Trend Czar

Trying to Find Silver Linings

I’m preparing for next week’s unveiling of Emerging Trends in Real Estate 2010 at ULI in San Francisco. I won’t be giving away the store to say next year won’t be the greatest in industry history…  I know audiences don’t want to hear all gloom and doom (who needs to sit through a downer?), and there will actually be some positive things to say. But can anyone feel good about where the economy is headed right now and especially the jobs outlook?

One of my colleagues, who knows I’m a glass-half-full-kind-of-guy wants to showcase an upbeat view and argues with me that the last six months of outsized stock market performance is a leading indicator of better times ahead and the “statistical” economic recovery is more good news. Certainly, the economy has bottomed and companies are producing better results by comparison over a year ago’s dismal performance. This has been accomplished in large part through productivity gains—slashing jobs and occupancy costs. And finance stocks have bounced part way back thanks to government infusions and trading gains off market lows.  But hate to say it, government prognosticators, who always look for a silver lining, are certainly under-promising in recent pronouncements—they see unemployment continuing to increase well into next year even with stimulus spending having an increased impact on creating new jobs.

And although the stock market, in fact, did its usual good job in predicting the end of recession with a six month performance spike, the surge appears to be over unless companies show they can ramp up production and their markets start buying again.  Now stocks shouldn’t collapse, but it looks like they’re sputtering—the dollar slide, the prospect for higher interest rates in the future, state and local government cuts, and long-term consumer and government deleveraging don’t paint a rosy picture.  The recent increase in house buying has been helped along by government tax credits and the cars for clunkers program temporarily boosted the automakers. The rate of jobs losses ebbs and more companies finally will start hiring next year as inventories need to be restored. But do we think the economy can stand on its own without all the government supports? For an answer, Congress extends unemployment benefits and considers extending the home buyers’ credit. Most realtors think home sales could go into a winter deep freeze without the tax break.

And then there are our in-full-scale-free-fall commercial real estate markets, which every week help to take down more community and regional banks. Capmark, aka GMAC Commercial Mortgage (a former employer of mine), once the largest commercial real estate lending organization, finally entered bankruptcy over the weekend.   In 2006, two private equity firms (Five Mile and KKR) bought a majority interest in GMACCM and did what private equity firms do—gutted the company of employees (productivity gains) and heaped on debt in a bond refinancing (to pay themselves an early return on their investment). These investment playmakers ran out of time to make their planned highly profitable (for themselves) exit in an IPO when the market collapsed—and ended up with the worst of both worlds—an overleveraged debt business that had lent too much just before the market cratered. And now we wait anxiously for the inevitable--more Capmarks and more Peter Cooper/Stuyvesant Towns.

So to put a good face on what’s happening--the economy may be at the start of recovery after bottoming. But that translates into things can only get better. And right now that’s still not saying much.

Dealmaking or Operations

Of course, the push back on government financial regulation over trading businesses isn't surprising. The people who run the big financial firms and who dole out massive political campaign contributions have had a good thing going--massive compensation with little downside risk to their personal fortunes no matter the recent credit market meltdown. Who wouldn't want that game, supported when necessary by bailouts and cheap Federal borrowing rates, to continue. Sure some big shots--Lewis, Thain, Fuld, Grasso-- have been washed out with damaged reputations. But on the Wall Street scorecard--how much money you make--these guys are still well ahead of the game.

Real estate players don't want to see big changes either--they want the Wall Street firms to rebound and fill up office space especially in New York and other major markets. And most of all they want the CMBS market to revive to float transaction volumes again. Deals mean fees and promotes and big compensation numbers.

But all this activity is about brokering and trading, not creating anything. Our economy and the real estate business can't sustain itself off dealmaking.  We learned the recent value gains from ramped up transaction volumes were a mirage. Office rents in many markets are back to 1980s levels and most of our jobs gains over the last decade have been wiped out.

The next five years climbing out of the current debacle will be about whether real estate backslides into a transaction-fixated business or orients more to operations and development. If the government implements only lackadaisical reforms and allows unrestrained capital to flood the financial system, transaction markets will come back in full force and middlemen will be back in business. But more regulation would restrict debt capital from higher risk plays and tamp down on transactions. Real estate investors would go back to earning profits off of down-and-dirty asset management, leasing and development strategies, not so much ephemeral financial structuring and trading. It will be a more boring business and less lucrative, but with less risk to the system.

The traders argue bringing back their business will create more jobs to fill buildings and their high incomes will fill tax coffers and support the consumer economy. It's the transaction business, they say, that made the good times so good for many people in our business.

But it's the transaction dominated business that has precipitated such bad times today and taken the banking system to the brink. Asset values haven't been enhanced, we haven't produced anything lasting that advances the world or the economy. The only leftover gains come from transaction fees and promotes, extracted from the deals.  America can't sustain itself going back to this. Neither can the real estate industry.   

The reality of austerity

No politician would dare say it--Americans spend (waste) too much and aren't taxed enough. But we need to spend less and save more at the personal level, and should be taxed more to pay for programs we all want like social security, medicare-health care, and defense. And we must insist on getting better value for every dollar we spend personally and by elected officials. Our freely elected government has led us into the ditch of huge deficits and massive debt service payments to foreign countries, because we bought the Kool Aid about having more by getting taxed less and borrowing to make up the difference. Now that the bills have come due it's doubly hard to change--it means a period of difficult austerity. But neither Democrats nor Republicans want to own up to it--since they want to get re-elected. Who has ever won on a platform of higher taxes and reduced programs?

But essentially that is what is going to happen to us. We can see the future by looking at state and local governments, which are forced by law to balance budgets. Property and sales taxes increase, the number of user fees expands. You pay more for car registrations and fishing licenses. Tolls go up. Cigarette taxes and parking fees increase. We get nickle-dimed and quartered everywhere. But people scream to keep schools funded and sanitation and police service untouched. They want roads repaired. So income taxes may have to increase too. And no official wants to see  the state bond rating go down, which would boost borrowing costs and dig a deeper fiscal hole. So governors and mayors close parks and slice at welfare spending.

At the personal level we can't afford to buy bigger houses that cost more to heat and cool, and we can't afford to spend as much driving around to get everywhere not only because it wastes a lot of time in traffic, but also because it costs so much--gasoline, insurance, repairs et al. And we won't be able to buy as much in malls and lifestyle centers or even on line, because we just don't have as much to spend and can't get as much credit. Although at least if we shop on line, we can save time and gas costs.

Now it would help everyone if our economy started to cook, more jobs were created and we could pay off our debts more quickly. But nobody and I mean nobody is talking about a sudden rebound.

So the trend lines are pretty clear--living closer to work in smaller homes, shopping less at malls, and saving more, while paying increased taxes. The politicians and the ideologues can yack all they want and throw blame around. It won't change the realities.  

Confronting the CMBS problem

Everyone I talk to says the key to real estate market recovery is resuscitating the CMBS markets. There’s plenty of equity “on the sidelines,” but without credit and refinancing sources, the capital markets will stay frozen. Ironically, the CMBS concept helped jump start market recovery 15 years ago, bringing new sources of capital into property sectors when banks and insurance companies were reeling from a prodigious round of poor-underwriting induced red ink. Now the moribund CMBS market hamstrings prospects for a near-term turnaround.

A year after TARP was enacted, the U.S. Treasury Department finally puts in place a scaled down program to help banks unload troubled mortgage securities. The Feds will match investments and provide a credit facility for big investment banks and their clients to buy problematic CMBS at significant discounts.  Of course, this is another classic case of the guys who engineered the mess with all their structured finance and reaped huge fees along the way, now getting taxpayer assistance to make more money with low risk in cleaning up the problems they helped create.

The government initiative—called the Public-Private Investment Program (PPIP)-- effectively provides matches and guarantees that will generate about $12 billion in troubled asset purchases—mortgages and CMBS--by private investors, about half the money coming from taxpayers. Well, it’s a small start at least, considering that worldwide financial institutions have about $3 trillion of bad mortgages and CMBS on their books. In the U.S. about $50 billion in CMBS loans mature in each of the next five years and will need to be refinanced. Many of these loans are or will be in technical default because properties have lost so much value.

Of course, the hope is PPIP will help markets identify a pricing floor and unfreeze the transaction universe so more bad assets can be moved off financial company books. Once that happens, the game of hope and pretend will be over--borrowers, lenders and owners who have been putting off their day of reckoning must finally recognize the extent of their losses.

Whether PPIP works or not, time inexorably moves markets closer to finding bottom. More borrowers will start giving back underwater properties since the lack of tenant demand savages cash flows and makes it ridiculous to keep servicing debt. The FDIC will step up assets sales from portfolios of failed banks it has taken over.

But then government regulators, bankers, and ratings agencies must figure out a system for restoring confidence to bond buyers so they have some idea what they are investing in when they buy CMBS. Self regulation--ha, ha—certainly didn’t work. And it makes no sense for offering sponsors to pay rating agencies for their imprimaturs. Nobody wants to deal with these thorny issues. And in the meantime, lawyers, special servicers and bond holders steer clear of confronting the bugaboo of who owns what and what it is worth in the ball of confusion of existing CMBS.

If recovery depends on the CMBS markets, we have a long ways to go.   

Dealing with change

"Change is good." That's what the head of an acquiring company once told me and other employees of a business he was taking over. For all the spin about mergers and acquisitions being good for companies--the majority do not pan out except for the bankers who engineer the deals and then later often come in to disassemble the conglomerations. In the case of my company, change didn't feel good and turned out to be bad. Indeed the business failed and had to be sold off in parts with many people losing jobs along the way.

But whether change is good or not, isn't so much the issue. Change is inevitable and often how well people and businesses cope with change determines how successful they can be.The need for change typically signals that our systems, businesses, and lifestyles need modification. The way we have been doing things can't be sustained without re-adapting. That's what's happening now in the U.S. and it's a struggle for all of us, especially when we have thought of ourselves as number one, impervious, the beacon of the world, etc., etc., etc., blah, blah, blah.

The U.S. economy and real estate businesses are dealing with a wellspring of change right now. Our high wage scale businesses are under relentless pressures from lower cost competitors overseas. The government and many consumers are overleveraged, and we must pay down our debt and spend less. The transaction-based economy of the past several decades has hit the wall without easy credit and all the middlemen, including brokers and lawyers, who made hefty incomes off lots of deals are on their backsides. We need to re-regulate the transaction markets to tamp down bad behaviors, which will limit future transaction volumes and broker/banker profitability. The investment industry will fight that change. Then there's healthcare and all the concern about transforming a system that everybody agrees doesn't work that well and is certainly economically unsustainable. But many people and businesses fear that any change could disadvantage them and oppose reforms. At the fringe, some folks worry about government takeover.

They see too much change and that's just too scary--they just want things to stay the same. But then they lose their jobs or their benefits shrink and they have those credit card bills to pay, and the IRS is just the enemy. Change is just plain bad. But it's happening whether we like it or not, and we can't stop it.

At my old company, most people I know re-invented themselves and found new pursuits--in many cases better jobs. They adapted and moved on. Change wasn't easy or preferable, but turned out okay, even better than okay. We all have to take that to heart.