REITs Racing to Bankruptcy

With vacation season ending in the Northern Hemisphere, we’ll start to see analysis rooted in experience and common sense driving stock prices. Through much of the summer, trading has been dominated by “quant” funds that are prone to “garbage in, garbage out” decision systems. You can see it in the tick-by-tick movements and in Level 2 quotes. These quant funds typically use backward-looking data on the U.S. economy to drive trading decisions, rather than assess how the outlook for the global economy has changed in the wake of last fall’s panic.

Consider this likely scenario: The heavy retail investor inflows into corporate bond funds last spring (far in advance of the peak in defaults, by the way) undoubtedly helped push corporate bond spreads down. The quant funds’ models detected this movement, concluded that the recession might be over, and proceeded to buy stocks that are highly sensitive to future U.S. consumer spending — including banks and REITs. This scenario likely explains some of the rally in bank and REIT shares, which occurred far in advance of the peak in credit losses.

This type of scenario could easily reverse this fall as experienced stock and bond fund managers start to question why they own barely solvent financial companies at valuations that imply 4-5% real GDP growth over the next two years. Huge swathes of the financial sector are insolvent (the mark-to-market value of assets is less than liabilities), and the debate over mark-to-market accounting boils down to whether losses should be recognized up front or over long periods of time. The losses are not going away, and were baked in the cake as soon as the bubble-era loans were made.

Last fall’s panic was not really a “black swan” event; it was the realization that much of the banking system was insolvent and at the mercy of electronic bank runs. Last fall, I thought that at the very least, the authorities had a plan to wind down Lehman in a controlled manner. Instead, Lehman went into forced liquidation and took the “shadow” banking system down with it. Our Lehman puts were huge winners, but even I was surprised at how quickly Lehman stock went to zero.

The issue facing REITs parallels that of the banks: an industry-wide solvency crisis. Only REITs lack access to enormous subsidies from the Federal Reserve, which include the manipulation of borrowing rates down to the range of 1%, resulting in a profitable spread on new lending.

If you carefully consider the combined statistics on commercial mortgage debt, equity, and future rental cash flows, you come to the conclusion that the value of many REITs is permanently impaired. Even if a core group of higher-quality REITs escapes bankruptcy, their equity will still be impaired because lenders will only refinance properties on very tight terms: strict covenants, high interest rates, and requirements of hefty equity infusions into upside-down properties. This is a transfer of wealth from REIT shareholders to creditors. This wealth transfer is occurring through many channels, but the most important one relates to claims on future rental cash flow, which will be bleak regardless of who owns it:

  1. Creditors will take a higher share of those rental cash flows via higher interest rates
  2. Of the cash flows that trickle down to shareholders, they will be divided up among more and more REIT shares as we see more and more dilutive secondary offerings

This unprecedented collapse in commercial real estate fundamentals means that for the next few years, you can throw out the analyses that rely on “cap rates” to value REITs. Distressed sellers and vulture buyers will make up the bulk of commercial real estate transactions for at least the next few years. Equity looking to invest will be scarce, so it will demand very low prices and high potential returns to invest.

Between now and 2013, $1.6 trillion in commercial real estate debt will mature. Bankers know this, so they’re going to keep conditions very tight for any refinancing that they grant. Plus, a hefty chunk of this debt is held by commercial mortgage-backed securities (CMBS), in which the lenders cannot sit across the table and renegotiate with stressed borrowers; owners of senior CMBS tranches will want to liquidate the collateral to get paid back, while owners of the junior tranches will want to refinance and pray for a recovery in value. I expect the motives of the senior lenders to win out, resulting in lots of property liquidations.

REITs Selling Must Compete to Dump Properties

Lots of REITs have plans to sell properties to pay down debts but… Sell to whom? And at what sort of price? Yet REIT investors seem unaware the hundreds of billions in new equity that creditors will require to refinance mortgages that were made during the 2006-2007 peak in values — and what that catalyst will do to the value of their equity.

On Wednesday, The Wall Street Journal ran a story that relates to this theme: “Tishman Faces Office Downturn.” Link in Web Version Only. The article describes the tough choices facing privately owned real estate investment partnership Tishman Speyer, which owns Manhattan landmarks like the Chrysler Building and Rockefeller Center.

Tishman also owns a levered portfolio of Washington, D.C., properties named CarrAmerica. You’d think that with all the crony capitalists flocking to Washington the lobbying business is booming. But apparently, even lobbying is not a strong enough business to justify CarrAmerica charging the pricey rents it needs to pay its mortgages. The WSJ describes the financing problem:

The Tishman partnership that bought the CarrAmerica portfolio has been in talks with its lenders, led by Lehman Brothers Holdings Inc., since late 2008 about modifying the credit agreement, according to S&P. But so far, nothing has happened and, until now, the talks have been kept quiet. “We have confidence in the long-term value of the properties,” Rob Speyer said.

S&P warned even if Tishman wins new covenants, its ability to refinance the loans in 2011 “will likely require additional capital investment or a recapitalization.” [emphasis added]

The Tishman mortgages were one of many credits that Lehman was marking at fantasy levels. As it turns out, the bears on Lehman were right: The loans that Lehman provided to Tishman to finance its acquisition of Archstone-Smith were impaired soon after they were underwritten.

What will the Tishman family do about its privately held portfolio? How much debt is carried against Tishman Speyer’s properties? I get the impression that it’s a lot, considering Tishman’s aggressive behavior at the market peak (as opposed to, say, Sam Zell, who unloaded a ton of properties onto Blackstone and Maguire, which will both wind up losing most or all of their equity). Tishman Speyer will probably hit a lot of low bids on its second-rate properties to raise the cash that banks will require as new injections in order to refinance — and keep to deeds to — its trophy properties.

The smart money in commercial real estate — including Sam Zell — certainly sees the mountain of debt maturities coming down the pike. Investors will certainly be looking for bargains in commercial real estate, and they will find the best deals in either foreclosure auctions or purchasing commercial mortgages from stressed banks at a discount.

Dan Amoss

August 27, 2009

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