The Calm before the Storm By Eric Kaufman July 11, 2009

As of this writing, we are in the middle of summer when things are generally quiet in the commercial

and residential real estate markets even in the best of times. Clearly, this is not the best of times. In

terms of transaction volume, there is an eerie chasm between what buyers are willing to bid and what

sellers are asking. This void or gap has made for a very difficult transaction completion environment

unless there is favorable debt on a property (either already existing financing or through seller or

purchase money financing). Otherwise, both buyer and seller are content to sit in their corners waiting

for the other to back off. Furthermore, an “extend and pretend” mentality lurks in the wings. As one of

my colleagues, Terri Gumula, alludes to most Institutions are handcuffed because a sale with any kind of

discount (also known as a “haircut”) would require a write down of similar assets remaining on their

books. Right now, the Banks neither have the available reserves nor the manpower of true work out

groups to take these write downs.

The Obama administration has endeavored to stabilize the financial systems through such acronyms as

TALF (Term Asset-Based Securities Loan Facility), PPIP (Public-Private Investment Program) and the OFS

(the newly created Office of Financial Stability). In many ways, the government’s creation of “calm” by

pumping money into the banking system has delayed what many conservative players have deemed the

inevitable, which is the “marking to market” of financial assets, including real estate. Most financial

institutions are trying not to “sell into this market” and are hoping that asset values will increase as the

economy improves. However, most experienced financial professionals realize that, at some point, bank

regulators will require institutions to sell assets at their true value (or at least carry the value of the asset

at its true worth). This period will be “The Storm.”

So, when is “The Storm” coming? One major player, Michael Katz of Sterling Equities, said in a seminar

about six months ago, that the bottom of the market would be six months after the government figured

out how to solve the current financial crisis. It is unclear whether the government has really figured out

the “solution” and many players are starting to gear up equity raises to capitalize on the “bottom” of the

market. For example, Colony Capital is raising $500 million and the Vornado REIT is raising $1 billion of

new private equity to purchase distressed assets. These entities have an excellent track record of calling

the troughs of the commercial real estate market. Assuming it takes three to six months to raise equity

capital (and this is not an easy environment in which to raise real estate equity capital), these

opportunity funds will be looking to start actively investing in +/- six months which puts us in the first

quarter of 2010. It seems likely that the real estate bottom in the U.S. will occur sometime in 2010,

probably in the first or second quarter. Of course, a major shock such as another war or energy crisis

could change this prognostication.

How will Sellers best handle the storm? My sense is that well executed property auctions will be the

key to setting the proper bottom for commercial real estate assets (including excess condominium

activity) and building/stabilizing asset value in the future. Many sellers are currently using a “top down”

approach where they set an artificially high price and reduce it periodically to try to stimulate demand.

This type of sales approach works best when there is liquidity in the debt markets and the availability of

relatively cheap money. However, this certainly is not the current situation.

The current situation involves a dearth of debt unless it is at opportunity rates. Insurance companies and

the other lenders still in the market have their pick of deals and can often achieve higher yields by

buying CMBS (Commercial Mortgage Backed Securities) debt that yields a lot more than a traditionally

underwritten first mortgage. Opportunity rates can range from a 9-10% current pay rate plus several

points as an origination fee. The rates might also include equity participations, exit fees and other yield

enhancement strategies for the opportunity lenders in the market to provide additional leverage for

borrowers.

Multifamily mortgage money is still readily available if it qualifies under government backed programs

by FNMA and Freddie Mac. Conventional first mortgage lenders for other commercial property types

are pretty picky today and rates for the best deals are hovering around 7% plus amortization, so debt

constants for prime commercial real estate other than multifamily are +/-8.5%. Equity returns are a

minimum of 12% (with many funds seeking 20+% IRR returns). If one uses 70% as the new leverage

point for commercial real estate financing (in some cases, current leverage is really more like 50-60%),

commercial cap rates would stabilize at about 9.55% (assuming mortgage rates remained at their

current levels). Currently, I would argue that the cap rate for most commercial real estate is closer to

10% due to a more realistic leverage factor of 50%-60% today. Take note that I am describing relatively

stabilized high quality real estate assets and not distressed or value added situations. Distressed and

value added situations are going to mandate cap rates on existing cash flow of at least 10% today

(assuming that cash is truly stable). If there is no cash flow or it is a development scenario, a discount to

replacement cost (or a realistic land value) is probably more accurate than a proposed cash flow

analysis.

A significant vehicle for transacting business in this difficult financing environment is the property

auction. A property auction sets the true value of a property based upon a buyer willing to commit to an

all cash date certain closing within a relatively short period of time, i.e., +/- 30 days. The competitive

nature of an auction creates action and helps to stimulate buyer interest beyond that which is

traditionally achieved through conventional marketing. Sellers can increase pricing by offering seller

below market rate financing as part of the auction process (or the auctioneer can arrange third party

financing to qualified bidders prior to the auction date).

The key for motivated sellers is that the auction exposes the property to a wide range of potential

buyers (assuming there is an adequate marketing budget and the auction company knows what they are

doing) and gives the seller a non-contingent date certain closing. I think these factors will prove

essential in the coming “Storm” environment.

Will property auctions denigrate the value of distressed condominium projects that have sold a few

units at inflated prices? Once again, if a bottom up approach to market stabilization is employed, what

happens is that the first sales are made at what the market determines to be the bottom, or the new

market price, due to a glut of existing inventory. Until inventories stabilize and the supply-demand ratio

hits a new equilibrium, buyers will be unwilling to pay what sellers are asking. It is assumed that many

financial institutions in the next several years will be forced to liquidate real estate at what a buyer with

cash is willing to pay (or unless attractive financing is put into place). It will be important to witness how

long institutions can hold inflated assets on their books before they are either forced or decide to

liquidate property assets.

A well-designed auction can actually generate higher prices than conventional marketing, especially if

the asset has something unique about it and is not a commodity-like asset such as a cookie cutter

condominium property or a net leased Walgreens drug store. For example, we recently sold the former

Upstage building in Asbury Park, NJ for a premium price due to the historic value of the asset, even

though the property requires substantial renovation to make it economically viable. The fact that the

Upstage Club was the venue where Bruce Springsteen got his start helped increase the value of the

asset. The building’s details and history also helped contribute to its value. Through effective

marketing, we got substantial public relations pieces on bloomberg.com and nj.com, and mentions in

the New York Post and Newark Star Ledger.

Keep in mind that this asset was sold the day before the auction because the buyer did not want to

compete in a face to face “hammer and gavel” auction situation. We see auctions as a flexible process

not unlike any other exclusive right to sell brokerage situation. The particular property can be sold

before, during or after the actual auction.

What does the future bring? I strongly suspect the two most important factors in commercial real

estate asset valuation going forward are the value of the dollar and inflationary pressures. Many people

believe that the value of the dollar will decline in the coming years due to the excess borrowing the U.S.

has and will incur to finance our deficits. Many foreign countries, especially China, hold our Treasuries

and will require higher yields as our credit worthiness declines. This upward pressure on Treasury rates

may result in increasing mortgage rates (and corresponding cap rates) for properties beyond what is

described above. The belief that inflation will increase in the coming years will be a mitigating factor in

cap rate expansion because people will want to take advantage of real estate’s traditional hedge against

inflationary pressures. Historically, real estate has proven to be a better hedge against inflation than the

stock market. So far, there is no reason to believe that the historical trend will not continue, so people

will again find real estate to be a sound investment in the coming years.

My conclusion is that real estate is now becoming very attractively priced and even though we have not

hit bottom yet, we are certainly not at the top of the market which was probably sometime in the 1st

half of 2007. Many market professionals say that it is not productive to buy at the real bottom as we

never really know where the bottom (or top for that matter) will be until after it happens. As always, it

is human nature to want to buy at or close to the bottom as possible and sell at or near the top. This

never changes.