What is your baseline real estate perspective at the start of 2009?
In this column at the beginning of last year, I noted 2009 would present challenges because of market imbalance and credit restrictions. Like most, I failed to comprehend how quick
and pervasive the problems would become, migrating out of the residential lending space, into commercial credit.
As I see it, we’re in a hail storm...everything having any kind of economic value is getting hammered...some are fortunate to suffer pea sized hits to values; others are suffering
catastrophic value implosions. Real estate today is just one more basket of commodities left out in the storm...a lot of remarkably unremarkable overleveraged commercial properties.
I’m a boater. As they say, if you can’t tie a good knot, tie lots of ‘em. Well, in the fall when the financial storm came onshore, Washington acted. They tied a lot of knots. They weren’t all good, but together they held the system together.
We’ve been in the eye of the storm since election day, imagining that things are returning to normal and sunny days are ahead. We now all know that is not the case. The market stress has fatigued systems to the point of failure. Tying more knots is now not the solution. As we go thru the back half of the storm, some ships are going to sink, some will break apart on the rocks, and some will sail thru to calmer waters.
The FDIC is just beginning to tackle the regulatory and compliance issues associated with that reality. We know how FEMA has dealt with natural disasters. Not well. Now we have an international economic storm event, and since mid-November, we’ve been operating essentially in an arena of “regulatory forbearance” simply because the regulators don’t as yet have a recovery game plan in place. They’ve simply been too busy dealing with stabilizing the financial markets in general, to be focused on the 8,000 plus banks spread across America.
The financial markets are unsettled, and until the forces of uncertainty play themselves out, we’re left with most ships out at sea and most sailors below deck where each is the safest. Now, as we brace for the backside of this storm, everyone in Washington wants to be captain of a ship, and most want to be admirals having the authority to dispatch ships along all sorts of new courses.
The way I see it, few are qualified for command and fewer still can carry the respect of those who stand to lose everything to indecision or grandstanding. 2009 and 2010 will be all about rough water sailing. Banks need to jettison the toxic debt in their cargo holds so they can ride the storm out and sail thru. Assuming they make safe passage, they can then take on new cargo that includes good old fashioned commercial real estate loans.
What bothers everyone is not knowing how bad the storm will be and the fleet will do during it. This is more metrology than quantum physics, and weather prediction is probably more imperfect than economic forecasting. Giving everyone in the fleet a raincoat because its raining doesn’t stop the wind from blowing or the water from rising.
Our baseline, therefore, is that 2009 will be a year of rough water sailing, most lending institutions will be out to sea with crews below deck and their ship overloaded with worthless cargo. No ship is safe under the command of an inexperienced captain, and great fleets have been lost to fate and recklessness. Get down, keep an eye on the horizon for balance, expect losses and casualties and rely on experienced commands to get you through. And when you do, shore leave will be memorable.
What does IAG intend to do in 2009?
Lets start with the old adage: Problems are opportunities in disguise.
I can’t add to the well reported prospect of commercial refinancing problems coming during 2009. Vacancies are up. Rents are down. Property cash flow is down. Values are down, and will continue to fall. Why? Lenders - big and small - have left the auditorium, and taken their capital with them. Libor and T Bill rates are at historical lows but the few who profess to be lending, really are not. Debt capital exists for lenders to generate safe and secure interest income. Today, there is simply no amount of safe and secure interest income that is of economic interest to banks, or for that matter, political interest to Washington. Banking today is all about loss management, and until that climate changes, there will be little in the way of debt to finance deals.
It is ironic, however. Banks today have a lot in common with real estate developers and investors...both are now being forced to deal with “lenders of last resort”. For the banks, if they’re strong enough to pass muster with the regulators, the terms on government bailout funds are simply so punishing, its not worth doing, or you do it for lack of options. In that case, management lives to see another day, but now is subject to new controls, restrictions and fee structures administered by a lender turned partner...which usually has a bad ending for everyone but attorneys.
As we head to the end of the first quarter, each Friday afternoon brings a new and longer list of bank failures. Unquestionably, the balance of 2009 is going to be a period when equity in banks and busted real estate deals finally is written off or traded for pennies on the dollar. The first thing the captain of a sinking ship does is jettison everything...first the worthless stuff, and then, anything that isn’t bolted down.
Last year, we set up IASG – Interlink Asset Solutions Group. We’ve spent time getting familiar with the regulatory mechanics of the banking world and drilling down on the raw performance data of Florida banks. I might add, its refreshing to be in an investment sector where there is so much financial data compiled and sorted for consumer use. There really are few secrets in the banking world.
Our interest is not buying loan tranches of CMBS mortgage pools. Too complicated. I don’t think the industry has a clue how those investment pools will unwind. So that’s the business of buying arcane financial instruments and harvesting a yield. It’s a business, but not real estate.
For firms of our size, opportunity this year and probably well into next, will be in acquiring troubled terms loans or REO properties from smaller banks as they jettison this type cargo. Our efforts are focused on sorting through the deals and determining where we and our partners and clients can bring value. We will hopefully find a deal or two that works for us, and broker others to our clients where the loan and underlying asset meet their investment criteria.
How are you sourcing deal flow?
There are a lot of institutions with problem loans; for many, its just not evident yet. But the storm wall is there. Some ships are into the back side of the storm; some are not. But everyone’s feeling or going to feel the effects.
Some lenders have organized their resources to respond to the rough water conditions. A number have hired national loan brokers to move loan inventory. Why? Because they know the loans offer little value, there are a lot of them to market, underwriting is far more complicated than it is in residential, and its seriously time consuming. Large nationwide brokerage organizations bring execution strength, and in turn make it more efficient for smaller boutique players like ourselves to sort through the opportunities.
For those who haven’t yet gone this route, or don’t have as large a portfolio of non-performing loans to warrant this approach, we find ourselves working the system in reverse. By that I mean, we canvas the market for properties that have traded during the past 36 or so months, or have been completed in the past 12 or so months, and cull from these the properties that would be of interest to own. From there, we go to the public records in search of a lender and a loan officer. Next and final step is a call to talk about buying the debt.
It is really an amazingly tedious process. There’s still a fair amount of denial out there. If you’re fortunate to strike up a conversation, it generally leads to a defense of loan value based on a bank appraisal, which even if recent, doesn’t have any transaction activity on which to base its conclusions. It does lead to interesting, if not entertaining conversations, when the lender takes on the role of promoter.
Seriously, if you can engage a lender in a conversation and through that interaction perform the analytics that he either has not or is not capable of performing internally, you end up creating credibility. Credibility with lenders to underwrite fairly and create an execution will be our best source of deal flow.
What types of "distressed debt" interests IAG ?
We’re focused on leveraging our experience. First, we know South Florida. We know the markets, the dynamics, the politics and the like. Second, as developers and real estate mangers, we know how to deal with the things that complicate a commercial real estate lender’s life – permitting, entitlements, property management, construction lien law and the like.
Finally, we know a lot about the most complex real estate sector known as hospitality – hotels, resorts, condo-hotels, marinas, restaurants and that sort of product. Put those skill sets together, and I think we have a compelling story to focus on distressed debt of “management” intensive real estate deals in South Florida. And of course, there’s a lot of that throughout southeast and southwest Florida.
Have you drawn any pricing conclusions on distressed term debt?
We’ve sea-trialed a lot of ships. We’ve tendered offers on some. If I had to pick a number, I’d say 25% of par is where we are. That’s a big generalization, but it seems to be emerging as a depth contour around a lot of underwater deals. And I have to believe, hazards to navigation will be many this year, so I’d set the depth alarm even lower.
What’s your view of the residential sector?
Generation 3 night binoculars. Seriously, you need military issue equipment to answer that one. Too much inventory, too little demand. That much is obvious. Paradise Lost? No, it is not. It will continue to be cold and snow up north. Taxes everywhere will continue to go up, so we here in Florida will continue to have a comparative and relative advantage. Couple that with the realities of a huge demographic bulge working its way through the US population, and there’s ample evidence that demand will flourish. And then, add the international factor.
Over the next five years, I can’t help but see the dollar weaken against other major currencies like the Euro. Hard assets in the US will be – no, must be – priced to bring dollars home from overseas, so US real estate will continue to be cheap, and may get cheaper.
For those who were disciplined enough not to have invested their savings in speculative residential real estate ventures, for those who want that place in Florida on the beach or on the golf course, and for those who have Euros to spend, there’s a great sale going on in Florida residential real estate. The buyers are there – it just takes them a long time to work through the massive inventory. Its simply a matter of underwriting the time for this demand to absorb supply. Fortunately, we don’t have to worry about any meaningful new supply coming on line any time soon.
Are you recommending investment in unsold condos ?
I have not been a fan of this investment space. We have a major overhang in both single family and condominium inventory that empirically will take years to absorb, and the market was simply not prepared to reprice unsold inventory to a level where a return can be had. I believe that has begun to change.
Look, there’s a lot of investment capital in the market. Much of the large institutional money is positioning to participate in the restructuring of billions in commercial real estate loans. The development market is moribund. So we’re left with acquisition of “shadow” residential real estate as a great play for individuals and smaller institutions. The transformation of home ownership dynamics during the next five years as the mortgage crisis plays out will drive sustained residential rental demand.
Bulk inventory deals require an entrepreneurial zeal, given the implied execution of a rental management platform nested within the dynamics of HOA regulations of a typical condo or subdivision. Bulk inventory is a commodity investment today. There’s a lot of generic inventory. But like any commodity, there’s a quality component, and quality always costs more. The key is finding a quality offering that’s fairly priced. The market will always buy quality first, maybe not at your immediate price expectation, but certainly if you can accept a minimal or negative return to “buy occupancy”, then you’re protected. As we say in the hotel business – “can’t raise rates on an empty room”. Same goes for holding for-sale residential inventory as a rental investment.