Industry News
Dec 22, 2008
Robert Brunswick, founder, president & CEO of real estate investment management firm Buchanan Street Partners, spoke with CPN senior editor Eugene Gilligan about the Treasury Department’s rescue package, the major trends of 2008 and what he will be watching for in 2009.
CPN: What is your opinion of the Treasury department’s announcement that the $700 billion rescue package will not be used to buy up troubled assets, and how this will affect commercial real estate?
Brunswick: It’s not particularly troubling, as I believe those monies can be better utilized within our economy than within the commercial real estate sector. The distress in commercial real estate is not currently prompted by bad assets or borrowers, but moreover by an illiquid capital market. Certainly the long-term impact of an extended recession will be the next shoe to drop and will increase capital market pressures on commercial real estate.
The federal government's presence as a purchaser of distressed debt had the potential to create a chilling effect on the market's clearing of these assets and marketing them to their appropriate value. Other prospective purchasers were likely to take a wait-and-see approach until they saw how the elephant in the room would play.
Ultimately, market forces not unduly influenced by an outsized participant are a better mechanism for valuing these assets. If the government overpaid for these securities--a real risk given its size in the market and its public policy mandate--comparable assets could end up trading at overvalued prices. This would have the effect of extending and incrementalizing the realization of these mark-to-market losses or delaying their trading because sellers would wait to get the "government price."
Personally, I'd rather see a short period of more intense pain, since this is what the market seems to have already baked into the cake, versus a protracted period of incremental write-downs. The government's strategy of shoring up the balance sheets of financial institutions will allow the banks to do what they're designed to do--make loans. This will inject needed liquidity into the real estate capital markets. Currently, too many assets, particularly distressed debt instruments, must be valued on an all-equity basis because there are few loans available to improve leveraged equity returns. With equity capital also dear in today's environment, this results in a steep devaluation of real estate assets.
The government's providing capital to position banks to lend again will soften the landing of the market revaluation. However, the government should provide incentives for banks to lend--or disincentives for not lending--and prevent them from simply hoarding cash and perpetuating the prevailing climate of fear.
CPN: What were the key headlines in 2008?
Brunswick: 2008 will take its place in the history of recent commercial real estate market corrections alongside 1986's tax reform and 1990's S&L meltdown. I believe the fortunes lost will dwarf the adjustments arising out of 1998's Russian ruble crisis and 9/11/2001. The system experienced a massive deleveraging which began in the second half of 2007 and accelerated in 2008.
The two primary sources of commercial real estate debt have been CMBS, which is all but dead, and commercial banks whose balance sheets are under siege, largely from defaulting residential loans and consumer debt. Interestingly, commercial mortgage defaults remain relatively modest by historical standards so far.... but expect this to change. With these sources curtailed so dramatically, insurance companies, commercial finance companies, and other lending institutions have not been able to take up the slack or have chosen not to--stepping out of the way of the proverbial falling knife.
An overheated market, where prices were inflated largely by the availability of cheap, high-LTV loans, had nowhere to go but down. With capital flowing like water in 2005-2007, spreads for commercial real estate assets versus the risk-free rate had been bid down to a level that was out of step with historical trends and did not properly reflect the risks associated with such high leverage. When leaks began to appear in the dyke, spilling over from the residential lending pool, it became apparent that the dam's construction was fragile having been largely constructed with debt - often short-term in nature.
We believe commercial real estate assets are off at least 20% in value on average across all product types.... less in the multi-family arena where Fannie Mae and Freddie Mac, despite their own woes, continue to provide better liquidity than the private sector will for other product types.... more in the retail and hospitality markets. However, sales data will probably not exhibit such a significant decline because so few properties have traded hands in 2008 with national sales volume off 80-90%. Many of these sales carried over from 2007 and were negotiated with a different market backdrop, and sales activity seems to have dropped off even more steeply in the second half of 2008.
Our sense is that the only owners selling today are those who must, but these are relatively few in number as evidenced by the lack of transaction volume and the relatively low level of mortgage defaults. Thus, much of the market's losses are on paper versus realized. However, we see this changing as more short-term loans originated in the "go-go" credit days of 2005-2007 mature, or run out of interest reserve, or get balancing calls.
The tonic that industry participants have been drinking to make us feel better about the state of the market in 2008 and to differentiate this downturn from prior real estate recessions goes something like this: "This time around the market fundamentals are better." While this may be true at present, it hinges largely upon the severity of the broader economic recession. Office vacancy rates are closer to 15 percent than 10 percent across most major markets and job losses are hitting levels not seen in 25-plus years. The retail sector faces what many perceive as a do-or-die holiday shopping season after which others will surely go the way of Mervyn's, Linens N Things and Circuit City. The apartment sector faces the challenge of rental competition from over-built condos and foreclosed homes in many markets and will have to deal with the eventual downsizing of Freddie's and Fannie's loan portfolios. While, unlike the early '90's, the supply side today remains governed by the lack of available capital for new construction, this could prove to be a demand-side recession if the consumer finally deleverages along with the rest of the market.
CPN: Where is the market is headed in 2009?
Brunswick: We believe things could get worse before they get better. The loose lending practices of the past several years will trickle through the lenders' balance sheets where they've already been marked to market, creating the current liquidity crisis, to the actual borrower-lender transaction. As more and more of those two and three-year loans face maturity or earlier capital events, expect defaults to rise sharply. Goldman Sachs estimates that this default rate could spike from sub-1 percent to over 5 percent, with most of these losses occurring in 2010 and beyond. This could create, in effect, a second wave of the commercial real estate liquidity crisis--realized losses following on the heels of unrealized right-downs.
Similarly, sales volumes will probably rebound somewhat over the next 12-24 months. However, this will probably be primarily the result of distressed selling to avoid foreclosure and salvage some equity and/or REO sales.
As with the loans that underlie these properties, we expect 2009 to tell a story of realization of prior unrealized losses. Here, as well, there's a panacea in "prevailing wisdom." The prevailing wisdom had been that there's plenty of equity capital in private hands waiting on the sidelines which will flood in once prices drop and yields increase enough to compensate for market risk. This appears increasingly less likely as many investors, particularly public pension plans, are reining in real estate allocations now that they're overweighted in real estate due to the so-called "denominator effect" which has arisen from their stock market portfolios deteriorating. Ironically, if real estate were marked to its true market value and revalued daily, as the stock market is, versus quarterly or semi-annually, this denominator effect would be less pronounced. Nonetheless, we're stuck with it as it is. This phenomenon could result in the market bottom being lower and/or less abrupt than previously thought. Instead of bouncing off the floor in 2009, as some predicted recently, we feel that a continued slide followed by a prolonged recovery is more likely, the government's efforts with TARP notwithstanding.
As a firm with capital to inject into an illiquid market, we're excited about opportunities to buy assets at reduced prices. With fewer players in the mix, we're able to originate debt and preferred equity investments with 25-30 percent equity subordination and garner very attractive risk adjusted returns. Similarly, we're pursuing opportunistic purchases of discounted debt and looking at properties which are trading at distressed prices. We believe that investment opportunities in 2009-2010 will be similar to the early 1990's when firms like Colony Capital and JE Robert realized fantastic returns in profiting from the duress in the markets.
Robert Brunswick, founder, president & CEO of real estate investment management firm Buchanan Street Partners, spoke with CPN senior editor Eugene Gilligan about the Treasury Department’s rescue package, the major trends of 2008 and what he will be watching for in 2009.CPN: What is your opinion of the Treasury department’s announcement that the $700 billion rescue package will not be used to buy up troubled assets, and how this will affect commercial real estate?
Brunswick: It’s not particularly troubling, as I believe those monies can be better utilized within our economy than within the commercial real estate sector. The distress in commercial real estate is not currently prompted by bad assets or borrowers, but moreover by an illiquid capital market. Certainly the long-term impact of an extended recession will be the next shoe to drop and will increase capital market pressures on commercial real estate.
The federal government's presence as a purchaser of distressed debt had the potential to create a chilling effect on the market's clearing of these assets and marketing them to their appropriate value. Other prospective purchasers were likely to take a wait-and-see approach until they saw how the elephant in the room would play.
Ultimately, market forces not unduly influenced by an outsized participant are a better mechanism for valuing these assets. If the government overpaid for these securities--a real risk given its size in the market and its public policy mandate--comparable assets could end up trading at overvalued prices. This would have the effect of extending and incrementalizing the realization of these mark-to-market losses or delaying their trading because sellers would wait to get the "government price."
Personally, I'd rather see a short period of more intense pain, since this is what the market seems to have already baked into the cake, versus a protracted period of incremental write-downs. The government's strategy of shoring up the balance sheets of financial institutions will allow the banks to do what they're designed to do--make loans. This will inject needed liquidity into the real estate capital markets. Currently, too many assets, particularly distressed debt instruments, must be valued on an all-equity basis because there are few loans available to improve leveraged equity returns. With equity capital also dear in today's environment, this results in a steep devaluation of real estate assets.
The government's providing capital to position banks to lend again will soften the landing of the market revaluation. However, the government should provide incentives for banks to lend--or disincentives for not lending--and prevent them from simply hoarding cash and perpetuating the prevailing climate of fear.
CPN: What were the key headlines in 2008?
Brunswick: 2008 will take its place in the history of recent commercial real estate market corrections alongside 1986's tax reform and 1990's S&L meltdown. I believe the fortunes lost will dwarf the adjustments arising out of 1998's Russian ruble crisis and 9/11/2001. The system experienced a massive deleveraging which began in the second half of 2007 and accelerated in 2008.
The two primary sources of commercial real estate debt have been CMBS, which is all but dead, and commercial banks whose balance sheets are under siege, largely from defaulting residential loans and consumer debt. Interestingly, commercial mortgage defaults remain relatively modest by historical standards so far.... but expect this to change. With these sources curtailed so dramatically, insurance companies, commercial finance companies, and other lending institutions have not been able to take up the slack or have chosen not to--stepping out of the way of the proverbial falling knife.
An overheated market, where prices were inflated largely by the availability of cheap, high-LTV loans, had nowhere to go but down. With capital flowing like water in 2005-2007, spreads for commercial real estate assets versus the risk-free rate had been bid down to a level that was out of step with historical trends and did not properly reflect the risks associated with such high leverage. When leaks began to appear in the dyke, spilling over from the residential lending pool, it became apparent that the dam's construction was fragile having been largely constructed with debt - often short-term in nature.
We believe commercial real estate assets are off at least 20% in value on average across all product types.... less in the multi-family arena where Fannie Mae and Freddie Mac, despite their own woes, continue to provide better liquidity than the private sector will for other product types.... more in the retail and hospitality markets. However, sales data will probably not exhibit such a significant decline because so few properties have traded hands in 2008 with national sales volume off 80-90%. Many of these sales carried over from 2007 and were negotiated with a different market backdrop, and sales activity seems to have dropped off even more steeply in the second half of 2008.
Our sense is that the only owners selling today are those who must, but these are relatively few in number as evidenced by the lack of transaction volume and the relatively low level of mortgage defaults. Thus, much of the market's losses are on paper versus realized. However, we see this changing as more short-term loans originated in the "go-go" credit days of 2005-2007 mature, or run out of interest reserve, or get balancing calls.
The tonic that industry participants have been drinking to make us feel better about the state of the market in 2008 and to differentiate this downturn from prior real estate recessions goes something like this: "This time around the market fundamentals are better." While this may be true at present, it hinges largely upon the severity of the broader economic recession. Office vacancy rates are closer to 15 percent than 10 percent across most major markets and job losses are hitting levels not seen in 25-plus years. The retail sector faces what many perceive as a do-or-die holiday shopping season after which others will surely go the way of Mervyn's, Linens N Things and Circuit City. The apartment sector faces the challenge of rental competition from over-built condos and foreclosed homes in many markets and will have to deal with the eventual downsizing of Freddie's and Fannie's loan portfolios. While, unlike the early '90's, the supply side today remains governed by the lack of available capital for new construction, this could prove to be a demand-side recession if the consumer finally deleverages along with the rest of the market.
CPN: Where is the market is headed in 2009?
Brunswick: We believe things could get worse before they get better. The loose lending practices of the past several years will trickle through the lenders' balance sheets where they've already been marked to market, creating the current liquidity crisis, to the actual borrower-lender transaction. As more and more of those two and three-year loans face maturity or earlier capital events, expect defaults to rise sharply. Goldman Sachs estimates that this default rate could spike from sub-1 percent to over 5 percent, with most of these losses occurring in 2010 and beyond. This could create, in effect, a second wave of the commercial real estate liquidity crisis--realized losses following on the heels of unrealized right-downs.
Similarly, sales volumes will probably rebound somewhat over the next 12-24 months. However, this will probably be primarily the result of distressed selling to avoid foreclosure and salvage some equity and/or REO sales.
As with the loans that underlie these properties, we expect 2009 to tell a story of realization of prior unrealized losses. Here, as well, there's a panacea in "prevailing wisdom." The prevailing wisdom had been that there's plenty of equity capital in private hands waiting on the sidelines which will flood in once prices drop and yields increase enough to compensate for market risk. This appears increasingly less likely as many investors, particularly public pension plans, are reining in real estate allocations now that they're overweighted in real estate due to the so-called "denominator effect" which has arisen from their stock market portfolios deteriorating. Ironically, if real estate were marked to its true market value and revalued daily, as the stock market is, versus quarterly or semi-annually, this denominator effect would be less pronounced. Nonetheless, we're stuck with it as it is. This phenomenon could result in the market bottom being lower and/or less abrupt than previously thought. Instead of bouncing off the floor in 2009, as some predicted recently, we feel that a continued slide followed by a prolonged recovery is more likely, the government's efforts with TARP notwithstanding.
As a firm with capital to inject into an illiquid market, we're excited about opportunities to buy assets at reduced prices. With fewer players in the mix, we're able to originate debt and preferred equity investments with 25-30 percent equity subordination and garner very attractive risk adjusted returns. Similarly, we're pursuing opportunistic purchases of discounted debt and looking at properties which are trading at distressed prices. We believe that investment opportunities in 2009-2010 will be similar to the early 1990's when firms like Colony Capital and JE Robert realized fantastic returns in profiting from the duress in the markets.
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