Morgan Stanley, Lehman, and Real Estate Investing

The day before Morgan Stanley is set to report earnings, the WSJ runs a story about the investment bank's attempts to deal with the $46 billion disaster that is MSREF, its commercial property investment funds. MSREF never met a commercial real estate investment it didn't love during the boom and is now stuck with a host of turkeys in every corner of the world. What now? Should it sell the pile of ailing (yet diversified!) real estate investments? After all, both Citi and Bank of America have sold off significant real-estate investment fund businesses in the past month, to Apollo and Blackrock respectively. Also, ING is looking to do the same and MS really does just like to do what everyone else is doing, just later, and less profitably. Should it hold on and hope for the best? After all, the fund still earns management fees even when it does stuff like lose 75% of its investors' money. Maybe leak a story to the press, see if anyone out there has any better ideas?

Here's an idea: Maybe Lehman can buy it? After all, Lehman's bankruptcy has done nothing to slow down the frantic pace of activity at the real estate arm of the now-defunct investment bank. The WSJ reports that Lehman just took over Innkeepers, a REIT that owns more than 70 hotels. Well, this was less of a traditional takeover and more of a "you're wearing it" type of deal, as the hotel operator filed for bankruptcy and Lehman was its largest creditor. Lehman's debt in Innkeepers stems from its participation in the 2007 $1.5 billion buyout performed by none other than Apollo Investment, a subsidiary of the same folks that just bought Citi's real estate portfolio (see above.) Buy low AND high. I think that's called dollar cost averaging.

What should Morgan Stanley do? Tomorrow's earnings announcement will offer some clues as to whether the firm can finally return to its former glory as a premier investment bank, rather than a GS also-ran. If so, maybe MS has a shot at reaping a solid price for its ailing commercial real estate investment funds based on the prestige factor associated with its name. Because it's not going to get top dollar based on the fund's performance.

I'm predicting a lousy quarter for MS. They might even lose money. Why? Because all its competitors have had a lousy quarter and MS does exactly the same thing, except usually worse, even though the market seems to grant them some sort of a premium. How much longer can the premium prevail? Tune in tomorrow.

FDIC Giving Distressed Real Estate Away and Other Distressing News

The FDIC conducted the second bulk sale of its sizable commercial real estate portfolio, which it inherited from all of the bankrupt banks deemed too small to survive. As a taxpayer, you'll be happy to hear it went off without the hitch and we get to keep much of the upside to boot! Wouldn't want to miss out on any of the upside, considering all the downside that's been shoveled down our throats in the past few years. Colony Capital and a minority owned investment firm named Cogsville LLC are proud owners of $1.85 billion (notional) in distressed assets. The investors paid 59 cents on the dollar, or $445 million for a 40% equity stake, with the FDIC retaining 60%, and (this is my favorite part) they get a seven-year, zero-interest loan, to reduce the upfront cash to $218 million. Let me repeat my favorite part: seven-year, zero-interest financing. I know I've been grousing for awhile now how all that zero interest financing is only benefitting the banks and they aren't passing the savings on to consumers and small businesses. Turns out I was wrong. All that zero percent money is helping large private equity funds goose their returns too!

Let's see, how else are we boosting the economy? Oh, according to the latest Fed lending survey, hedge funds, in addition to private equity funds, are getting better terms from their lenders. Consumers? Not so much. Dealers reported that funding markets for key consumer loans remained under stress, with a quarter of dealers reporting that liquidity and functioning of the consumer loan market had deteriorated in recent months. So what to do if you are a small business or consumer that needs a loan and you can't get one because your bank is too busy offering good deals to hedge funds? Quit complaining and start your own fund! Better yet, find the nearest woman or minority, call them CEO, and give the FDIC to call. You'll get all sorts of zero-percent financing, provided you take a few Las Vegas condos off their hands.

Living the High Life as Renters in Miami

Bloomberg's story on the condo-turned-rental scene in downtown Miami makes me wish I were a recent college graduate with an accounting degree. Who cares about the financial meltdown when you are having this much fun? If you can fast forward through the crazy amount of real estate development of the mid-oughts, when developers neglected to give each other a call or count the cranes already littering the skyline and deduce that maybe the city didn't need ANOTHER luxury condo development in downtown Miami, things haven't turned out too bad. Oh wait, you also have to fast forward through the real estate bust, when a bunch of empty and half-built buildings sat among the chirping crickets, awaiting a buyer for all the excess units. Then forget about the part where a bunch of buildings were handed over to the lenders, prices were slashed, bulk sales occurred, and large losses were booked. Finally we come to present day in downtown Miami, where are bunch of 24 year-old accountants are renting luxury condos with wraparound decks, rooftop pools and spas, and going out every night to the restaurants and bars that have popped up to satisfy the partying needs of a its new tenants.

See? It all worked out after all. Developers didn't really misjudge demand, they just mispriced it. There are plenty of people that want to live in luxury high-rises in the middle of the action in exciting downtown locations. It's just that most of them are accountants in their 20's, who noted that it was far cheaper to rent a unit from a bankrupt developer for $900 a month than pay $500,000 for it. I know accountants get a bad rap, but for once they actually did the math right.

The biggest problem now? Older residents (probably owners who are bitter about paying too much for their unit) are complaining about "crowds by the pool, loud music, and women taking their tops off" in one particular development that has been overrun by recent University of Miami graduates who are renting. Jorge Perez, President of The Related Group in Miami which was forced to hand back two of the three Icon Towers it built said it the best: “Over the long run, what we did in building those buildings, was it wrong?” Perez said. “I wish there wasn’t the suffering on a personal basis, on a banking basis and individual basis. But have we made Miami a much better city? Absolutely, yes.”

Whitehall Bests MSREF For "Worst Real Estate Fund Ever"

So the conversation must've gone something like this:

GS exec 1: This commercial real estate fund needs to sound very exclusive. Because everyone wants in but we definitely want the riffraff to know they're not good enough.

GS exec 2: Right! It needs to sound pure from the taint of retail investors.

GS exec 1: How about White Shoe?

GS exec 2: Yes, I like the "white" part. But "shoe" is not highbrow enough.

Gs exec 1: White House?

GS exec 2: Too political.

GS exec 1" White Door? White Room? White Bridge? White Street?

GS exec 2: No. Something more grand, impressive. I've got it "Whitehall"

GS exec 2: Perfect!

For all those rich folks lucky enough to get in on Goldman's snooty sounding Whitehall Street international real estate investment fund, you should give them a call. Your two cents are waiting for you. For two cents on the dollar, or $30 million, is about what is left of the $1.8 billion in equity that the fund started with back in 2005, when piling leverage on to a bunch of commercial real estate investments at the peak of a bubble still sounded like a great idea. Anyone keeping score, and Wall Street loves to keep score, should note that this bests the 70% or so loss revealed yesterday by Morgan Stanley's international real estate investment fund. But the fund doesn't expire until 2014, so they have plenty of time to make it back.

Earnings, Losses, and Excuses

First the good news:

• Both JP Morgan and Intel reported solid earnings. Profit at JP Morgan rose by 55% from a year earlier to $3.3 billion helped by a sharp 30% reduction in provisions for credit losses. Oh, and zero percent interest rates. It's always nice when you can borrow money at zero percent from your friends at the Fed and then charge consumers 20%. Really pads the bottom line.
• Meanwhile Intel's quarterly profit nearly quadrupled to $2.44 billion, while revenue rose 44% to $10.3 billion. The tech giant's good quarter bodes well for the rest of the tech sector.

In somewhat disappointing news:

• Investors in Morgan Stanley's $8.8 billion MSREF VI real-estate fund were recently informed that they have likely lost two-thirds of their money. The WSJ helpfully points out that this would probably make it the largest dollar loss in the history of private equity...so far. The losses stem from a buying frenzy during the peak in the commercial real estate market using oodles of leverage. The property purchases were global, so you know, at least they were diversified. Possibly the biggest bummer about the loss is that it's really putting a damper on the firm's plans to raise the $10 billion follow-up vehicle called MSREF VII. Here's a bit of unsolicited marketing advice for the folks at MSREF that I learned in MBA school: maybe you want to rebrand? Give the fund a different name, or something? If I'd lost two-thirds of my money in your last fund, I'm definitely not investing in your new fund, because at this point I'm thinking you guys aren't very good at investing in real estate.

In hilarious, as well as infuriating news:

• From Kerry Killinger, overseer of the multi-billion dollar fraud-infused-subprime-option-arm bubble-frenzy that was Wa Mu in its hey day before it collapsed under the weight of its stinky mortgage self: "For those that were part of the inner circle and were 'too clubby to fail,' the benefits were obvious. For those outside the club, the penalty was severe." Because underwriting over $100 billion in negative am mortgages without asking for a single W2, or verifying that the borrower actually had only $10K in annual income and $3 in his bank account before giving him a $2 million mortgage on a house that had sold for $300,000 last year had NOTHING TO DO WITH WASHINGTON MUTUAL'S COLLAPSE. No, it was the lack of a government bailout. You see, if only Washington Mutual had been bailed out by the government instead, it would've survived and would've been in tip top shape. This was all part of Mr. Killinger's business plan, and the FDIC had to go and ruin it all by seizing his bank. I mean, really, they had some nerve.

How Dumb Did CMBS Investors Get?

Even on the most boring financial news day, the WSJ Property Report always offers up a few tasty morsels of mock-worthy stories. You can skip over the tale of Istithmar World Capital, the private equity arm of the Dubai government's investment fund, which is handing back yet another building to lenders. As it turns out, buying a former hotel-turned-office building in Times Square, kicking out all the cash-flow producing tenants, in the hopes of turning it back into a high end hotel, maybe wasn't such a great idea. Must've been a bug in that excel spreadsheet that spit out the ridiculous purchase price in 2006. Then there are the continuing problems of former real estate mogul Kent Swig who used to like to do deals in just nine days because he was just so great at ripping apart the numbers and analyzing the deal "very, very quickly." Now Mr. Swig is being sued by lenders and five of his properties are listed by Real Capital Analytics as "troubled." You don't need nine days to analyze that.

No, the real juice this morning is in the article about the Biscayne Landing development (or lack of development) in Miami. Sure we've read a multitude of stories about silly CMBS issued in the 2005-2007 period secured by properties with extremely optimistic and preposterous future cash flow assumption. But this is the first time I've read about CMBS that was used to finance a land acquisition. In Florida. On landfill. That had been on the EPA's Superfund site list. Sure it was taken off the EPA's list in 1999, but still. Are you kidding me???

The developer of the project, Boca Developers, had grand visions to build 6,000 residential units, a hotel, a town center, pools and clubhouses. Oh, and they were going to cleanup the groundwater that had been contaminated by the aforementioned landfill. Credit Suisse gave the developers a $233.5 million loan, of which $163 million was repacked into CMBS secured by the ground lease and sold off to a bunch of investors who were apparently too sophisticated to read offering documents. In any event, the project is now largely unbuilt except for two condo towers that are involved in a separate foreclosure action. Furthermore, the affordable housing and the Olympic training facility that the developers agreed to help build elsewhere in the city has yet to materialize so the Mayor is pissed. "The project currently is a failure" says the angry Mayor. Ya think? Apparently the next step for the failed development is for someone to step up to take on the ground lease. Shockingly, there are few bidders that are willing to sink equity into unimproved property that doesn't throw off any cash flow. Any takers?

Tishman Speyer's Stuyvesant Pain Over As Ownership Handed Over to Creditors

Tishman Speyer finally mailed in the keys to creditors of its massive Peter Cooper Village and Stuyvesant Town apartment buildings in Manhattan. In what is likely to be known for some time as both the biggest and dumbest residential deal (until the next bubble,) the drawn-out and painful saga of Stuyvesant Town will be sorely missed by those who have chronicled the tale. First, came the shock and awe when the deal was actually done in 2006 ("they paid how much at what cap rate???), followed by a period of intense speculation over how long it would take for the deal to burn through its interest reserve, followed by the lawsuits from furious tenants who did not want their below-market rents to rise, followed by the collapse of the economy, and the actual depletion of the interest rate reserve. Now, in what is largely a ceremonial move, Tishman will cede ownership to creditors. No doubt the folks at Tishman won't be shedding a tear as they put in only $112 million into the deal, leaving a trail of other equity investors holding the bag. The creditors will not be left unscathed either, as the properties are currently valued at $1.8 billion, with roughly $4.4 billion in debt piled on top. Who will take the reigns next? Stay tuned for Stuyvesant the Sequel.

Got $2 Million For a Manhattan Hotel?

The glitzy W Hotel in Manhattan was sold to the highest bidder in a foreclosure auction on Tuesday. The winning bid was $2 million. That's a far cry from the $282 million ($50 million in equity and $232 million in debt) that Dubai World's private-equity arm Istithmar World Capital ponied up in 2006 for the prestigious property. Oh sure, Dubai has some financial issues and many high profile real estate investors are losing properties left and right, so what's the big deal? Well, Istithmar World Capital has $20 billion in private equity investments, much of it spent in 2006-2007. As evidenced by the loss taken on the W, any or all of those investments can go to zero in a hurry. And you thought Nakheel was Dubai World's biggest problem...

The $232 million in debt on the W was divided into $115 million in senior debt, now in CMBS, and $117 million in mezzanine debt. The mezzanine debt defaulted in October and the most junior of the three mezzanine investors, LEM Mezzanine, pushed the property into foreclosure and won the auction with the $2 million bid. It is now LEM's responsibility to bring current any defaulted debt that is senior to it ($97 million of mezzanine debt senior to LEM's original $20 million piece) as well as keep the first mortgage current. Istithmar made a last ditch effort to keep the property by throwing out a $2.1 million bid contingent on not having to pay anything to bring the hotel's senior debt back to current status. That whole "we don't feel like keeping our debts current" thing might work in Dubai, but not in the US. Unless, of course, you are a systemically important financial institution and can get the Fed to bail you out.

Capmark Files For Chapter 11

Capmark Financial, one of the nation's largest property lenders with $20 billion in assets, has filed for Chapter 11 bankruptcy protection. Capmark used to be the commercial lending unit of GMAC, the residential mortgage lending arm of GM that has since received excessive amounts of government aid. Seems like everything that GMAC ever touched was bound to be a lousy investment. At least GMAC had a bit of foresight in spinning off Capmark in 2006 to KKR, Goldman Sachs Capital Partners and Five Mile Capital Partners, who paid $1.5 billion in cash to acquire the doomed commercial lender. I'll let you guess what that investment is worth today.

Capmark has a bank in Utah with $10 billion in assets that is not part of the bankruptcy filing. However, the bank has been warned by the FDIC that it needs to boost its capital levels. The bank makes and holds commercial mortgages making it a likely candidate for seizure by our friends at the FDIC. Speaking of the FDIC, it closed seven banks on Friday bringing the YTD total to 106. Now if that isn't bullish news for the stock market, I don't know what is. Otherwise, I have no explanation for this morning's rally.

Clock Ticking For Manhattan Apartment Complex

My vote for most preposterous real estate transaction of the bubble, Tishman Speyer's $5.4 billion purchase of Stuyvesant Town in 2006, is two months away from defaulting on its massive debt load. The problem? When the deal was put together, lenders were projecting that the complex's net operating income would triple to $336 million in 2011 from $112 million in 2006. Since net income is projected to be around $139 million this year, it's a bit of an understatement to say that rents are lagging. Meanwhile, that nifty $400 million interest reserve that was supposed to service the debt while rents skyrocketed to the moon was down to its last $33.7 million at the end of September. With a $16 million monthly burn rate, I'll let you do the math. A special servicer is taking over the handling of the CMBS, which is very necessary considering what a debacle this default will become once the various lenders begin to argue over who gets what when so little is left. A recent valuation of $2.1 billion on the properties would wipe out all the equity, mezzanine and some of the senior debt. The geniuses at Tishman, who put this deal together, don't seem to have too much on the line financially, as they left the honor of holding the bag to the folks like the retirees of California (via Calpers' $500 million investment), the Florida State Board ($250 million), GIC (the people in Singapore who probably don't know their government invested over $575 million in a crappy NY real estate deal) and the God-fearing folks at the Church of England (only $70 million but locusts and general pestilence might ensue at Tishman's headquarters.) Fannie and Freddie own $1.5 billion in senior debt. But at least it's senior, so the US government should recover significantly more than the aforementioned losers in this giant turkey of an investment.

Earnings To Begin in Earnest

This week marks the beginning of a deluge in earnings reports. We'll hear from banking heavy-weights like JP Morgan and Goldman Sachs (both busy allocating bonuses), as well as lightweights like Citi (getting lighter by the quarter as it expected to post yet another loss.) In the meantime, here are some highlights from this morning's financial rags:

• Potential bidders for one of the many half-built bankrupt Las Vegas luxury casinos, Fountainebleu, are attempting to decide whether it is worth paying anything to assume the liability of spending another $2 billion to finish construction. Penn National Gaming is supposedly expressing interest.
• Foreclosures are hitting the high-end, with about 30% of foreclosures in June involving the top third of local housing values, up from 16% three years ago, according to Zillow.com. This is likely due to the souring economy, as well as recasts on Alt-A and option arm loans that continued to be underwritten well after the subprime market came to a screeching halt.
• Interesting article in the WSJ about venture capitalists shutting their doors, particularly in recent outposts like Dallas. Disappointing returns and an inability to attract money for new funds is causing many less established venture firms to wind down. CenterPoint Ventures was not able to raise a new fund in 2007 after investors demanded to see returns from earlier funds. The nerve of investors actually wanting to see returns before handing over more cash! Overall venture fund-raising this year is down sharply, with just 83 new funds totaling $8 billion raised in the US through the end of September, compared to 205 new funds totaling $30.5 billion in 2006.
• KB Home is being investigated by the SEC for its accounting. Add this to the long list of scandals in KB Home's recent past, including accusations of stock option manipulation by its chief executive and federal charges that it engaged in improper mortgage lending.
• The trial of former Bear Stearns hedge fund managers Cioffi and Tannin will begin in Brooklyn tomorrow. This one will be interesting.
• The US Pay Tsar is cracking down on executive pay among lower level employees at AIG. Naturally everyone will leave if they aren't paid enough, except for the new CEO, who's allowed to keep his $7 million annual salary.
• Citigroup was hit with a $600,000 fine for helping wealthy clients evade taxes through the use of total return swaps. Apparently this is merely the first in a wide crack down against Wall Street banks, most of which apparently use this strategy. I'm sure they're all quaking in their boots at having to take that $600k hit.

Fed Worries About Commercial Real Estate

Ok, so maybe it's a bit too late to start worrying about the impending commercial real estate crisis, since it's already begun. But at least one of our regulators has finally woken up and smelled the rot lying on our nation's banks' balance sheets. The WSJ reports that the Federal Reserve made a presentation to banking regulators last month that claimed that banks in the US "are slow" to take losses on their commercial real-estate loans that are being battered by slumping property values and rents (please see prior two posts.) The Fed document was prepared by an Atlanta Fed real-estate expert who is part of the central bank's Rapid Response program to spread information about emerging problem areas to federal and state banking regulators. While this is hardly a rapid response to a problem that reared its ugly head over a year ago, I'll give the boys at the Atlanta Fed bonus points for being ahead of the bank regulators, who allow reckless lending at a financial institution right up until the day the FDIC locks the front doors.

Banks with heavy exposure to commercial real estate loans set aside just 38 cents in reserves for every $1 in bad loans, according to an analysis by the WSJ. This is a sharp decline from $1.58 in reserves for every $1 in bad loans from the beginning of 2007. The WSJ's analysis included more than 800 banks that reported having more than half of their loans tied up in commercial real estate. To make a precarious situation even worse, many US banks have adopted a policy of extending loans when they come due even if they wouldn't make these loans now. It beats the heck out of going through the hassle of seizing the property, attempting to dump it on a market that has little appetite for commercial real estate, and taking a loss because the value of the property is below the loan amount. Best to keep your head firmly buried in the sand, and continue rolling that loan until everything returns back to "normal circa 2007." Another really ingenious tactic used by banks is the practice of using interest reserves to mask bad construction loans. When the loans are made, banks typically calculate interest that would be paid and set that money aside, paying themselves until the loan becomes due or the property generates cash flow. What happens when the developer is stuck with a half-empty building because he couldn't sell or lease the units and he can't get another loan at the same terms? That's when the bank finally takes the hit, even though all the clues were there to begin with.

How big is this problem? $3.4 trillion dollars of commercial real estate debt is outstanding, with more than half held by banks. Obviously not all of it is going to go bad, but much of the issuance from the past five years might unless a solution is found to the refinancing problem. With commercial real estate values already down over 30% and headed for steeper losses, nearly every property financed in the past few years is under water. Most commercial real estate loans are short-term in nature and investors just assumed they could refinance when the loans came due. Are they really going to cough up extra equity to hang on to buildings that they overpaid for? Or are they just going to hand the keys to the bank? Seems like banks need to beef up their property management arms because they are going to wind up owning alot of buildings. But don't worry, the Fed's Rapid Response Team is on it.

Snippets of Data

Not much in the headlines worthy of a longer discussion, but here are some interesting data points to ponder:

• ADP reports 298,000 job cuts in August. More cuts, more bad news for employment numbers.
• An upscale luxury hotel in Stockton is offered at $19 million, just a third of the $58 million in debt, liens and unpaid taxes owed on the property. The hotel opened in late 2007 and was delinquent on its loans by July 2008. But with all 42 condo units unfinished and unsold and an occupancy rate of 25%, it's amazing the place operated for that long. This must be a complete shock to all of those many travelers who demanded an upscale hotel/condo development in Stockton.
• Speaking of hotels, let's talk about one that is in a location where upscale travelers actually want to go. The Maui Prince Hotel is facing foreclosure. The Morgan Stanley real-estate fund and local developers bought the hotel for $575 million two years ago (aka "the high".) The owners failed to pay the resort's $192.5 million mortgage when it came due in July so the mortgage-holders sued to foreclose. The foreclosure threatens to wipe out the $227.5 million in mezzanine debt held by a UBS fund and the $250 million in equity that MS and its partners put into the property. To add insult to injury, the resort's manager will stop managing the property on September 16th due to a shortage of funds for pesky unimportant things like payroll. So if you hold a reservation after September 16th, you might want to cancel, unless you don't mind washing your own linens.
• A vacant parcel of land in Miami has sold for $39 million, down from the original price of $88 million in 2006. The deal, which was struck between seller Africa Israel and buyer Falcone Group got tied up by legal issues due to what appears to be a case of buyer's remorse. Sometimes lawyers really do come in handy because the delay bought Falcone enough time to put the screws to Africa Israel, now facing major liquidity problems, who agreed to the draconian price cut. Should you care about a silly $39 million land deal? Not really. But the total value of sales of vacant land through July of this year fell to $636 million, down from $5.5 billion last year. In aggregate, those numbers start to look ugly.

More From the Property Report

A couple more highlights from the WSJ Property Report this morning:

Calpers has given up control of its stake in a trophy office tower in Portland, Ore. The Koin Center, nicknamed the "mechanical pencil" for its signature shape, was purchased for $109 million in 2007 by a partnership that included Calpers and CommonWealth Partners, a real-estate investment company based in LA. The partnership has defaulted on the $70 million debt, and New York Life, the lender, has appointed a receiver to control and possibly sell the property. The article has a great quote from a senior vice president of corporate services for Colliers in Portland "Calpers is the gold standard, and its surprising that their backup plan is to walk away." I wonder why that is so surprising since it appears to be Calpers' least expensive option. That's sort of the whole point of an option. I might have paid $1 for the Microsoft $50 calls, but since the stock is only trading a $23, I'd be an idiot to exercise them. The building's office vacancy rate is set to rise from about 7.9% in the second quarter to the 26% range by about October. I'm sure that California retirees are cheering Calpers decision to walk away from this turkey.

Stockbridge Real Estate Funds is considering a takeover bid for the management of a $2.6 billion fund run by Deutsche Bank's real estate investment unit. Apparently, this is a rare move in the real estate world. In this instance, however, some of Stockbridge's top executives are intimately familiar with the 92 investments in the fund because they used to work there and manage the fund. The former managers of the Deutsche fund bolted in 2007 when their five-year retention pay plans ended and were hired by Stockbridge. They did such a great job managing the fund at Deutsche that the fund has warned investors that it may seek bankruptcy protection. Safe from their new perch at Stockbridge, the former managers would like to buy back the crap that they left behind at Deutsche. Isn't it fun doing this with other people's money? As long as you get a nice retention package to pay you for all your talent, who really cares about the consequences when you saddle your former investors with a bunch of really crappy real estate investments?

Meanwhile, the "Technically Speaking" section of the WSJ has a ridiculously bullish piece on REITs. It explains why REIT stocks are going to continue to rise despite the many, many problems in the commercial property market. The article gives such solid evidence as "Because the sector's heavy debt load was such a big contributor to its precipitous drop last fall, REIT stocks are expected to go nowhere but up if debt refinancings occur." Also "Given the appearance that the banking system has stabilized, that leads you to the belief that most of these REITs will be able to get their refinancing in order." And my favorite "From a technical view, REITs look set to rise as much as 35% from current levels." I don't know about you, but I'm convinced. Forget everything I said in the past two posts about commercial property values plummeting, "gold standard" investors walking away from their investments and saddling lenders with half empty buildings, defaults, declining cash flows and covenant violations. I'd better go load up on some REIT stocks!

Tishman Speyer's Commercial Real Estate Debacles

The WSJ Property Report has an interesting piece on Tishman Speyer this morning. For those who haven't heard the name, Tishman is a venerable real estate property developer that holds an approximately $35 billion portfolio of properties from all over the world. Tishman, the cream of the cream of the commercial real estate crop, finds itself in the unfortunate position of being in default on debt tied to one of the largest office portfolios in the Washington area. Back during the Great Bubble Pandemic of 2006, Tishman Speyer paid $2.8 billion for what was known as the CarrAmerica portfolio, a collection of 28 buildings leased to law firms, lobbyists and other hoity toity tenants. Naturally, Tishman borrowed from the piles of easy money lying around at the time, levered up, and paid way too much for the properties based on unrealistic cash flow assumptions. Cash flows have since declined so much that they barely cover the debt service. The company is in violation of its covenants and must find a way to refinance the debt due in 2011. By the way, who were the lenders? Lehman was involved, of course, and also happened to put equity into the deal too. Because every good investor knows that the best hedge against a debt investment is a side-by-side equity investment. The seller of the CarrAmerica portfolio to Tishman was Blackstone, who proved to be the winner in the 2006 commercial real estate hot potato tournament by flipping the portfolio for an enormous profit months after buying it.

But fear not, Tishman Speyer itself isn't threatened by the problems with the CarrAmerica portfolio, according to the WSJ. No, Tishman is probably more threatened by other bigger, dumber deals like the monster $20 billion LBO of Archstone- Smith, which closed after the credit crisis was in full swing, and the brilliant $5.4 billion acquisition of Peter Cooper Village and Stuyvesant Town that paid a fabulous 2.5% cap rate. The Archstone deal was also done with debt and equity investments from Lehman, (seriously, did that firm even have a risk management department?) which recently received bankruptcy court approval to put $230 million more into Archstone, hoping the apartments will regain their value on the other end of the recession (you can take a few minutes to laugh, I did.) Tishman pointed out that it has been very profitable over the years and it has $2 billion in liquidity for new deals. Seems like it should focus on cleaning up the old deals first before they throw any money into new deals. After all, Bear Stearns had $17 billion in cash and Lehman was most definitely NOT HAVING ANY LIQUIDITY PROBLEMS days before they went bankrupt.

Maguire Prepares to Mail Keys to Lenders, Reports Loss

Maguire, one of the largest Southern California office-building owners, has warned it plans to hand over ownership of seven buildings with $1.06 billion in debt to its lenders. Like many commercial property investors, Maguire borrowed heavily in recent years to purchase properties based on hockey stick-shaped assumptions for future rent increases. The reality of a 20% office vacancy rate in Orange County, up from 6% just three years ago, is not really helping Maguire meet debt service payments. Who are the lucky new owners of the buildings? LBA Realty, who purchased the debt on one property at a discount in the spring, already has a deal in place to take over Park Place One, in Irvine, California. The other six properties were packaged into CMBS and are coming to a default rate near you in CMBS Land. The seven buildings make up about 20% of Maguire's portfolio.

It should come as no surprise then that Macguire posted a $375.7 million loss this morning due mostly to the $384.7 million in write-downs related to the aforementioned properties. Funds from operations were a negative $7.10 a share, but it you exclude the write-down, they were a nifty eight cents a share. From a company that only reported revenue of $134.78 million, results like these are disastrous.

For other, depressing commercial real estate news, please turn to page A5 in the WSJ where an article discusses how difficult it will be for commercial real estate in Southern California to rebound from current depressed levels. During the peak four years ago, construction was the fourth-largest employer in the Inland Empire counties of San Bernardino and Riverside. Housing contributed more than $24 billion in revenue to the Southern California economy in 2008, more than double the revenue from Hollywood movies. Fast forward to today where construction has ground to a complete halt and new office buildings sit empty or with few tenants. A few stark statistics: the greater Los Angeles area has lost approximately 15% of the total construction jobs, while the Inland Empire has lost 49% since 2006. The number of housing permits in the five county greater Los Angeles area has dropped by 85% from 2005. San Bernardino has seen housing permits plunge 96% since the 2005 high. Office vacancy rates have grown to 24% in Riverside counties while the retail vacancy rate in the Inland Empire hit 10.6% in the second quarter. With stats like these, it is hard to imagine that construction will help lead the area out of its current slump.

East Coast Vs. West Coast Commercial Real Estate Blowouts

The WSJ reports that Deutsche Bank has finally found a buyer willing to shell out $600 million for the Worldwide Plaza in Manhattan. Duetsche, for those who are fuzzy on the details, was one of the bankers who thought it was a great idea to lend to Harry Macklowe back in early 2007 so he could pay the all-time record high in commercial real estate prices. Mr. Macklowe was the first high profile developer to default on his loans and start handing over the keys to his lenders during this real estate bust, although he certainly has plenty of experience doing it in the last real estate bust of the early 90's. Maybe the next time around, bankers will think twice before lending to him? But really, who am I kidding? Next time around, we'll have a whole new set of fresh-faced bankers throwing money at anyone with a pulse and a grand idea for why this time, things really are different and fundamentals don't matter.

The Worldwide Plaza is a lovely building on the fringes of better neighborhoods, but it obviously wasn't worth the $1.75 billion that Mr. Macklowe shelled out for it. The new owner, George Comfort & Sons., should do much better on his investment than Mr. Macklowe given that he paid 65% less, but he still has some work to do. The building is 50% vacant, which is nothing that a good slashing in asking rents can't remedy, much to other midtown Manhattan's office property owners' chagrins. But I'm fairly certain that this is how markets work. Prices adjust until we reach equilibrium. Unfortunately, an equilibrium price that reflects a 65% drop in Manhattan office property values should everyone involved in a deal during the boom years browning themselves.

Meanwhile, over on the West Coast, New York developer Millenium Partners, owner of the Four Seasons, didn't make payments in May and June on the hotel's $90 million securitized mortgage in a bid to compel the loan's special servicer to rework its terms. The developer claims that withholding the debt was a strategic decision, but I'm guessing it had something to do with the property not generating enough money to meet the debt service. You see, Millenium wants to restructure its debt and it's hoping to get conversations started. Funny thing is, when you or I "strategically withhold payments on our mortgages", the bank takes the damn house away. I guess that's not the way it works when you are a hoity toity NYC developer. We'll see how the lenders feel about this one.

In May, Barclay's put the Stanford Court Hotel into receivership because of a default on the hotel's $90 million mortgage. I'm fairly certain there was nothing "strategic" about that default. The WSJ journal points out that hotels aren't generating enough cash to make interest payments on their mortgages, which has caused the delinquency rate on securities with hotels pledged as collateral to jump to 4.3% in June up from 0.5% in a year earlier (data from Trepp LLC.)

The Four Seasons and the Marriott (owner of the Stanford) can blame their lack of cash flow on AIG of course, and that stupid junket that the company refused to cancel, which has put the kibosh on most luxury business travel. 2008 was the death of the boondoggle as we knew it. Oh, and also the depressed economy, which AIG is sort of also responsible for. In any event, the slow motion train wreck that is the commercial real estate market is playing out all over the country and is likely to pick up steam as a wave of defaults lead to foreclosures and bank liquidations. I happen to think this will be equivalent and possibly worse than the subprime problem. But then again, subprime was "contained" so we have nothing to worry about.

FHA Working Hard to Sell Some Condos

What to do about the glut of new condo developments around the country sitting half-empty, waiting for buyers to save them from the inevitability of foreclosure proceedings?  Rest assured that some sort of government bailout is the answer.  If a developer can get a building approved by FHA, then potential buyers can get a mortgage from an FHA-approved lender with only 3.5% down.  Tack on the $8,000 first time homebuyer credit and you can practically get a condo for free.  For a building to be approved by FHA, it must be 51% sold, so the developers have to do a bit of work to get to the threshold, but then, the condos should practically sell themselves.  Congress helped the cause by boosting FHA loan limits from $417,000 to $729,750, making virtually all condos eligible for FHA loan guarantees, except for all of the luxury buildings in Manhattan that are attempting to sell buildings full of units for $5 million a pop (I wish them luck.)  With Fannie and Freddie both tightening condo lending standards by requiring 70% of the units in the building to be sold, FHA is actually considering LOWERING its standards for approval, out of concern that the condo market is going to implode if somebody doesn't stop the madness.  I mean, really, how are developers supposed to sell all of this condo inventory that was conceived and built during an unsustainable condo-flipping frenzy at prices that nobody can or is willing to pay if the government isn't going to offer to insure no down-payment loans?  

The good news is that 93,000 condo units are scheduled for completion in 2009, a 28% increase over last year, according to Reis Inc.  So that should really help clear up the inventory problem.  Even better news is that nearly one-third of all first mortgages are now being originated through FHA, up from about 2% in 2006, when all of those highly successful subprime lenders, none of whom remain, were the leaders in the no down-payment mortgage game.  Best news of all, of course, is that delinquencies on FHA-backed loans rose to 7.5% in February from 6.2% a year earlier.  With unemployment rising and housing prices falling, delinquency rates will no doubt surge higher.

To be honest, at least FHA-backed loans are simple, fixed-rate mortgages that most people can comprehend.  They might not understand the math, but they can handle having to pay the same amount of money every month for the next 30 years.  We won't see the same leap in defaults once borrower's payments triple when their negative-am loans recast, because the payments won't change over time.  So hopefully the FHA program will help some who otherwise wouldn't have been able to purchase a home.  But let's hope that when the next housing bubble rolls around they don't screw it up with a cash-out refi.   

Fed Takes a Hit in Extended Stay Hotel Chain Bankruptcy

Chalk this bankruptcy filing up to yet another really leveraged commercial real estate deal crafted at the peak of the market, based on unrealistic expectations for future growth.  Extended Stay Hotels filed for bankruptcy on Monday.  Who were the crack real estate lenders who facilitated this transaction?  Why Bear Stearns and Wachovia.  Hmmm, those names sound sort of familiar.  Extended Stay Hotels is one of the many, many reasons why we don't hear the names Bear Stearns and Wachovia much anymore.  

Lightstone Group led the buyout, but only contributed $200 million in equity to the $8 billion deal, most of which was apparently borrowed.  Lightstone's Chief, Mr. Lichtenstein, has apparently learned a thing or two from past real estate meltdowns.  It's always best not to put too much skin in the game, just in case your overly ambitious growth assumptions turn out to be wide of the mark.  Apparently, investors didn't think Extended Stay would be able to file for bankruptcy because of a provision in the CMBS structure that would make Mr. Lichtenstein personally liable for $100 million if the company filed for bankruptcy.  Somehow Mr. Lichtenstein managed to weasel out of the $100 million personal liability by helping the secured lenders wrest control of the hotel chain.  So much for that theory.

The hotel chain is now valued at $3.3 billion, which isn't even 41% of the original buyout price and even lower than the amount of the first mortgage, $4.1 billion.  So clearly the junior lenders are getting wiped out, and the senior lenders will be taking it on the chin as well.  The really awesome part of this particular commercial real estate blow-out is that the Fed actually owns $744 million in face value of various junior classes of the debt on Extended Stay and also held $153 million of the senior debt that was packaged and sold as bonds.  That is courtesy of the Bear Stearns collateral that the Fed guaranteed so it could coerce JP Morgan into buying the now defunct broker dealer back in March of 2008, when "the worst was over."  Maybe those that believed that the hits the Fed had taken on that portfolio so far were just mark-t0-market losses but this one is for real.  We don't get to make it back on this one.  

Comercial real estate deals like these are one of the many reasons why I have never wanted the Fed involved in collateralized lending versus any collateral other than Treasuries.  Too many stupid deals crafted at the high that are going to go bust, one a a time.  Let the lenders and the equity investors eat the losses.  No bailouts for real estate developers and investors please.  I'm OK with Sheila Bair liquidating what she seizes from defunct institutions.  We can eat the losses then, last, like we're supposed to.     

S&P Awakes From Slumber, Downgrades CMBS

When the Fed decided to open up the Term Auction Lending Facility to newly issued AAA-rated CMBS in March, CMBS investors cheered. The CMBS market has been dead for nearly two years, with zero issuance so far this year and only $10 billion in all of 2008. How’s anyone supposed to make any money if nobody is doing deals? After their success with opening up the TALF to new issuance, commercial real estate investors lobbied the Fed, begged and pleaded to seek inclusion of legacy CMBS, particularly those issued during the highly toxic 2005-2007 era, into the TALF. It seems the market has been “distorted” by the fact that everybody on the planet knows that most of those deals were structured using too little equity and anticipating overly optimistic increases in rent and valuation. Nobody wants to buy these deals anymore, at least not at the prices where current investors are wearing them. So if the Fed could just do everybody a big favor and grease the wheels a little bit, then we could all just get back to the business of doing really moronic commercial real estate deals that make zero financial sense with everyone collecting their fees along the way, leaving the US taxpayer holding the bag. The Fed, of course, complied by allowing legacy CMBS into TALF, much to the chagrin of many a taxpayer that actually understands how disgusting it is that the Fed, who is supposed to be the steward of monetary policy in this country, has somehow morphed into a big supporter of commercial real estate dealmakers that made their own bed, in this case even without the help of unsophisticated subprime lenders. But then something remarkable happened. One of the rating agencies actually woke up from its slumber and decided it must put an end to the madness. Yesterday, S&P warned that it would downgrade billions of dollars of AAA rated CMBS, specifically those issued between 2005-2007, thus making them ineligible for TALF. Now a cynic might claims that perhaps S&P should’ve never rated these deals AAA to begin with, because frankly, they were stupid. But at least they’re doing something now. I would like to offer my gratitude to S&P for finally doing its job, that of protecting investors, which in this case could’ve included all US taxpayers.

Other interesting tidbits in the WSJ Property Report are follow ups to recent posts. First is a quick story about Arcandor’s potential impending insolvency. Arcandor, the German department-store operator is 51% owned by Whitehall Funds, which is run by Goldman Sachs, faces a June 12th deadline to gain an extension on its debt. It is hitting up the German state-owned development bank for a loan, because government funds are the best bet in getting an investor to throw good money after bad these days. In any event, this would be yet another pie in the face of Whitehall Fund investors, not to mention Goldman Sachs.

A follow up to another recent post is an snippet on real estate developer Kent Swig. Last we checked in with Mr. Swig, he was tied up in legal proceedings with the Lehman bankruptcy estate over 25 Broad, a 346-unit luxury condo development that has since soured. Lehman filed to foreclose in January, and last week a New York state court granted a request to appoint a receiver for 25 Broad. No doubt this story will only get more interesting. I'll keep you posted.