Trend Czar

Broken models

One of the open questions coming out of last Fall was how would pension funds approach the looming (now underway) reversal in commercial real estate fortunes. Many observers pointed to the estimated hundreds of billions of dollars of sidelined institutional commitments in opportunity funds just waiting to get into the market at the right moment and cushion against severe value losses. But there was also talk about the denominator effect--where lowered stock portfolio values had increased real estate allocations above targets in consultants mixed asset models. That meant pension funds would need to sell down properties to meet pension consultant formulas just as the market swooned at the edge of a cliff.
 
Of course, many of these same consultants had been providing cover for pension funds to move into more opportunistic real estate investments--adding leverage and going into more risky high-growth overseas markets like China and India. In recent years, consultants were also pushing their plan sponsor clients to sign up with advisors (Wall Street high flyers) whose fees were heavily tied to promotes which would "better align" interests between investors and portfolio managers. The CEO of a more stodgy manager, complained to me last summer, that his firm was penalized by consultants for spreading bonus money around the firm rather than rewarding star portfolio managers with outsized payments.
 
Now after a year of a bear stock market and systemic financial meltdown --the consultant models are in shambles and pension plans wonder how they will meet future commitments to a splurge of baby boomer retirees in the next decade. The shortfalls among public funds will be especially severe. State and local governments will have no choice but to cut back on retiree payouts. Memo to public employee unions: look what is happening today with pension plans at GM and Chrysler. That's where you're headed too.
 
All this means that the capital cushion of sidelined institutional commitments for future real estate investments has lost its padding. Pension funds send signals to advisors that they will not be funding commitments. The queues grow to get out of open end funds. Consultants examine all the data they collect from advisors on fund performance and kick their computers. Their models don't count for much anymore.
 
At least falling real estate values will temper the denominator effect... at least.

Please check out http://citiwire.net/,which features weekly articles from the Citistates Group (I'm an associate).  The Citistates Group is focused on metropolitan regions and how they position themselves to cope with the demanding economic, environmental, and social challenges of the 21st century.

Peace of Mind

The key to recovery is getting America to spend again, economists say. That means people have jobs with reliable incomes and financial institutions resume lending so that businesses can expand and grow. In your typical recession, people lose jobs and when they are hired back, the economy reignites as they begin spending more. This time is different. And nobody talks about it or wants to face up to it, because maybe that's just too depressing.
 
The difference in the 2008-2009 downturn is that so many people, businesses, financial institutions and the government for that matter are in hock. America's recent affluence was based on a mirage of borrowed capital and we certainly borrowed prodigiously on all fronts figuring asset values would keep going up to cover our obligations. For several years borrowing levels even exceeded people's incomes on average and we all forgot about savings. Now the capital mirage has disappeared, but the debts haven't. And since savings levels have been so low, many people don't have any cushions to get them through the current period--their debt holes grow deeper by the day. Even worse, 401Ks have been hammered in the stock market collapse and pension plans terminated by organizations looking to buttress flagging balance sheets--prospects for comfortable retirements vanish for many babyboomers.
 
So now when government stimulus kicks in, the tax rebates and jobs income will go to paying down debt from mortgages, credit cards, and auto loans. Many people will still need to sell their homes or give them back to banks, deflating the housing market for some time to come. And given so many people put so little equity down in the recent buying binge why should they keep feeding mortgages when their home values are well below mortgage values?
 
Shell-shocked folks suddenly won't be rushing out again and spending on new homes and more stuff to put in them any time soon. Our new reality will be deleveraging and recapitalizing, a process that may take many years. I know a woman whose family had been living large in the capital mirage. Her parents had grown up in the Depression and had been very frugal. "I resented it when I was growing up, I thought they could be buying us more things," she related, "but they saved instead, I never understood it until now. I'd do anything to have the peace of mind that they had from saving. I get it now, but I learned too late." 
 
The shift is on from a psychology of spending to a psychology of saving. People are grasping to live within their diminished circumstances, giving up trappings of affluence.  And while the government can print money and ratchet up the national debt for stimulus, people have lost their appetites to borrow and banks, the broken engines of the capital mirage, won't be lending to the credit-compromised. Ultimately the country will need to shrink the government debt burden too--(that's all about higher taxes, but we discussed that a few weeks ago)
 
 Peace of mind has its own considerable value, but it also has a cost.        

No generational boundaries

There's been a bit of generational divide in reaction to last week's blog about "gray and wrinkles"--early 1990s experience coming in handy as we get ready to confront the ugliness in institutional real estate and mortgage portfolios. The younger crowd shouldn't take offense just because they haven't had the opportunity to work through a cyclical low. And the older crowd has no reason to be smug--most went along for the ride in the last few years, as it turns out right off the cliff. I know of a few veterans who told me they were pulling back in '07 and warned others to do the same. But not many. And look at all the big "old" names facing defaults and losing properties with more to come. There are a few celebrated cases of Dads turning over the company reins and seeing their sons leverage up and overpay in '06 and '07,threatening carefully built family empires. But typically Dad wasn't saying no after sending his boy out to test his mettle. Out of control exuberance for making money (is that another way of saying greed?) has no age boundaries.
 
In that spirit, a lot of people begin to get excited about making a next killing in the work out arena. Banks put together swat teams to handle their toxic assets--some erstwhile real estate CEOs sign up and stand ready to move into action when called. Other former company heads put together teams to take over troubled portfolios from pension funds. Former private equity shops convert into workout advisors. No doubt there will be plenty of opportunity for Generation Xers to get in on the action, if they reinvent themselves.
 
No doubt, some players will make big money over time. And "over time" are key words here. Since most  forecasters predict an extended decline and slow recovery, cashing in quickly may not be easy. Just figuring out what is in some of these securitized portfolios may require the patience of Job combined with the perspicacity of Charlie Chan. In addition, I haven't met too many people who get an adrenaline rush negotiating often torturous workouts. And will a vibrant market suddenly regenerate with the banking system in such a shambles?
 
The graybeards understand that it will be a really tough slog before a turn around takes hold. As the sub 40-set is finding out--that lesson is all part of character building. We earn every one of those frown lines.    

Please check out http://citiwire.net/, which features weekly articles from the Citistates Group (I'm an associate).  The Citistates Group is focused on metropolitan regions and how they position themselves to cope with the demanding economic, environmental, and social challenges of the 21st century.

Gray and Wrinkles Look Better and Better

The switch is on...
 
Real estate investment managers transform into asset managers and work out specialists from deal people. It's a matter of survival. To clients, the sell is stick with us so we can help you lose less and protect value. Raising new money isn't in the cards. But taking over portfolios from advisors who drown in problems and don't possess asset management/workout skill sets presents opportunity to build assets under management or at least helps offset some of the inevitable drop off.
 
Not surprisingly, the post-2002 crop of private equity/hedge fund style investment firms face uncharted waters when it comes to managing their real estate holdings. Asset management wasn't part of job descriptions when the strategy was to buy and sell as quickly as possible in upturning markets. You didn't have to pay much attention to holding onto to tenants and cutting operating expenses. Now knowing tenants and understanding bricks and mortar building issues trumps broker relationships. Knowledge of special servicing process and bankruptcy issues has greater currency than pricing acquisition bids.
 
But more than a few investment managers, which grew up in the wake of the mid-1990s recovery, never staffed appropriately to focus on asset management and never knew workouts. They entered into operating partner relationships with "local sharpshooters" to handle managing properties and execute leasing strategies. Interests were aligned as long as operating incomes increased along with values. Now that property cash flow forecasts get trashed and writedowns ensue, many operating partner relationships fray, especially in ventures that used plenty of leverage to acquire or worse yet develop properties. Negotiating refinancings with bankers or dealing with capital calls pushes once friendly partnerships into acrimonious divorce, and fund investors may be caught in the middle. Many advisors discover that managing through these problems is a lot more time consuming and complicated than negotiating buying or selling properties. And of course, the prospects for big promotes and extra fees don't present themselves when you're trying to stanch portfolio losses. It's not fun or highly profitable while you try to handhold upset clients.     
 
The advisors who have an edge are staffed with more wrinkles and gray than recently minted MBAs. Clients get comfort, working with managers who navigated through the early nineties and have the battle scars to show for it--if for no other reason than they are testament to making it through tough times. But these old pros are just better equipped to deal with the problems.
 
A couple of years ago, one of my old colleagues, now more than slightly balding, told me the story of meeting with the early 40-something head of a major whiteshoe law firm's real estate practice. This lawyer wasn't paying much attention to workout issues in drawing up contracts with partners and bankers, and most of his clients weren't paying much attention to what he was doing either. It just wasn't part of the mindset. My friend gave the attorney a copy of his old workout manual from RTC days to provide some perspective and guidance in drawing up the contract for his deal.
 
Well, the new RTC days are here and experience counts for a lot.  

Please check out http://citiwire.net/, which features weekly articles from the Citistates Group (I'm an associate).  The Citistates Group is focused on metropolitan regions and how they position themselves to cope with the demanding economic, environmental, and social challenges of the 21st century.

Trend Alert: The End of Tax Cut Era

With this stimulus bill--we witness the last hurrah for tax cuts.  
 
It was a nice run while it lasted--for much of the past 30 years, and especially the last eight. The idea that we could pay less and get more was particularly effective in winning votes for tax cutter politicians. They said we could have lower taxes and still spend for all those programs we don't want to do without--defense, health care, social security, education, and infrastructure (well not nearly enough on infrastructure). And we could even fight two overseas wars and have tax cuts too.  Tax cutters thought tax cuts would boost the economy, people would become more entrepreneurial and take more chances, and they'd make more, generating more tax revenues as a result. As it turned out, their calculations just didn't work out. And meanwhile, Americans certainly became more entrepreneurial and took more risk, if that means over-leveraging. We all accumulated more (houses, cars, stuff) by liberally borrowing. And the financial markets took more risk by larding up on debt at every turn. Of course, the biggest borrower of all turned out to be the government--the national debt doubled and tripled in recent years. Suddenly we're in recession, verging on depression
 
Now, tax cutter purists say if we just had curtailed more welfare, pork, food stamps, foreign aid, and all the other "government waste", we still could have tax cuts and fight wars. Well, the math doesn't work there either. Those programs amount to a drop in the bucket compared to entitlements and debt service. But hold on, the government pulls out the equivalent of an American Express Black Card and is ready to spend whatever it takes to reverse the recession and stem the financial crisis (brought on by everyone spending more, but paying less).   Tax cutters don't like the spending part, but they still want more tax cuts. As a result, for one more year we will be spending more (a lot more) and paying less (in taxes), which means our debts become even larger.
 
Of course, the irony of this latest round of tax cuts is--just about everyone has less income and capital gains to tax while the national debt balloons--taxpayers will be forking over north of $500 billion in debt service to China and other T-bill holders this year.
 
Obviously, the madness--both on the spending and tax cutting side--must stop. It's not sustainable and never was. If the country wants strong defense, health care, an old age safety net, decent schools, and paved roads--we all will need to pay the government more. That means more taxes and user fees like road tolls and higher transit fares. The yawning national and consumer debt also means we will need to spend less: living in smaller homes, driving fewer cars per household, and wasting less energy.
 
The spend more and pay less days are over. We're entering a different time. Tax cuts RIP.

Will it ever get better?

Remember Didi?
 
She's the lady friend who went shopping for dresses last fall when the stress of family financial meltdown became a little too much. I had a call from her the other day. She said she had reformed--"I'm the brand new Didi." She claims her son understands about eating every meal on the college food plan and not going off campus to splurge with his credit card like he used to. She buys the cheapest stockings and has no trouble flying coach. But she has to keep up appearances and go to the $1,000 a seat fundraisers and that cute $400 dollar dress in the corner store was on sale, a perfect fit for her teenage daughter. Well, at $300 it was a bargain she couldn't pass up. Her little girl was having a rough day at school, you know, and Moms "need to be there". It would make "angel cakes" feel better. New duds have that effect, as we know. But Didi wasn't buying for her self. She's holding back.
 
In the meantime, Didi's townhouse is on the market and the country place may follow soon. "But who is going to buy? It's scary," she asks. "Will it ever get better?" Hubby can't get any traction finding a new job in financial services (no surprise there) and now Obama is clamping down on executive salaries--$500,000 a year won't go very far. Oh and she revealed "entre nous" that she went for one last "special evening" on Friday night to Daniel--being careful to order wine by the glass. "We'll I might not be able to do this tomorrow,"  she explained. She bewails the fate of the real estate mogul she knows whose stock is now under $1. Can you believe it? "He may have to sell all his art."
 
Lucky for Didi she never met Madoff, but she heard through the school grapevine that his grandkids changed their last name. "Oh Lord."
 
Yeah, "Will it ever get better?" The brand new Didi can only hope. 

Delaying the Inevitable

The Treasury Department is delaying announcement of its financial recovery plan (Son of TARP) for another week to figure out the dirty details. It's pretty clear what the end result needs to be--getting banks and other financial institutions to writedown asset values to rational levels. And that means values are headed well below current prices. Only when investors, homebuyers, and lenders are convinced that the market is at or near bottom will more normalized transaction activity take place. And then recovery can begin.
 
Of course, the reason for the delay lies with everyone--the government, the banks, investors and owners. We're all afraid to face the reality of staggering losses precipitated by an out-of-control investment environment. Over the past year we've been in the "Fear of Loss" phase, delaying the inevitable. More recently, writedowns have picked up in a "Start of Recognition" phase. Once the government figures out its program to cushion full recognition, 2009 will turn into the "Slammed By Reality" phase. And reality means that some investors will be wiped out, more banks will fail, and more homeowners will be on the streets. It won't be a pretty picture. So no wonder, we're all putting off this true-up.
 
The government program will amount to "socializing" (that loaded word) the losses--having taxpayers buy up all the bad assets and taking the chance that in disposing of them over time, some of the losses can be recouped. The problem is the amounts could be so large. Remember back in the relatively happy days of Summer 2007 when subprime losses were pegged at few $100 billion or so. Now we are at a couple of trillion dollars and maybe counting. We really won't know until all the banks start pulling back their kimonos.
 
The fact that this process is taking so long gives greater credence to concerns that the problems are worse than we want to know.