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December 20, 2007

Do You Remember When I Said Commercial Real Estate Was Sure To Fall?
by Reggie Middleton

My first post on my blog in September warned about the coming drop in real estate prices. I revisited the topic a couple of weeks ago, as I prepared the research of a short position in the sector. Well, we are almost done with the research and the position and I will release a summary of the research and the performance (expected and actual) of the position after Christmas.

In the meantime, this is a tidbit gleaned from my studies. We literally modeled and valued 260 properties of a certain REIT (each model is about 65 pages long, and very detailed and analytical - in real terms, no fluff here) that came up in a scan for CRE participants with bad numbers. We canvassed brokers, institutional data sources, sellers and buyers (9 sources in total) to get a detailed understanding of the lease rates, climate, and sentiment of the geographic area of each individual property. This is probably one of our the most ambitious works this year, and makes for extremely informative reading for those who have a real interest in the sector. We covered 41 states 2 countries and a whole lot of cities, all accurate to within a distinct business district of each property, where available.

What I found was that, at least where this REIT operates, the commercial real estate bubble (yes, there was an easy money induced bubble) peaked in Q4'05, where the spread between new leases and existing leases maxed out at about $5.30/ft. This spread actually went negative in Q4'06, and that negative margin increased substantially.

What does this mean? Well, for one, most people think the commercial property sector will start to drop soon. They are not aware that the main value driver of CRE, NOI, started dropping 2 years ago. Operating expenses are rising due to inflation (which is real, and not to be confused with the fudd that the government puts out), while rents have been dropping.

In addition, the easy money liquidity has been pushing cap rates down (as if the falling net operating profit wasn't enough to do this), thus prices up. This money didn't dry up until a few months ago, probably marked by the Blackrock deal flipped from Sam Zell's properties in near real time. That was just a few months ago. So, revenues go down and expenses go up even as prices shoot up for two years straight (I guess nobody stopped to count the money), then easy and lax funding suddenly disappears... I have above a considerably astute constituency for my blog, so you know how this story ends. New rents are now coming in below existing rents as we approach a potential economic hard landing. To exacerbate the matter, leases expiring(ed) in '06 are 20% below that of the current asking price, and 29% below the average in place rent. This means that the companies renewing these leases have a much larger chunk coming out of their cash flows for rent. These are big numbers for low margin businesses, and even bigger numbers for low margin businesses going through an economic hard landing.

We will see what happens next, for those that bought buildings with lessors attached to highly inflated leases are going to get a lot of pushback for renegotiation, or worse, actual breach. Just as in the residential housing sector, stakeholders don't want to see their investments (leases, or homes) underwater and falling even farther as they struggle to make the payments. With such a big jump in rental prices up for renewal, landlords are going to be hard pressed to have any pricing power, for the resistance has already shown itself to be much more than just a few months ago. If you paid a 3% cap rate for a building with expenses trending upwards, you will need pricing power - and that is not even taking into consideration the use of leverage. Such inelasticity can lead to lower economic value.

This leads me to the value of the CMBS that these properties back. With a overly optimistic assumptions of cash flows, expenses and forward looking macroeconomic trends, there is no wonder why the spreads in these securities have widened so much as of late. It is not sympathy for the residential market - the commercial market has issues of its very own. Even the high end NYC (where it was thought that real estate was bullet proof - you know, the "But it's different this time" mentality) commercial real estate rags who have been bullish for the past 6 months while I have been a virtual grizzly bear, have decided to come around to my way of thinking. You think maybe they started reading my blog:-0

• The Commercial Slowdown
• Technical defaults rise, but foreclosures don't hit
• Big block leasing activity taps the brakes
• Manhattan office market sees vacancy rise
• City revenue from big building sales expected to dry up
• Rental market shows some signs of weakness
• After slow fall, inventory starts to grow
• Brokers saying 'no thanks' to stubborn sellers

Neophyte and/or overzealous (like those who bought from Blackrock recently) investors are sure to be bathed in buyer's remorse as well, as the realization of purchasing at the top of a sinking market sinks in. No pun intended. A summary of the analysis will be available on www.boombustblog.com for free after Christmas (Merry Christmas), and the full analysis will be available to our paying subscribers.

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

Who am I?

Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

Since I use my research as a tool for my own investing to actually put food on my table, I can stand behind it as doing what it is supposed too - educate, illustrate and elucidate. I do not sell advice, I am not a reporter hence do not sell stories, and I do not sell research. I am an entrepreneur who exists just outside of mainstream corporate America and Wall Street. This allows me freedom to do things that many can not. For instance, I pride myself on developing some of the highest quality research available, regardless of price. No conflicts of interest, no corporate politics, no special favors. Just the hard truth as I have found it - and believe me, my team and I do find it! I welcome any and all to peruse my blog, use my custom hacked collaborative social tools, read the articles, download the files, and make a critical comparison of the opinion referencing the situation at hand and the time stamp on the blog post to the reality both at the time of the post and the present. Hopefully, you will be as impressed with the Boom Bust as I am and our constituency.

I pay for significant information and data, and am well aware of the value of quality research. I find most currently available research lacking, in both quality and quantity. The reason why I had to create my own research staff was due to my dissatisfaction with what was currently available - to both individuals and institutions.

So here I am, creating my own research for my own investment activity. What really sets my actions apart is that I offer much of what I produce to the public without charge - free to distribute and redistribute, as long as it is left unaltered and full attribution is given to the author and owner. Why would I do such a thing when others easily charge 5 and 6 digits annually for what some may consider a lesser product? It is akin to open source analysis! My ideas and implementations are actually improved and fine tuned when bounced off of the collective intellect of the many, in lieu of that of the few - no matter how smart those few may believe themselves to be.

Very recently, I have started charging for the forensics portion of my work, which has freed up the resources to develop the site to deliver even more research for free, particularly on the global macro and opinion front. This move has allowed me to serve an more diverse constituency, which now includes the institutional consumer (ie., investment turned consumer banks, hedge funds, pensions, etc,) as well as the newbie individual investor who is just getting started - basically the two polar opposites of the investing spectrum. I am proud to announce major banks as paying clients, and brand new investors who take my book recommendations and opinions on true wealth and success to heart.

So, this is how I use my 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. I have included a more in depth bio at the bottom of the page for those who really, really need to know more about me.

Visit his blog Boom Bust Blog.

Copyright © 2007-2008 Reggie Middleton

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