John Mitchell’s Interest Rate Forecast

John Mitchell, a well respected economist, gave his economic update at the annual HFO Investor Roundtable event January 8^th.  It was another excellent presentation by Mr. Mitchell who has the uncanny ability of making economic forecasting interesting. 

To summarize Mr. Mitchell’s economic forecast, he believes we will continue to see an improving economy, albeit at a slow growth rate of about 2.0% annually.  Certainly this is nothing to be excited about but it’s far better than falling into recession.  

What I would like to focus my attention on today are Mr. Mitchell’s comments about where interest rates are heading over the foreseeable future.  So let’s first discuss what The Federal Reserve has been doing recently and then discuss what policies they intend to adopt going forward.     

·        From the standpoint of monetary policy, The Federal Reserve cannot push interest rates down any further.  Short term rates are near zero and they can’t go any lower than that.

·        The end of last month, The Fed’s Operation Twist was terminated.  This program manipulated the market by selling short term treasuries and purchasing long term treasuries which has resulted in driving down long term interest rates.

·        The Fed recently announced QE4.  Recall that quantitative easing is an unconventional monetary policy of buying financial assets from banks and private institutions thus injecting a quantity of money back into the economy for the purpose of stimulating economic activity.

Now let’s see what The Federal Reserve plans to do going forward.  QE4, as it is being implemented this time around, has two components: 1) the purchase of $45 billion of U.S. Treasuries a month with maturities in the 4 to 30 year range; and 2) the purchase of $40 billion a month of mortgage back securities.  Both types of purchases will keep long term interest rates artificially low. 

The Federal Reserve announced in December that they plan to keep interest rates exceptionally low as long as unemployment remains above 6.5% and inflation is no more than 2.5%.  Currently, the U.S. unemployment rate is 7.7%.  The buying of securities by The Fed is open ended until these two benchmarks are achieved.    

So the big question is: Do you think that the unemployment rate will decline significantly in 2013 or that there will be a jump in inflation this year in order for QE4 to be discontinued?  Not very likely is it?  As much as I would like to see unemployment fall below 6.5%, at the present pace of the economy we are likely two to four years away from that happening. 

Mr. Mitchell then posed a very troubling question to the audience: How will The Federal Reserve unwind QE4?  The Fed currently owns about $3 trillion in securities.  By the end of the year that number will be about $4 trillion.  Discontinuing QE4 will result in a significant “pop” in interest rates and selling the $4 trillion they currently own will further cause interest rates to rise.  Long term this looks like a gigantic problem with no easy solution.   

But back to the original question: Where can we anticipate interest rates to go this year?  It all depends on our economy.  There are two likely scenarios.

1.   If the economy continues at the current pace, then interest rates should stay where they are. 

2.   If the world economy begins to slow down at the end of this year due to the current recession in Europe and the economic slowdowns of other countries such as China, Japan and Brazil, then our economy will begin to slow down too.  If the U.S. economy were to show signs of a recession I believe The Federal Reserve will double down on its efforts to keep the economy going.  If true they would buy more securities which means interest rates would go down even lower than they are today.       

I believe there is no chance that rates will go up this year as long as QE4 is being implemented.  In fact I will go out on a limb and say I believe the second scenario is the more likely.  If true, then interest rates a year from now will be lower than they are today.   

Either scenario bodes well for commercial real estate.  Keeping interest rates low will continue the current trend of rising real estate values in the Pacific Northwest. 

Four Common Mistakes That Make Financing Your CRE Difficult, If Not Impossible

I’m surprised how often I am asked to find financing for a property that for one reason or another is obviously not financeable.  It’s as if the borrower wants the lender to forgo the use of common sense.  I’m going to let you in on a little secret: IT ISN’T GOING TO HAPPEN!!!  Anyone who is at all knowledgeable about commercial real estate lending realizes that lenders are risk averse.  They are not in business to take on any more risk than is absolutely necessary. 

So if you want to either refinance your property or to sell your property there things you must do a year or two before financing is needed to get the property to the point where I call it, “lender friendly.”  Not doing so will likely make it much more difficult, if not impossible, in getting a lender interested.  Here are four common mistakes:

1.   The property is in poor physical condition.  It’s a big turn off to lenders to see a property poorly maintained.  Why would a lender refinance a property for a borrower that is not willing to maintain his property?  If you want to refinance a property that has a lot of deferred maintenance you better have an excellent explanation as to why it’s in poor condition.  Better yet would be to get the big ticket items fixed prior to refinancing your property. 

2.   The occupancy rate for the property is below market calling into question the seller’s property management company’s ability to professionally manage the property.  If the property is self-managed you’re in deep trouble.  If the property is for sale some sellers or listing brokers think that providing a rent guarantee on the unoccupied space will satisfy a lender’s concern.  WRONG!!  It does just the opposite.  It’s a great big red flag that something is wrong with the property.  A better solution is to offer as much free rent as needed to get the vacant space occupied.  Offer the free rent at the beginning of the lease.  Once the free rent has burned off, then refinance or put the property up for sale.  You still need to disclose the free rent to the lender but it is much better to have your property at stabilized occupancy with free rent than to have a property with a high vacancy rate. 

3.   Operating expenses are well above normal for a property of that age and condition.  You need to investigate if there is a reason for this.  Is it an anomaly?  Are some ongoing maintenance expenses actually capital expenditures?  Can you explain why?  If you can determine that the additional expenses are costly one-time expenses then capitalize what you can identify and operate the property for a year to show what your operating expenses should be for a normal year.  If you rush to refinance the property with higher than normal operating expenses it will likely lower the loan amount because of the lender’s minimum debt coverage requirement.  And if you’re trying to sell the property, the value of the property will be adversely impacted because the NOI for the property will be lower than it should be.  Worst case scenario, the lower NOI could reduce the loan amount and thereby increase the equity required by the buyer beyond what he is willing to invest in the property killing your sale.      

4.   Most tenants are on a month-to-month basis (not a concern for apartment renters) or have only 1 or 2 years remaining on the term of their lease.  Most lenders will not accept rollover risk.  Again, proposing a rent guarantee on those tenants whose leases have expired or will expire shortly is a big turn off to lenders.  One way to mitigate risk is to identify when each tenant originally moved in.  If they have been a tenant at the property for 10 or more years then it is much less likely they plan to move once the lease expires.  But the best thing to do before you sell or refinance your property is to get as many tenants re-leased for as long as possible.  Once you’ve minimized the rollover risk then seek financing. 

Remember, it’s all about getting the lender as comfortable as possible with financing the property.  You’re asking the lender to lend you or your buyer lots of money.  Make sure to take some common sense steps prior to requesting a loan that makes it easy for the lender to say yes. 

Timing Is Everything When Financing CRE

They say that, "Timing is everything."  Right?  Well it certainly holds true when it comes to financing commercial real estate.  There are times during the year when trying to get a loan financed is pure misery and there are times when the financing "gods" are looking down benevolently on you.  But let me tell you a little secret: It's not rocket science to figure out when is the optimal time to get things financed.  It's plain common sense.  Shown below are the worst times and then the best times to get your property financed.

Worst Times to Finance CRE

1. June 10th through Labor Day - If you haven't signed your loan application before summer starts, good luck!  Summer is the time when kids are out of school and family's take long vacations.  Loan officers, underwriters, loan processors, real estate brokers, mortgage brokers, attorneys, appraisers, etc. all lose focus during the summer months and as a result the financing process slows down to a crawl, or so it seems.
2. November 1st through Year End - If your loan is not expected to close before year end, your deal will go to the bottom of the pile.  All the focus during the end of the year is to work on deals that will close before year end so loan officers can make their quotas and for those who have had a good year, to make their bonuses.

Best Times to Finance CRE

1. First Quarter - The best time of the year to start the financing process is during the first quarter.  Bankers are refreshed after the holidays and eager to start working on their annual quotas in order to acheive their year end bonuses.  Most insurance companies will be back in the market ready to lend.  As the year progresses, they become more and more selective on property type and quality of transaction.  
2. Labor Day through October 31st - People are back from vacations, kids are in school, and lenders are again eager to get their last round of deals started for the year so that they close before the holiday season. 
3. November 1st through the 15th - To paraphrase Charles Dickens, "These are the best of times and the worst of times."  No sane loan officer should commit to closing a loan in less than 60 days.  But those loan officers who haven't reached their quota, or have, but want to increase their bonuses even further go into "warp speed" trying to cram in the final deals for the year.  If the "moon and the stars" line up perfectly or they're just plain lucky they succeed.  I just found out late last week that I have a client that must close his commercial real estate purchase before the end of the year or he will experience adverse tax consequences.  There are less than 50 days to the end of the year and the deal is not yet under application.  I haven't closed a loan this year under 75 days, most have been considerably longer. And yet, I have four lenders who have committed to closing on this deal before year end. This just tells me there are a lot of hungry loan officers who want to get deals closed no matter what it takes. 

So when is the best time to finance commercial real estate?  It's plain common sense: Whenever your loan officer is highly motivated to get the deal done.

Source: The Importance of Luck and Timing in Real Estate, by Kevan McCormack, Metropolitan Capital Advisors

The 800 lb Gorilla in the Room

Whether Obama or Romney gets elected tonight, the next administration within the next four years will have two major crises that they will have to confront head on. One has been discussed frequently on the campaign trail – Iran getting a nuclear weapon, the other has been virtually ignored.  It's the 800 lb gorilla in the room.  We would prefer not to acknowledge that it even exists, which is, the inevitable financial collapse of Europe.

What most people don’t realize, or are unwilling to admit, there is no solution to the sovereign debt crisis in Europe. European leaders could assemble the brightest economist minds from all around the world together in one room, give them complete authority to act on the crisis as they see fit and it still would not change the ultimate outcome: Europe is going down. It’s inevitable. They are too far down the path to their own destruction to turn it around.

It’s only a matter of when, not if. True, they’ve done an excellent job “kicking the can down the road” these past three years and can continue to do so for some time to come but at some point the market is going to perceive their feeble attempts at a solution as putting a band aid on a gaping wound. When that occurs, market confidence will collapse taking down the European bond market and many of the European banks.

By now I suspect that many of you consider me a “nut job,” a “doom and gloom” type who thinks the world is coming to an end which I categorically deny. Humor me for a moment and for the sake of argument let’s assume my prediction is true. What then? How will this affect commercial real estate in the Pacific Northwest? To answer that question the following questions need to be answered:

• How will this affect trade with our largest trading partner, the European Union? We will see a substantial decline in our exports to Europe.
• How will this affect the U.S. economy? This will likely throw our economy into another recession.
• How will this affect our stock market? The stock market is affected by emotion. When things are good it soars far beyond any justification. When things are bad it plummets far lower than it should. In this case the stock market will initially plummet similar to what happened in 2008, maybe worse. At best it will be a roller coaster of a ride, soaring to new heights on good news and plummeting back down with any hiccup in economic news. This will not be a good time to be heavily invested in the stock market.
• How will this affect our bond market? It’s likely that Europeans will see our bond market as a safe haven and heavily invest in U.S. treasuries. If true, treasury yields, which are at historic lows, will likely go lower.
• How will this affect our financial institutions? This is where it gets ominous. The vast majority of our lending institutions should be unaffected. Only our five largest banks – Bank of America, JP Morgan Chase, Goldman Sachs, Citigroup and Morgan Stanley are heavily invested in credit default swaps on European sovereign debt. A credit default swap is a fancy term for bond insurance. Our five largest banks have insured a boat load of European sovereign bonds. When these European countries default on their bonds, these U.S. banks will be left holding the bag. Though these banks have confidently stated they have it under control, call me a cynic but I don’t believe them.  Between you and me, I hope they do. I truly hope they do because the alternative is these banks are going down.
• What response will the president (Obama or Romney) make to minimize the fallout on the American economy? This is where it gets interesting. The president has a very difficult decision to make: Does he let these five largest U.S. financial institutions go bankrupt? Or does he bail them out? Is the country in the mood to bail Wall Street out once again? Are these banks too big to fail? If he doesn’t bail them out will it not bring down the rest of the world’s financial system? Good luck Mr. President!
• So back to the original question: How will this affect commercial real estate in the Pacific Northwest? I think this can best be answered by looking back to the 2008 financial debacle. Four years ago some commercial real estate investors survived while others did not. The common denominator for survival was:
• Property type mattered. Apartments fared well. Office, raw land and single family subdivisions did poorly. Everything else was in between.
• Those properties that were modestly leveraged survived. Those that weren’t were taken over by the lender. 
• Those who have subsequently locked in long-term, low interest rate financing were the big winners.

When the Europe bond market collapses commercial real estate will be the investment that has the best chance to weather the economic storm. The stock market, on the other hand, will be a roller coaster basket case, the bond market will have incredibly low yields, and cash in the bank will yield no return. As long as investors invest in the right property type, leverage their properties modestly and lock in low interest rate, long-term fixed rate financing they will come out of this future economic crisis intact. And if inflation is the natural result of this disaster what better hedge against inflation than commercial real estate?

So am I a “nut job?” You decide.

Be Proactive and Anticipate Financing Road Blocks Before they Happen

In the past, a borrower was typically asked to provide a simple financial statement with a credit check, and that was the extent of the credit items required.  Ah, the good old days.  In today’s environment, lenders have upped their borrower documentation considerably requiring an extensive amount of information on the borrower. 

I’m continually surprised by most borrowers who don’t know the necessary documentation they need to provide in order to get a lender interested in them.  They could avoid many of their financing problems if they anticipated the financing road blocks before they happen.  Shown below are seven of the more common examples of issues to watch out for:

1.   Minimum Net Worth to Loan Ratio – Each lender has different requirements but they typically require the borrower’s net worth to be equal to the loan amount.  Some require a borrower’s net worth to be as much as two times the proposed loan amount.  Find out what your lender requires before signing the application.  

2.   Minimum Number of Months of Debt Service Required of Liquid Assets - Again each lender is different but they typically require liquid assets showing on the borrower’s balance sheet equal to 6 to 12 months of debt service.  Find out what your lender requires before signing the application. 

3.   Complete the REO Schedule with all the Details Filled In – Many lenders are now creating a global cash flow spreadsheet on the borrower.  They want to see if the prospective borrower is generating a positive cash flow or slowly draining himself of all his cash.  Much of the detail required to determine his global cash flow comes from the real estate owned schedule.  Prepare the REO schedule before you begin talking to lenders so that when they ask for it, it’s ready for them.  If you need a copy of a REO schedule contact me and I’ll email you one. 

4.   Credit Rating & Explanations of 30 Day Late Payments – Run a credit report on yourself before you start looking for a lender.  Find out your credit score.  Most lenders require that your credit score be a minimum of 680.  If yours is not that high, you better have a good explanation.  Also you need to explain every payment that is 30 days late or more.  Put it in writing before they ask. 

5.   Explain Past Tax Liens, Judgments, Litigation – have written explanations with back up documentation already prepared before you sign the application.  Give the prospective lender your explanations and have him verify in advance of signing your application that your explanations are satisfactory and will not impact loan approval.  Do it before you sign the application when you have the most negotiating power, not after when you have little or none. 

6.   Tax Returns, not just Schedule 1040s, signed and dated including all K-1s – Lenders want all of your federal tax returns, not parts of them.  Typically, most borrowers forget to sign and date their tax returns and most times it takes two or three attempts to get all of their K-1s.  To speed up the process get it done correctly the first time. 

7.   Thoroughly Read the Application and Ask Questions Prior to Signing the Application – It is imperative that you understand every clause in the loan application.  Lenders become frustrated, and rightly so, when borrowers and their legal counsel voice issues at the closing table about lending requirements that were disclosed on the loan application.  Negotiate any onerous lending requirement prior to signing the application.

One of the truest statements ever uttered about commercial real estate is, “Time kills deals.”  A lengthy, drawn out loan underwriting process will at the very least move your deal to the bottom of the pile.  It has the potential of killing the deal altogether.  Many of these seven issues can be avoided if the borrower will be proactive and anticipate what the lender is going to require.  A good borrower, a good mortgage broker should work towards making the lender’s process as easy as possible to avoid ever hearing the words, “I’m sorry to inform you, your loan has been turned down.”  

Source: From the Analyst Chair: Anticipate the Road Blocks in Commercial Real Estate Finance by Metropolitan Capital Advisors Blog, September 4, 2012. 

CRE Delinquency Rates Continue to Plummet

The commercial real estate market is getting better.  What we've sensed was happening has numbers to prove our thinking.  There are two very insightful charts by SNL Financial that show the slow but steady decline in delinquency rates over time on commercial real estate loans.

U.S. commercial banks reported a delinquency rate of 5.28% on CRE loans compared to a high of 10.76% nine quarters ago.  Oregon has fared even better with a delinquency rate of only 3.04% on CRE loans. 

The asset quality of CRE loans has been improving at a faster pace than one-to-four-unit plexes (considered residential).  However, residential loan delinquencies have also declined by about 200 basis points to 12.66% as of the end of the 2nd quarter of this year. 

Looking at delinquency rates by state shows that the Northeast, the Plains states, Alaska and Hawaii have fared the best, while the Southeast and the state of Nevada have the highest overall delinquency rates.   

Source: CRE delinquencies continue to plummet; by Harish Mali and Robert Clark, SNL Financial, August 29, 2012

Another Questionable Decision by The Federal Reserve

The Federal Reserve last Thursday released a proposal that would implement a global agreement known as Basel III. This agreement is a regulatory standard that proposes minimum capital requirements and liquidity standards for all financial institutions worldwide.

I know what you’re thinking as I was thinking it too: I’m tired of reading another boring article on banking regulations. But I would encourage you not to delete this blog post before you get a “view from 35,000 feet” on how Basel III is going to impact the commercial real estate industry. It could have an enormous adverse impact on our industry if not implemented gradually.

From our perspective the most egregious new implementation being proposed by Basel III is assigning a higher risk weight to commercial real estate loans of 150%, up from a current risk weight of 100%. How does that affect the bank? The more risk, the more capital that’s required by financial institutions to have on hand as a buffer. So the more they lend on commercial real estate the higher their capital requirement. If they lend on other assets, home loans or businesses for example, they will not be required to hold as much in reserve.

So what do you think the banks are going to do when this new rule is fully implemented? Do you think they will lend more or less on commercial real estate? Of course, the tendency will be to lend less. And how do you think in real terms that will be done? I think there will be fewer banks lending on commercial real estate and those that do will find a plethora of ways to make it that much more difficult to get a loan approved and closed (as if we need more banking regulations to slow down the loan approval process).

This isn’t me just “crying wolf.” Fitch Ratings estimated last week that the world’s 29 largest banks will need to raise another $566 billion by the end of 2018 to meet these new international liquidity requirements against risk. Where is that going to come from?

I wonder why they consider commercial real estate so risky? The Great Recession was brought about by a housing bubble and lax underwriting standards for qualifying borrowers of home loans, not because of excesses in the commercial real estate industry. So why pick on us? Why make commercial real estate the scapegoat? The Federal Reserve needs to think this through and figure out what the ramifications are to our economy if this is fully implemented. Basel III ultimately means less lending on commercial real estate which means a slower economy which means fewer people being employed.

I’m all in favor of reforming the banking industry (remember I’m in favor of Dodd Frank) but increasing the risk weight for commercial real estate may be over the top. There’s got to be someone on The Federal Reserve Board of Governors who has enough common sense to understand this and has the courage of his convictions to push back. Don’t you think?

Sources: Basel III, Wikipedia; Fitch Ratings: World's Biggest Banks May Need To Raise $566 to Comply With New International Rules, Huffington Post, June 7, 2012; Fed ups capital buffer for commercial real estate, Market Watch, The Wall Street Journal, June 7, 2012; Federal Reserve unveils Basel III bank capital proposal, The Economic Times, June 8, 2012.
 
 
 

1st Quarter 2012 Sales Activity - How Did We Do?

From a sales standpoint how well did we do in for the 1st quarter of 2012 compared to previous years? Shown below are the criteria we used to tabulate the results:

• Sales information is from the CoStar database as of March 31st. My guess is that it will take a few more weeks before CoStar has all the 1st quarter sales activity recorded but this is what they’ve recorded so far.
• Transactions closed between January 1st and March 31st, 2012
• Investment properties only (no owner user)
• Property types - flex, industrial, mixed use, multifamily, office & retail
• Transactions with sales prices of $1 million or larger
• Arms length transactions (no partial conveyance of ownership)
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on these criteria the chart below compares the sales activity for the first quarter of 2012 with each of the preceding five years:

As you can see 1st quarter sales activity was less than last year but more than in 2010.  It gives me the impression that that we've bottomed out but we are bouncing along the bottom, ie, it's not getting worse and it's not getting better.  For the past four years, the first quarter sales activity has been roughly the same.   

We then analyzed the 47 closed transactions by property type:

Not surprisingly, multi-family leads the way with the most sales transactions in the first quarter.  What is a bit surprising is the number of office transactions.  This is significantly up from the past few years.  Is this a trend or an anomaly?  We'll have to wait and see how the rest of the year develops. 

Of the 47 transactions, 16 had broker representation on both sides of the transaction.  Eleven had no broker representation.  The remaining 20 transactions had only one side of the transaction represented.

If you add it all up, there were a total of 52 paydays (2 x 16 + 20).  So if you want to know your personal market share of all the broker paydays divide your number of paydays by 52. 

Shown below are the lending sources for these transactions:

The banks continue to provide the bulk of the acquisition financing for Oregon and SW Washington.  There is almost a complete absence by the life companies, Freddie & Fannie, and the credit unions.  A big surprise is the lack of seller financing.  Over the past several years seller financing was the predominant way most non-apartment transactions were financed. 

Shown below are the top 6 real estate brokerage firms based on total broker representation of closed transactions for the 1st quarter of 2012: 

The real estate brokerage community is not dominated by any one firm.  In fact, Joseph Bernard Investment Real Estate, who is ranked #1 on the list with 5 broker representations, represents less than 10% of the total market.  The top 6 firms present only 42% of the total market.

So how do I summarize the first quarter?  It's been surprisingly quiet.  I was expecting more activity than last year, and so far that has not materialized.  That's not to say it won't but it needs to pick it up a few notches if the market is going to show a sustained improvement over the previous couple of years.  Here's hoping that the coming quarter shows improved strength over the one we've just finished! 

Should Dodd-Frank Be Repealed?

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama in 2010 is considered the most sweeping change in U.S. financial regulations since the Great Depression.

Many of those regulatory changes will become effective beginning January 1, 2012. If you’ve listened for any length of time to the Republican presidential debates one of the re-occurring themes that is bandied about by several of the candidates is that Dodd-Frank should be repealed. They consider this legislation a quintessential example of government red tape that is crippling our economy. Hmm… Is that really true?

I freely admit I’m no expert on the subject of the Dodd-Frank bill which totaled over 2,300 pages in length and most likely neither are you. So let’s begin by doing a quick overview of what was in the bill and how it impacts commercial real estate.

1. Banks are required to have 5% “skin in the game” for every loan that they approve. No longer can they approve a risky loan and then sell it to some unsuspecting investor by passing it off as a quality investment. This means that lenders are now scrutinizing and documenting real estate loans more carefully. Anyone in the mortgage lending business will tell you that it takes much longer and requires much more paperwork today than it did three years ago. You can thank this 5% rule for the reason why loan processing has become so much more cumbersome.

2. Banks are required to carry more capital reserves. They now have to prove they have the correct amount of reserves, and based on recent default rates and delinquencies, they have had to increase capital reserves significantly over what they were required only a few years ago. This has resulted in decreasing the overall amount of lending capacity in the market in addition to decreasing significantly the number of lenders lending. Pre-2008 lenders were tripping all over themselves competing for loans.

3. Rating agencies now bear more risk and liability under Dodd-Frank. Gone are the days when credit agencies were fearful of losing lucrative business if they came down too conservatively on risky loan pools. As a result CMBS issues today are much more conservative, with lower LTVs and higher debt coverage ratios. It is no surprise that the CMBS market is a shadow of its former self. In 2007 there was $228 billion in the CMBS market compared to a measly $12 billion in 2010. There are several reasons for this downturn but the rating agency reform in the Dodd-Frank bill is certainly one of them.

I would be the first to admit that the Dodd-Frank bill is having a huge adverse impact on the banking system in the short term. But would you prefer to go back to where the banking regulations were prior to the sub-prime loan debacle? I don’t think so. Yes it’s painful and it certainly makes a good sound bite on the campaign trail to rail against the Dodd Frank bill. But all three of these changes are just plain common sense. They are needed in order to slowly repair a battered banking system that has lost all the respect that it once had. If you disagree, I welcome your comments.

Source: Regulatory Reform: What Impact Will It Have On Commercial Real Estate?, CoStar Group Real Estate Information, Randyl Drummer, July 28, 2010.

IREM Forecast Breakfast - Optimism Abounds

The 24th Annual IREM Forecast Breakfast was awash in cautious optimism as the commercial real estate industry is slowly rebounding from the most difficult recession in our lifetimes. For 2012, each of the presenters, whether it be for office, retail, industrial or apartments, forecasted modest but steady improvements in both occupancy and rental rates for the Portland real estate market for the coming year.

But I would prefer to focus my commentary today on the presentation given by Nawad Othman, Chief Executive Officer for Otak, Inc. Mr. Othman, a self-described “optimist” gave a compelling presentation about current world affairs that he described as a time of uncertainty and an age of complexity. It would be easy to focus on all the real and ever pressing issues that confront us, and they are legion! Or we can, as Mr. Othman did, focus on the many things that truly make us the envy of the world. I would like to take the liberty to expand on Mr. Othman’s list.

• We live in a country of laws that protect our civil liberties. We should never take this for granted. Franklin Roosevelt described them as our four fundamental freedoms: freedom of speech and expression; freedom of worship; freedom from want; and freedom from fear. These freedoms are the bedrock upon which our government was founded.

• Our business environment fosters, promotes, and encourages innovation like no other country in the world. It isn’t by accident that Microsoft, Google, Facebook, Amazon.com, to name just a few, are American corporations. China may be able to make things cheaper but they have no ability in creating the next new idea. They, and the rest of the world, look to us to do that.

• Our kindergarten through high school educational system may not be stellar but our universities are the best in the world. Students from all over the world flock to our universities.

• We have a strong commitment to fostering and maintaining a viable middle class. Unlike many countries of the world, we believe in public education. We believe in the American dream where someone who works hard and takes risks can rise to the very top of our society.

• Unlike many countries of the world (Japan, China, Europe) we have a growing population base. People from all over the world want to come to live in our country. Population growth is absolutely vital in order to have a healthy economy. And if you believe in Social Security, Medicare and other social welfare programs that help the most disadvantaged among us, a growing population is absolutely necessary to fund these programs.

Yes, we can focus on all of our problems or we can pause for a moment and see how blessed we are as a nation. So are we willing to view the proverbial cup of water half empty or half full? Even those of us who have gone through tough times (as most of us have during this recession) deep down realize there is no better place to live then where we live right now at this time in history.

Have a Merry Christmas or Happy Hanukkah and a prosperous new year! If this closing offends you, get a life! :)

Source: IREMOregon.com; 2011 Forecast Breakfast Transcript, December 8, 2011. 

First 9 Months 2011 Transaction Activity

The first 9 months of 2011 has come and gone!  From a sales standpoint how well did we do compared to previous years?  Shown below is the criteria we used to tabulate the results:

• Sales information from the CoStar database
• Transactions closed between January 1st and September 30th
• Investment properties only (no owner user)
• Property types - apartments, industrial, flex, office, retail, mixed use
• Transactions with sales prices of $1 million or larger
• Arms length transactions
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on these criteria the chart below compares the sales activity for the first 9 months of 2011 with each of the preceding four years for the same time period.

As you can see, the sales activity for the first 9 months of 2011 has almost doubled from last year and is almost back to the same number of transactions recorded in 2008.  We are definitely on the rebound!

We then analyzed the 205 transactions by property type:

Multi-family and retail properties continue to dominate the property transactions but other property types are beginning to make their presence known.  All other property types represented 35% of the total sales transactions compared to 28% for the first 6 months of this year. 

Of the 205 transactions, 96 had brokers representing both sides of the transaction.  Forty-nine transactions had no broker representation.  The remaining 60 transactions had only one side of the transaction represented.

If you add it all up, there were a total of 156 broker paydays (2 x 96 + 60).  So if you want to know your personal market share of all the broker paydays divide your number of paydays by 156.  Shown below are the first 9 months lending sources for the 178 sales transactions where the lender was identified:

Seventy-three out of the 178 transactions (41%) were either all cash transactions, assumed the existing debt or were seller financed.  Only 105 transactions (59%) used conventional financing.  Of these, the vast majority were financed by banks 67 (64%). 

Thank goodness owners have to refinance their properties from time to time or most of the mortgage brokers would be out of business.

The sales transactions for the first 9 months of this year strongly suggests that commercial real estate is on the rebound.  Let's hope for all of our sakes that this trend continues into the foreseeable future. 

How Bill Gross Got It All Wrong

Earlier this year Bill Gross, the head of bond giant PIMCO, announced in grand fashion that he was getting out of U.S. Treasuries. His reasoning was quite rational: The end of the Fed's quantitative easing program, which ended in June, would be bad for bonds. Prices would fall causing yields (or interest rates) to rise. This would happen because the Fed was the number one buyer of U.S. debt. Without the Fed buying bonds one of two things would have to happen to prevent yields from rising:

1. Some other country would have to step in to buy the Fed's volume of U.S. Treasuries which was highly unlikely, or
2. The U.S. government would have to significantly moderate their borrowing to shrink the volume of U.S. Treasuries being sold on the market. At the present time for every $1 spent by the federal government about 40 cents of that amount is borrowed.

So what do you think are the chances of either #1 or #2 happening? Not likely is it? Looking at it from this perspective, it seemed quite unlikely that another country could purchase the enormous quantity of bonds that the Fed had been buying over the last two years. And it also seemed unlikely that the federal government would reduce its need to borrower.

This past week people were crowing about how Bill Gross got it all wrong and how he lost a lot of money for his bond fund investors. He even admitted sheepishly that it had been a "mistake" to get out of U.S. treasuries. Since Mr. Gross’s announcement in March the 10 year treasury rate has plummeted from 3.46% to 2.02% (Sep 2nd). So how does someone of Mr. Gross's caliber get it wrong? What did he miss?

Back in March when Mr. Gross made his announcement there was no way for anyone to predict:

1. That the sovereign debt crisis in Europe would reach critical mass this year. European leaders had been successful over the years in “kicking the can down the road” and it seemed likely this year would be no different. Wrong!
2. What the impact of the sovereign debt crisis would have on the U.S. treasury market. Fear of a default of sovereign debt by Greece and then by Italy has caused a panic among Europeans. And when panic ensues, investors take their money out of risky investments promising a return on their money and instead invest in less risky investments, in this case U.S. treasuries, where they focus on getting a return of their money.

What has happened is the law of supply and demand has kicked in. Concerned European investors have dramatically increased the demand for U.S. treasuries while the supply has stayed the same. When that happens, yields decline. It’s really that simple.

But the big question is, “How does this affect those of us in the commercial real estate market?” We are currently seeing historically low interest rates.  A lower interest rate means a lower mortgage payment which means better cash flows after debt service. If you own commercial real estate now is the time to lock in long term fixed rate financing.

I know I sound like the boy who cried wolf one too many times but some day we are all going to wake up and the world will be different. Some unpredictable catastrophic event will have occurred (a run on U.S. banks perhaps) causing interest rates to skyrocket and when that happens those who had the foresight to lock in the low rates will be the big winners.

Source: Bill Gross and the Case for Buy Low and Hold, Morgan Housel, The Motley Fool, August 31, 2011.

First Half 2011 Transaction Activity

The first half of 2011 has come and gone!  From a sales standpoint how well did we do compared to previous years?  Shown below is the criteria we used to tabulate the results:

• Sales information from the CoStar database
• Transactions closed between January 1st and June 30th
• Investment properties only (no owner user)
• Property types - apartments, office, flex, industrial, retail, mixed use & specialty use
• Transactions with sales prices of $1 million or larger
• Arms length transactions only
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on these criteria the chart below compares the sales activity for the first half of 2011 for each of the last five years:

As you can see, the sales activity for the first half of 2011 increased significantly over the same time period for the last two years: up 17% over 2009 and a whopping 54% over 2010.  We are still well below the transaction activity that we achieved in previous years but the trend is going in the right direction.  Hey that's encouraging!

We then analyzed the 91 transactions for 2011, starting by property type:

Multifamily and retail sales comprise 72 percent of all the sales transactions which is similar to what we've seen in the past couple of years.

Of the 91 sales transactions, 75 of them identified the broker representation and 77 of them identified the lending source that was used.  The remaining transactions did not identify broker representation or lending source.  Shown below is a summary of broker representation fo these 75 transactions:

Assuming that the trend for the 75 sales held true for all 91 sales transactions, then there were about 73 paydays for all of the real estate brokers in our area in the first half of this year (91 x 53% x 2 + 91 x 15% + 91 x 12%).  So if you want to know your personal market share of all the broker paydays divide your number of paydays by 73.

Shown below are the first half lending sources for the 77 sales transactions that a lender was identified:

Thirty out of the 77 transactions (39%) were either all cash buyers, assumed the existing debt or were seller financed.  Only 47 transactions (61%) used conventional financing.  Both regional and national banks made up the majority of these loans.  Insurance companies only made 2 acquisition loans in the first half of this year.

Thank goodness owners have to refinance their properties from time to time.  Refinancing properties is not included in the figures above.  If we had to live solely off acquistion financing many of us on the lending side would be out of business.

Let's hope for all of our sakes that the upward trend in commercial real estate activity continues to improve so there are more paydays for all of us in the industry. 

Exposing the Soft Underbelly of the Beast

For those of us who believe the Federal Reserve, Wall Street and the major financial institutions in this country wield too much power, something recently happened that has me baffled. 

In March the US Securities and Exchange Commission requested a few of the regional banks to clarify their loan modification policies, what we call in the business "extend and pretend."  Last month the Financial Accounting Standards Board (better known as FASB) also got into the act by issuing new accounting guidelines for "troubled debt restructurings" (TDRs).

On the surface the new accounting guidelines for troubled assets seems quite reasonable.  FASB wants to standardize the definition of what constitutes a TDR so all financial institutions are operating under the same rules.  Right now that isn't happening.  In order to determine if the restructuring is a TDR, a lender must separately conclude that both the borrower is experiencing financial difficulties and the restructuring constitutes a concession.

Beginning June 15th lenders must re-examine their restructured debt to determine how much of it qualifies to be a TDR.  If so, the lender must classify it as such.  The end result is that for the very first time we will see how much of a lender's loan portfolio is deemed "troubled."  At the present time, lending institutions have been able to hide their TDRs with the hope that one day the market will turn around and the loans will be refinanced at market rates and terms, or better yet paid off in full. 

The new accounting rules could have enormous implications, most of which fall in the range between bad and catastrophic.  At the very least the number of loans classified as troubled debt will rise dramatically throughout the banking industry.  But the big question is, "Will the general public's confidence in a bank's solvency be adversely affected?"  Once the cat is out of the bag will the stronger financial institutions be reluctant to transact business with their weaker brothers?

Which leads me back to my original thought: Why did the SEC and the FASB do this?  If you believe like I do (most days) that the Federal Reserve, Wall Street and the major financial institutions wield way too much power, why would they allow these new TDR accounting guidelines to be implemented?  This is not in their best interests.  The change in these accounting rules has the potential of exposing the truth that they desperately want to keep hidden from the public - most banks are hopelessly insolvent.  This only helps to expose their true predicament.

The huge bank bailouts by both the Bush and Obama administrations, the extend and pretend lending policies of the banks, and the historically low interest rates by the Federal Reserve have all been implemented to directly benefit the financial institutions of this country.  So why are they now exposing the soft underbelly of the beast?  If you have an explanation, I'd like to hear it.

Sources: The Extend and Pretend Expose' - coming to a bank near you, ft.com/alphaville by Tracy Halloway, May 20, 2011; More Transparency Coming to Hidden Costs of 'Extend and Pretend' Strategies, CoStar Group by Mark Heschmeyer, May 18, 2011. 

1st Quarter 2011 Transaction Activity

The first quarter of 2011 is over.  From a sales standpoint how well did we do compared to previous years?  Shown below is the criteria we used to tabulate the results:

• Sales information from the CoStar Group database
• Transactions closed between January 1st and March 31st
• Investment transactions only (no owner occupied)
• Property types - apartments, office, flex, industrial, retail, mixed use & specialty use
• Transactions with sales prices of $1 million or larger
• Arms length transactions only
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on this criteria the chart shown below compares the sales activity for the 1st quarter for each of the last five years:

 
As you can see, the sale activity for the first quarter of 2011 increased significantly over 2010 but fell well below previous years.  The good news is that if this trend continues for the rest of this year, 2010 will have been the bottom of the market with a good possibility of improving sales activity going forward.   


We then analyzed the 45 sales transactions for the first quarter by property type.

As you can see apartments still are the most favored property type with 42 percent of the sales in the first quarter followed by retail.  Most of the retail sales were fast food franchises or single tenant buildings. 

Of the 45 sales transactions, only 35 identified the broker representation and only 38 identified the lending source used.  The remaining transactions did not provide sufficient information to determine the lender or if brokers were involved in the transactions.

Another way of looking at it, there were 45 paydays for all of the real estate brokers in the first quarter (17 x 2 = 34 + 7 +4 = 45).  So if you know how many of these transactions you were involved in, you can determine your market share. 

Shown below are the first quarter lending sources for the 38 sales transactions that a lender was identified.

Almost half of all sales transactions in the first quarter did not need new financing.  These results also explode the myth that life companies are back in the market.   After you take away the all cash buyers and assumed loans only 20 loans were placed in the first quarter, most of these from banks.  This paltry number of loans for the first quarter does not bode well for the mortgage brokerage community but hopefully we are on an improving trend.  I look forward to seeing how this quarter turns out.  Keep your fingers crossed.

What Impact Will Inflation Have on Commercial Real Estate?

After decades of little or no inflation there is mounting evidence that the Federal Reserve's Quantatitive Easing program is beginning to take its toll on the value of the dollar.  Shown below are some of these indicators:

• The Producer Price Index (PPI), which measures average changes in prices received by domestic producers for their output, is up 5.6% for the twelve months ending February 2011.
• Commodity prices are rising in relation to the dollar.  The price of gold hit an all time high earlier this week before settling down a bit.  Silver prices continue to soar hitting a 31 year high.  So far this year silver has gained 33% in value.
• A recent Deloitte Consulting poll indicated that 74% of those polled believe their spending will slow due to rising prices they are currently experiencing.

So what impact will inflation have on commercial real estate?  In the short-term the real question is what impact will the threat of inflation have on the Federal Reserve raising interest rates?  An increase in the federal funds rate would ease the concerns of those who fear inflation but it would likely have a detrimental impact on the fragile U.S. economy which is just beginning to show signs of recovery.  It's a delicate balance between these two policy positions.

In the long run, modest inflation would be a great benefit to commercial real estate, as long as it happens gradually so that the market can make the necessary adjustments along the way.  Real estate over the long run has been an excellent inflation hedge and it should be the same this time around too.  Over time, with modest inflation those commercial real estate investors who are currently upside down on their investment portfolio could gradually become whole again. 

My greatest fear is what happens in June when the Federal Reserve ends its own bond purchase program known as quantitative easing.  Who will fill the gap in buying U.S. Treasuries?  If no one steps in to the fill the void what will happen to interest rates?  Doesn't the law of supply and demand require that interest rates have to increase?  And more importantly how quickly will they rise and how dramatically?

Those are the questions that are currently being debated.  Surprisingly there is no clear consensus among the pundits.  We'll have to watch and see.  Stay tuned.  It's going to be fascinating to watch! 

Sources: PIMCO bets against U.S. government debt, Reuters, April 11, 2011; Don't Believe the Inflation Fear-Mongers, The Mark, April 12, 2011; Inflation Not a Threat? Most Consumers Aren't So Sure; CNBC.com, April 12, 2011; Gold Price Sinks After Hitting Ne High at $1,478, Gold Alert, April 11, 2011; Producer Price Indexes - February 2011, Bureau of Labor Statistics, March 16, 2011.

The Six Immutable Laws of Real Estate Investing

James Montier, the well known author of "The Little Book of Behavioral Investing" recently wrote an article called "The Seven Immutable Laws of Investing."  In this article he identifies seven principles for sensible investing in the stock or bond markets.  I was intrigued by the title so I read the article and somewhere along the way I realized that 6 of these 7 "immutable laws of investing" also apply to investing in commercial real estate.  So I thought what the heck, maybe I should take a stab at writing an article on the "Six Immutable Laws of Real Estate Investing."  So here goes:

1. Always insist on a margin of safety.  In other words the goal is not to buy at fair market value but to purchase with a margin of safety as property performance, market conditions, etc. may not live up to expectations.  In our world of real estate this means finding properties that are under performing the market but with a change in ownership will turn the property's performance around. 
2. This time is never different.  The four most dangerous words in investing - "this time is different."  The dot.com bubble that occurred about ten years ago is a perfect example.  Investors were buying stock in companies that hadn't turned a profit on the expectation that they would be the next Google, or Amazon.com.  Stock prices soared and even though it made no logical sense the argument that was bandied about was, "this time is different."  The same was true of real estate.  How many believed that house prices could never go down?  In both examples a speculative fever resulted in a bubble causing stocks and house prices to plummet in value.  Whenever someone starts saying this time its different, get out of that investment as quickly as you can.
3. Be Patient and Wait for the Fat Pitch.  As Mr. Montier states in his article, "Patience is integral to any value-based approach on many levels... However patience is in rare supply."  In commercial real estate there is a time to wait and there is a time to act.  When things go bad, like they have for the last three years the tendency is to dump our real estate holdings as quickly as we can when the prudent thing to do is wait.  Most investors suffer from an "action bias" - a desire to do something.  But often times the best thing to do is to stand at the plate and wait for the fat pitch.     
4. Be Contrarian.  Humans are prone to the herd instinct.  When everyone is buying they buy; when everyone is selling they sell.  Last year the value of BP's stock plummeted due to the gulf oil crisis.  BP stockholders were dumping their stock and only a few contrarians were buying.  Less than a year later those that fought the urge to follow the herd have made a handsome profit while those who sold lost money.  Now's the time to be buying commercial real estate, especially those that have been hardest hit - office, retail and industrial.  Years from now we will realize that that there were bargains to be purchased in 2011.  Or we can go along with the herd and sit on the sidelines.
5. Be Leery of Leverage.  I really shouldn't have to say much of anything on this topic.  In many instances those owners with properties that were over leaveraged have paid the ultimate price - the loss of their properties.  Those homeowners who used their homes as ATM machines learned the hard way too.  Three years after the the collapse of the housing bubble about 1 in 4 homeowners have no equity in their homes.
6. Never Invest In Something You Don't Understand.  This is just plain old common sense.  It's not uncommon for for me to talk with real estate investors that are clueless about their real estate holdings which puts them at the mercy of their real estate advisors.  Many times these advisors have a different agenda than the owner but the owner not knowing the fundamentals of commercial real estate is unaware of the conflict of interest.  It's a simple truth: If you don't understand the investment concept, then you shouldn't be investing in it.

I personally believe that now is the time to be investing in commercial real estate as long as you follow these six fundamental principles.  Cap rates have risen significantly, the frothiness of the market has long since disappeared and  interest rates are low... at least for the time being.  Or you can be a part of the herd that sits on the sidelines waiting for a better day, a day that will likely never come.