Come to Win
July 22, 2010
How can sports prepare you for success in life?
"The greatest lesson I’ve learned in sports that helps me run my
business is there's no "I" in team."...
Hear more of my thoughts in Chapter One of "Come to Win" by Venus Williams.
Tiring and Boring???
July 21, 2010
by Tom Barrack
Click here for printable version
It seems last week I caused a bit of a stir in an article on my thoughts about the current state of the US real estate market. I indicated that as a global financial investor I am feeling as though I enter the octagon every day, training with the top Ultimate Fighters in the world. Tap outs and submissions do not come quickly or without learning the art of "taking a punch." This is applicable to every aspect of life.
Business is anything but boring and the challenges on every continent are manifold while the visibility, transparency and predictability of all asset classes in all regions is a blur. I indicated that the US real estate market in particular was tiring and boring and the greatest tool kit today was to be well versed in hand-to-hand combat. Some reporters and pundits believed I had committed a mortal sin by not waxing poetic about the invigorating, refreshing and unlimited upside attributes of real estate speculation at this cyclical inflection point. Let me shed a bit of lucidity on my point of view, which was intended to properly align expectations with reality - something we do not do often enough in the global investment world.
Real estate investing is a complex, cyclical business made up of trillions of dollars of disparate non-homogeneous assets. The industry today does not lend itself to speculativetrading based upon cheap and plentiful debt and euphoric future rental growth projections. Let's start with the basic and very general premise that US commercial real estate fundamentals are still poor and recovering slowly, if at all. This is of course a generalization; however, with soaring deficits, weak GDP growth, massive unemployment and continuing corporate contraction of G&A, it could be no other way.
There are intermittent signs of hospitality occupancy rates leveling, regional mall sales resuming and an occasional sale of an asset at nosebleed levels. However, according to Moody's All Property Real Estate Index, US values are still off 40% from their peak in late 2007 (see chart below). The nominal CAGR for real estate values since the beginning of the decade is just over 1%.
Note: As of March 2010, Indexed to December 2000 - 100
For the most part, the fundamental law of supply and demand is alive and well, which largely explains why real estate rents and revenues in current dollar terms have been flat since 1994 (see chart below).
Source: PPR
Additionally, zero interest rates and the regulatory relaxation of mark to market requirements for banks has all but abated the flow of troubled commercial debt to be recycled through the system. Rather than a tsunami, it has been a knee-high wave.
To make matters worse, capex has been scarce in many projects since 2007 and the amount of deferred capex in most property types is significant. Thus cash flow for leasing commissions, tenant improvements, key money and deferred maintenance is nowhere to be found in a still opaque and weak new real estate lending environment.
The disposition of distressed commercial mortgages has not happened at a scalable level as a result of relaxed mark-to-market regulations; untested special servicers and CMBS waterfalls; tranche warfare amongst holders of various classes of debt; zero interest rates; "pray and delay" and "extend and pretend" strategies. Consequently, the anticipated recycling profits from a massive macro correction in debt has been slow to come and many funds have been frustrated by the lack of product at what they believe to be attractive discount pricing. As a result, there are very few market clearing transactions for non-strategic, long-term buyers.
Many owners realize their equity value is gone but in many cases, due to historically low floating interest rates, can still make debt service if the term of the loan is extended. Everyone is playing for option value and it is a slow moving train, which becomes a bit "Japanese-esque," and the tea leaves tell me that this stage will be here for a while.
Commercial banks feel no pressure to mark the loans to market value because the regulatory requirements have provided a relaxation of LTV mark-to-market tests if sufficient debt service is still available. Consequently, a loan originated in 2007 on a $100 property at 70% LTV and 1.0x DSC with a 5.5% interest rate can still be "OK" at an LTV of 150% because artificially low interest rates are driving up coverage ratios to acceptable levels (see chart below); thus the dawning of "extend and pretend" and "delay and pray."
(1): Floating rate assumes L+100 bps with 30-year amortization
Real estate equity is moving slowly because a substantial disparity between most buyers and sellers still exists. Buyers have been anticipating price corrections as a result of the market downturn and continued deterioration in fundamentals while sellers who are not under bank or mortgage pressure are simply holding their ground. In most cases they have little incentive to sell, and due to their own debt issues, more likely than not, have lots of reasons to hold.
With the cost of their liabilities near zero, banks have been earning money in recent quarters and reserves are building. A more vibrant flow of private treaty real estate loans is beginning to materialize and we expect, as loans get closer to term limits in 2011 and 2012, there will be significantly more loan sales coming to market.
In an environment where the government continues to print money and create massive accumulating deficits, inflation will surely return at some point. However, the deleveraging cycle in real estate must first run its course. A resurgence of demand for product will coincide with better pricing power, which will once again drive values. After we experience deflationary correction across our economy we will then be in the wake of significant inflation. The only non-printable currency is hard assets and over time hard assets will carry the day.
In summary, solid risk-adjusted returns will be made by true real estate professionals with the tools and the teams to plow and hoe. By being in the marketplace, we will sense when that next repricing opportunity exists and will avail ourselves of it. The business is not about inventing the next iPad or launching the largest leverage buyout. It is about showing up, doing a good job, harvesting reasonable returns for our investors (which will look strong in hindsight against other asset classes), and waiting for the repricing moment.
The fast money, high velocity, handsomely leveraged, quickly appreciating days of real estate investment are not in the near-term tea leaves. Real estate has returned to the hands of real estate professionals, not financial arbitrageurs, and most real estate opportunities in the US involve hand-to-hand combat on restructurings or intensive value-added implementation. In either of those two circumstances, the process is slow and low. It is an era of what real estate is supposed to be - singles and doubles. Home runs will be few and far between, while the World Series is still a bit in the future and only after a very long season of individual games, made up of individual innings, made up of individual at-bats.
If my rendition of the above has been a bit tiring and boring, then I have effectively conveyed my message. Thankfully, the business has finally returned to the real real estate business.
Bottom line, there's nothing new. As in all aspects of life, expectations based on anything other than reality will always lead to disappointment. Reasonable expectations are the key to peace of mind.
