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December 11, 2007

Will the Commercial Real Estate Market Fall? Of course it will.
by Reggie Middleton

Required reading for this article: The very first paragraph of the very first post I made on this blog and "the Great Global Macro Experiment".

Of course commercial real estate is going to fall. Why? For the exact same reason residential real estate is falling. But, there hasn't been an oversupply of commercial real estate, you say. Well, the oversupply is not the core reason why residential is falling right now. Residential RE's problem is that easy, cheap money brought upon wreckless, imprudent speculation from players who were not well versed in the real estate game - and even those who should have known better. The current oversupply is a byproduct of that liquidity induced speculation. Why split hairs? Because the devil is in the details. The downfall of CRE is the rampant speculation that caused many to significantly overpay for assets that are quite illiquid and take significant expertise and time to improve (or even sell), even incrementally. Not only did they overpay, but they applied significant leverage as well, much more than the industry norm.

A Quick Commercial Real Estate Primer: Pricing Commercial Real Estate

There are several ways to price and value CRE, but the simplest and most straight forward is the capitalization rate (cap rate).

The cap rate is simply net operating income/price. The result is a yield that you can use to compare to other investments in order gauge relative price/return - such as the 10 yr. note yielding 4.114%. For instance, I buy a building for $100,000 and it throws off $10,000 after all operating expenses. $10,000/$100,000 = .10 or 10% = the cap rate. Thus this building is priced at a 10% cap rate, or priced by the seller to give the buyer a 10% return, unleveraged. This 10% return priced into the building allows a 589 basis point risk premia over the 10 yr treasury. Why, you ask? Because the office building is much riskier, being very illiquid, taking many months or years to close on and sell. The office building inherently has risk of litigation, operational risk, and market risk. It also requires a modicum of operational expertise, and in addition there is credit risk (through your lessees(?) So, as you can see, the risk premia is well deserved.

Now, many (in order to juice the return a bit) apply leverage through mortgages, bank loans, etc. to spice up the return, albeit at the risk of higher volatility of cash flows and the possibility of running negative cash flow in tight years. Assume, I used 30% of my own monies ($30,000) to buy this building and borrowed $70,000 for the rest. I now get that same $10,000 net operating income off of a $30,000 cash outlay, vs a $10,000 cash outlay. So now I yield 33% return instead of a 10% return due to leverage. Of course my astute readers realize that the cost of this leverage was not factored in. Let's assume the debt service for this loan is $4,900 per year. I must deduct that interest and principal repayment from my operating profit. This is reality. Thus, my leveraged yield is really something akin to 17%. Still not bad, and still better than 10%.

The realities of the liquidity boom generated leverage, the absence of risk premia & how the combination of the two will bring down commercial real estate

There are additional caveats to the use of leverage. For one, it greatly reduces operating flexibility. If you paid all cash in the deal above, and two out four of tenants move out or go bankrupt, your (variable) cashflows are not as hindered by your debt service (fixed) which offers you the flexibility to pay more bills until you replace your income. If you took on debt, you have less room to maneuver since the debt service is a fixed cost. Of course, the more debt you take on, the less room you have.

Now, over the last year or two, I have witnessed market participants purchase apartment and office buildings at cap rates of,,,, hold your breath now,,,,, 1.5% -4.5%. That's right. These are supposed professionals, acquiring multi-million or even multi-billion dollar risky assets yield less than a 10 yr treasury or your local money market fund - much less. There are only way two ways to justify paying a low cap rate:

1. A clear path towards increasing net operating income, such as doubling rents (this ain't gonna in this economic downturn with corporate earnings disappointing and the residential housing stock at all time highs), or reducing expenses, or -
2. selling to an even greater fool at an even lower cap rate. With the easy money drying up and CMBS market looking rather scary, fools that are easily departed with thier money are increasinly hard to come by. Now, we can find fools, still - but the money part is the kicker these days - And even if you find a fool who still has some of his money, how do you convince even him to pay between 0% to 1% return on his money for your risky asset when treasuries are currently yielding ove 4%. This is not even taking into consideration leverage - which would assuredely drive this asset into negative cash flow, with NO MARGIN for ERROR in operating. Trust me, you will need a margin for error. Everyone makes mistakes, even me. I made one back in the early '90s... :-)

Sam Zell, one of the most successful real estate investors of our time, sold his Equity Office Properties Trust of Class A and B buildings to Blackrock for what I assuredely thought was a fools price. When I saw the numbers, I said easy money or not, there is an ass for every seat. Well, little do I know. Blackrock found someone to pass the cherry on to, and in near real time at that - and they paid even lower cap rates than Blackrock did. Hats off to the Blackrock folk. You found the guys at the very tip top of the market to drop those cap rates off on.

Now, the problem for the last guys to buy these properties (as Sam Zell sits there smiling on his $21 billion pile of cash) is that it is going to be nigh impossilbe to find someone who will pay a ZERO cap rate, and try as you might it will be damn hard to raise lease rates amongst an economic hard landing and negative trending earnings... And thus, this is the fate of commercial real estate. The many guys who overpaid, will get burnt as values tumble from their peak bubble highs. Old school real estate guys email me and say they never even heard of 5, 6 and 7 percent cap rates until recently (after 30 years in the biz). Well, some of these guys are pushing zero (literally 1.5% to 3 and 4%).

So I told my team to find the low cap rate buyers so we can short 'em. We, of course, started looking at the profile of those who bought from Blackrock (I mean, who wouldn't?) and then moved on when we saw that their were some entities that were in some real (and I mean real) trouble. Here are a couple of companies that we passed on because they weren't bad enough off:

Vornado - implied cap rate of 4.2% (currently about that of a risk free note, but fraught with risk), and debt to equity of 163%. This means $1.63 of debt to every dollar of equity or in terms of residential real estate.

Equity Residental - implied cap rate of 5% (currently about that of a risk free note, but fraught with risk), and debt to equity of 193%. This means $1.93 of debt to every dollar of equity. Inserted comment: Error correction, hat tip to Kiku below. It has been pointed out in the comments that published equity numbers are misleading for REITS, which is why we measure portfolio value independently, as we did with the mononline insurers and the homebuilders. Could you imagine going to a bank (like Countrywide, with mortgage backed structured products insured by Ambac) and saying, "Hey, I'd like to borrow twice what my house equity is appraising for, and I want to do it now, Dammit!" :-) Alas, this is what "The Great Global Macro Experiment" has wrought.

If you think these numbers might look just a little hairy, just wait and see the numbers of the companies that I am actually shorting. The one's above were actually cut off of the short's short list, so to say. Once you see, you will be a believer just like me - commercial real estate is on its way down. See comments below for more on the accuracy of the book calculations I use in my analysis vs. used in this story.

Details of transactions for sale of properties by Blackstone Group

Reggie Middleton
http://boombustblog.com/

Reggie Middleton is the personification of the freethinking maverick--the penultimate nonconformist as it applies to macro strategies, investment, and analysis. He uses his background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation, and financial analysis to pursue, analyze, and capitalize on global macroeconomic opportunities.

Finding most available research lacking, both in quality and quantity, Mr. Middleton assembled his own talented research staff. As forensic research is a lynchpin for his own investing, "to actually put food on the table," he stands behind it as doing what it is supposed to do - illustrate, elucidate and educate.

He does not sell advice or research. He is an entrepreneur who exists outside of mainstream corporate America and Wall Street. This allows him the freedom to do things that many cannot--perform without conflicts of interest and corporate politics. He prides himself on developing some of the highest quality, actionable research available - regardless of price. He welcomes any and all to peruse his blog of freely available analysis, opinion and participatory social media; use his custom tools, download files, interact with the community and make critical comparisons from a results orientated perspective. Reggie believes ideas and implementations are improved and fine-tuned when bounced off of the collective intellect of the many, in lieu of that of the few - in essence, a form of collaborative open source financial analysis.

Visit his blog Boom Bust Blog.

Copyright © 2007-2008 Reggie Middleton

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