by Gary H. London
Over the past year most statistical indicators are showing a decrease in the rate of value decline for real estate, a stabilization of values, or modest increases. For instance, the National Council of Real Estate Investment Fiduciaries Property Index, which tracks commercial property investments throughout the U.S., is showing a valuation drop over the past year of 1.5 percent, as compared to the drop over the last three years of 4.7 percent (it grew prior to that).
With the economic news getting better, we have now reached a point in the market where the buyers know that the bottom has probably passed, and now is the time to purchase distressed property on the assumption that the market will rise.
While it is hard from my vantage point as a fiduciary in many transactions to discuss these deals, nevertheless here is a flavor of what is happening.
It was recently reported that Miami-based Lennar Corp. has acquired approximately $740 million worth of real estate owned (distressed) real estate assets in three transactions involving both residential and commercial properties. The sellers were three large financial institutions. The deal as constituted is one of the largest distressed purchases made recently, involving a combined portfolio of 397 loans and 306 properties. The total unpaid principal balance is approximately $529 million (appraised value of approximately $211 million). The assets are spread across 17 states primarily in the Mid-Atlantic and Southeast regions. Lennar anticipates that the investment opportunities in both of these sectors will continue to grow as the Federal Deposit Insurance Corp. and the banks unload distressed assets.
Large debt providers — entities which primarily provided construction loans on properties that were developed with this money, but have subsequently failed and not paid back the loans — are also aggressively unloading assets and portfolios. They are “selling the debt” or otherwise making deals — which involve the capitulation on the part of the builder, but also prevent a long, drawn out bankruptcy fight.
“Hard money funds” — defined as investors seeking high returns on relatively risky deals — are also buying FDIC pools of distressed single-family mortgages at dramatic discounts. Funds have been established throughout Southern California to buy these pools. Then, the funds foreclose on the assets and sell off the inventory at a profit.
The lenders in these types of deals try to achieve a sale at as close to full loan amount as possible. Depending on the loan-to-value ratio of the original loan, the deals are often great because they reset the economic base to a much lower value, thereby enabling lower revenue flow to still make the asset viable.
Economics Are Upside Down
This is a time when economics are upside down. We are re-establishing the economic base. The new world of valuing assets faces the stark reality that properties are not worth what they once were. This is due at least to the following factors:
Rents are down in all asset classes — commercial office, industrial and retail — with the possible exception of apartments. There is a direct correlation between revenue and value because appraisers employ a Capitalization Rate analysis, an equation which values real property assets based on their revenue.
Oversupply is rampant across most commercial asset classes. The financial position of most holdings is weakened, as a result, setting the stage for deals marked at a lower value.
The market is in “re-valuation” mode. Vacancies are being filled at new lower lease rates. We know of at least one very large owner of commercial office high-rises who will only sign maximum three-year leases because they are unwilling to “lock in” low rates over a more normal five- to 10-year leasing period. These low rates, however, will continue to re-price assets downward.
Economic growth will not automatically erase value deficits. First, vacancies are high in the commercial world. They will not come down briskly. While relatively strong economic growth can be anticipated over time in Southern California, this is not an automatic ticket to filling these vacancies, as much of the empty space is obsolescent. The solution for many assets may well be a change of use — for instance, from commercial retail to mixed-use, or from office to residential. But it might also invite the demolition of buildings and the construction of something new. This also means that land value — the value of the property minus the building — might be the proper metric of valuation for many assets.
Building costs, which dropped during the recession, will rise relatively quickly again. This includes both materials and labor. But it is this unpleasant marriage between low revenue and high construction costs which will inevitably delay or prevent new construction. So whatever the current valuation dynamics are today, an investor can bet that there will be limited supply at some point in the future.
There Is Money
However, there is not a lack of money out there. In fact, the problem in the investment world at the moment is that there is too much money on the sidelines, looking for good deals. Along all asset classes, not just real property, it is hard to find investments with decent returns.
The danger might be that values will get bid up too fast because too many people are chasing them. I wouldn’t bet on gold anymore or bonds, which have already been bid up too high and are likely to tumble. A better bet would be under the mattress.
This situation is no better than the frenzy for real estate prior to 2006. Except that we are in reverse: too many properties, too little faith, a lot of money, an uncertain future.
Sometimes I think I am in the economic triage business, fixing wounds, stopping the bleeding, evacuating the patient. Much of what my firm has been doing over the past several years has been about analyzing and fixing bad things that have happened to real estate deals. Based on this experience, I offer some ways to carve out an investment strategy:
Buy when the market is low: You make money in real estate at the time of purchase. Under that premise, now is the time. Most sophisticated investors agree with this strategy. They recognize that while the world has changed, and that there are no guaranteed investments, on a selective basis there are opportunities.
Look at replacement costs — that is the most important metric in the distressed world. The most basic strategy is to do a pro forma on what it would theoretically cost to build a project.
Buy the note: It is the lenders (or the FDIC) who are holding the debt. Most borrowed money involves a front-end equity infusion. If the property is in distress, the equity is gone. Purchasing debt, even if it involves legally foreclosing on the underlying real property, is a powerful way to own the real estate at a low economic base.
Buy the potential: It often does not make sense to buy real estate for the use or the revenue streams that the asset has historically achieved. Study the market, find a fit for the asset in the new market.
Look for alternative use: This is a corollary to the previous bullet point. Many assets need to be at least repositioned, or physically rehabilitated, to accommodate new uses, or at least contemporary consumer propensities.
Most importantly, see the future differently. Past is not prologue. I am uncertain of what the future holds. But I am absolutely certain it does not look like the past. The economy is rebuilding to something different. That means that space will be occupied differently. Throw away what you know of the past and focus on the space needs of people, businesses and industries going forward.