Distressed Commercial Real Estate Soars to $180 Billion

December 15, 2009
National Real Estate Investor

The amount of distressed commercial real estate properties in the U.S. has reached a record $180 billion, according to a new report by New York-based research firm Real Capital Analytics. The distress reaches across all property types, with the greatest amount plaguing retail assets, the report shows.

By far, the market with the highest dollar value of troubled assets is Las Vegas, with $17.7 billion of properties that are delinquent, in default, bankrupt, foreclosed or otherwise owned by lenders.

Manhattan had the second-highest amount of troubled properties as of November, $12.3 billion, followed by Miami, with $7.6 billion and Los Angeles, $7.1 billion.

“The distress is formidable,” says Dan Fasulo, managing director of Real Capital Analytics. Most of the financial problems accumulated between September 2008, following the collapse of Lehman Brothers, and November 2009, he says. “Before 2008 there was no material distress in commercial real estate — period. It was just a normal market. This isn’t something you can compare with other periods. This is new for everybody.”

Unfortunately, the pace of the distress process is not slowing, says Fasulo. “I think we’ll continue to see more distress come to market well into 2010. I like to think we might hit the apex in the middle of 2010 and then start working our way down.”

As the flow of distressed properties continues unabated, resolution of the problem has been slow in taking effect. Just 10% or $18 billion of the distress has been resolved, according to the research firm.

Recent federal regulation is likely to restrict defaults among commercial properties with continuing cash flow by encouraging loan extensions and restructurings. But when it comes to properties without cash flow, such as failed developments or vacant buildings, lenders will have little alternative but to foreclose, according to the report.

“Those are assets that have no chance of recovering their full value in the short term. In those situations lenders just aren’t in a position to carry those assets for a long time. Many are [real estate owned by banks] already, but even more working are their way through the process,” says Fasulo.

Retail was the hardest-hit sector with $37.5 billion in troubled assets. Hotels were second with $32 billion, followed by office, $28.2 billion, and apartments, $27.9 billion. The industrial sector had just $5 billion in distressed assets.

Much of the distressed retail property lies in U.S. suburbs, where new residential developments were planned but never completed, because of the recession and credit crisis. “I’ll never forget driving around the loop in Vegas. There’s a brand new retail center on the desert next to the highway,” near an abandoned housing development. “It’s all plotted out for new houses. Obviously they’re not going to build the houses now,” says Fasulo.

Industrial properties fared better than other types, and are expected to remain strong into next year. “It’s not the sexiest sector. It never got over-levered the way some property classes did,” notes Fasulo. Another plus: the warehouse industry is upgrading the market with new, high-tech facilities, he says.

Investors voice frustration

Despite the high level of distressed properties, on the demand side many investors are aggravated. “I get upset calls from investors almost every day, frustrated that they can’t find anything to buy. It sounds so counterintuitive,” says Fasulo.

But a lot of the sale action is taking place on the debt side. In this difficult economic climate many properties don’t come to market in the usual way, with the help of brokers. “A lot of investors are trying to sneak in and buy the first mortgage or mezzanine debt to take control of the property that way instead of participating in a public auction,” notes Fasulo.

For the most part, investors who expected to see prime retail or office properties trotted to the market at huge discounts have been disappointed. Instead, the investors have had to become highly creative at ferreting out attractive distressed properties with bargain prices.

Because the deals have been hard to find and often have entailed “back door” access to lenders and other sources, requiring thorough knowledge of a market and connections, many investors have turned to their own local markets to find deals, says Fasulo.

For example, the recent auction of the trophy W Hotel in New York took place at an attorney’s office. There’s no way an investor sitting at a computer in Los Angeles could gain proper entrée to a deal like that, says Fasulo. That’s why so many investors now are taking a closer look at available deals in their own backyards.

Mortgage Bankers Oppose SEC Proposal on Disclosure of Preliminary Ratings

December 15, 2009
National Real Estate Investor

The Mortgage Bankers Association has notified the Securities and Exchange Commission (SEC) of its opposition to a proposed rule requiring the disclosure of preliminary ratings of securities. The rule could potentially affect many investors in commercial real estate securities.

The Washington, D.C.-based bankers group contends that disclosing preliminary ratings of commercial mortgage-backed securities (CMBS) carries the risk of providing misleading information to investors in commercial real estate.

The SEC is considering a number of steps to make the process of rating securities more transparent in order to protect investors. The proposed rule is intended to curb the practice of “ratings shopping,” which involves soliciting a number of rating agencies for a preliminary rating and choosing an agency based on the early rating that is most favorable.

The mortgage bankers group says that the composition of a group of loans can change substantially after it is initially rated, before the final selection of loans is made, so that the early rating often is no longer relevant for the resulting security.

“In the case of CMBS, the pool of properties comprising the securitization can change significantly from the initial pool that received the preliminary rating,” John Courson, president and CEO of the Mortgage Bankers Association told SEC Secretary Elizabeth Murphy. Therefore, disclosure of the preliminary rating information for a loan pool is unlikely to accurately reflect the final pool of loans that were securitized, Courson said.

“What this rule requires is that the preliminary rating be disclosed. On paper, it doesn’t sound like a bad idea but once you understand how a commercial mortgage-backed security works, it’s really not a good idea,” says George Green, associate vice president of MBA.

For example, if 100 loans are contributed to a pool and packaged into a commercial mortgage-backed security, the loans are stratified by rating and different investors buy different portions of the pool, says Green. Some tranches of the security may be rated AAA while others are rated BBB.

The investor who buys sub-investment grade tranches, below a B rating, can pick and choose and eliminate some loans from the original pool, which affects the final rating.

In addition, an initial rating can be very cursory, says Green. After rating examiners conduct due diligence and investigate the quality of the bundled loans, the final rating can also change.

The proposal to require disclosure of preliminary ratings of securities would amend statements filed under the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act of 1940. After devastating losses throughout the CMBS and other securities markets over the past two years, the SEC is trying to assure that investors are properly informed before making investment decisions.

The agency called for comment on the proposed rule change, and now that the comment period is closed it will study the responses for several weeks or months before making a final determination on whether to require the disclosure of preliminary ratings.

In general, the mortgage bankers group supports transparency in the ratings process, says Green.

One way potential investors can learn more about CMBS is to weigh both solicited and independent ratings.

An emerging group of ratings agencies conduct unsolicited or independent ratings of securities. The agencies are not paid in the traditional way, by the issuer of the security, but by subscribers to the agencies’ services. The independent ratings have become increasingly popular.

“Really they are providing a second opinion of the issuer-provided ratings,” says Green. “They can then be compared to the ratings that were performed by the issuer-commissioned ratings. We see that as the way to resolve the problem.”

Tudor Jones Turns Away Investors as Hedge-Fund Outflows Persist

Dec. 17 (Bloomberg) -- In a year when investors pulled an estimated $118 billion from hedge funds through November, Paul Tudor Jones was one of at least six managers who decided it was time to turn away cash.

BVI Global Fund Ltd., Jones’s biggest, stopped taking new investments after bringing in $1.3 billion from March to July, according to a person with knowledge of the matter. Brookside Capital Partners LP and Woodbine Capital Advisors LP also have closed or restricted inflows, said people familiar with the firms, who asked not to be named because the funds are private.

Institutions and wealthy individuals have sought out managers with consistent long-term gains, especially those with funds previously closed to new investors. After firms such as D.E. Shaw & Co. and Polygon Investment Partners LLP froze or limited redemptions, investors also gravitated to funds that avoided such steps or eased restrictions quickly.

“Those managers that honored their agreements and treated their investors as partners during the last 18 months of economic difficulties are being rewarded with additional money this year,” said Debra Pipines, founder of New York-based Asperion Group LLC, which raises capital for hedge funds.

Managers usually stop taking new cash when they are concerned that their funds are getting too big to run effectively. They give up the chance to manage more money and earn more fees, usually 2 percent of assets, to protect their ability to produce investment gains, of which they typically take a 20 percent cut.

Hedge funds are loosely regulated private partnerships that can bet on rising or falling prices of any securities.

Bain Affiliate

Jones, 55, has returned an average of 22 percent a year since he founded Greenwich, Connecticut-based Tudor Investment Corp. in 1986. The firm limited investor withdrawals from the $9.5 billion BVI fund in November 2008. It removed those restrictions three months later, placating some clients. Tudor, which oversees $11.5 billion, has kept smaller funds open.

Another manager that is restricting new cash is Brookside Capital Partners, a $10 billion affiliate of Boston-based private-equity firm Bain Capital LLC. It raised about $1 billion from investors, according to a person familiar with the firm. Brookside, which invests in stocks, has returned about 16 percent this year, after losing 16 percent in 2008.

While investors tended to flock to established firms, one exception was Woodbine, founded in January by Josh Berkowitz and Marcel Kasumovich, former executives at George Soros’s hedge- fund company, along with three other partners.

$2.5 Billion

The New York-based firm, which started with $185 million, cut off new investments last month after assets reached $2.5 billion, according to people familiar with the matter. Woodbine runs a so-called macro fund, which seeks to profit on broad economic trends by trading stocks, bonds, currencies and commodities.

Berkowitz, Woodbine’s chief executive officer, also worked at SAC Capital Advisors LLC and New York-based Goldman Sachs Group Inc., the most profitable securities firm in Wall Street history. During his three years at New York-based Soros Fund Management LLC, he returned an annual average of 34 percent after fees, according to Woodbine’s marketing documents.

The firm has as much as $500 million in commitments made before last month’s closing that it may take in January, a person familiar with the matter said.

“The combination of a strong pedigree, investment process and a favorable strategy goes a long way,” said Richard Tomlinson, founder of London-based Tomlinson Investment Consulting, which advises clients on hedge funds.

Brevan Howard, Clive

Brevan Howard Asset Management LLP, Europe’s largest hedge- fund firm, closed its $2 billion Asia Fund and $2.5 billion Emerging Market Strategies Fund to new investors as of Nov. 1. The London-based company may consider shutting its $21.3 billion Brevan Howard Master Fund Ltd. after clients said it may be too large, people familiar with the matter said earlier this month.

Two other London-based managers -- Clive Capital LLP and Lansdowne Partners LP -- also closed funds this year.

All the firms declined to comment on their decisions to restrict inflows.

The hedge-fund industry, which managed $1.47 trillion as of November, continued to see net withdrawals this year as investments returned an average 18 percent, compared with the 24 percent gain by the Standard & Poor’s 500 Index, according to data compiled by Singapore-based Eurekahedge Pte.

Last year, withdrawals were $198 billion, an all-time high, Eurekahedge data show. Hedge funds lost a record 19 percent in 2008, though that was half the 38 percent decline by the S&P 500, a benchmark for large U.S. stocks.

“Before, managers could rely on their returns to sell themselves,” said Andrea Gentilini, head of strategic consulting at Barclays Capital’s Prime Services unit in New York. “Now investors want more transparency and communication.”

Cohen’s SAC Capital

About 40 percent of funds have yet to return to their peak asset level or high-water mark, data compiled by New York-based Morgan Stanley show. Those funds can’t collect their share of investment gains. Of those funds, about half are 10 percent or more away from breaking even, meaning it could be another year before they can earn performance fees.

SAC Capital, the Stamford, Connecticut-based hedge fund run by Steven Cohen, attracted $1.3 billion for its main fund, while Highbridge Capital Management LLC, a New York-based unit of JPMorgan Chase & Co., received more than $500 million, people familiar with the firms said. Both remain open to new investments.

Smaller Funds

As some well-known managers close to new investments, smaller funds will begin to benefit from inflows, investors said. After outflows in January through April, funds have gained $82 billion, though are still negative for the year, according to Eurekahedge.

“I’m seeing more interest in mid-sized managers,” said Brad Balter, who runs Boston-based Balter Capital Management LLC, which invests in hedge funds. In part, that’s because clients are worried that in some instances funds are growing too large and that returns will suffer, he said.

The influx of new money has come from pensions, foundations and sovereign wealth funds, overtaking university endowments and firms that invest on behalf of wealthy individuals as the biggest hedge-fund investors, Morgan Stanley said in a Nov. 23 report.

Investors are steering clear of some managers that were slow to return money after restricting redemptions last year, or those that left them holding hard-to-sell assets that were segregated into separate funds, known as side-pockets.

“Patience has worn thin among investors over the last 12 months,” said Simon Atiyah, a lawyer at London-based Lovells LLP, whose clients include hedge funds. “Some managers that prevented investors from getting their money back have done terrible long-term damage to their businesses.”

Money Trap

About 60 percent of the money that clients sought to withdraw from funds hadn’t been returned as of Sept. 30, according to data compiled by Credit Suisse Tremont Index LLC, based on its index of 480 hedge funds that oversee about $531 billion. About 55 percent of money put into side-pockets has been released.

Philip Falcone’s Harbinger Capital Partners LLC told clients that it may take 12 months to 24 months to return their money after limiting withdrawals from its largest fund last year. The New York-based firm has given back less than 10 percent of the assets that the firm restricted.

Citadel Investment Group LLC, the $13 billion firm run by Ken Griffin, returned $250 million of the requested $1.5 billion at the end of September after suspending redemptions last year. The Chicago-based company said in October that it plans to return the rest of the money at the end of the year.

Both Harbinger and Citadel have raised about $1 billion in new cash.

‘Acted Like Traitors’

Drake Management LLC, the New York-based firm run by Anthony Faillace and Steve Luttrell, told clients in April 2008 that it was liquidating its biggest hedge fund. As of October 2009, it hadn’t returned all the money.

Hedge-fund investors including Amit Shabi, a Paris-based partner at Bernheim Dreyfus & Co., say they won’t put money in a hedge fund that had imposed limits on client redemptions.

“Many managers acted like traitors,” said Shabi. “They hid the fact that they were invested in illiquid assets.”

Leading Economic Index in U.S. Rose 0.9% in November

Dec. 17 (Bloomberg) -- The index of U.S. leading indicators rose for an eighth consecutive month in November, a sign economic growth will extend into the first half of 2010.

The New York-based Conference Board’s gauge of the outlook for the next three to six months rose 0.9 percent, more than forecast, after climbing 0.3 percent in October. Separate reports showed Philadelphia-area manufacturing grew in December at the fastest pace in more than four years, while initial jobless claims rose last week.

Rising stocks and fewer job losses are supporting consumer spending, which makes up 70 percent of the economy. The Federal Reserve said yesterday it intends to keep its benchmark interest rate near zero for an “extended period,” to spur growth as unemployment at 10 percent poses a risk to the recovery.

“The nascent recovery is ending 2009 on a high note,” said Richard DeKaser, chief economist at Woodley Park Research in Washington, who correctly forecast the gain in leading indicators. “The consumer is doing all right, housing is clearly in an upswing and business investment is improving.”

Economists forecast the leading indicators index would increase 0.7 percent, according to the median of 61 estimates in a Bloomberg News survey. Projections ranged from a gain of 0.5 percent to 1.2 percent.

Philadelphia Manufacturing

Manufacturing in the Philadelphia region expanded for a fifth month as sales and employment grew. The Fed Bank of Philadelphia’s general economic index rose to 20.4 this month, the highest since April 2005, from 16.7 in November. Readings greater than zero signal growth.

Figures from the Labor Department showed jobless claims increased to 480,000 last week from 473,000 a week earlier, indicating the labor market will take time to strengthen.

Stocks declined for a second day this week after Citigroup Inc. sold stock at a discount and FedEx Corp.’s profit forecast trailed analysts’ estimates. The Standard & Poor’s 500 Index dropped 0.8 percent to 1,100.18 at 10:20 a.m. in New York.

Six of the 10 indicators in the leading index contributed to the gain, led by the difference between short- and long-term borrowing costs and fewer jobless claims. A longer factory workweek, higher stock prices, more building permits and a rise in money supply also helped the index.

Weaker consumer expectations, faster supplier deliveries and fewer capital goods orders were a drag on the index. Consumer goods orders had no effect on the index.

Coincident Indicators

The Conference Board’s index of coincident indicators, a gauge of current economic activity, rose 0.2 percent in November after no change the prior month. The index tracks payrolls, incomes, sales and production, the measures used by the National Bureau of Economic Analysis to determine the beginning and end of U.S. recessions.

The gauge of lagging indicators dropped 0.4 percent last month. The index measures business lending, length of unemployment, service prices and ratios of labor costs, inventories and consumer credit.

The world’s largest economy probably expanded at a 3 percent annual pace from October through December after growing at a 2.8 percent rate in the prior quarter, according to the median estimate of economists surveyed earlier this month. That followed a 3.8 percent contraction in the 12 months to June, the economy’s worst performance since the 1930s.

Yield Curve

The index’s positive spread between the yield on the 10- year Treasury note and the overnight fed funds rate is based on mounting expectations of an economic recovery.

Jobless claims averaged 482,000 in November, down from 524,200 a month earlier. Building permits rose 6 percent in November, the government reported yesterday, a sign home construction is gathering pace.

U.S. stocks continued to rally last month as reports suggested the economy was stabilizing. The S&P 500 averaged 1,088.07 in November, compared with 1,067.66 in October. The index reached the highest closing level in 13 months on Dec. 14.

Weighing on the index, the Reuters/University of Michigan’s reading on consumer expectations for the next six months fell in November from the prior month.

Seven of 10 indicators for the leading index are known ahead of time: stock prices, jobless claims, building permits, consumer expectations, the yield curve, factory hours and supplier delivery times.

Federal Reserve

The Conference Board estimates new orders for consumer goods, bookings for capital goods, and the money supply adjusted for inflation.

Reiterating its pledge to keep rates “exceptionally low” for “an extended period,” Fed policy makers yesterday said the recovery is facing hurdles.

“Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit,” they said in a statement.

Manufacturers that export to emerging economies such as China are among companies anticipating stronger growth.

General Electric Co. Chief Executive Officer Jeffrey Immelt said global orders for the world’s biggest maker of jet engines, power-plant turbines and medical imaging equipment were picking up in the fourth quarter compared with the prior three months.

“Orders will be improving sequentially as we get into the fourth quarter of the year,” Immelt said at an investor meeting Dec. 15. GE had an order backlog of $174 billion at the end of the third quarter, with total company orders of $18.4 billion in the third quarter, including service contracts.

Greenspan Says Stock Rally Means Lower Stimulus Need

Dec. 17 (Bloomberg) -- The biggest stock market advance in seven decades is reducing the need for additional government stimulus measures, according to former Federal Reserve Chairman Alan Greenspan.

The Standard & Poor’s 500 Index’s 64 percent jump since March made Americans richer by restoring $5.4 trillion to U.S. equities and helped spur a 1.3 percent increase in retail sales last month, data compiled by Bloomberg and the Commerce Department show.

“The stimulus is only a third spent, and its order of magnitude is not large enough to compare with the strength and power of the remarkable global equity increase that’s occurred since early March,” Greenspan, 83, said in a telephone interview yesterday from Washington. “Capital gains have proved a far greater stimulus than one can attribute to the $787 billion program that has been only partially spent.”

Increasing spending beyond the $11.6 trillion already pledged may also be unnecessary because higher stocks will help boost profits and make loans easier to come by, Greenspan said. Earnings among S&P 500 companies are forecast to rise 65 percent in the fourth quarter, ending the longest series of declines since World War II, data compiled by Bloomberg show.

“When stock prices go up, the market value of common stock or of equity in banks and other financial institutions rises,” he said. “And the market value of liabilities is importantly affected by the size of the equity market value cushion on banks’ balance sheets.”

Wealth Effect

The S&P 500 fell 0.8 percent to 1,100.01 at 10:18 a.m. in New York today after New York-based Citigroup Inc. sold stock at a discount, Memphis, Tennessee-based FedEx Corp.’s profit forecast trailed analyst estimates and jobless claims unexpectedly increased.

Net worth for U.S. households increased to $53.4 trillion in the third quarter, up $2.7 trillion from the prior period, helped by share gains, according to a Fed report released on Dec. 10. Assets in so-called defined contribution plans such as 401(k) retirement accounts and IRAs climbed 35 percent to $1.93 trillion from the first quarter to the third, the data show.

Retail spending rose in November at more than twice the 0.6 percent median estimate in a Bloomberg survey, Commerce Department data showed. The Reuters/University of Michigan index of consumer sentiment for December increased to 73.4 from 67.4 the month before.

Adding Liquidity

“All of the statistical evidence indicates that the level of household wealth is a major factor in consumer expenditures and indeed apparently finances directly and indirectly about 15 percent of consumer outlays,” Greenspan said. “The impact on consumption expenditures is significant, largely because the amount of wealth is five times the level of income.”

Greenspan ran the central bank from 1987 to 2006, a period in which the S&P 500 climbed more than sixfold, including dividends, according to data compiled by Bloomberg. He reduced interest rates to a half-century low of 1 percent in 2003 and didn’t raise them for a year, helping spur a 16 percent gain in home prices in 2004 and setting the stage for a housing-market collapse that led to more than $1.7 trillion in global bank losses and writedowns.

Fed policy makers pledged yesterday to keep their target rate for overnight loans between banks “exceptionally low” for an extended period after a two-day meeting in Washington. U.S. stocks erased most of their increase and 10-year Treasury yields rose on concern Chairman Ben S. Bernanke is preparing investors for higher interest rates next year after holding them near zero since December.

Mutual Funds

“Financial market conditions have become more supportive of economic growth,” policy makers wrote. Along with government actions, “market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability,” they said.

U.S. mutual funds are poised for their biggest gain since 2003, according to Morningstar Inc. data. Funds that invest in stocks returned an average 31 percent this year, according to the Chicago-based provider of investment research, after losing 39 percent last year.

“There’s no need for a second stimulus,” said Philip Orlando, who helps manage $392.3 billion as chief equity market strategist at Federated Investors Inc. in New York. “People feel better about themselves. They’ve had some of their lost money restored, and now they’re going to go out and spend some of it.”

Jobless Rate

Employers in the U.S. cut the fewest jobs in November since the recession began, and the unemployment rate unexpectedly fell, the Labor Department said on Dec. 4. Payrolls decreased by 11,000, compared with the median forecast for a 125,000 decline in a Bloomberg survey of economists, while the jobless rate dropped to 10 percent.

Ratings cuts by S&P on U.S. issuers have declined each quarter this year, falling to 145 downgrades in the current three-month period from 282 in the third quarter, 554 in the second and 756 in the first, Bloomberg data show. Three-hundred forty-two companies have been upgraded in the second half of the year, compared with 204 ratings increases in the first six months of 2009.

“Equity is there to cushion liabilities,” Greenspan said. “The greater the market value of equities, the greater the support for the liabilities, which means bond prices and their ratings go up.”