Big Dog Redux

I got an e-mail from a former colleague reflecting on the state of commercial real estate today.  We worked together on some large deals in the past, including one that showed the power of easy financing.  The deal we worked on was a classic FHA project loan deal — you know, those apartment buildings with subsidized housing.

Shortly after we bought a package of loans for our deal, a developer came along and paid off a New York City FHA loan nearly 20 years early.  Not too long afterwards, we saw the ads for luxury apartments at that same address, with sale prices running as high as $500,000 per apartment.

Turns out, the developer was willing to pay each of the low-income tenants $30K to $50K to move out.   Apartments that were producing $400 to $600 a month were renovated and sold at levels that imply rents ten times that high.

Rumor has it that the building has been refinanced at even higher levels a couple of times since then (twelve years ago), and the last mortgage in the series may be in trouble.

With that, here’s his reflection on the state of the commercial real estate (CRE) union. By the way, PM stands for Portfolio Manager.

Brings to mind one of my favorite Monty Python skits where a fellow is
wheeling a cart heaped with the bodies of plague victims down the street
of a medieval village while repeatedly crying out "bring out your dead." 

A man comes out of a hovel to add a body to the pile on the cart when the
latest victim objects, saying he's not dead. The cart man looks him over and
proclaims "you will be soon enough, now get in the cart."

CRE is truly the "elephant in the living room" issue of the moment. 

Everyone has dissected the problem academically but the investor community
still looks at the problems largely in the abstract since the debt structures often
allow the impending defaults to be pushed out as terms are extended on loans
that couldn't come close to being refinanced, etc.,  and various amorphous
modification schemes are being floated about. 

In addition there was an announcement from the SEC regarding "carte blanche"
modification authority that could be construed as a "no action" letter inviting
restructuring of even performing loans if a claim can be made that some problem
could potentially arise in the future. Now, how do you think that a developer would
react to such an invitation for relief. Somehow the image that comes to mind here
is one of those people that line up at Walmart at 4:00 AM on the Friday after
Thanksgiving to get the 75% discount on the big screen TV and trample each
other to death in the ensuing frenzy.

The "fusion" nature of typical CMBS deals structured at the height of the boom
wherein there are several very large loans and the rest of the deal is comprised
of filler was always suspect from my point of view. 

The conventional wisdom was that an investor would perform surveillance on
the large loans, and deftly trade out of the position at the first hint of deterioration
and somehow the anonymous dross would never become a matter of concern.


Any one of the large loans going bad would surely be a seismic event, and
even the small ones would have major consequences, for example when fraud
was discovered at a bottling plant for a company called "Le Nature" in Arizona
in 2006, an entire ~1bln deal became toxic or a ~50mm loan. I will go out on a
limb here and say that no one looked at the "Le Nature" loan when making their
purchase decision on that security.  

I also vividly remember the day back in 1999 when I got a call from a friend at
Nomura to tell me that they had discovered fraud in a 50mm loan made to a
"hospital" that was in fact appraised at roughly 3mm. At the time I was managing
a REIT that had blown up, and the '95 vintage Nomura deal was one of the legacy
assets that hadn't been liquidated. Apparently the underwriter was ~47mm short of
proceeds prior to the transaction closing. That little fiasco was "Doctor's Hospital"
in Chicago. It was one of the most egregious frauds in CMBS securitization, and
cost me around 7mm in losses that I wasn't expecting to take when I woke up that
morning. What's more, there was no way I could see it coming. 

Years later, think of my reaction to an anecdote relayed to me after my CRE
PM returned from a road show where he had overheard a junior trader casually
mention that upsizing a deal meant that they now had to find more "crap" to
flesh out the proceeds with. He thought it was funny. He was a well regarded
analyst in the sense that he was schooled in all of the "check the box" questions
to ask, was absolutely confident that everything the dealer community told him
was the gospel truth, and that spreads would never widen.

Looking back, I just have to shake my head at the absolute level of orthodoxy
that was prevalent in the analyst community of a certain vintage.

It was a deadly kind of mutual admiration society at work, the consequences of
which have lead us here.


3 Responses to Big Dog Redux

  1. Joe says:

    I am looking to buy mulit-family properties next year. I can’t speak for anything else in CRE, but the MF rental market should bottom next year IMO. Right now, rents are still falling. However, I see UE peak around the turn 2009/10 and household formation to turn positive next year. By then, one should be able to pick up MF units at a good price. I also see more foreclosures in MF hitting the market, other than the declining number of SF forclosures.

  2. hhill51 says:

    Thanks, Joe….

    Keep us informed, as these “Boots on the Ground” (BOTG) reports are part of the information mosaic that lets us try to play the market as it plays us.

  3. Tom says:

    Large investors will need analysis and independant appraisal of properties in a CMBS. Financial companies/banks will keep the best loans for themselves and scuritize and sell away the marginal and bad loans.

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