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Perspectives on Commercial Real Estate: Are we heading in the right direction, and why a “V” formation?

Perspectives on Commercial Real Estate: Are we heading in the right direction, and why a “V” formation?. Presented : September 24, 2010 By: K.C. Conway, MAI, CRE Kiernan.Conway@Atl.FRB.org.

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Perspectives on Commercial Real Estate: Are we heading in the right direction, and why a “V” formation?

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  1. Perspectives on Commercial Real Estate: Are we heading in the right direction, and why a “V” formation? Presented : September 24, 2010 By: K.C. Conway, MAI, CRE Kiernan.Conway@Atl.FRB.org The opinions expressed are those of the presenter, and not those of the Federal Reserve Bank of Chicago or Atlanta, the Federal Reserve, or its Board of Governors. The oral comments are critical to context. Without them, this presentation can be misinterpreted.

  2. I will use the analogy of RR Tracks to set forth my R.E. perspectives: How much damage to the R.E. track? What dangerous crossings lie ahead for R.E. to cross over to recovery? What signals should be monitored & factored into R.E. appraisals?

  3. Q. How much damage to the R.E. track? • Substantial damage to both rails… • Real Estate rail & the Bank Capital rail. Let’s start with the R.E. side of the track… Sources: FHFA Purchase Only Home Price Index, Case-Shiller Home Price Index, and NCREIF Commercial Property Index

  4. Let’s first look closer at Housing, and then Income Producing Real Estate

  5. Key Note: 25.5% Key Note: 1995 level Key Note: 12.5 Mos What is equilibrium? (6 Months)

  6. A good resource to cite. Why? Demand for Housing 14.6% of mortgages are NOT current. Prime Mtgs. are now the delinquency problem. Why? 50%+ of all Loan Mods re-default after 9 months. HELOCs and ALLL

  7. OCC / OTS Mortgage Modification Metrics Report: Note: In CY 2009, there was a 78% increase in “Prime” mortgage foreclosures. Note: Nearly 60% of all Loan Mods default again within 12 mos. We only have 6 mos history, but Q3 ’09 mods on track with prior mods.

  8. Negative Home Equity: It affects 1 in 4 US households. Neg Equity >50% NV, AZ, FL, MI, CA National Average: 23% Neg Home Equity Source: First Am Core Logic • Relevance to Appraisals? • Paint the true “Demand Picture” • Good example of “all R.E. is local” • Look for the “new metrics” not present in prior recessions or the typical appraisal to give your client answers to: Why the decline in value?

  9. Easy method from 1978 AI Ed Memorandum to measure…Value decline Note: The prices being paid today for residential land correlate to the technique. Note: Q. What is the max price a builder can pay for a finished lot? A. 15%-20% of Home Price.

  10. Housing – Key Takeaways: • Behavior impacts value, and its effect can be measured. • “Strategic Defaults” is a new behavior. • How many have seen “SDs” analyzed in appraisals? • How do we know what is the tipping point to default? • Is it loss of equity, or loss of income (job). Which variable to use? (Home Equity or Employment)? • How did the type of mortgage product used impact value? • An “IO” with no escrows (78% of sub-prime) – Payment Vs Price • Look beyond the metrics of prior recessions to what is new. • Negative Home Equity is another new metric we need to think about • Loan modifications are a new wrinkle too. The data suggests Loan Mods delay and amplify the Loss. • Housing is not as homogeneous as we are led to believe & model. • 10 states account for most of the foreclosures and losses – why? • Barrier-to-entry markets (where its hard to add new supply) are recovering & did not have the same degree of HPA decline & LGD. • What metrics identify where VALUE DECLINE will be worse? • (Mos. supply, VDL, Employment:Permit ratio, Neg Equity, HPA rise)

  11. Now let’s take a macro look at Commercial Real Estate Values have followed declining home prices…Why? • 2007 Peak to Q1 2010 trough CRE Value Declines: • 43% overall avg. decline (moderated to 39% - expected to decline in 2H2010) • Worse decline for “Distressed” CRE (un-leased new constr. & 2nd –Tier MSAs) • Less decline (35%-40%) for “Healthy” CRE – The decline due to higher Cap Rates. Source: Barclays Capital 2010 Outlook Report

  12. And, falling Values have led to a contraction in Sales activity and Lending. • Real Estate Transaction Activity: • 2010 CMBS issuance may only total $5 billion – compared to $234 billion in 2007 (the peak). • Mortgage originations to ReFi maturing CRE debt are at the recessed levels following 9/11. • Value becomes difficult to estimate with a dearth of transactions (Cap Rate volatility). • Appraisal skills need a tune-up. It requires more skills to appraise “distressed CRE.” 85% Decline

  13. What is the Commercial R.E. metric that has had the most material impact on R.E. Values in this recession? • A. The 300 bp swing in Cap Rates Vs 20% drop in NOI. • Three Questions: • Q. What is the long-term average Cap Rate? • A. 9.5% • How do you get a Cap Rate when there is a dysfunctional market with few or no transactions? Slide 17 • How do you address Cap Rate volatility in a market with few transactions – like now? Band of Inv. The nearly 6% avg Cap Rate (NCREIF), and sub 6% Cap Rates (CMBS and Banks) were historically unprecedented and unsustainable.

  14. Spread between 10-Yr Treasury Bond Yield and Avg. Cap Rate. Historically: A 300 Basis Point Spread 9.5% L-T Avg 1965-’10 450 BP Spread Today 590 bps Q1 ‘09

  15. Why is Cap Rate volatility such an important value concern? What is selling… influences the Cap Rate more directly. We now know what a 300 bp swing in Cap Rates does to value

  16. Cap Rate skill set – Let’s go back to the tool-bag (Band of Investment & Mortgage Equity techniques) Pre-2007Post 2H08 and Today Required Equity 20% Required Equity 30% Need to know: Need to know: Equity IRR 10% Equity IRR 20% Allowable Debt 80% Allowable Debt 70% Use Mtg. Constant 6.42% Use Mtg. Constant 7.94% Need to know: Need to know: 1. Interest Rate (5% - L+ <200 sprds) 1. Interest Rate (7% - Tr + 300 to 400 sprds) 2. Loan Amort. (30 yrs) 2. Loan Amort. (30 years) Indicated Cap Rate:Indicated Cap Rate: Equity (.20 *.10) Equity (.30 * .20) + Debt (.80 * .0642) + Debt (.70 * .0794) Indicated Cap Rate: 7.14% Indicated Cap rate: 11.56% Q.How did we get to 4%-6% Cap Rates? Q.Why are Cap Rates at 8%-9% Vs. 11%? A. The market over-reacted. Leverage >80%? A. We may be heading to 11%. Ask what is selling. • Help you visualize the impact of: • Less expensive Equity; but • More expensive Debt when rates rise Key Analysis Tool “Healthy” Vs. “Distressed” CRE

  17. These are common R.E. value problems blocking the track that need to be cleared to move forward. 1. Construction Management is a material factor in construction lending losses. Construction “mis-Management” Actual photos from UPDATE appraisals by banks with “Impaired CRE” projects. The appraiser “assumed away” the construction defects (Hypothetical Vs. Extraordinary Assumption), and the Bank: i) had a “lax” construction mgmnt; ii) a weak “Administrative” appraisal review program; and iii) had not inspected the collateral 2. 3. 4. Will the banks be there to lend with this kind of construction oversight? How much capital to fix?

  18. Conclusion Re: How much damage to the Real Estate track? • Clearly, there has been a lot of damage to the R.E. track: • Home Prices have retrenched to pre-2004 levels. • Approximately 25% of all households with a mortgage have “negative equity.” • R.E. values have fallen 40%-45% from their 2007 peak. • Transactions are off 85%-90% as investors and capital struggle with value. • Appraisals are less reliable, and valuation problems block the track ahead. • What are the R.E. loss and valuation takeaways? • Cap Rates are the metric that have had the most influence on R.E. value loss. • How do you model Cap Rates in a dysfunctional market with few transactions? • Transaction activity and volume are important CRE metrics to monitor. • Appraisal reliability has been poor. Is LTC a better metric than LTV? • Like housing, behavior in R.E. is an unpredictable risk that is hard to measure.

  19. Now let’s look at the Capital/Bank side of the track “tied” to R.E.? • Clearly, there has been a lot of damage to the Capital & Bank side of the track: • “Charge Offs” are climbing to 3% - more than 2X where they peaked in 1992 • Loan Defaults have risen above 4% • The “Noncurrent Rate” for Constr/Dev. Loans is nearing 10%. • Former GSEs are forcing banks to “buy-back” their defaulting mortgages. • CMBS loan delinquencies have hit a record 8.71%, & are forecast to reach 11%. • Loans Transferred to Special Servicing (LTSS) has spiked to 11.29% of all loans

  20. Q. How much damage to the bank capital side of the track? R. We won’t know until we get to recovery (2-4 yr lag in CORs) 2.78% 1.26% 09/1992 0.04% 12/05

  21. Defaults have risen above 4%.

  22. The “Noncurrent Rate” on C&D loans now exceeds 8% Q. Will it surpass the 1992 record of 14%? R. Yes - If more of the following is in bank portfolios. Why such a steep increase? It wasn’t just due to the market! Refer to previous slide 15… Construction Mismanagement!

  23. Another hit to bank capital - GSEs forcing mortgage buybacks Note: Understanding the agreements and clauses, like “buy-back” or co-tenancy in retail CRE, is critical to coming close to LGD when loans default. The forensics of this CRE crisis will reveal this failing to be material in why the rating agencies mis-rated CRE and mortgage risk.

  24. CMBS delinquencies keep rising - to a record 8.92%. (Aug 2010 ) Update: August delinquencies resumed a higher rate of delinquency. Up 21 bps to 8.92%. Why? What to expect for Sept-Dec? And, the leading indicator of default – LTSS – rises to a record 11.29%

  25. CMBS Delinquency: July ‘09 thru July ’10 Source: TREPP – August Monthly Delinquency Report • What is really behind the June and July 2010 slowing rate of CMBS delinquencies? • The rate of increase in the delinquency rate for CRE loans in CMBS securities slowed to 17 basis points in June, and 12 basis points in July. Some have interpreted “the slowing pace of increase” to be a sign that the worst is over. However, it is important to have some context: • * CMBS delinquency has more than doubled to 8.71% from July 2009 when it was 3.71%; • * CMBS delinquency is still rising (worst for lodging at 18.4%); • * CMBS issuance and delinquency have seasonality to them. • Most issuance is Q3 and Q4 back-ended as loans were created in Q1 and Q2 of a CY. Thus, the slowing in June and July was due to fewer loans maturing and adding to “maturity delinquency and default.” This trend will be short-lived, and likely rise again in Q3 & Q4 to something closer to the 40 bp monthly increase over the prior year.

  26. CMBS Delinquency by State Q. Why so important to banks? R. Competing Inventory AZ was first state to exceed 14% DQT rate. NV, MI, FL, GA & TX all exceed US avg. US Avg 6% in Jan ‘10 has now risen to 8.92% AZ MI Q.Why is understanding of CMBS DQT by GEO important to banks and regulators? A.Competing inventory /new distressed comps in appraisals FL AL TN GA TX Q. What is impact of Gulf oil spill? A.We know FL(#5), AL (#6), GA (# 9) and TN(# 8) have CMBS DQT > US avg. CA IL Source: Moody’s CMBS Delinquency Tracker Q1 2010 report

  27. So, with all that cheery news about R.E. conditions… What dangerous crossings still lie ahead for R.E.? • To navigate this kind of complex and dangerous crossing, it is critical that one correctly “read” all the signals. • First, how did we get to this intersection? The direction from which we approach affects what we see and do. • Second, what are the track and traffic conditions - How much Debt to ReFi? Principles of ANTICIPATION & SUBSTITUTION • And finally, what signals require our most immediate attention? • Then, don’t forget the “human behavior” element: “Strategic Foreclosures.”

  28. First, How did we get to this situation/dangerous intersection? It is important that APPRAISERS analyze the DEMAND DRIVERS We had a lot of demand being generated from factors not tied to JOBS: i) investors; ii) speculators; iii) subprime mortgages. Population Growth, Baby Boomers, Gen X, Gen Y Securitization, Immigration Loan Servicing Existing Homes Carrying Costs Employment, Income, Finished Inventory Demographic Interest Rates, Alternative Draws on Investments Lending Lines Economic Starts Loan Payoffs Liquidity Construction Supply Demand Owner Cycle Occupied Developed Lots Raw Land Home Sales Affordability Underwriting • Key Concepts: • Demand stopped • Supply continues • Risk is elevated • Values decline • Capital becomes scarce & more expensive • How do you ReFi? Recent Price Appreciation, P&C Insurance, Construction Property Taxes, Loans NINJA Loans (No Income, No Job or Ability to Pay) Cost of Living, Credit Scores, Acquisition Exotic Mortgages, Liar Loans, Loans Second Mortgages NINA Loans We had a lot of Supply ramped up to meet this DEMAND that can’t stop on a dime. Condo Conversions CRE Loans Investors, Federal Reserve Bank of Atlanta – Supervision and Regulation Flippers

  29. Second, How dangerous is this R.E. debt crossing? How much R.E. debt to cross over to ReFi? The banks are pulling the most R.E. debt car-load. Can they pull all that debt load to the other side?

  30. Third, What are the signals? What R.E. linkages do we need to understand & address? EconomicHousingCapitalCRE * Employment Growth * Home Prices * CMBS/Securitization * Concentration Negative in all but 60 MSAs Still Declining $5 mm Vs $235 mm peak >100% Tier 1 * Business Bankruptcies * Negative Equity * CRE Debt Maturities * Absorption Record level & rising 25% of all Homes 2012-2017 is the peak Net negative * NFIB Small Bus. Survey * Months Supply * Cap Rates – cost of $ * New Supply #1: Poor Sales by 29% “Shadow Inventory” Volatile / Few transactions >2% of Inventory * Small Business Conditions * Home Ownership * ALLL in Banks * ReFi Gap The SB and CRE linkage 67% Vs 69% peak ’04 More for NPAs, Reg., etc. LTC Vs LTV

  31. Signals – Let’s look specifically at Five : • Commercial Real Estate Debt Maturities • Recovery of CMBS • ReFi-Gap and Cap Rates • Small Business Lending & Linkage to R.E. • A few key “CRE Leading Indicators” using specific markets as examples.

  32. #1: What is the CRE debt maturity profile 2010-2017? Is there a window in which this CRE debt has to cross/ReFi? 2011 to 2016 is a “dangerous crossing.” HUGE Value implications!

  33. Refinancing Risk is High for 2004 - 2008 Vintage Current LTVs By Vintage Original LTVs Source: Trepp and KBW estimates; data are for CMBS loans, National Real Estate Investor

  34. #2 - Recovery of CMBS - How does capital come back to R.E.? Let’s look at the structure of post financial crisis issuance. Single Borrower No “scratched & dented” sponsorship Low LTV; >1.80DSCR • Other key features: • <10% lease roll-over during ln term • Change of mgmnt if vacancy rises >20%; etc.

  35. What concerns me most about CMBS…Strategic Defaults

  36. #3: Cap Rate volatility in an environment of “few sales.” A few sales influence the value at any given point in time. Retail R.E. Office R.E. Key Note: A dearth of Real Estate transactions creates a value challenge. Most sales are occurring in only the top 5-10 US MSAs.

  37. The antidote to the Cap Rate volatility is… (Band of Investment & Mortgage Equity techniques) R = LTV * DSCR * Mc Pre-2007Post 2H08 and Today Required Equity 20% Required Equity 30% Need to know: Need to know: Equity IRR 10% Equity IRR 20% Allowable Debt 80% Allowable Debt 70% Use Mtg. Constant 6.42% Use Mtg. Constant 7.94% Need to know: Need to know: 1. Interest Rate (5% - L+ <200 sprds) 1. Interest Rate (7% - Tr + 300 to 400 sprds) 2. Loan Amort. (30 yrs) 2. Loan Amort. (30 years) Indicated Cap Rate:Indicated Cap Rate: Equity (.20 *.10) Equity (.30 * .20) + Debt (.80 * .0642) + Debt (.70 * .0794) Indicated Cap Rate: 7.14% Indicated Cap rate: 11.56% Q.How did we get to 4%-6% Cap Rates? Q.Why are Cap Rates at 8%-9% Vs. 11%? A. The market over-reacted. Leverage >80%? A. We may be heading to 11%. Ask what is selling. • Help you visualize the impact of: • Less expensive Equity; but • More expensive Debt when rates rise Key Analysis Tool “Healthy” Vs. “Distressed” CRE

  38. #4 – The Small Business Linkages to CRE… “As goes Small Business, so do R.E. conditions.” 4 Key Points: The NFIB Small Bus Optimism Index has collapsed; 80%-85% of all Goods-Producing & Service employment is by companies with <500 employees. “Poor Sales” is the #1 small bus. problem. 75%-80% of all Bus bankruptcies result in a retail or office CRE vacancy. As goes small business, so goes CRE conditions.

  39. #5 - Let’s conclude with a look at a few of the R.E. “leading indicators” by property type. • A type of R.E. analysis produced quarterly on 180 markets for FRB examiners • Where are appraisers in this kind of market-by-market analysis? • What are the R.E. metrics to focus on? • Employment, Bus. Bankruptcy, MF concessions, net absorption, new supply, etc. • Note context: Current Vs Year Ago; Market Vs US; and the key comment guidance.

  40. Where are R.E. conditions improving around the US? (In growth restricted markets, like Austin, Baltimore, etc.)

  41. Where are R.E. conditions improving around the US? (And, improvement in a few “surprise markets” that lost jobs and were overbuilt)

  42. Where are R.E. conditions still deteriorating around the US? In CA, FL and overbuilt SW markets, like Houston, Las Vegas and Phoenix.

  43. Concluding Remarks and Real Estate observations • A lot of damage has been done to commercial real estate. • Re-establishing job growth – especially at the small business level – is what will cure all. Jobs, Jobs, Jobs! • We cannot under-estimate the Small Business and CRE linkage. “As goes small business, so does R.E. conditions (occupancy, rents, value, etc.). • CRE debt maturities are ominous. The combination of a large “ReFi Gap,” coupled with this evolving “Strategic Foreclosure” behavior, suggests that R.E. losses are still ahead of us. Borrower behavior is as critical a metric to monitor as market conditions. • And to conclude on a positive note, there are three improving trends in CRE: • i) MF – occupancy is up to 92% nation-wide and concessions are coming out of the market; • ii) Hotels – RevPar has ceased its decline and is rebounding due to increased business travel; and • iii) Additions to Supply are winding down.

  44. But let’s answer the real question from my cover slide… Why do geese fly in a “V” formation? Maybe our appraisal techniques need “goosing-up?” Will your tax appeal be 71% more effective by getting the metrics to fall into a proper “V” formation?

  45. If your appraisal “reads” all the SIGNALs found at Dangerous R.E. Crossings, it will. THANK YOU K.C. Conway, MAI, CRE Kiernan.Conway@Atl.FRB.org

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