Commercial Real Estate Finance

Archive for February, 2009

VERDICT:

In today’s tough marketplace, anything that helps move a property is welcome. Because we are simply looking for the ability to market a property as LEED certified–to show that the property is “green”–it would make sense that all we would really need to achieve is the minimum certified rating. Sure, those higher rankings would be great, but they also are going to cost a lot more.

Because obtaining construction debt in today’s challenging capital market environment is difficult to come by except for the most compelling projects in the most compelling markets, adding unnecessary costs to a project is unrealistic at best, and taboo at worst. Furthermore, many tenants, along with the economy, are contracting in terms of space requirements, and are subsequently looking for additional ways to cut costs. These market conditions certainly do not lend themselves to increased project costs, or the increased rental figures necessary to support them.

In a supply constrained market, however, this isn’t necessarily a bad thing for a green building landlord. Tenants are more likely to examine ways to cut expenses at the bottom line. They will be indifferent as to how that reduction is achieved. Often, a landlord will be able to show a prospective tenant how they can save money in the long term by going green. The challenge will be whether or not they can show an immediate return on investment given the current credit landscape.

Typical green-building tenant candidates are those with environmentally-conscious executives, well-capitalized private firms where cost-trimming is not the top priority, tenants whose public image is tantamount to their success, and companies whose business lines or functions are tied to the environment in some capacity. Furthermore, with a new administration in Washington focused on leading the charge in environmentally-friendly practices, it wouldn’t surprise me to see government agencies, or government sponsored entities becoming more interested in sustainable energy work environments.

If land/buildings are obtained at a low enough cost basis, and energy saving features are chosen in the most cost judicious basis, then the lowest certification level appears to be the best bet for investors in terms of return. This, of course, is assuming your property is in a market which has demand for “green” products. Unfortunately, the capitalist society we live in is at direct odds with the economic hurdles that being more environmentally conscious entails.

Perhaps in 3-5 years when the economy is functioning more efficiently, tenants and landlords are less cost-conscious, and green design and implementation becomes more streamlined and therefore cheaper, financial demand will catch up with theoretical demand, and drive supply to a healthy equilibrium.

Before we wrap up this week’s LEED discussion with our verdict on Friday, we had the chance to discuss some of our questions with an expert. We sat down with Emile Chin-Dickey, a principal of Zero Energy Design, a green-focused architectural design and mechanical engineering firm based in Boston, to gather some professional insight into our queries.

Llenrock Blog (LB): What are the cheapest features of building green for a developer to implement? Most Expensive?

Emile Chin-Dickey (ECD):

This type of question is best answered with an “it depends.” For example, it depends on whether this question is asked for a new or existing building. For an existing building, it depends on how old it and its systems are, whether tenants will be occupying spaces or not (which would prevent envelope upgrades). For example, we did a feasibility study on a 128,000 sf building in FL that had recently replaced their chiller and upgraded to an energy management system which resulted in a 1/3 reduction in their electricity use. This was the best option for them because it didn’t require major disruption of their 40+ tenants. In new construction, the general approach is to invest in efficiency measures before energy production features (i.e. renewables). This approach prioritizes more mundane things like walls, insulation, windows, etc. and puts the more “sexy” things like PV at the bottom.

LB: Is the LEED point system conducive to enhancing overall value for the developer? Is there a way, in your eyes, to improve the system?

ECD:

LEED as a framework is great for thinking in terms of building design and using it as the definition of “green”. Unfortunately, green means different things to different people, but USGBC, through LEED, serves to standardize the definition as it applies broadly across a wide range of areas (from operational impacts, like energy use, to human factors, like daylighting). Its value is in being a standard definition of “green”.

However, at the end of the day, for a developer it still comes down to what the bottom line impact is. I have seen studies that point to LEED buildings commanding higher rents, so perhaps there is some value there. LEED will become more valuable as the benefits of its credits can be better quantified for the developer. This will come over time. LEED is still in its adolescent stages. For example, one of the big problems of the previous LEED versions was an internal problem–the seeming disconnect between credit ratings and the percieved environmental impact. The recent LEED 2009 update serves to resolve some of those problems. As LEED matures, its value to developers will grow.

LB: In a tough economy, which type of green ( cost-cutting or green building sustainable savings) do you see winning out in the short and long run, and why?

ECD: In the tough economy I think the features that have tangible impacts on operational expenses will win–generally anything that reduces energy costs would fall into this category. Paying a premium for a product that has a higher recycled content may be passed over for the time being.

Obviously, the tough economy means you go for the low-hanging fruit. For a new building, thats in the efficiency investments. For an existing building, the tough economy may mean the owner is not interested in major capital improvements like a new chiller or energy management system, so it may be as simple as replacing lightbulbs. If the owner is able to make big ticket capital improvements, the economy probably doesn’t change the investment criteria.

…..Please check back on Friday for a synopsis of the challenges facing LEED construction and design, and our verdict as to the perceived value in the marketplace for both tenants and landlords as it pertains to LEED certification.

In this week’s blog posts, we will dedicate our discussion to examining LEED certification, the pros, the cons, and ultimately whether or not its worth it. Today, we will provide background information on what LEED is all about, and give you a better sense of the market for it. Wednesday, we will interview an expert on going green, regarding the important questions in a challenging market. On Friday we will give an overview, try to navigate its value, and ultimately give our verdict on whether it pays green to build green.

The Basic Facts:

The Leadership in Energy and Environmental Design (LEED) Green Building Rating System™ encourages and accelerates global adoption of sustainable green building and development practices through the creation and implementation of universally understood and accepted tools and performance criteria.

LEED is a third-party certification program and the nationally accepted benchmark for the design, construction and operation of high performance green buildings. LEED gives building owners and operators the tools they need to have an immediate and measurable impact on their buildings’ performance. LEED promotes a whole-building approach to sustainability by recognizing performance in five key areas of human and environmental health: sustainable site development, water savings, energy efficiency, materials selection and indoor environmental quality.

LEED certification can be awarded in four levels: certified, silver, gold and platinum. Each level, of course, requires more points, and thus will be more expensive to obtain for a property. As an investor in or developer of a potentially LEED certified building, one would certainly need to figure out what the costs will be, and what the potential return will be.

Market Sustainability:

The biggest return for owners, developers and investors in these properties will certainly lie in the marketing and desirability of their property to tenants. The first thing to consider is the level of demand for such properties in a given marketplace. A simple check could be whether or not you have a Whole Foods or Trader Joe’s store nearby. If there is one near you, then chances are there are a good number of environmentally and health conscious people, and therefore prospective tenants, around who would be willing to pay for a property with LEED certification.

All things being equal (including net effective rent) most prospective tenants would choose to locate in a LEED certified building, however, due to the extra cost involved in making a project “green,” this usually involves a landlord having to demonstrate value for the tenant, usually by reducing the portion of operating expenses that a tenant might pay for in order to justify higher rents to comparable “non-green” options in the marketplace.

For decades the industries of gambling and drinking have been thought of as recession proof. Its no wonder, given that one industry often fuels the other. Yet, this historic collapse of the credit markets, and subsequent (and seemingly endless) recession, have challenged their recession-proof aura. Last week, reports came out that Las Vegas Strip casinos have lost 9.7% of their income in 2008. That number doesn’t seem that bad considering the Dow Jones has dropped more than 4 times that percentage over the same period of time. But consider this: That is the first significant drop in gaming income in over 50 years.

For the fiscal year so far (July 1, 2008 through Dec. 31, 2008), Strip gaming win is off 15.8%, Downtown gaming win is off 12.44% and Clark county as a whole is off 14.55%. The state Gaming Control Board last month issued its report on the previous fiscal year (July 1, 2007-June 30, 2008), during which the casino industry’s net income tumbled 68% statewide, 57% on the Las Vegas Strip and 54% Downtown. And the increase in gambling problem hotlines isn’t the only reason for such a dramatic decline.

Most Vegas strip casinos, and casinos in general for that matter, operate as hotels. Hotels, as a real estate sector, are the first to show the effects of a sagging economy because income is generated on a day to day basis, rather than monthly as in the multi-family sector, or annually for most other sectors. When people stop spending money, hotel bookings are typically the first to see the drop-off.

Last week, the Las Vegas Convention and Visitor Authority issued its monthly report, showing a 1,000-point decline in hotel occupancy to 76.7% in December 2008 from 87.4% in December 2007. The LVCVA also reported a 14.2% decline in the average daily room rate to $96.39 from $112.36 in December 2007 and an 11% decline in visitor volume to 2.7 million from 3 million in December 2007. The number of hotel rooms in the market jumped by 5.7% during the year, to 140,529 from 132,947.

Add to this the political pressure on corporations to scale back corporate trips and frivolous client entertainment spending, and this further impacts the health of destination-based hospitality.

As a result, billionaire real estate magnates and casino developers alike have been halting projects faster than the ball stops on a roulette wheel.

In January, Harrah’s Entertainment delayed the opening of its new tower at Caesars and MGM Mirage delayed and cut 21 floors of condominiums from its now 25-story Harmon Hotel, one of several towers that are part of its 18 million-square-foot Citycenter development.

In November, Las Vegas Sands Corp. halted construction on high-rise condo tower in front of its new Palazzo resort and offered up 181.8 million common shares to raise $2.14 billion in new capital and avoid defaulting on its credit agreements. Boyd Gaming was the first to react to the softening market, halting construction of its multi-billion-dollar Echelon integrated casino resort development on the Strip in July.

And just three days ago, Trump Entertainment, owner of three casinos in Atlantic City, filed for Chapter 11 Bankruptcy…again.

However you look at it, if your proposed income is based on a vice, now isn’t the time to roll the dice.

For some time now, institutions have been taking losses on their holdings of residential mortgages and securities and on their residential construction and development loans. However, as the recession has deepened, banks are now experiencing rising credit problems in their nonresidential real estate loan portfolios. The only way to deal with the coming problems is to build up capital reserves - and that can’t be done if banks are making loans.

If banks cannot identify specific problematic loans, but know they are likely to come, there is no way to measure the size and scope of the problem for any individual bank. If government insists that they loan the capital they are receiving from programs like TARP directly to the consumer, there is no way a bank can ensure it has enough capital reserved once bad commercial real estate loans rear their ugly heads. If this happens, banks will fail.

The government realizes this. They also realize that this would make everything much worse than it already is. So what is their answer?

Last November, the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency and the Office of Thrift Supervision issued a joint statement to help banks and thrifts navigate these waters. The statement noted that “at this critical time, it is imperative that all banking organizations and their regulators work together to ensure that the needs of creditworthy borrowers are met.”

The real message?

Avoid “imprudent practices that would put your institutions at risk.” But don’t completely hunker down, just “resist extreme risk aversion, since it would undermine efforts to get the economy going again.”

Translation: Lend to the well-capitalized guys who don’t really need the money since there’s less of a default risk.

So let’s see of we have this straight. A flow chart that should look like this:

Taxpayers $$ –> Government –> Banks –> Consumers = Solution!!

Instead looks like this:

—>Taxpayers —> Gov’t —> Banks —>

This blog editor has a few things in common with Sam Zell. We’re both Jewish and we both got our start as businessmen as adolescent youth selling Playboy magazines to our friends for profit. Unfortunately for me, the similarities end there.

Yet wherever and whatever Zell has had his hand in, there has been a remarkable pattern of disaster once he has washed his hands clean of it. Call him the Reverse King Midas. Call him Real Estate’s Reagan. Zell seems to scoop up every bit of fortune with a massive fisherman’s net, and all the misfortune shakes out, and trickles down on the rest of us.

Whether its 1960’s adolescents getting scolded by their mothers upon discovery of their literary indiscretions, or real estate moguls getting burned by their acquisitions of Zell’s massive Equity Office Properties Trust real estate portfolio, if you have done business with Sam Zell, directly or indirectly, you probably wish you hadn’t.

In 2007, Zell sold a 573 building portfolio to Blackstone Group for $39 billion, resulting in the largest private equity deal in history. Blackstone, almost immediately spun off hundreds of the buildings for $27 billion. It probably wishes it had spun off even more, as the value of what they still hold from the acquisition has lost 20% of its value since they bought it. It’s been even worse for the flipees.

Harry Macklowe narrowly avoided personal bankruptcy after over-leveraging his $6 billion acquisition, and lost 7 trophy office towers to creditors in the process. The founder of Maguire Partners was forced to step down as CEO last year after dealing with crushing debt amassed from the acquistion of 24 buildings from Zell’s portfolio. The list of those negatively affected by acquiring some piece of Zell’s portfolio reads like a whose who of commercial real estate giants. RFR Properties’ acquistions from the Equity Office Portfolio are now worth less than the mortgages on them. Tishman Speyer has unsuccessfully tried to flip three of the four buildings it acquired. Even the investment banks that financed many of these transactions (you know, the smart guys on Wall Street) have collapsed as a result of Zell’s trickle down effect.

One can only wonder if Zell’s most recent highly publicized sale of the Chicago Cubs, a wholly owned subsidiary of the Tribune Company, will be as tumultuous for the buyer (Larry Ricketts, founder of TD Ameritrade) as it has been for the buyers of his real estate empire. If I were a Chicago Cubs fan, I’d be more worried about the curse of Sam Zell than I would about the curse of the black cat, a billy goat or Steve Bartman. Then again, as Cubs fans are so fond of reminding us failed season after failed season, there’s always next year…in the mean time, I’d switch my account to E-Trade just in case.

While a prudent student of finance ought to be skeptical of expert “advice” (after all, anyone willing to tell you their strategy is likely to gain on their own investments by doing so) Warren Buffett has long been a staple of the American investing community and has been considered an expert for decades. If you didn’t know what to do, it couldn’t hurt following Buffett’s advice, or, if you had the means, investing alongside him directly. Then again, that’s the same way many people felt about Bernie Madoff.

Buffett announced in mid-October that he was investing heavily in U.S. equities, particularly the stock market. He rationalized his contrarian move by quoting one of his principle investing philosophies: “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”

Not convinced? You shouldn’t be.

Buffet had another tidbit of investing advice which he imparted on us back in 2001: When the relationship between the stock market’s value as a percent of U.S. GNP is close to 70%, it’s time to buy.

If you bought in 2000 right before the tech bubble burst, when this ratio was 190%, you got murdered; Likewise in late 2007 when the stock market reached its peak of 14,000. But look at the chart historically before 2000 and his target ratio doesn’t hold water. In 1929, the ratio was around 75%. I wouldn’t exactly call the eve of the Great Depression a good time to buy. In 1972 the ratio was also around 75%, only to dip below 50% a year later. Considering the ratio has never been below 40% in the 85 year history of the Dow Jones, I would say 50% is a much safer threshold.

After all, does anybody really believe that now is a good time to invest heavily in the stock market as opposed to waiting a few more months? After all, Buffett invested heavily in October, and the Dow has slid an additional 10% since then. Some analysts suggest that the Dow could easily dip below 7,000 before we see a sustained turnaround.

If Buffett ends up being wrong about his timing, its a minor blip on his financial radar screen. If you end up being wrong, you might lose your house….that is of course if you haven’t lost it already.

On Monday, we featured Jason Friedland of Iron Stone Real Estate Group, who offered his take on the bid-ask differential between buyers and sellers. Today’s post is Jason’s follow up commentary on how Iron Stone sees deals getting done in today’s environment. Please give us feedback via the comments section below the post. Enjoy!

We work with banks and lenders directly to discuss troubled debt or portfolios of REO properties. In many cases, we’ve found that banks are seeking a better price by negotiating directly with large, well-capitalized investors rather than taking the risk of a public auction or bidding process. At the same time, an investor with cash in hand can close quickly, allowing a swift resolution for the seller. But banks are not the only ones competing for these liquid dollars. Hedge funds and private capital funds also wish to sell portfolios that were picked up in the rising market and which now need to be cut loose.

The acquisition of performing and non-performing debt requires market knowledge, specialized legal and financial expertise, property development capacity, and access to capital that are necessary to pursue distressed asset and debt deals successfully. We are seeing deals structured a variety of different ways, but our principal focus now is on acquiring senior mortgage positions with the potential to eventually control the real estate and create value by repositioning the asset.

In turbulent markets, it may seem that new potential buyers crop up on a weekly basis. But how can banks and other financial institutions find qualified buyers for distressed assets? Beyond the obvious qualification of having the capital to complete the transaction, sellers have begun to realize the necessity of engaging a buyer who will close – not hedge, prolong due diligence, stall, and walk away. The buyers who can close are the ones with the real estate expertise to redevelop and reposition the property for the best chance of success. This is our company’s bread and butter, and while we continue to exercise patience and discipline, we look forward to the opportunities that are sure to present themselves in the months ahead.

Our first two posts this week will feature commentary from Jason Friedland, Partner and Director of Operations and Investments for Iron Stone Real Estate Group, a Philadelphia-based, multi-disciplined, value-added real estate investment group of companies. Jason will discuss the bid-ask gap between buyers and sellers on today’s post, and give his take on how deals are getting done in today’s environment on Wednesday. We would love to hear your feedback via the comments section below the post, and hope you enjoy.

(If you are interested in being featured as a guest blogger for Llenrock Blog, please contact us and provide your business, contact information, and relevant topics on which you would like to blog.)

The majority of the real estate opportunities the next 6-18 months will be in the form of performing and non-performing bank notes. With the credit markets still in turmoil, only cash buyers will be able to take advantage of these opportunities. Purchasing in cash results in lower rates of return compared to an equivalent deal that uses leverage unless, of course, the asset acquired with cash is acquired at a substantial discount. Sellers tend to adjust slowly and grudgingly to a weakening market, and through 2008 sellers were reluctant to dispose of assets at discounts commensurate with the changed market conditions. But in recent weeks we have seen greater downward flexibility in pricing from banks that need to dispose of mortgage notes in order to clean up their books.

The uncertainty of asset valuation is driving down the prices of real estate, leaving lenders in control of assets. Banks and other financial institutions are selling performing and non-performing notes to mitigate their portfolio exposure, limit potential losses, generate cash flow and improve their balance sheets. For sale portfolios normally include distressed mortgages on multifamily urban residential, commercial, retail and mixed-use properties that are already in default as banks prepare to reclassify them as real estate-owned (REO). But many lenders are willing to sell performing notes at well below par value due to the deleveraging pressures they face. This situation presents an opportunity to make money simply by purchasing a cash-flowing instrument at a discount.

With that said, the bid-ask differential between buyers and sellers remains substantial overall. While we continue to see tremendous deal flow and opportunities, we will remain patient and cautious as the market continues to correct. The good news is that there are ever more sellers and relatively few viable buyers. On the seller side, a variety of pressures are forcing their hands, and the seller’s principal motivation is the need to liquidate the asset, not maximize dollar value. In the universe of buyers there are relatively few in the market who have the cash and the capacity to price, negotiate, and execute a deal in a timely manner. The bad news is that we expect underlying real estate asset values to continue to decline or move sideways in the near term.

Some companies like to own their own real estate. Some refuse as a matter of business principle. There are numerous advantages to both, but ultimately the decision boils down to this: Would I rather not pay rent at the cost of being illiquid and having a liability on my balance sheet, or free up working capital for my business at the cost of paying rent?

Of course the answer to that question, as any trained economist would tell you, is it depends. It depends on the type of business, the size of the business, the philosophy of the business, and the financial strength of the business. When traditional means of access to capital dwindle as we have seen happen in the economy as a whole, that last “it depends” becomes of vital importance to most companies.

While the volume of sale-leaseback transactions dropped off the face of the earth in the fourth quarter of 2008 as did the velocity of all types of real estate transactions, we would be remiss to suggest that is a trend.

While many private real estate investors are unlikely to sell voluntarily in 2009 due to rising CAP rates and declining prices, corporate real estate owners aren’t making decisions based on internal rates of return, CAP rates, or typical hold periods, but rather what will be in the best interests of the company. And in this environment, most companies are sorely in need of cash to grow operations and in some cases to even make payroll.

So is there opportunity for investors to capitalize on the economic swoon of corporate real estate? Well, sorry to go all economist on you again, but yes and no. Yes, there will be opportunity, and we will see a rise in sale leaseback transactions in 2009. However, most likely will not occur until the second half of the year due both to economic uncertainty for many companies, and the bureaucracy with which such a process is undertaken, with decisions being made on multiple levels and flowing through what can be a disjointed chain of command.
That being said, when these deals do hit the market, at attractive CAP rates nonetheless, investors will have to keep one thing in mind. What exactly am I buying, and is this really a good deal? Sure, the real estate is good real estate, and the price is right, but if its a single tenant deal, what’s my downside protection should my new tenant report poor earnings this quarter? Will their credit rating decrease? Are they going to be financially solvent for the term of the lease? After all, if they were in such good shape, why would they need to sell me their asset?

Our guess is that, while the size, scope and return on these investments will vary largely on a case by case basis, the strength of these deals will lie not just in the strength of the tenant, but the profile of the new landlord. A well-capitalized, but straight yield buyer may have to rely more on luck than a developer with a relatively low hurdle rate. At one time, developers could never compete for deals like this cause there was little value to add and CAP rates were too low. Now however, stable returns will be higher, and should the tenant go bankrupt, the developer would have the wherewithal to reposition the asset more quickly and efficiently.

One thing we can steadfastly tell you without wavering? Caveat Emptor.