Tiring and Boring???

Thomas J. Barrack, Jr. July 21, 2010

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 estatemarket. 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 withoutlearning 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 estatemarket 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 aboutthe invigorating, refreshing and unlimited upside attributes of real estate speculation at this cyclical inflectionpoint. Let me shed a bit of lucidity on my point of view, which was intended to properly align expectationswith 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 speculative trading based upon cheap andplentiful debt and euphoric future rental growth projections. Let’s start with the basic and very generalpremise 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 andcontinuing 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 anoccasional sale of an asset at nosebleed levels. However, according to Moody’s All Property Real EstateIndex, US values are still off 40% from their peak in late 2007 (see chart below). The nominal CAGR for realestate values since the beginning of the decade is just over 1%.

Note: As of March 2010, Indexed to December 2000 – 100

100110120130140150160170180190200

Moody’s All Property Real Estate Index

For the most part, the fundamental law of supply and demand is alive and well, which largely explains whyreal 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 hasall but abated the flow of troubled commercial debt to be recycled through the system. Rather than atsunami, 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 inmost property types is significant. Thus cash flow for leasing commissions, tenant improvements, key moneyand deferred maintenance is nowhere to be found in a still opaque and weak new real estate lendingenvironment.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 warfareamongst 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 beenslow to come and many funds have been frustrated by the lack of product at what they believe to be attractivediscount pricing. As a result, there are very few market clearing transactions for non-strategic, long-termbuyers.Many owners realize their equity value is gone but in many cases, due to historically low floating interestrates, can still make debt service if the term of the loan is extended. Everyone is playing for option valueand it is a slow moving train, which becomes a bit “Japanese-esque,” and the tea leaves tell me that thisstage will be here for a while.Commercial banks feel no pressure to mark the loans to market value because the regulatory requirementshave 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 upcoverage ratios to acceptable levels (see chart below); thus the dawning of “extend and pretend” and “delayand pray.”

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