Oct. 14, 2009 - Distressed Portfolio Transactions? Be Patient…..

Another week went by, we prepared valuation models for three distressed single family portfolios we bid on and were rejected by the seller for being to low.  In today’s market we need to submit ten proposals just to buy one.  The Buy/Sell difference for distressed notes and REO’s are all over the place, compounded by poor information and overstated valuations of “portfolio value” by sellers who are often politically reluctant to sign their names on the loss to move the assets off the company’s books.

When an investment becomes distressed, the first option is to sell: But at what price? The value of the asset is what someone will pay after they understand the risks. There are serious detailed technical matters to address in today’s market the buyer must understand before moving to commitment.

As a buyer it is difficult to value property of any kind when prices are declining.  An economist will tell you a real estate assets value is driven by supply and demand, interest rates, the economy, unemployment, immigration, etc. and even more economic fundamentals.  That maybe true, but with falling or stagnant prices in most markets across industries and across the economic spectrum, the difficulty in valuation makes most assets today distressed.

Accordingly the seller may not want to face the fact that their assets could be worth far less than what was paid for them. Yet the question is will the asset be worth more in a few months from today?  Most will agree not. 

Our question we are confronted with is, how can you value an asset especially when we may hold the asset over a 12 month period?  With the multi-levels of risk and uncertainty it is difficult to logically understand why so many distressed assets are being held off of the market.  The incentive to sell is just not as strong as you would think given the facts. 

As a buyer the key to success in today’s market is patience as we continue doing our due diligence and prepare our next letter of intent.  Until the market resolves the current Buy/Sell difference deal flow and the REO's entering the market will remain a trickle. 
 

Aug. 25, 2009 - “CHANGE” The Economic Reboot

Looking back at the 1970’s the America entered a recession with some similarities we see today.  We were at war; we had a spike in energy prices, a period of high unemployment resulting from the declining importance of manufacturing.   A growing Japanese economy filled the manufacturing void with products while evening news reported plant closures. The economy sputtered Americans were feeling the golden age was over.

In 2008 the American people feel China will soon dominate the future economy and our golden age is over once again. High oil prices, war, wasteful consumption, and a world in peril has uprooted the world economy.   Today in board rooms, Washington, in kitchens and broadcast media across the national attention is refocusing on “economic change”.  

For 200 years “CHANGE” has been the American economic engine.  While most world economic systems support existing interests we have always been in search for the “next big thing”. During past economic downturns large companies routinely becomes focused on survival which creates space necessary for a major change in our economic system to take place.   The important lesson of the 70s was our nation’s adaptability to the sharp loss of manufacturing which eventually gave rise to the powerful knowledge-based economy that became the cornerstone in America’s economic revival for over 30 years.  
 
The 70’s recession ended an era of very large monopolistic like companies; companies which dominated industries like IBM, Pan Am, AT&T etc.  During most of the 20th century the economics of scale lead to prosperity, but in the 70’s the now familiar names like; Steve Jobs, Bill Gates, Larry Ellison and their small ventured backed startups faced down the giants and transformed our nation’s economy.  More significantly it was a time small companies trumped the advantages size and ventured backed startups lead to an explosion successful startups and the IPO.

After the dot com bubble burst, we reverted back to 20th century economic thought; that large companies where our best investment for growth in the future economy.   During this period the small startups lost there allure they once had.  Then last September it all came toppling down, inflated by debt at levels never before imagined, Lehman Brother’s’ overnight went bankrupt.  The next day Bears and Stern, General Motors, AIG, etc defined a new class of super large companies known to the public as “to big to fail” (ouch).

We now see in this recession the downside of size.  Large companies require longer decision time and have many more levels of regulations and compliance issues to manage.  Big companies today are harder to run on cash flow alone, they require more debt and have little success in providing meaningful growth in innovation or employment.  To produce meaningful results large companies must place bigger bets in a competitive, web connected, diversified marketplace, substantially increasing risk. 

Harvard professor Juan Enriquez made a commented recently that, “Venture backed investment receives.02% of our national investment while being responsible for about 17.8% of our economic output.”  His comments appear to support the notion that the ‘speed of change, trumps the advantages of size’.   Today small 21st companies have the advantage from nimbleness to risk-taking, while cloud computing is turning our workforce into small globalized teams, loosely joined in collective projects working on; renewable energy, robotics, nano technology, informics and bioscience, etc, which may already be engineering solutions for the next generations economy.

Twenty months into the recession the economy is still struggling yet there are recent signs the recession is moderating as the financial industries are beginning to lend and the government stimulus moves into the pipeline.  The freefall appears to be over, but today for the first time the best people are moving from the large firms to small firms and independent contractors.  The framework of success is changing, with little more than laptop and friends tens of thousands of small companies are forming and reforming, CHANGE is already hard at work.
 

Jul. 22, 2009 - Bernanke and the Commercial Real Estate Market

The economic downturn is pushing the commercial real estate markets into a difficult period in this deepening recession.  Business bankruptcy are growing, a steady decline in commercial property yields make it difficult for many real estate groups to meet current debt-servicing commitments, creating a major problem for economic recovery. 

Recently Bernanke told the House Financial Services Committee that the commercial real estate borrowers are having difficulty refinancing their loans.  In an effort to shore up the market and the banks balance sheets, Bernanke is urging banks to help creditworthy borrowers refinance, while the central bank is trying to jumpstart the securitization market by accepting new and legacy commercial mortgage-backed bonds as collateral in its Term Asset-Backed Securities Loan Facility, or TALF. 

The banks get to hide their there troubled loans in a maneuver being called in financial circles "extend and pretend".   But do we risk repeating what happened in Japan’s economy which became paralyzed as banks failed to deal with their troubled real estate loans?  It is stunning after Timothy Geitner referred to the Japanese “lost decade” as what we would not do, that the U.S. banks are not cleaning up their books and are hoping real estate values rebound quickly.

Most commercial property loans are structured as balloon notes. Borrowers pay only interest for the first five or 10 years until the loans mature, and then the entire amount must be paid back.  The banks' willingness to extend loan maturities are hoping rental rates and building values return to levels seen during the peak of the real-estate market in 2007.  But what happens to the economy if it doesn’t?

On paper this plan looks like a plus; the bank extends’ the note to the borrower who pays a fee or agrees to pay a higher interest rate, or both, which allows the bank to grab fees and avoids having to foreclose or write down the loans as an impaired asset. They also can keep the loans on their books as if nothing were amiss.

The banks post quarterly results that are misleading, which now has become a different problem because the loans have greater risk than they are disclosing and can pretend things are better than they are.  That is what did happen in Japan during the 1990s.  After their debt-fed real estate bubble burst, Japan slid into the "lost decade", a time of economic and financial malaise.

Despite all the tough talk out of Washington and Wall Street the U.S. seems to be on course to repeat what happened in Japan, granting extensions to commercial real-estate investors, so they don't default. The hidden loans cause banks and especially regional banks to restrict their lending to business to build new facilities, do renovations, or make capital investment which can grow the economy.  What's worrisome is the lack of transparency in the over all system so we are not able to properly evaluate our banking system and make intelligent adjustments.  

So I am left to wonder; what happens in a few years from now if the loans are still under water?  I can only hope Bernanke and Geitner have the skills to maneuver this economic ship through torturous economic waters, to sound economic stability.
 

May. 25, 2009 - The End of the Moratorium on Foreclosures

Earlier in the year I wrote a piece about the surprising housing market resurgent’s due to failing prices and great values for first time home buyers.  Then the moratorium on foreclosures which began in January has recently ended.  Between December and March 2009 the number of REO properties on the market dropped by more than 80% from the level while a build up of homes for foreclosure did not move to market.

The attempts to revive and stimulate the housing markets into recovery when homeowners are losing their jobs have failed to solidify current home prices.  Properties are affordable for potential buyers but buyers are becoming scarce.

The build up of REO inventories due to the moratorium will soon flood the market which should further weaken prices.  Banks' are currently selling REO assets at about 50%-75% of what they initially calculated while their expenses to bring these properties to market and manage them are growing. More and more homeowners being evicted are stripping homes to the bone, removing appliances, fixtures, carpet, cabinets, air handlers, motorized garage-door openers and anything else that they can carry off or sell, lowering home values to new lows.

Unemployment increases have diminished the number of potential home buyers and making it more difficult for many to meet current mortgage payments forcing more people to put their homes on the market.  Second homes are also coming onto the market at an alarming rate, as many middle- and upper-class sellers need to raise cash. In some very exclusive private communities in Florida, where home prices are in the seven figures, more than 50% of the homes are on the market.

Unfortunately, the longer it takes to put all of the homeowner recovery plans into place the more difficult of a task becomes.  The end of the unofficial moratorium on foreclosures, combined with rising unemployment, signals that the REO housing market is only just beginning.  The rest of the story is still unfolding.

May. 8, 2009 - Mortgages, Housing Market and Loan Modifications

The housing market continues to experience significant deterioration; declines in new and existing home sales, housing starts and home prices, as well as increases in mortgage delinquencies.

High levels of unemployment indicated by the total number of Americans receiving unemployment benefits increased to the highest levels on record dating back to 1967. The U.S. Bureau of Labor Statistics reported successive increases in the unemployment rate in each month of the first quarter, reaching 8.5% in March. Unemployment rates are much higher in Florida, California, Arizona and Nevada where home foreclosures are that the highest levels.  Coupled with severe declines in home equity and household wealth has resulted in a continued increase in residential mortgage delinquencies.

Congress is moving closer to enacting a law intended to ease a foreclosure but the legislation that came before the Senate did not contain all that President Obama wanted – namely, new authority for bankruptcy courts to rewrite the terms of mortgage loans on individuals’ primary homes.
the immense power of the banking and real estate lobbies was revealed. 

Last week the issue failed 45 to 51 in the Senate last week. All you need to do to look at the 2008 campaign to see the finance, insurance, and real estate sector contributed $463.4 million to candidates for Congress, according to the Center for Responsive Politics in Washington. That’s more than contributions from the healthcare, energy, agriculture, transportation, and defense industries combined.

Senate Republicans were united against the mortgage reform provision. “There are already numbers of agreements under way to help people modify mortgages,” says freshman Sen. Bob Corker (R) of Tennessee. “Should we throw to the courts the ability to change contract law that will penalize vast numbers of Americans because they build in such a risk premium for the future to solve it? No.”  But what is not said is bankruptcy courts change contracts all the time.

Courts are already allowed to write down the terms of loans on secondary homes, yachts, and other big-ticket items involved in bankruptcy proceedings, but not on an individual’s primary residence. As a candidate, Mr. Obama campaigned to change that by allowing bankruptcy judges to rewrite mortgages for primary homes, too.

This week the Senate approved the bill, 91 to 5, that did not include the provision that would have allowed bankruptcy judges to modify the terms of primary mortgages.   The bill, however, does expand federal efforts to prevent mortgage foreclosures, shield mortgage service companies from lawsuits if they participate in federal loan modification programs, and give renters of foreclosed properties at least 90 days’ notice before eviction.

So far, the federal programs to reduce foreclosures have largely fallen flat, particularly the Hope for Homeowners program approved by Congress last summer. Only one mortgage was modified under the program, which lawmakers had hoped would help as many as 400,000 homeowners.

“This bill is principally designed to provide that long sought-for relief for people who are facing foreclosure,” Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the banking committee, said at a news conference after the vote. “The bill does other things, but certainly, a major target is to deal with peoples’ housing issues and try to stem the tide.”  Let’s hope Senator Dodd and his colleagues are correct  and the bill does in fact clear the way for loan modifications.  Home owners in the elections in 2010 have the last say and this vote could become a pivotal issue.
 

Apr. 23, 2009 - Lessons from a REO Portfolio Transaction

Foreclosed properties create an immense pressure on financial institutions to dispose of assets in relatively short time while trying to get as much value back as possible. This process is frequently hindered by confusing and blurring important terminology. Negotiating REO housing portfolios for investors I have found confusion in the market over terminology among real estate professionals. When a broker negotiates a REO portfolio deals it is important to have a clear understanding of REO terminology and the different mechanics motivating by different sellers.

Apr. 15, 2009 - 90 Day Residential and Commercial REO Trends

Residential REO supply has not kept up with demanded.  In Stockton, California, one of the hardest hit housing markets in the country the unexpected rise in home sales caught brokers and builders by surprise.  http://www.cnbc.com/id/15840232?video=1085562265&play=1    Similar stories are being reported from around the country.

Tracking market interest in the REO market over the past 90 days we see a substantial increase in search activity across the internet.  Here is a list of the top ten markets reflecting interest in the REO markets for Residential and Commercial REO properties.

Web Search by Volume: “reo properties”
Regional interest by State for REO properties

1. Georgia  
2. Florida  
3. New Jersey  
4. California  
5. Ohio  
6. New York  
7. Texas  
8. Illinois  
9. Pennsylvania  
10. Virginia

Interest by City for REO properties

1. Phoenix  
2. Atlanta  
3. Los Angeles  
4. Dallas-Fort Worth  
5. New York  
6. Chicago  
7. Philadelphia  
8. Washington  
9. San Francisco  
10. Fresno

Commercial real estate interest has fallen by 40% since 2004 with the lowest level of interest in December 2008.  Since that time there has been a slight increase in interest.

Regional interest by State for commercial property

1. Oregon  
2. Florida  
3. Texas  
4. Georgia  
5. Tennessee  
6. Michigan  
7. Arizona  
8. Colorado  
9. Washington  
10. New Jersey  

Interest by City for commercial property

1. Orlando  
2. Tampa  
3. Miami  
4. Los Angeles  
5. Dallas-Fort Worth  
6. Detroit  
7. Houston

Mar. 30, 2009 - The Housing Investment Rush of 2009/10?

The media is blaring terrifying headlines about how bad the real estate market is, and there are plenty of pundits ready to declare the death of real estate as an investment.  But are there early signs of recovery in those foreclosed field of dreams?

The real estate market is restless.  Foreclosures are at record highs, prices have had the biggest drop since the Great Depression, and nobody expected much of an improvement in the overall market until well into next year.  Yet sales of previously owned homes in the U.S. have unexpectedly begun to rise.

Prices for houses have dropped so significantly that they have begun to find a market, with distressed properties playing a major role. Indications are small local investors recognizing opportunity are buying properties, installing renters, setting the stage for a housing recovery.  Ironically, the renters are sometimes former homeowners, as banks now are allowing owners to stay in the homes after foreclosure.

Despite house price falls, investors are still committed to property as an asset class.  A new survey conducted by Knight-Frank found that a significant number of high net worth investors plan to increase their residential real estate investments over the next one to two years.  Liam Bailey at Knight Frank said, “In turbulent times the wealthy want their investments to be both tangible and transparent,” recognize opportunity as conditions change in the real estate market.

The great real estate crash may have driven some people away forever, but for some, real estate continues to be as good as gold.

Mar. 26, 2009 - Private Investment Stimulates the REO Market

When the financial crisis first emerged, it manifested itself in the subprime area. Holders of subprime paper scrambled to get out of it, either because they realized that it was seriously impaired from a credit perspective, or because mark-to-market losses triggered calls for more collateral. A massive liquidation began and much of that paper found its way back onto the balance sheets of the major banks and dealers. Banks and dealers, in turn, found themselves overleveraged due to the additional risk assets on their balance sheets, and then became capital impaired as they unloaded those assets at ever reducing prices.

The foreclosure crisis, resulting from the residential mortgage debt burden, depressed home prices, and consumer spending, acting as a drag on the broader economy.  By November 2008 more than 3.5 million subprime and alt-A mortgages were in foreclosure, pending modifications or facing foreclosures overloading the banking system.

It does not take long to realize to fix the economy we first need to divest the nation of millions of REO's without a process to move the unexpected volume of product.  The biggest problem we found was the institutions no longer had the institutional knowledge to know what to do with a large volue of foreclosures and the 1992 banking act formed barriers in the process.

The new administration has in the past few months been busy finding ways for private investors to re-enter the housing market.   Capitalizing on historic low housing prices the private investors have begun to buy government-owned REO assets in larger portfolios at less than market value to expand the capacity to move non-performing assets back into the system.

Move Inc., conducted a survey in the first week of March of over 1,000 respondents and found  about one-fourth of people surveyed said they have plans of buying a house in the next several years, with nearly 13 percent planning to buy within the next couple of years.

Additionally, more than 18 percent have plans of buying a house this year to capitalize on the tax credit worth $8,000 offered to first time homebuyers under President Obama’s program to stop the increase of foreclosed homes. Also, more than 50 percent of respondents planning to buy a house within the next nine months are people buying a home for the first time.

Americans are also changing their views about home ownership and the housing market. More than 62 percent are planning to stay in their homes, as opposed to buying them and selling them later for investment purposes, all good news for the future of the housing market.

Private investment efficiently bringing REO housing to market is showing early signs of stimulating housing sales around the country.  Good news in this decidedly downtrodden economy. 
 

Mar. 17, 2009 - The 21st Century Blue Print for Recovery

During the past century we believed that reason and logic could solve all problems.  Reason has created unimagined prosperity but is now delivering diminished returns and at what cost?  Now, as we look into the future, we see rising populations, aging populations, income disparity, and social uncertainty and economy decline.   A more complete form of thinking is now required, focused on 21st Century complexities, to form the lasting foundation for economic recovery. 

I would argue the lack of public awareness and deregulations of our business and government institutions lead to a distorted economic reality, causing an ultimate correction to take place; and the pain of this correction is "The Great Recession of 2008".   We need to change; to develop a fluid, creative, thought process that question our past assumptions and provide a fresh look at the 21st century world.  Our brains enormous capacity must be used in new ways to solve problems of greater complexities.  We need to become Problem Solvers once again, instead of Problem Managers, engaging ourselves in a more socialized process of reasoning.

I am an American optimistic who believes in the creative empowerment our nation has uniquely developed.   Surrounded by economic opportunities; global warming, toxification, energy management, hunger, medical transformation, with the great advancement of scientific knowledge we have the ability to meet the challenges before us. Our cultural ingenuity, capital, and entrepreneurial culture will tackle the problems of the 21st century and new economic leaders and solutions will emerge from the, “The Great Recession of 2008” leading the way to new enterprises and economic growth. 

The speed and complexities of globalized world require our American innovation.   We must lead by challenging ourselves and our institutions to change course in service of a better tomorrow.  In a finite, high speed world, responsibility for business to serve the common good is critical.  People, Planet and Profit, are becoming the 21st century measurement of performance, ‘The Triple Bottom Line’.

No longer can the speed of change out pace regulations by a 20 and 70 year old regulator gap.  Disconnected markets can only cope with a certain amount of bad policy, and can adjust to some bad policy, but by piling up bad policy after bad policy, markets can not respond rationally.  We need technology, intelligent policy and a high level of transparent governance to modernize our approach to regulations. 

We need to all be more knowledgeable about the world we live in, and not confuses knowledge and science, with opinion. Pay attention to government, governance matters, and do not let the world numb you from asking questions and challenge conventional wisdom. Just look at where the financial leader’s lack of government oversight has led us to. Markets do not always know best but neither does government. We need informed judgment to select enlightened leadership.

We need to hold ourselves accountable to reestablish trust and faith; the requirements for a healthy economy.  The concept of a hand shake, ‘my word is my bond’ and ‘we do what we say’, are not just slogans but the very pillars of trust which has served America so well for over 200 years. It is time for Business to focus on personal responsibility and ethics as much as they focus on creating wealth.  The commitment to ethics is not an option.  Without the immediate establishment of ethics in business we will not see the return of wealth.   It is our American responsibility.
 

Mar. 4, 2009 - Why did Banking Fail?

Final post in the series “Real Estate Booms and Banking Busts”

As a real estate IT data expert, I have for years been uncomfortable with the import of “best practices” from Wall Street which were applied to real estate assets without rigorous data assessment. Out of the box concepts like; modern portfolio theory, securitization, option-based pricing, and so on were applied to real estate assets by teams of banking analysts and IT engineers, but without in my view, sufficient knowledge of the differences in behavior of two distinctly different asset classes.  How the practicality of “market” concepts interplay with the mathematical rigor given the difference between the “markets” and real estate investment was never understood leaving bankers blind to the facts and without remediation plans. 

Why were banks slow to react when there was recognition the exposure to real estate was endangering the banks economic vitality?

Traditional bank-supervisory processes were not designed to deal with exposure to major shocks such as a collapse of real estate prices.  They did not have a prepared remedial action plans in place. The primary thrust of supervision is to follow plans and procedures designed to manage normal banking condition. Even in the face of evidence of trouble they had not prepared for, their behavior did not change, even in the face of evidence of a serious disaster.  Without an action plan to follow, no actions are taken.

Bankers under the illusion of high profitability created additional problems. Industry salaries and bonuses are based on reported short-term profits, without adjustment for reserves, when the downturn happened the line officers who are in the best position to assess such dangers are rewarded for disregarding them. In the US this incentive to take a short-term view is strengthened by the prospect of job mobility. Executive job create an expectation, a perfect escape, if thing are going bad they will be elsewhere in another institution or retired by the time problems emerge.

At a resent congressional hearing bankers were confronted by evidence that challenged the competence of their decisions, the bankers answers tended to ignore the facts, under questioning their first answers reject any responsibility.  Under follow up hard questioning they finally accommodated the facts by changing other beliefs in order to protect their self-esteem as prudent lenders.  It was a startling admission of denial.
 
In conclusion: real estate-related loans have caused such serious problems that regulator authorities and accounting principles should monitor real estate exposures carefully and report the vulnerability of individual banks. After watching the congressional hearings the notion we can trust the stewards of banking to make the right decision without oversight appears to have been sadly misplaced.  Once data is collected and analyzed the results should be indexed and published for public consumption.  Without such an index we lack the transparency needed in order to make proper investment decisions.  We need better accounting.

Mar. 2, 2009 - When Greed Overrides Fundamentals

Third post in the series “Real Estate Booms and Banking Busts”

On June 22, 2000 we were off and running; A group of companies and organizations led by the Mortgage Bankers Association of America and the Commercial Mortgage Securities Association published standards for commercial mortgage transactions conducted over the Internet with the goal to bring uniformity to the commercial real estate finance industry for commercial-mortgage backed securities (CMBS).

At the time is was said, "For the first time in the eight-year evolution of CMBS, the industry now has a primer encapsulating the key elements of documents that essentially comprise standard industry operating procedures today," commented Mark Hill, senior vice president of Laureate Capital and vice chairman of MBA’s Asset Administration Committee.

The goal was to develop a market environment to securitize real estate debt.  This created a system to generate investment into the commercial real estate sector, which generated huge profits for the financial community.  But at what cost?

The result was the loosening of standard industry fundamentals.  Every deal made created huge profits for the bankers and as long as there was a need for real estate product everyone was a winner.  The investment bankers kept the engine running as product need was evaporating and in 2005 the entire industry generated “need” by lowering the qualifications of the borrower and made “the great mistake”.

The big question is; Why, despite the evident dangers of heavy concentrations of real estate lending, did the banks permit their exposures to real estate to become so large?

Banks found securitizing real estate was attractive and extremely profitable, or so it appeared.  Rising real estate prices extended the value of collateral, encouraging growth, and slowly banks increased their holdings of real estate backed loans.  This increase in the price of real estate resulted in an excess in the supply of credit for real estate backed loans, which in turn furthered increased the price of real estate and stimulated supply.

Banks unaware of improper accounting models hid the mounting exposures from managers, creditors and investors. Inadequate information and analysis contributed to the banks growing vulnerability. (See: Uncertainty of Real Estate Derivatives)   Confident reliance on real estate collateral merged with the socially excepted concept, ‘housing is the best investment and will always increase in value’, resulted in a false sense of security and lead to a decline in the perceived risk of real estate lending.  Appraisals based on rising prices justified further lending in a boom market. Bottom line, happy bankers saw the increases in the price of real estate increasing the book value of the banks they were managing.

When declines in real estate prices began to reduce the value of real estate collateralized loans the increase in defaults began, exposing banks to the vulnerability of falling real estate prices.  Banks reduced the flow of credit into the real estate market sharply eroded real estate values, creating downward pressure on the banks capital reserves. This diminished lending to other sectors of the economy as well, as banks tried to assess their exposure and rebuild their capital reserves to cope with increased housing defaults.  These measures diminished available credit, further weakening the real estate market and the over all economy. The downward cycle undermining banking reserves eroded the stability of the banking system at an accelerated rate.

A flawed standard and data model will always fail.  It is only a matter of time.  We need to establish a greater understanding in unforeseen consequences in today’s complex global world. Future guidelines and generally accepted business practices must be tested to support global economy and not one which was written by an industry intended to profit their industry with little thought of the larger consequences.  Today, the bankers could read: The larger the portfolio the greater the fall.  We all lose when greed overrides fundamentals.
 

Feb. 27, 2009 - Banks Gamble on Real Estate and We Lost

Real estate markets are in flux.  The key question looking over the wreckage in the capital markets is whether real estate risk should have ever been defined, and transacted as it has been done in the public securities markets? 

Wall Street recognized a huge opportunity in the new world of globalized banking.  If they could transact the high rate of savings in the growing economies in Asia into market securities in the US and Europe the profits would be enormous.  In order to capture this large amounts of capital, Wall Street required a supply chain of securities to market.  Brilliantly, or so they thought, Wall Street looked at derivatives as a means to market the largest untapped source of equity backed debt in the industrialized world, mortgages.

Why did banks underestimate the risks of heavy concentrations of real estate lending? 

Standard accounting practices are helpful in monitoring, pricing and provisioning frequent financial fluctuations, but are not designed to track infrequent economic occurrence for reasons that would require another article to cover.   Basically, infrequent economic events are ignored by accounting systems and as such there is a tendency to underestimate the ‘shock probability’ of a once in 20 plus year occurrence.  Over years of good time, accounting systems are adjusted and tend to discount the probability of a low-frequency economic occurrence, decreasing reserves to cover real estate risk, leading banks to become more vulnerable.

What happened next will be studied for years to come.   Wall Street made a huge mistake; they applied a ‘securities market data model’, to ‘real estate assets’, without rigorous data assessment given the difference between markets securities and real estate investment

Market securities are forward looking liquid assets where investors speculate on one single risk; the future business value by the free trade of assets and prices, which vary in equilibrium by the degree of earnings and risk.  The investment value is transparent, dynamic and simple to calculate: Number of Stocks X Stock Price = Total Asset Value.

Real Estate Value is complicated and is not a liquid asset.  The ‘market price’ of real estate is negotiated, based on a fixed location and determined by supply and demand.  Risk is determined by multiple variables, complicating the establishment of Asset Value making real estate difficult or imposable to develop an open securitized market for real estate assets.  For conversation the following over simplistic calculation shows how different the value calculation is; Market Price – Physical and Environmental Risks = Asset Value, where as ‘market value’ is a variable of time and local conditions. 

In applying the application of a short term, ‘mark to market’ valuation, on long term real estate assets, Wall Street ignored predictable market mechanics which uniquely apply to real estate asset values.  As a result Wall Street badly missed the risks they were taking as they over capitalized the market while simultaneously undermining the natural auto-correlation price equilibrium which historically balances supply and demand in real estate markets.  In fact, the Wall Street data models were so wrong they were reporting huge profits at a time they were in fact loosing huge sums of money.  A major reason; asset values were incorrectly formulated.  

Banks made a huge miscalculation when over there last 10 years they began to out source their competency.  Major Banks across the country dismantled 40 plus years of intellectual capital and turned their IT departments over to consultants.  Thousands of people from their IT departments were let go, CFO’s touted the savings to stack holders and Wall Street, but at what intellectual cost was never considered.  With such a loss of institutional memory and knowledge, banks created an intellectual gap in their command centers.  Banker’s unshakable faith in 40 years of accounting IT systems were built and modeled on 1950 banking principles.  With the rapidly changing rules, globalization and ‘new capital instruments’ did not work, the models were behind the times. 

The convergence of globalized banking required a serious re-examination of many investment paradigms and mythologies.  The real estate investment community will need to re-establish creditability with invertors for long term stability.  From a technology view point, the real estate industries should recognize the need to advance there data models for evaluating ‘risk’ in a globalized real estate ecology.  It’s a new world just beginning to come to grips with globalizations.  Knowledge has never been more impotent just look at what the lack of knowledge has wrought.

Next Blog: Why - Despite the evident dangers of heavy concentrations of real estate lending, did the banks permit their exposures to real estate to become so large?

Feb. 26, 2009 - Real Estate Booms and Banking Busts

I have heard our current economic crises referred to as a ‘Black Swan Event’.  That no one could have seen the banking mess coming.  NEWS FLASH!  HISTORY REPEATS ITSELF!  Real estate busts have happened throughout our countries history and are in fact, PREDICTABLE. 

History demonstrates real estate booms have often ended in banking busts. When banks over capitalized real estate; markets become overly optimistic.  As the difference grows between, sale prices and replacement costs, development increases, followed by over supply and sharply falling prices.  Real estate is difficult to sell short and in a falling market with excess supply, defaults increase.  Historically, real estate prices climb steadily upward for a significant period; a generation has passed since the last crash, which sets the stage for: A Real Estate Boom and Banking Bust Repeat.

Speculation in the capital markets over the past few years creating down ward pressure on real estate values

Several factors conspired to bring illiquidity to real estate markets today and to understand how our crisis is intertwined with globalization and banking. .  For years the economy has been driven more by the availability of credit, overriding real estate fundamentals, pushing consumer demand, contributing in no small measure to a crisis in the financial industry.

This brings to questions:

1. Why - Did banks underestimate the risks of heavy concentrations of real estate lending? 
2. Why - Despite the evident dangers of heavy concentrations of real estate lending, did the banks permit their exposures to real estate to become so large?
3. Why - Were the banks slow to react when there was recognition the exposure to real estate was endangering the banks economic vitality?

In the coming days I will address the questions in three blog posts to shed light on our current state of affairs, providing a framework of understanding.  After which I will share with the readers in a following blog post why I am an optimist.
 

Feb. 24, 2009 - Time to Re-Think the Needs of the Investor

The framework of real estate is profoundly changing.  We have entered an era of international knowledge and cultural economics.  It is the age of real estate globalization.  The requirements for success are becoming increasingly abstract, which brings me to a fundamental question; how will real estate evolve to meet the needs of the 21st century real estate investor?

Commercial real estate ecology draws upon such an enormous amount of unstructured information; economic, geography, finance, sociology, engineering, architecture, building sciences, law, marketing and more.  Changes in the world; globalization, the re-urbanization of our cities, movement of populations for jobs, global warming.  From a technology view point the real estate investment community needs to better lateralize and absorb existing information in order to gain an accurate knowledge advantage.

In the past decade the application of technical advances created for the capital market, which today show strong signs of structural failure on Wall Street have been applied to commercial real estate investments.  Concepts like; modern portfolio theory, securitization, option-based pricing, and so on.  How does the practicality of “market” concepts interplay with the mathematical rigor given the difference between the “markets” and the commercial real estate market? 

The convergence of a vast amount of data in a global economy requires a serious re-examination of many investment paradigms and mythologies, to develop a more accurate understanding of the complexity of commercial real estate value.  A more fundamental approach using information in new ways to examine the relationship of commercial real estate ecology and real estate value are needed.

The dichotomy of value in recent years has mostly focused on cash flow rather then the underlying equity value of a property.  In a strong market this is the easy approach as value evaluation requires a more rigorous process.  But with the collapse of the credit markets we will begin to see a shift back to fundamentals in determining value.   In the late 1980’s this shift in investor focus along with regulator changes happened after the collapse of the commercial market as a result of the Savings and Loan crises.  It was then that our current ideas about due diligence were developed. 

With twenty years of advancements in technology and market theories it is time to re-examine the roll of commercial real estate due diligence for the 21st century investor and improve data integration.  What solved the problems twenty year ago has not kept pace with the times.