Financial Challenges For Commercial Properties

Two years after the financial meltdown, the finance industry and its sub segments are continuing to experience major difficulties. Availability of credit continues to be limited at best and in numerous cases nonexistent. The recent passage by both the United States House of Representatives and Senate of the Small Business bill is a small victory and also a sign that the financial world is continuing to suffer and that credit continues to be difficult to obtain. This bill also only address one segment of the economy the owner operated properties and businesses. Financing for any type of investments is very, very difficult to obtain, this is especially true when looking at real estate investments.

Today institutions are looking a providing credit with a more critical approach than they ever had. Borrowers and property owners cannot qualify easily for financing under the new guidelines, but more importantly they don't understand how credit is approved today. In addition, numerous institutions that are still providing some type of credit will ask for much tighter numbers and higher margin. From a financial perspective this makes a lot of sense, but, from a property owner perspective it makes for a much more challenging environment.

Until 2008 numerous investors thought of real estate as a type of investment that will allow them to make money based on appreciation. They could leverage their assets to the hilt and as long as property values increased then everything will work out. In addition, numerous investors were looking at returns on these investments much higher than they should have. Part of the reason for all the difficulties in commercial real estate today is that starting in the early part of last decade, the financial fundamentals of investing in real estate were pushed aside by both institutions and property buyers and owners. Today, as we move back to a more rational world were financial fundamental are the key to success, the industry is experiencing a difficult awakening.

Commercial Real Estate Challenges

The real estate industry in general is facing a number of difficulties to come back to health. In no particular order of importance here is a lists of challenges, difficult economic conditions, lack of credit, significant decline in values, institution owned properties, decline in personal income etc… While a number of these problems have been discussed there is one, institutions owned properties, that is in general not explored. As those of us who have spent sometimes trying to work with these institutions know, on behalf of investors, it is clear that there is still a major challenges ahead of us.

On the residential front, between banks, Fanny Mae and Freddie Mack it appears that institutions own 1M properties. These properties are held by institutions and not being listed on the market. When somebody asks me is it a good time to buy? Or are we at the bottom of the price decline? I am puzzle on what to answer. Today, I read that home prices declined by 0.1% in July after an increase of 0.2% in June which is still 7% higher than in April 2009. Imagine if the properties held by institutions were put on the market the consequences on pricing. The bottom line is that the increase, year over year, in price is artificial and that value of residential properties is questionable today.

Looking at the commercial real estate sectors, the picture is not much brighter. For the past two years values of commercial real estate properties have significantly declined, banks have had to foreclose on a large number of them and cannot decide what to do with these assets. Related to the problem of foreclosed properties, is the amount of debt on these properties. Banks have not recognized their losses on foreclosed assets, and it may take years for them to do so. In most cases institutions are keeping them on their books so that their losses will be lower. If by keeping a property for a year or two can permit an institution to sell it few millions less in losses then it is a good bargain. However, this is betting on the economy recovering and the market improving. Since the economy is taking longer than most people expected to recover, and that the recovery maybe much slower then problems will linger. Institutions bet on holding foreclosed asset may not solve anything and potentially create more problems.

Another major difficulty is the amount of debt on performing asset, which in most cases is too high based on current values and income. With performing assets financial institutions are taking a different approach. As long as the loan is performing, even if the value of the property has decline, they will either extend financing that is due or re-write a new loan without lowering principal. In both cases institutions are waiting to see if the market recovers enough and hoping that in the next five years, better credit conditions will allow the property owner to secure new financing. They hope that the new financing, from another institution, would match the debt they are owned so that they don't have to recognize losses.

The way institutions are dealing with their problems today is by delaying recognizing losses. This means that we most likely will continue to see credit problem and a soft market in commercial real estate until banks have cleaned their books. As we discussed this may take few more years and maybe up to four or five years before we start seeing a more stabilized commercial real estate market. As with everything some market most likely will recover faster than other, but clearly there is a long road ahead.

 

Lending Or Not That Is The Question?

Granted this is bad Shakespeare paraphrasing but it raise the point of what is happening in lending today. In a Reuter's article "Bernanke says spurring credit key to rebound" the Fed Chairman makes the point that credit needs to be extended. However, he also indicates that at this time banks are not lending. No segment of the lending world appears to be allowing people or companies to borrow money. Clearly the Federal Reserve wants banks to provide access to capital or credit to companies and individual, however, as far as I can tell this is not happening. A month ago, Wells Fargo announced that it was closing 638 branches and terminating 3800 loan officers New York Times article "Wells Fargo & Company". Most financial institutions are making qualifying for any type of credit very difficult. Currently banks prefer to borrow money from the Federal Reserve at close to 0% and buy treasuries returning between 3% and 4%.

Based on historical evidence we can make the argument that banks and institutions have problems understanding long term risks and how to price them. Clearly the difficult situation we are in today is a direct result of not estimating and pricing properly the risks that lenders were taking. More to the point, if lenders do not start to lend soon, then they will increase the risks that the economy is not going to recover and potentially increase their losses. As businesses need credit and cannot get it, they are not able to meet their debt obligations and start to default. The lack of actions by financial institutions and the continued tightening of lending requirements increase the problems that the economy is facing. Thus not lending can become more dangerous than extending new credit.

All lenders should be encouraged to make new loans and new credit should be extended. There are some glimmers of hope, but it is too soon to see if there is a beginning of a change in credit policies. In residential real estate, some jumbo programs are starting to surface. At the same time there is an increase in default in higher priced residential real estate. In commercial real estate, well the picture continues to be gloomy at best. Most financing appears to come from the following sources, the Small Business Administration through their SBA loan programs, Fannie Mae and their multi units' apartment building programs, insurance companies and local and regional banks that were able to make appropriate lending decisions when their competitors were too aggressive.

While some credits are extended in specific areas and to specific borrowers, it is not enough. As mentioned in previous posts some foreign banks, mainly Chinese ones are coming into the US lending market as they believe that there are lending opportunities. The longer the lack of credit is continuing, the longer it will take for the economy to recover. To obtain credit today borrowers need to work with professional who understand the challenges to getting approved. Loan officers cannot just collect paperwork, they need to understand how to prepare a credit file for review and write a credit memo, or they need to work with people that can do it for them. Working with borrowers, I have seen credit approval successes when both credit professional and borrowers were working closely together.

The bottom line in credit today is that there is a lot of confusion and that it may be this way for times to come.

A Year Of Opportunities

Well the numbers are in for the first 6 months of 2010 and it does not look great. After improving the employment numbers are starting to falter, consumer spending is not great and business and economic trends are not looking good for the next six months. Residential real estate after seeing some upward trends is now faltering as the government is removing incentives and tax credit. The number of 1 to 4 units residential properties owned by banks and financial institution after going down will go back up. In a Wall Street Journal blog post "More Bank-Owned Homes Likely to Hit the Market" the writer use two sources to assess the size of the issue, is appaears that between 530 thousand and 570 thousand homes are owned by banks and financial institutions. Using the same source 7.3 million household are 30 days late, implying that more REOs are on the way. We have two good news interest rates are low and should stay in low for the next 6 months or even a year and some banks have re-started lending beyond government sponsored loans. They are now started to keep some loans in their portfolios.

On the commercial real estate front the issues are there to stay and we are going to start seeing additional problems caused by a lack of economic growth. As discussed in previous posts, banks who own commercial real estate are in trouble and since there is no economic recovery, more investors who have tried to kip properties are going to start to default. In addition, numerous property owners are starting to see that their notes are due and they have nowhere to go to get refinance, forcing banks to foreclose. Until the economy start to improve significantly and until banks clean their books the commercial real estate market is going to continue to experience major difficulties.

Even with all these bad news it is a time of opportunities because when there are problems, there are also opportunities to fix them. In residential real estate numerous small investors have been buying properties for the past year from banks, cleaning them up, improving them and re-selling them. The most active market segment appears to be for properties below $400,000.00. While the residential real estate market could go down, most likely it will stay depress and in some very specific areas markets may go up. Investors that are, recognizing these trends, who are willing to take the risk to buy properties at auctions, from banks etc… and can find ways to turns them at profit are going to continue to make money.

On the commercial side opportunities are also going to create themselves, investors are starting to recognize that while the market is down and depress investment opportunities exist with limited risks. In another Wall Street Journal article "Fortress Is Buying While Real Estate Is Down" the private equity firm is acquiring companies related to commercial real estate in order to have access to assets at depressed prices. The ICBC or Industrial & Commercial Bank of China is moving into commercial lending in the United States for loan $100 M and above. They recognize that they can lend at low valuations and that there is limited or no competition.

As describes above opportunities already exists for investors in both residential and commercial real estate. I believe that while we are in a difficult economic situation investors are going to be able to see significant returns over the next few years on their real estate investments, either by directly investing or by investing through funds and other conduit. As you see these opportunities develop and encounter success stories, let me know I will post them here, email me.

Investors Getting Financing For Investment Properties

Before addressing the above topic, I want to do a quick follow up on the last topic discussed "buying of Commercial REOs". Based on my own experience and supported by articles in the Wall Street Journal and other publication, financial institutions are currently continuing to foreclose on commercial properties and are not making them available for sales. Speaking with numerous current and former banks executives during the past week, it was made clear to me that they will continue to do that until they have no other choices. Banks / financial institutions today do not want to recognize their commercial real estate losses. However, as the economy continues to stagnate we may start seeing a change, potentially by the end of the year.

Getting financing for investment properties is one of the most challenging aspects of real estate finance in general and commercial real estate finance in particular today. Because most large financial institutions, funds, insurance companies, etc… have not yet cleaned their portfolios and recognized their losses, they are not able to invest. Two of my favorite business shows World Business News from the BBC and Bloomberg First Word have had interviews and discussions on this topic. The bottom line is that commercial investment financing is not going to come back soon. The longer it will take financial institutions to recognize their losses the longer the crisis will continue.

Here is what to do when you need to get financing for your commercial and sometimes residential investment properties, call me. Here I am being factitious but not that much really, it is difficult to get commercial financing done in general and commercial investment financing in particular because a lot of people do not have the expertise. As an example a new client of mine was looking for commercial financing on an office building for 6 months and could not find anything. He worked with banks, brokers etc… and nothing happened. However, once I started working with him, we were able to find him a solution within 2 weeks. The key to success was team effort, good financial analysis and the ability to think outside of the box.

To be successful today in getting the financing you need, it is important to be realistic and aware of the financial market conditions. My first recommendation would be to make sure investors understand that there are different type of valuations, an exchange valuation and a financing valuation. This difference applies less to residential real estate investment than to commercial. I would recommend reading my post on Cap Rate Vs. Cap Rate Vs. Cap Rate. Credit valuation is, in a lot of cases, different than Pro-Forma valuation and then there is the income component.

Another recommendation would be to be aware that rates for residential are different than for commercial. It is important to note that residential rates are artificially low. In addition, since there are limited sources of capital for commercial investment properties, it is important to focus on getting the financing done rather than to shop for the illusion of finding the greatest deal. This is true even if an investor has good credit, reserves and the property is stabilized. Today the costs of borrowing are higher than they were 2 years ago, the choices in terms or financing programs are much more limited and fewer people know how to do a proper credit evaluation and analysis. Finding an experienced team can mean the difference between financing success of failure.

My final recommendation, is for investors not to wait until the last minute before they start the financing process as it will take sometimes before the financing close. Investors need to make sure they have all the documents lined up and then be willing to work twice as hard with their financial partner to get it done. Also, if there is any problem with the property, or any other aspect of the file to be upfront so that the problem can be addressed and that there are no surprise halfway through the financing process.

Buying REO A Disappointment

Recently in a Wall Street Journal article, it was made clear that banks had not done much with their portfolio of real estate owned. Here I will focus more on the commercial real estate segment, however, some of it may ring true for residential real estate. One of the reasons advanced by the journalist is that banks have been waiting for the economy to comeback. As the pace of recovery is much slower than anticipated, banks are now faced with the hard fact that they have to start taking actions with their portfolio of owned property. I am not expecting a flood of new commercial properties coming on the market any time soon, however, I am expecting banks to start making sales decision.

Dealing with asset managers and decision makers at banks is quite an experience for most us. I remember having to do that on the residential side of it and it was not very pleasant. Dealing with asset managers on the commercial side is not simple either. To be successful we need to understand what are banks motivations and the challenges they are facing. Banks want to minimize their losses, as nobody likes to accept that they are not going to get their investment back. They don't have a good idea of what would be a good price at which they should sale. Is the market tomorrow going to turn or is it going to take another year. They are looking at the costs of keeping the property vs. the costs of selling today. They are trying to define guideline and policies in a very difficult market. Finally banks in numerous cases are not dealing with credible buyers or buyers' representative.

Banks are going to start making selling decisions because well they have too. They are realizing that the economy is not coming back as fast as they were expecting, thus the losses are going to be permanent. They are under pressure from regulators to clean up their portfolios and to restructure them. In some cases the properties are continuing to lose tenants making it even more difficult to hold on to it. Finally they are starting to be have a better sense on how to price these properties.

Even if they have to sell their real estate owned it is not going to be easy to have access to these properties. One of the challenges that numerous real estate professional are facing is credibility. I have seen emails from banks that state that they are inundated by calls from brokers etc… who in most cases have no experience but want to try to put a deal together. In addition, in numerous cases brokers and professionals are not taking the steps to make sure those potential buyers and investors are qualified. By quailed I mean that they have experience in buying the type of property they are bidding on. They know how to evaluate the property and make an acceptable offer. Finally, real estate professional need to make sure potential buyers can execute on the offer.

This process is going to continue to be tedious but will pick up some speed in the last quarter of 2010 and beginning of 2011. Broker to be successful have to make sure they understand the transaction and do the work required with potential buyers and investors. When real estate professional don't have the experience they should partner with other professional to help them. Finally doing the proper due diligence and making sure that financial institutions have the intention to sell will make an a difference.

Cap Rate Vs. Cap Rate Vs. Cap Rate

It can drive you mad to try to understand what people are talking about and it nearly did. I was listening (hears dropping) to different commercial real estate professionals speaking about property valuation, I had problem understanding why the conversation was so lively. Then I realize that the different people involved in the conversation were comparing apples and oranges. They were using in the discussion two different cap rates one use to value a property for transaction purpose and one use for financing purpose.

While the two cap rates discussed should be the same, in numerous cases they are not. Here is our take on the differences between these cap rates and why they exist. To start with there is always some difference between transaction value and finance value, it is a classic one in real estate, it is experienced both in residential and commercial. If a buyer was acquiring a property for cash it is somewhat irrelevant to care if the cap rates are different. Recently, I was peripherally involved in a transaction where we had estimated the price of a property at a different level than what the sales price was. The buyer did not care to pay more for it, as they wanted the asset, they were going to put more down payment. The difference of cap rate does matter when the buyer needs financing or when a property owner needs refinancing. Most investors need but also wants financing for leverage purposes, thus the importance of the financing cap rate.

Cap Rates are somewhat market specific, but somewhat not. In addition different property types will have different cap rates, we are now speaking of 3 different cap rates. They are all linked to income, income growth and property liquidity. The more a property is seen as liquid the lower a cap rate could be. In this case liquidity can be defined as demand for a property type, financing available to it etc… For example in today's market, there is no liquidity for gas station property and there is no financing available, thus cap rates will be high. A seller and / or real estate transaction person will look at potentially lower cap rates since it supports higher valuation. A finance person who look at risks will consider higher cap rate since it takes into consideration numerous different short and long term factors.

The right cap rate is the one at which the transaction and / or refinance close. Where it can be a problem to have two or three cap rates, is when it comes time to refinance if a buyer has paid a property for cash. Another problem can happen when it is a development and reality vs. projections is different and initial valuations were overly aggressive. Today some property types in some markets trade with a differential, in other markets we are seeing either no difference or very small ones. In general I recommend to be aware of the different cap rates in your markets, the more informed you are the better decision you will make.

Over Promising Under Delivering

One of the major problem of our industry is the over promising and under delivering or what some people would call bait and switch. How many times do I hear from real estate professional that they were offered this great financing deal, but that it did not happen for one reason or another. I was going to call this post the disease of our industry, because, I believe that bait and switch is really a problem that we all have to deal with. Over promising under delivering provides people with not very realistic expectations this affect investors, borrowers and all of the different parties involved.

From an investor stand point we know that when something is too good to be true it will come back and be hurting us one way or another. After speaking with a friend of mine this week and after reviewing his investment and valuation, we came to the conclusion that on one of his investment he was going to lose couple of hundred of thousands of dollars. Originally the deal looked great, well only if you look at it from a stand point that everything will ever be perfect. Since I regard every deal from a number stand point, I was even wondering how he could have made the investment he did. If there is something to remember here, is that if we rely on verifiable numbers, as investors we would have fewer chances to get burned.

Real estate professionals have also a duty to their clients to be realistic and be able to do their due diligence. Numerous professionals try to get financing done at the lowest cost imaginable, even if it does not appear reasonable. Today we have two types of lending in commercial real estate, Federal Government backed financing or private lending. Anything in between does not really work. Some private banks are making limited deals but that's it. A Government backed financing will get your borrower financing between 5% and 7%, a private financing deal will be between 9.75% and 12.5%. Getting a private money loan at 9% does not exist even if it is promised. A 9% private money loan will turn out to be between 10% and 11%. A conventional commercial loan that does not meet government backing criteria will most likely be impossible to approve. The lesson for me here is for everybody to be realistic.

Once or twice a week, I get a call from a real estate professional who asked me about a client that need financing on a great deal. The property is being sold under value and borrower wants 100% of purchase price since it is either a property owned by a bank or litigated by a court. When I receive these calls, it always makes feel uncomfortable because clearly the person calling me does not understand the reality of real estate today. I would encourage all the professional to make sure they have an understanding of the market and do some homework.

Last word, when it is too good to be true it is too good to be true.

 

Facts Or Fiction

In today's real estate market there are a lot of rumors, miss understanding and half truth. In my last post I mentioned that there were great opportunities to be realized, understanding these opportunities is more complicated than it first appears. I spend my days looking at demand for financing, at trying to understand where our capital is going to be invested and what are good investments and what are not. Because of my work, I come across a number of half truths, miss information but also about opportunities, for example buying notes and assets from banks etc…

One of the most challenging aspects of looking at investments today is to differentiate reality and fiction. One of the biggest fictions that go around is the belief both by real estate professionals and others that their market is special. How many times I have heard, " the industry is not doing well but our specific market is not affected" or act differently from every other markets. From San Francisco to New York, from Seattle to Miami contrary to facts a lot people believe that their market will act or is acting differently. This idea of exceptionality is fuelled by anecdotes and rumors difficult to debunk.

Other fictions are related to properties real values, availability of capital, the number of people that can afford to buy certain property types, valuation methodology etc... The facts are more rational for example properties values will be base on either and/or the income it generate. Capital availability is limited it does not matter the type of property people have, its location, the financials etc… Higher end of the market is not affected by downturn, as we are seeing the downturn affect every market segments and property types (residential and commercial).

As a private investor, working for a private investment fund it is important to be careful in the way we look at opportunities. Today we have one truth when looking at a funding, an investment or a transaction we are negotiating, it's all about the income of the property. This income approach applies primarily to commercial real estate, however, residential deals are also evaluated in part this way.

New Era Of Opportunities For Private Investors

For a number of months I did not write on this blog. An important challenge for anything and particularly for blogs is to keep discussions relevant. During the past months I have looked and worked on projects that make for interesting experiences and new pots. Today, what I wrote in a blog a number of months ago is more relevant than ever, we are at a perfect time in real estate history and for private investors.

Only a few times in a person's life we are presented with the type and size of opportunities that we have today. The gold rush, the internet boom are some of these times. We are currently experiencing another one of these moments focused on real estate and finance. In 2009 a number of investors have started to take advantage of opportunities created by the perfect storm. As the storm continues, opportunities are being created for private investors to embrace. These opportunities all differ in terms of size, type, value etc… and are available to most investors.

The economic situation in which we are today came about for numerous reasons that are still debated today and was centered on two sectors of the economy the financial and real estate sectors. In 2006 the real estate sector represented approximately 25% of the US GDP while the financial sector represented over 8.5%. Combined these two sectors represented more than a third of the U.S. GDP, thus when they started to experience difficulties, all sectors of US the economy suffered. Because we are in an integrated world and because the US economy is the largest one in the world, the all world was impacted by the crisis that was started here.

To appreciate the size of the problem you can have a look at the Mortgage Lending Implode – O – meter or read the following article from the Wall Street Journal, February 11^th, 2010 edition "TARP Panel: Small Banks Are Facing Loan Woes". In this article the author outline some of the challenges of banks and points out that out of some 8,100 US banks, nearly 3,000 of them could be forced to limit or stop lending. This is addition of already 230 banks who failed in the past two years and of the approximately 250 will be failing in 2010. Banks are the conduit to providing liquidity to the economy, so from a certain perspective we are in a lot of trouble.

When systems go down they establish the foundation for rebuilding new ones, taking advantage of the rebuilding effort is creating numerous opportunities. Here since we are talking about two sectors that affect directly a third of the U.S. economy, the number and sizes of the opportunities are and are going to be quite substantial. Opportunities are and will exist in some of the following areas, any type of lending, financing, banking, real estate buying, real estate financing, buying of financial instruments secured by real estate, debt restructuring etc… As private investors focusing on real estate, today this will sound a little cliché, but the sky is the limit.