Will the commercial real estate market fall? Of course it will.

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

Date	Particulars of transaction	Purchaser	Amount
12th June, 2007	Sold Extended Stay Hotels	The Lightstone Group LLC	$8 billion
9th August, 2007	Sold 38 assets comprised of 106 office buildings and 5.9 million square feet in San Diego, Orange County, San Francisco, Seattle, Portland and Salt Lake City. The properties are from the CarrAmerica West Coast Collection that Blackstone Group purchased last year as part of a national portfolio.	GE Real Estate-owned Arden Realty	NA
17th July, 2007	Merlin Entertainments Group, the leisure park operator owned by Blackstone, sold its property assets to London property firm Prestbury Group plc owned by real estate investor Nick Leslau.	Prestbury Group plc	$1.27 billion
27th August, 2007	Sold 9 suburban Chicago office complexes to GE Real Estate. Blackstone acquired these properties when it bought Equity Office Properties Trust.	GE Real Estate	$1.05 billion
27th August, 2007	Sold a portfolio of downtown Chicago properties to Tishman Speyer. Blackstone acquired these properties when it bought Equity Office Properties Trust	Tishman Speyer	$1.72 billion
9th February, 2007	Sold 6.5 million square feet of Manhattan office space Macklowe Properties. Blackstone acquired these properties when it bought Equity Office Properties Trust.	Macklowe Properties	$7 billion

   

Comments

[Calvin]

Forgive my ignorance but how do you calculate the "implied cap rate"?

For example, VNO from google finance:

Quarterly (Sep '07)
Total Revenue 853.04
Gross Profit 393.67
Operating Income 222.95
Net Income 145.90
Balance Sheet
Total Assets 22,253.77
Total Liabilities 16,047.41
Total Equity 6,206.36

thanks

[Dan]

Thank you for your insight. I assume you mean Blackstone (not Blackrock) talking about the Sam Zell Equity Office Properties Trust transaction.

[Reggie]

Rock, stone, pebble, you get my drift:-)

Thanks for the correction

[Reggie]

@ Calvin
When analyzing companies, you can't rely on data aggregation sources like google or yahoo. You have to do it the old fashioned way and open up the companies' financial statements. Do that and all will be found.

[Reggie]

@ Calvin
When analyzing companies, you can't rely on data aggregation sources like google or yahoo. You have to do it the old fashioned way and open up the companies' financial statements. Do that and all will be found.

[Mark]

Apologies for contaminating this discussion by reverting back to MBIA, but I can't help but ask if you have any thoughts on the capital infusion from Warburg that was announced today? Do you have any idea if the additional $500M commitment is based on the current share price or the approximate market price in the first quarter?

The $1B seems like a drop in the bucket compared with MBIA's exposure, but to be honest, I was somewhat surprised that MBIA was able to find an outside investor willing to make what appears to be a genuine capital commitment. If Warburg already has a stake and is trying to minimize the loss, this is a different story. Who knows, maybe it will be enough for MBIA to hold onto the AAA ratings until fourth quarter results are released.

The mark-to-market write-downs were no surprise (perhaps even on the low side), but case reserve emergence of $500M to $850M seems like a lot for this early stage.

[nl]

Financial debt/equity values for REITs are not very meaningful. It merely shows the relationship between the price paid for the building and physical capex, minus rather hefty depreciation, and existing debt. Since they could have bought the building many years ago, at much lower rents, this book value can be very dinky.

Real debt/equity values are a little trickier, and involve placing a true value on the properties. This includes applying a capitalization rate, and typically a market rate is used. This may not be appropriate, since, as you mention, market cap rates may be totally whack -- 4%?

Also, debt/equity values are not comparable to LTV. The debt/asset ratio is more like LTV, although once again we're talking real asset value (whatever that may mean), not book.

In general, REIT managements are fairly conservative, and apply about 50% debt/assets (LTV) on conservative valuations of property.

[Reggie]

Thanks for the correction on the LTV bit, my error (trying to be funny as I write the post at midnight with no sleep:-) I'll correct that. As for how reliable the debt to equity or asset ratios are, for the sake of my analysis it is irrelavent for the prospects that I have selected (I am familiar with some of Vornado's purchases). Once I select a target, I calculate book by hand (as was done for the homebuilders and the monoline insurers - see those pdf reports). I don't trust published numbers. In reference to the particular short that I am fosusing on, I am evaluating each property individually - each property with it's own valuation model (or at least most of them), then a portfolio model to aggregate the properties which then feeds into a model of the corporate entity/trust/etc. The target company has a portfolio of approx. 200 properties. This is why it takes so long, but I have to be sure of my position.

As for the conservative nature of REITS, I have seen several instances of their catching the same fever that everyone else did. That is what makes a trade, you need two guys with differing opinions. Like stated in my thought on the builders post linked in the first paragraph of the article, recent buyers were totally too optimistic concerning rates of return and potential for rent increases - which they cannot get in the current environment. If I am right, we will see in a few quarters.

[Ralph Allen]

I am an amateur to investing but have done systems engineering analysis for years. I have read other analysts opinion about the over valuation of Commercial REITS. I took that along with the realization that the market will have a huge correction once the average guy gets a glimpse of what’s coming in the economy. A correction of 50 to 75% in stock value is due. SOO I bought puts a year out for leverage with the belief that the correction will occur during that time. I stayed with companies that had at that time a yield of 4% or less and where the options cost 10-14%. If the yield returns to historic levels a 50% price reduction will be easy. I will be waiting with baited breath for your short company disclosure.

By the way Vornado was one of my shorts. GGP was another since they were heavily into development with 50% of earnings.

[Reggie]

You sound like a smart guy. Let's wait and see how your picks pan out.

[Reggie]

@mark
I haven't been ignoring you. I actually dedicated an entire post to your questions. I don't think the guys at Pincus fully understand what it is they bought. They got a good price for it though. Less than market price.

[nl]

Hi Reggie,

Certainly there have been people buying buildings at vastly exaggerated prices. There is always some justification for such behavior at the top, typically something (sales, profits, eyeballs) that "only goes up," in this case rents. I have had the impression that the biggest suckers here were institutional buyers (esp. pension/endowment fund types) looking to "diversify" into "alternative investments." (All bubbles come with their own terminology as well.) Some real-estate pros (Kushner) got pretty silly as well.

However, there is a difference between the valuation of the STOCK and the buildings/REITs themselves. Even if there were stupid assumptions of rent increases on a few recent purchases, that wouldn't show up in the trailing earnings reports. Most REITs are pretty religious about keeping debt service to around 50% of trailing cashflow, as the REITs themselves, as a group, were born of the commercial property bust of the late 1980s where too much leverage led to insolvency.

[Reggie]

It is not the trailing earnings reports that I look at. I look at, and value, actual assets and cash flows. The company(ies) in question get a thorough forensic examination, independent of published numbers and management commentary. Both management's and investor's reliance on trailing numbers is what causes problems. It is akin to looking in the rear view mirror while driving fast forward. One of the main reasons stocks trade at a premium/discount to underlying assets is that many investors never bother to look at and properly value the underlying. Lennar, Hovnanian and Ambac are three perfectly good examples. REITS and closed end funds often are subject to the same misvaluation until an exogenous event occurs that wakes everybody up.

If rents drop appreciably and companies bought a lot of buildings at 50% trailing cash flow to debt and at very high prices (since rents were sky high for the last couple of years and money was very cheap) then the next few quarters/years should look pretty ugly since 50% of $100 rents is really 66% of $75 reduced rents, if you know what I mean:-) I sat back and witnessed this buying first hand over the last 2 years.

Notice how the homebuilders, banks and monolines all failed to warn mid year '06, when a good look at their actual business would have told a different tale. Take WaMu for instance. If you go back to my first (or second) post on WaMu, I noticed that hey had 5 quarters running (2 quarters ago) of losses in their mortgage division. A forensic accounting of their holdings would have led to a very profitable short. The same goes for the homebuilders, whose inventory showed obvious signs, as well as the macro environment.

I am valuing the holdings of a company or two, one by one (the short list does not consist of only reits). I believe one to have real problems, but we will see exactly where it stands in a week or two. If I am right, then the stock will eventually reflect my findings because the shareholders should be noticing cash flow and valuation issues, albeit a little late. Like I said, time will tell and if I am wrong and you are right I will be the first to admit it (okay, maybe the second:-) I really do like the attention you pay to this and your apparent knowledge an background though. I am developing a new site and need a beta tester. Email me if you are interested.

[nl]

Hi Reggie,

It's not about being "wrong or right." Actually I've been short the REITs since June. Too expensive, and things are not going their way. Although I did quite a bit of work on the apartment REITs back in 2004 (backing long positions, which worked), I'm not that familiar with the office/retail type stuff and how it could perform in a recession. I'd love to see estimates of cashflow impairment going forward. It's one thing to have disappointments of expectations, and another to actually have declines from trailing cashflow. As you mention, the combination of cashflow impairment, leverage and more conservative valuation of remaining cashflow would be quite the one-two-three punch.

[Reggie]

I'll post some highlights of my research when it is complete. I have also taken a hard look at banks (again) and have some interesting info there as well.

[San Diego Real Estate Blog]

Hey I agree I think Commercial Real estate is going to take a tumble as well. Residential has been falling adn commercial is sure to follow. You know, I wrote a related article called Government is Real Cause of The Real Estate Bust. Check it out if you have time: http://www.brokerforyou.com/brokerforyou/?p=332

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[quail hill homes]

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.

[turtle ridge homes for sale]

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.