planning purposes, it is much easier to liquidate shares in a diversified REIT than a fractional interest in one building

There are more reasons while a consolidation makes sense. The logistics are tough, and obstacles would include valuations for the exchange and reluctance of just a handful of investors, and on some deals even one investor, could stop a particular transaction.  It is my opinion, that after a few more events like those surrounding the property in the Wall Street Journal article, TIC sponsors and investors will be looking for ways to preempt problems.

Bong Water

I encourage you to read the letter sent to investors in the Inland Western REIT.  It is obscene.  Inland Western has valued itself, for ERISA purposes, at $6.85 per share.  I am going to conclude that the valuation is also part of FINRA Notice to Members 09-09 requiring non-traded REITs to provide a NAV eighteen months after the close of their offering period.  The letter (which I am unable to reprint without retyping it) states that, in general, real estate prices and REIT prices have declined since the start of the financial crisis.  As such, the value of Inland Western has dropped, too.  My question is whether the $6.85 per share estimate reflects enough of a discount.

Where to start, where to start?  The facts are usually the best place to start.  The book value, as of Inland Western at September 30, 2009, was $5.19 per share, a straight calculation of equity divided by outstanding shares.  The REIT is yielding 1.0%.  Its portfolio is approximately 84% occupied.  Its Funds From Operations is $.34 per share, which I annualized based on nine months of operations.  Now, pick an FFO multiple.  Developers Diversified (DDR), a publicly traded REIT specializing in retail properites, is trading at 8.3 times forward FFO.  If you apply this to Inland Western, its value is $2.82 per share, assuming its FFO does not decrease.  If you use a 10 or a 12 multiple, the value jumps to $3.40 or $4.08.  A multiple of over 20 times FFO is needed to arrive at the $6.85 value.  I don't think, even in the REIT frenzy of a few years ago, that FFO multiples ever got too far above 15 for the best REITS.

Inland Western acquired its properites in the middle of the 2000s during a real estate bull market.  As I posted last week, Ray Torto, chief economist at CB Richard Ellis told the New York Times that anyone who acquired commercial real estate in the last six years has had their equity wiped out.  I'll admit that this is an extreme statement, but even Inland Western, quoting the NCREIF property index, tells investors that commercial real estate prices have fallen 27%.  So, if Inland Western had 12% offering costs, and the remaining share value has dropped 27%, this puts the value at $6.42.  But this is false, because if a property is leveraged, equity holders feel the drop in value more than the decrease in property value because the debt obligation is approximately a constant.  For example, if a property or portfolio that is 60% leveraged drops in value 27%, the equity holders lose 68% of their value. 

Inland valued the properties itself using a "combination of different indicators."  It used a direct capitalization approach.  It must have used a forward, pro forma, net operating income with some optimistic assumptions on lease rates, occupancy and lease growth rates.  I wonder whether all properties were valued, or if a sample was valued and then a total value extrapolated from the sample. If this was the case, I bet all those properties with vacant space due to Mervyn's, Circuit City and Linens & Things bankruptcies were excluded. Most important is the admission that Inland Western did not use independent appraisers.

I am not going to value Inland Western's share price, but question its $6.85 per share value. I think investors need to press Inland Western on its valuation and push to get an independent valuation.  I have heard that Inland with its Inland Western REIT valuation is not the only non-traded REIT sponsor valuing its REITs at prices that seem high.  It is time to stop swimming in the bong water and face reality.

Smart Money And All That
I have seen a number of investment opportunities over the past year attempting to raise capital to acquire distressed real estate and real estate debt through the independent broker / dealer market place.  Some of these deals have had attractive business models and may have a chance of making money for investors.  Unfortunately, these deals have not caught on with independent broker /dealers and have struggled to raise capital.  This contrasts with private equity that raised over $40 billion in 2009 for opportunistic real estate investing, which I noted here.   In talking to executives at independent broker / dealers, I am told that their brokers want to sell income, not value or opportunity.  This is unfortunate, as real estate programs with legacy properties - i.e. pre-2008 acquisitions - that are paying more in distributions than their properites are earning are attracting capital from broker / dealers.  To restate, any income is better than opportunity, even if the income is mostly false.  I wouldn't be shocked to learn that some income-oriented investment sponsors eventually talk to the private equity money for help.

Geithner Watch
I would put the over/under on Geithner's tenure as Treasury Secretary at ten days, or next weekend.  It is ironic that Geithner's chief inquisitor is congressman Darrell Issa, who is no brain surgeon and who is no stranger to the justice system.

Here Come The Sharks
The money guys are circling Peter Cooper and Stuyvesant Town.  Here is a Bloomberg article and a Wall Street Journal article on the players involved.  The special servicer is CW Capital.  I found this gem buried in the Bloomberg article:

Tishman Speyer and BlackRock each invested $112.5 million out of total equity financing of $1.9 billion. They took out a $3 billion mortgage from Wachovia Bank and $1.4 billion of mezzanine debt. The mortgage was packaged with other commercial- property loans and sold as securities. The biggest holders are Fannie Mae and Freddie Mac, the U.S. government-owned home-loan finance companies.

So Tishman Spyer and BlackRock each only put up about 2% of the entire purchase in equity.  This does not surprise me.  So why didn't this deal implode sooner?  Here is an outtake from the WSJ article showing a glimpse of the complexity facing the debt holders.

The leading contender to get initial control is CW Capital, a servicer that represents the investors who hold the $3 billion first mortgage on the property. That mortgage was packaged into commercial mortgage-backed securities known as CMBS. But the property's debt structure is complicated and others are likely to push for control, including possibly the thousands of residents of the more than 50-year-old complex.  When complex deals like the one for Stuyvesant Town fall apart, who is in control? The News Hub panel discusses what they call "the $4 billion question."

In addition to the first mortgage, there is $1.4 billion of junior, or "mezzanine," debt on the property and some holders of that debt have also been maneuvering for control in recent weeks. Some junior creditors may try to replace the Tishman venture as owners by agreeing to pay the debt service on the first mortgage. If CW Capital takes over, the mezzanine investors likely will suffer a big loss.

CW Capital is involved because most, if not all, of the debt is in CMBS.  CW Capital's job is got get as much money as possible for CMBS owners.  Freddie Mac and Fannie May own about $1.5 billion of the $3 billion of CMBS.  This story is going to evolve over a long, extended period. 

Flying The Coop
Tishman Speyer and Blackrock Real Estate gave the high profile Peter Cooper Village and Stuyvesant Town apartment complex back to their lenders today.  Restructuring talks collapsed over the weekend making a loan modification unlikely.  I think this deal sold on a cap rate of like 4.5%, which was eye-popping in 2006, but in retrospect makes me wonder why this property was not lost sooner.  This low cap rate looks even lower when it's taken into consideration that the two complexes had many apartment units that were rent controlled.  Articles on the property are here and here.  I posted last week that that the estimated value of the property is now $1.8 billion.  For comparison purposes, the 2006 sales price was $480,983 a unit, and today the unit prices are $160,328 a unit.

Tranche Warfare Article
Hat tip to CRE Review, again.  Here is a BusinessWeek article on CMBS.  Not too much on the intricacies of tranche warfare, but more of a summary of all the big, highly leveraged real estate deals that are imploding, which used debt now lodged in CMBS. 

The article does give a glimpse of the problems facing commercial real estate and what form the solution will arrive.  The problem, which is mirrored throughout the country, is exemplified by Stuyvesant Town / Peter Cooper Village, the mega-apartment complex in Manhattan.  It was acquired for $5.4 billion in 2006 and used $1.4 million of mezzanine debt and $3 billion of mortgage debt, which are both in CMBS. The property is worth $1.8 billion, so its equity is gone, the mezzanine is gone and almost half the mortgage is gone. 

The solution is going to be new equity (and new owners) and a refinance of the CMBS debt.  Here is the equity available:

Real estate private-equity firms raised $6.8 billion in the fourth quarter of 2009, according to London-based Preqin Ltd., and more than $40 billion for the year. Sternlicht, the former chairman of U.S. lodging company Starwood Hotels, raised $930 million when he took Starwood Property Trust public in August.

The solution is going to get ugly,  but there is capital available to buy the properties and refinance the debt.   The legal wranglings combined with how much new equity is available is going to dictate the fate of commercial real estate.  A few precedent setting decisions and workouts will spread across the CMBS market.  The question for many CMBS tranche investors is do you want 100% of nothing, or a smaller percentage of something?

Errors, Errors, Errors....
Here is an article with significant misrepresentations on non-traded REITs.  It is from some website called Before You Invest.  Here is the article titled "Behringer Harvard REITs Continue Trend in Non-Traded REIT Market:"

Investors who placed their money in unlisted REITs, including Behringer Harvard, have been awakened to the myriad of issues related to the nature of these products. Unlisted, or non-traded, REITS differ from listed REITs in that they are not traded on an open market. Rather, non-traded REITs are sold to investors who then hold the product until the end of an investment term.

Behringer Harvard and other non-traded REITs contain a fundamental flaw which is many times not evident at the time of purchase: their value is set by the very companies which sell them. To clarify, a listed, or public, REIT is valued daily based on the market in which it is traded whereas a non-traded REIT’s value is determined by the staff of the REIT, or sometimes by a third party consultant paid for by the REIT which it is supposed to objectively value. Obviously, a conflict of interest can easily develop in the standard valuation procedure of a non-traded REIT.

Another issue with non-traded REITs is that if one chooses to sell their shares, it must do so in conformity with the procedures of the REIT. The usual procedure is to sell shares through a redemption program; however, many such programs have been suspended due to adverse financial conditions when many investors attempt to redeem their shares at once. The consequence to investors is that they are stuck in the investment until the redemption program is reinstated.

When sold Non-traded REITs, many were not informed of these obvious drawbacks to the product. Some have posited that it might have something to do with the somewhat common 15% commission given to the selling party, or the broker. Though regrettable, many investors may be able to recover losses in such products, including Behringer Harvard, through arbitration.

This article is full of assumptions and misleading statements.  The title of the article infers that Behringer Harvard has done something wrong, which is not supported in the article.  I think that Behringer Harvard's non-traded REITs deserve extra scrutiny, but you don't learn why from this article.  Shock - non-traded REITs have their price set by their sponsor.  How else would a non-traded REIT or any other non-traded investment be valued initially?  The SEC requires that non-traded REITs provide a per share, net asset value eighteen months after the close of the offering period.  Non-traded REIT valuation is typically done by third parties, not the REIT sponsor.  The share valuation is not the largest single flaw of a non-traded REIT.  Larger flaws include non-traded REITs' inability to quickly access capital markets for equity or debt, and their outside management structure. 

By law, a non-traded REIT can only redeem up to 5% of its shares per year, or it changes the REITs registration status.  Sure, some REITs have suspended their redemptions, but not all.  All non-traded REITs are sold as illiquid investments. 

"When sold Non-traded REITs, many were not informed of these obvious drawbacks to the product," is a crazy, reckless statement.  How does the author know this?  Was he or she in client meetings?  Most non-traded REITs have significant disclosure, written in language that is not hard to understand.  All investors are required to receive a prospectus and meet suitability requirements.  The article implies that investors are not told of non-traded REITs' drawbacks because the selling broker makes a 15% commission.  First, the maximum amount a non-traded REIT can pay for offering expenses is 15%.  Most REITs offering costs are in the range of 10% to 12%, not the full 15%.  The amount of commission paid to a broker's broker / dealer is 7% plus a marketing fee that's typically 1% or less that the broker / dealer keeps.  The selling broker receives 90% or less of the commission. 

Non-traded REITs need analysis and investors need to question their brokers about the pros and cons of including a non-traded REIT in a diversified portfolio.  This article is irresponsible for its innuendo and lack of supporting facts.  Investors should look elsewhere for information than from Before You Invest.

Now You Tell Us
Here is great quote from Ray Torto, chief economist at CB Richard Ellis from today's New York Times:

“Anybody who bought property in the last six years has their equity pretty well washed out,” said Ray Torto, chief economist at CB Richard Ellis, a real estate firm. “People are looking back on that period as the peak of the madness, the bubble. The expectation was that there was always someone who would pay a higher price after you.”

I saw Torto speak at a Tenant In  Common Association conference a few years ago, '06 or '07, when he was with Torto Wheaton, and if I remember correctly, was touting real estate and saying that there was no bubble and justifying the drop in cap rates.  He was as the cliche says, preaching to the choir.  It is funny that so few "experts" realized that the whole real estate  bubble was finance driven, and that when the finance stopped so would the drop in cap rates.

CMBS News
This morning I saw some CMBS news on Calculated Risk and CRE Review and followed the links to various articles.  CMBS defaults are expected to peak at 12%, which is much higher than the record defaults of the late 1980s, which peaked around 6% (although the CMBS market is much larger today than in the '80s).  The current default rates are at 4.71%, so a jump to 12% is big.  Currently, hotels and multifamily are leading the default parade at 9.13% and 7.54%, respectively.  Here is a counter intuitive post from a Reuter's blog stating that CMBS investors are set to benefit in 2010 as investors believe that their worries were overstated at year ago.   I hope the poster is correct.   Either way, the loans done between 2004 and 2008, and really I am thinking the loans done from mid-2005 through the end of 2007, are going to cause the most trouble.  This is stating the obvious, especially since real estate prices are down 44% from their peak, according to the Reuter's blog linked to above.

No Surprise

According to Bloomberg, Tishman, Speyer Properties, LP and BlackRock are going to miss a scheduled bond payment on debt from their $5.4 purchase of Stuyvestant Town.  This deal was the poster child of the real estate boom.  This default has been telegraphed for several months.  Now the transaction is going to get interesting as the parties struggle to retain their interests in the property.  I like this quote the article ends with:

“The joint venture has been engaged in discussions with CWCapital, the special servicer acting on behalf of the lenders, and hopes to continue good-faith negotiations toward a potential restructuring of the debt,” Tishman and BlackRock said.

The talks sound so nice and friendly, I wonder who brought the bagels and coffee?

Happy New Year and Good Riddance
I am looking forward to the new decade. Finally a decade name we can all agree with, wait, er.. the tens until its the teens. Oh well, its only ten years until the '20s. Anemic economic growth, the tech bubble burst, the real estate bubble and corresponding burst, the credit crisis, real stock declines... the aughts or noughties are a decade to forget.

Return of Lending
Obama's meeting with the "fat cat" bankers made news yesterday. Apparently, Obama pressed the bankers to make loans. This is all well and good, but talk can only go so far. There have been glimmers of hope that lending is going to return without presidential prodding. As I have noted before, the CMBS market is re-emerging. Now I see this article on Bloomberg discussing the return of Collateralized Loan Obligations (CLOs).

The idea of traditional banking exists on a limited level - i.e. making loans and collecting interest until the loans mature. This is portfolio lending and it limits banks' capital because they cannot recycle and grow capital until the loans mature. Bankers now want to originate loans, package them into CLOs or CDOs or CMBSs, and then sell these groups of loans to third parties. The collapse of the packaged loan market and the inability to price these securities sparked the financial crisis of 2007 through 2009.

In an ideal world, the bankers now know how to price these securities and they surely know how these loan packages perform in down markets. The collateral backing the loans will be more realistic now due to the drop in asset prices over the past two years. A return of securitized lending will help the economy. It will also help companies that need to refinance debt.

Fairfield's Bankruptcy and a Non-Traded REIT
Behringer Harvard's Multifamily REIT I has three multifamily properties that are nearing completion that were developed by Fairfield Residential. Fairfield Residential filed for bankruptcy this morning. To Behringer's credit, it looks like it has made moves to limit the impact of Fairfield's bankruptcy. It is worth reading Multifamily's recent 8-K filings. The complexity of Multifamily amazes me every time I read one of its 10-Qs. In a nutshell, the REIT invests in apartment developments via mezzanine loans that are then converted to equity, although Multifamily is now buying existing apartments.

The complexity is detailed here in an 8-K filing regarding of the properties being developed with Farifield:

Parties. The Baileys Project is owned by Behringer Harvard Baileys Project Owner, LLC (“Baileys Project Owner”), which is solely owned by Behringer Harvard Baileys Investors, L.P. (“Baileys Investment Partnership”). Baileys Investment Partnership is owned by Behringer Harvard Baileys GP, LLC (“Baileys GP”), by Behringer Harvard Baileys REIT, LLC (“Baileys REIT”), by BREOF Baileys, LLC (an equity investor unaffiliated with Fairfield Residential or us) (“BREOF Baileys”), and FF Investors III East LLC (an affiliate of Fairfield Residential) (“FF East”). Baileys Venture owns 99% of the economic interest in Baileys REIT and manages Baileys REIT. Baileys GP, the general partner of Baileys Investment Partnership, is wholly owned by Baileys REIT.

What?!?! Another way to look at this 90% completed property is that it is 414-units and the development cost is $143.2 million, or about $346,000 per unit. I know nothing about the Virginia sub-market where the property is located, but my gut tells me that $346,000 per unit is expensive no matter the ownership structure. And this is before adding the syndication costs, and worrying about selling or adding permanent financing....

Inland Western CMBS Pricing
The CRE Review is all over the Inland CMBS offering and is where I found this Reuters' link. The top two classes, representing $389 million out of the $500 million CMBS offering, were oversubscribed, and the final pricing was at yields at the low end of expectations. From Reuters:

The 10-year CMBS, just the third U.S. deal since issuance broke an 18-month void in mid-November, was oversubscribed, according to documents reviewed by Reuters on Wednesday.

Inland Western's two top-rated classes sold at yield premiums of 1.5 percentage points and 2.05 percentage points above an interest-rate benchmark, about a third of current levels on existing CMBS made at the height of the real estate boom. The yield spreads were at the low end of expectations.

I am finding it hard not to see why this is not good for Inland and commercial real estate in general.

Simon Clarification
Through The CRE Review I have more clarification on the Simon/Prime Outlet deal. Looks like the sales price is $283 per square foot and the implied cap rate is 6.7%. I still think this deal is positive for the commercial real estate market.

Commercial Real Estate Continues to Gain Traction
Simon Property Group's acquisition of Prime Outlets is a big deal. Here is the Bloomberg article on the transaction. Simon is gaining twenty-two outlet properties and now has sixty in its portfolio. Patching information together with help from The CRE Review, it looks like Simon is paying approximately $315 per square foot. Not sure whether this is a good deal or what the aggregate cap rate is. The Bloomberg article quotes an analyst saying that the deal is good for Simon. Six of the properties are in Florida, which is another good sign for real estate, since Florida has been in such a slump. The slow emergence of the CMBS market will generate more transactions like this. It is interesting to note that Simon's outlet malls generate more sales per square foot than its regional malls ($492 v. $438).

Big Week In The Non-Traded REIT World
There have been three big news items so far this week. First was the news that Piedmont Office Realty Trust has filed an S-11 as the first step in listing its shares on an exchange. I encourage you to go to Piedmont's website and follow the link to the SEC's website and read the S-11. The listing is not as straight word as you'd think. It involves a reverse stock split and dividing Piedmont's shares into four classes, where only a quarter of the shares will have liquidity initially, and the remaining shares will have delayed conversions to liquidity options.

On the heels of this news, Wells has filed Wells Real Estate Investment Trust III, a $5 billion office and industrial REIT. I don't think these two events are unrelated. I would question the financial advice to sell Piedmont, when it is listed, and buy Wells REIT III.

Inland's troubled Western Retail REIT refinanced %625 million of debt, and $500 million of it will be sold as Commercial Mortgage Backed Securities. Here is a link to the Wall Street Journal article and a key passage:

Inland Western Retail Real Estate Trust Inc., which owns some 300 retail properties nationwide, closed on Tuesday $625 million in new financing from J.P. Morgan Chase & Co. to pay down its existing debt. The bank is expected to convert the $500 million first-mortgage part of the financing into a CMBS offering and sell through private placements the remaining $125 million in "mezzanine," or junior, debt to investors hunting for higher returns, according to people familiar with the matter. A spokesman at J.P. Morgan declined to comment.

This reads like good news:

For Inland, of Oak Brook, Ill., the $625 million in new financing represents a big relief as it has about $789 million in debt coming due by the end of this year and another $1.5 billion maturing in 2010, according to the company's third-quarter report. So far, the company has refinanced almost all the debt maturing this year and a sizable portion of the debt coming due next year.

The debt is secured by 55 properties, has a 10-year term and a 75% loan to value, with the underwriting taking into account the current market values and potential for leases renewing at lower rates. I have not read what yield is expected on this deal.

Developers Diversified Sells CMBS
Here is a Reuters article on Developers Diversified's (DDR) sale of three tranches of CMBS. The largest tranche, a $323 million AAA-rated CMBS, was priced to yield 3.8%, which was a lower yield than expected due to high demand. DDR used the government sponsored TALF (Term Asset-Backed Securities Loan Facility). The two smaller tranches, $42.5 million and $3 million, did not use TALF and were priced at 5.75% and 6.25% yields, and came with ratings of AA and A, respectively.

This was the first CMBS deal since June 2008. The level of demand was encouraging. DDR bought one of the Inland REITs a few years ago and if I remember correctly, investors received approximately $12 per share in cash and $2 in DDR stock. The original investment was $10 per share. A large portion of that $12 per share in cash rolled in to Inland's American REIT, and was a primary reason Inland American raised so much money. DDR has also done business with Dividend Capital.

Article on Impending Doom in Commercial Real Estate
Here is a Bloomberg article on the "huge," pending commercial real estate crash. Really? Thanks for letting us know - three years too late. The commercial real estate crisis in now in its second year, and about a year ago cap rates jumped over one whole percentage point almost over night due to the credit crisis. Commercial mortgage backed securities are expected to approach record high default rates above 6% in 2010. The doom is already upon commercial real estate. In talking to various real estate professionals, I am hearing that cap rates have stabilized and are no longer increasing, which may lead stabilized values. Decreasing rents and higher lease expenses will put pressure on net operating income, which despite level cap rates will lower valuations.