RealEstateFlux

As late as September 10, CalPERS announced it was expanding it real estate allocation with $700 million in fresh commitments. The funds in questions went to a JER Partners fund focused on Latin American Investment, and a buyout fund lead by GI Partners. Given the historic federal intervention in markets since September 10, it is an open question how institutional real estate investors such as CalPERS will be impacted. In particular, with real estate being a high profile trigger of the Lehman Brothers blow up, will the sector be tarnished? Real Estate is historically a debt driven vehicle, with a huge amount of capital necessary to make deals. With new financing increasingly scarce since the credit crisis began, it is uncertain how the massive federal bailout will impact the industry. Hopefully the removal of the damaging mortgage portfolios choking balance sheets will allow lenders to turn the page on the credit crisis.

The New York Times | Jenny Anderson & Charles Duhigg | September 20, 2008

Earlier this year, when Lehman’s chief financial officer, Erin Callan, met with some investors at the company’s headquarters in Midtown Manhattan, she exuded confidence. During the meeting an investor challenged Ms. Callan, according to two participants who requested anonymity because they did not want to jeopardize their relationships with senior executives. With firms like Citigroup and Merrill raising capital, the investor asked, why wasn’t Lehman following suit?

Ms. Callan was brusque, the two participants recalled. Glaring at her questioner, she said that Lehman didn’t need more money at the time - after all, it had yet to post a loss during the credit crisis. The company had industry veterans in the executive suite who had perfected the science of risk management, she said.

According to both investors, she said Lehman’s real estate investments were top-notch. “This company’s leadership has been here so long that they know the strengths and weaknesses,” participants recalled her saying. “We know when we need to be worried, and when we don’t.”

One of the more surprising results of the credit crisis to date has been the lack of distressed sales activities. The fundamentals of commercial markets have generally remained in tact, and sellers have been stubborn about getting their price - per their appraisals of 6 months or a year ago.

There is good reason to believe that with the end of Lehman will also come a narrowing of bid ask spreads. Lehman’s commercial debt, securities, and property portfolio was marked to market at $40 billion as of May. Now with the liquidation of this portfolio, price pressure is turning downwards.

The Wall Street Journal | Lingling Wei and Michael Corkery | September 17, 2008

“As a result of Lehman’s bankruptcy, other financial institutions will feel more pressure to sell assets at deeper discounts sought by investors,” said Spencer Garfield, a managing director of Hudson Realty Capital, a New York-based real-estate fund manager.

Goldman Sachs Group Inc. on Tuesday said it had reduced its portfolio of commercial mortgages and securities by about $2 billion to $14.7 billion as of the end of its third quarter, which ended Aug. 29, taking a $325 million loss.

The weekend was unkind to Lehman Brothers as the leaders of Wall Street met to consider their fate and a possible buy out of the investment bank and influential commercial real estate player. Yet after Bank of America and Barclays examined Lehman’s books, they balked. There were no other takers. Apparently no bids for Lehman’s distressed assets were viable, or in and of themselves would have forced Lehman into bankruptcy. Therefore, the cleaner solution became a Chapter 11 filing at the holding company level.

Bloomberg | Peter Robison & Yalman Onaran | September 15, 2008

Fuld waited too long to write off bad debt, then didn’t act quickly enough to sell a stake to raise capital, said Richard Bove, an analyst with Ladenburg Thalmann & Co. In the third quarter, Lehman said it reduced its exposure to residential mortgages 31 percent to $17.2 billion and commercial real estate 18 percent to $32.6 billion. New York- based Merrill Lynch & Co. moved faster under new CEO John Thain, agreeing July 29 to liquidate more than half of its mortgage-linked securities at a fifth of their price and raising $8.55 billion in capital.

Seeking Alpha | J.D. Steinhilber | September 15, 2008

Going into the weekend, the outcome Wall Street was expecting was a buyout of Lehman Brothers. Instead, it got a Lehman bankruptcy, a buyout of Merrill and increased pressure on AIG. These developments have intensified fears of a financial panic.

The New York Times | Joe Nocera | September 15, 2008

Ever since the crisis took hold last summer, most of the big firms have been a day late and dollar short in admitting that their once triple-A rated mortgage-backed securities just weren’t worth very much. And, one by one, it is killing them.

After months of uncertainty, a resolution is at hand for Lehman Brothers. Once a preeminent force in commercial real estate lending, the overextended investment bank is in forced sales talks, hosted by U.S. financial regulators. In spite of CEO Richard Fuld’s announcement earlier this week that the struggling bank had settled upon a restructuring plan, the equities markets voted down the planned measures with massive sales pressure. Lehman’s public shares are down over 90% since last February.

At the root of Lehman’s demise has been an aggressive contrarian bet; a year ago when commercial real estate markets began to slow, Lehman continued pumping out debt and equity investments while many of its peers were reigning in. For the last several months Lehman has been desperately trying to sell these investments, to no avail. Unfortunately, Lehman’s exit strategy for its commercial real estate investments had vanished. Just 12 - 18 months ago, Lehman was regularly feeding its securitization program vast chunks of CRE mortgage debt which were regularly sold off to bond investors, but now these markets are frozen.

The forced sale of Lehman Brothers is a welcome conclusion to the gory saga of Lehman’s implosion. Of course, any strategy which would have sustained Lehman would have been preferable. Yet the months of uncertainty regarding Lehman’s future have weighed heavily on the financial markets. Lehman has been a high profile train wreck, strewing wreckage in slow motion.

Assuming that Bank of America, Nomura, or HSBC is able to acquire and stabilize their platform, our financial system will more quickly get over it and move on. An important question is what level of guarantees the federal government will need to extend to Lehman’s buyers?

Centro’s plans to raise capital were dealt another blow this week as its agreement to sell a portfolio of U.S. retail properties was terminated.

FT.com | Peter Smith | September 15, 2008

Centro, which has a large portfolio of shopping malls in the US, Australia and New Zealand, said in July it had agreed to sell 29 of the 31 properties in the Centro America Fund to a private real estate investment advisor for A$735m (US$592m), at a 10 per cent discount to book value.

After six extensions in the last year, Centro Properties Group has approached its Lenders with a new plan in the hopes of getting more time. Centro is floating the idea of offering a hybrid security to its Lenders allowing them to swap debt for equity in the company. The problem is that this would further dilute the value of existing shareholders, who have already lost 96% of the value of their stock since December 2007.

The initial thrust of Centro’s turnaround strategy was to offload assets, and it has already sold 29 US properties for $714 million according to the Wall Street Journal. Yet Centro is now saying that they will need to obtain new equity commitments in the firm to stay afloat, and Blackstone and others have considered options including breaking off what is left of their US portfolio. Yet looking into the bottom of Q3 2008, Centro believes it is unlikely that new equity can be closed in time to comply with its Lender’s late September and Mid December deadlines.

IHT | August 25, 2008

“While banks have provisioned for their exposure to date, it would be of some concern to lenders that neither asset sales or an equity injection is a near-term possibility,” said a hedge fund manager who asked not to be named because he was not authorized to speak to the news media. Centro said it had begun preliminary talks with its bankers on converting a portion of its debt into some form of hybrid security.”

The Wall Street Journal | Andrew Harrison | August 26, 2008

“Centro will look to obtain debt extensions from its lender group, and has started talks with lenders on terms, the company said. Centro’s Australian lenders include Australia & New Zealand Banking Group, Commonwealth Bank, National Australia Bank and St. George Bank Ltd. Foreign lenders include J.P. Morgan Chase & Co. and Bank of America Corp.”

In a move designed to protect its turf, Walgreens has launched a competing bid for Longs. Given the prior shareholder dissent and now a competing bidder for Longs, CVS’ original deal is in jeopardy.

Los Angeles Business Journal | September 15, 2008

If the deal goes through, Walgreens would acquire Walnut Creek-based Longs’ retail drugstores in California, Nevada, Arizona and Hawaii. The acquisition would include Longs’ prescription benefits management subsidiary, RxAmerica, LLC.

Longs’ shareholders are reportedly looking to scuttle the merger with CVS due to what they believe is an undervaluation of the firm and it real estate.

The Wall Street Journal | Heidi N. Moore | September 5, 2008

“Longs’ largest stakeholder, the investment firm Advisory Research, has renewed calls for the Walnut Creek, Calif., drugstore chain to release details about its real-estate holdings. Longs owns as much as 20% of its 500 stores, and where it doesn’t own, it holds long-term leases struck long before real-estate prices boomed…Investors say that means Longs should be fetching more than the $71.50 offered by Woonsocket, R.I.-based CVS.”

Retailers nationwide are facing the strain of shrinking consumer spending, especially now that  tax rebate checks have already been spent. Therefore, the news of a significant consolidation amongst retail drugstore operators invites questions about possible redundant locations and possible store closures. Reports indicate that CVS is not considering any closures in the near term.

CPN | Michael Fickes | August 13, 2008

“In one of the year’s notable retail acquisition announcements, Longs Drug Stores Corp. has agreed to be acquired by Woonsocket, R.I.-based CVS Caremark for $2.9 billion or $71.50 per share. The purchase price includes the assumption of Longs’ outstanding debt. “

Globe St. | Brian K. Miller | August 13, 2008

“As part of the integration of the Longs chain into CVS, Ryan said CVS will look to relocate 10% to 15% of the Longs stores in Northern California that aren’t already well-located to freestanding locations “if we can find them, but there’s no rush,” he said. In addition, he said CVS would look to learn a little something from Longs about its general merchandise business, which accounts for more of the stores’ overall sales than CVS stores, and use that to improve operations at its existing CVS stores in California. “

Late last year when ULI published their Emerging Trends 2008, both Seattle and Portland were singled out as markets likely to withstand the storms brewing over other West Coast metros. Those predictions are now looking clairvoyant as Seattle is garnering increasing attention for the strength of its markets. A Wall Street Journal Article published this week cites Seattle’s office, retail and apartment rent growth as holding strong. Indeed, this conclusion is borne out by a Real Estate Flux prediction market forecasting the national multifamily market with the greatest rent growth in Q3 2008; Seattle is the 33.52% favorite. Of course, the WSJ piece is careful to cite risks in the Seattle marketplace, not the least of which includes Starbuck’s cutbacks and newly conservative growth strategy.

A participant in Emerging Trends 2008 identified Portland as “a miniature Seattle”, and Portland is also performing well considering broader macroeconomic influences. Globe St. reported earlier this week on the recapitalization of the US Bancorp Tower in Portland. A JP Morgan lead investor sold out of the property while a LaSalle fund acquired the lion’s share of its position. What is notable about the transaction is that the asset basically held its 2006 valuation while in many markets the asset would have lost significant value from any 2006 valuation - further proof of the relative stability of Portland.

Globe St. | Brian K. Miller | September 9, 2008

US Bancorp Tower includes the nameplate 750,000-sf, 43-story high-rise and the adjoining 260,000-sf low-rise office and retail center. The Energy Star property is 96% leased and on track to gain certification early next year from the US Green Building Council. The anchor tenant is Minneapolis-based US Bancorp, which leases 473,000 sf. The lease runs through 2015; about 70,000 sf of the bank’s leasehold is subleased to third parties.

The Wall Street Journal | Maura Webber Sadovi | September 10, 2008

“I wouldn’t say it’s recession-proof, but Seattle’s going to weather the recession a lot better than most markets,” said Stephanie Hession, a real-estate economist with PPR. Still, even with Seattle’s rents largely in positive territory, Ms. Hession says inflation will leave most landlords losing ground.

The owners of Starrett City are currently examining four final offers for the 46 building, 5,881 unit complex in Brooklyn, New York. Yet the owners already sold the property last year to Clipper Equity LLC for $1.3 billion - but Clipper’s winning bid would have required them to bring many more apartments to market rate rents than acceptable to affordable housing advocates.

Starrett City has become Exhibit A in a simmering conflict between tenant’s right advocates and investors including private equity funds and developers. In recent years a popular investment strategy has been to acquire and actively manage affordable multifamily units so as to bring them to market rate rents. However increasing scrutiny and political pressure may make these strategies more difficult, time consuming and expensive to execute.

The new agreement at Starret City between the owners and city, state, and federal housing authorities stipulates that a larger percentage of units will remain affordable. While this will reduce Starrett’s sale price by $300 million or more, it will also guarantee subsidies of approximately $70 million a year provided by the government. These guaranteed subsidies are risk free cash flows, while returns from apartment conversions and expected rent increases are much more uncertain.

A new component of active management strategies for affordable housing projects will need to be greater public private partnership and concessions so as to ensure their success.

Fannie Mae and Freddie Mac have been seized by the U.S. government in a dramatic step to shore up national and global credit markets. Rather than a single equity infusion, treasury Secretary Henry Paulson announced four separate measures to shore up the ailing mortgage giants: (1) Form a conservatorship to manage daily operations and install new leadership (2) Agreement to cover all loses stemming from mortgage defaults, and in return receive preferred stock in each company (3) Creation of secured credit facility for Fannie, Freddie, and Federal Home Loan Banks (4) Purchase of Mortgage Backed Securities to stabilize pricing and add liquidity to frozen secondary market

According to the Mortgage Banker’s Association, 9.2% of outstanding single family home mortgages were at least a month overdue as of the end of the second quarter. With defaults and foreclosures only expected to rise, it is questionable if Fannie or Freddie would survive without intervention. The two GSEs own or guarantee almost half of the $12 trillion in U.S. home loans outstanding, so without a doubt, Fannie and Freddie meet the test of being too big to fail. Yet government intervention and the risk to U.S. taxpayers is at the heart of criticism of Fannie and Freddie in their current forms. Alan Greenspan criticized the inherent incompatibility of their business models: on one hand they promote affordable American home ownership, yet on the other hand they must maximize shareholder returns. To accomplish this, they borrowed at almost risk free rates due to their quasi governmental status, and then lent at market rates. Furthermore, they never were required to meet the capital reserve standard of private competitors, and were only required to maintain about $75 billion to support their $5.3 trillion portfolio. Fannie and Freddie maintained extensive lobbying operations in Washington in order to keep their mandate to stay in business in spite of the risks their leverage implied.

Warren Buffet commented that “Secretary Paulson has made exactly the right decision for the country. He is minimizing the problem of moral hazard and maximizing the benefits for the housing market and for the smooth functioning of financial markets.”

Bush administration officials argued that Fannie and Freddie are too deeply embedded in the economy to allow them to founder. Indeed, many of the measures might be considered too little, too late if Fannie and Freddie became further compromised.

The question is what impact such sweeping measures will have on the housing markets. The new measures are expected to reduce the cost of borrowing and to bolster housing demand. A look at the S&P Case-Shiller U.S. National Home Price Index begs the question of whether home prices have further to fall. The index began the decade at 100, and by Q2 2006 the index reached a peak of 189.93. Now, the index has fallen to 155.32 - still over fifty percent greater than valuations of only eight years ago. See the Real Estate Flux prediction market here.

Bloomberg | Rebecca Christie and Dawn Kopecki | September 7, 2008

“Our economy and our markets will not recover until the bulk of this housing correction is behind us,” Treasury Secretary Henry Paulson, who engineered the takeover along with Federal Housing Finance Agency Director James Lockhart, said in Washington today. “Fannie Mae and Freddie Mac are critical to turning the corner.”

A rash of commercial foreclosure news has hit the markets, including a Deutsche Bank loan on The Drake property in New York, a Gramercy Capital loan on Cupertino Square in Silicon Valley, and the Riverton House project in Harlem. Yet these are examples of mismanagement and overleverage at the height of the market rather than a significant new trend in commercial foreclosure rates. According to Bloomberg and REIS data, the US market with the highest commercial foreclosure rate in 2Q 2008 was Chicago at 0.34% - hardly a significant trend.

Take for instance the Cupertino Square mall in Silicon Valley - mall owners took out a $195 million construction loan from Gramercy Capital two years ago at the peak of the cycle. Now that markets and mall operations have contracted, and presumably because the project couldn’t obtain further financing, Gramercy is looking to seize assets and make its investors whole. This is poor strategy, not a sign that responsible retail operators will start defaulting at any significant rate.

Another sterling example of an overextension is the foreclosure by Deutsche Bank on the $510 million loan collateralized by The Drake in New York City, part of the remnants of the Macklowe portfolio. If Macklowe’s strategy at the time of the Drake acquisition wasn’t predicated upon capital appreciation, with the market already at a high water mark, this would not be a story today. But otherwise, it is a spectacular flameout that is read into for signs of a growing trend in commercial foreclosures. Yet the reality is that commercial foreclosures are still at very low rates.

A white knight in the form of Korea Development Bank (KDB) has entered the fray to possibly bail Lehman Brothers out of its write down turmoil. Earlier this week it was announced that KDB is in advanced talks to acquire a 25% stake in Lehman for as much as $5.3 billion - reportedly KDB is also pushing for an option to increase their stake to 40%. While KDB has not been a household name in the US, a dossier on the firm in The Wall Street Journal emphasizes their ambitions for growth. For KDB, a stake in Lehman may also be an investment in the institutional knowledge of global investment banking - and in the end if no deal is consummated, KDB has certainly raised their profile through this flirtation with Lehman Brothers.

The crux of the matter is that Lehman must announce quarterly earnings at the end of September, and that may include a further write down of $4.0 billion according to analyst reports. Therefore, a timely recapitalization is critical. After another big write down is announced, Lehman’s ability to maneuver will only be reduced.

Lehman is fast becoming emblematic of the Credit Crunch, and it is important for the health of financial markets for them to regain their footing. One need look no further than The Wall Street Journal’s reporting of Lehman’s SunCal investments to see how their appetite for risk grew at the height of the market. Last year when commercial lenders had pulled back and were generally looking for safe haven, Lehman essentially doubled down and kept pumping out commercial property and debt investments.

The Wall Street Journal | Michael Corkery & Susanne Craig | September 3, 2008

“Lehman made many of its real-estate investments using funds it raised from others, selling much of its debt to other investors. But the investment bank ended up keeping $2.2 billion in exposure to SunCal on its books. The firm already has written down the value to $1.6 billion — and could face further write-downs if home prices and land values keep sinking.”

Deal Journal | Heidi N. Moore | September 3, 2008

“The story of KDB is in some senses a struggle between the bank’s ambitions and the government’s needs and wishes. Most recently, Korean government officials warned KDB about making a Lehman investment, even though the bank said it may proceed.”

Forbes | Ruthie Ackerman & Lisa LaMotta | September 3, 2008

“Lehman has tough choices to make in the coming months as it decides whether to raise capital, sell off some of its assets or sell the business in its entirety. “There is no optimal solution here,” said Walter Todd, principal at Greenwood Capital Associates. “Depending on how much capital it needs to raise, utilizing several of these options would probably be the best avenue for it.”

Further credence to the possibility of a spin off of mortgage related assets has been reported by sources familiar with the matter at Lehman Brothers. The Real Estate Flux prediction market indicates a 22.27% chance that a spin off will occur as of Tuesday August 26 at 9PM, PDT.

Bloomberg | Yalman Onaran | August 26, 2008

“Investors in the new venture would also manage the holdings, which are linked to commercial real estate, the people said, declining to be identified because the proposal hasn’t been made public and no decision has been made about how to proceed. The New York-based firm had about $40 billion in commercial-mortgage assets as of May. Lehman, the largest underwriter of mortgage bonds last year, has been trying to reduce assets linked to that market as demand dried up and prices plummeted, generating more than $8 billion in writedowns and credit losses. BlackRock Inc., the largest publicly traded U.S. money manager, is considering a purchase of some of Lehman’s commercial mortgages, people familiar with those discussions said last week.”

Lehman Brothers’ distress sale of CRE assets may be billed as an opportunity for well capitalized players. NYU’s Lawrence Longua is quoted in Commercial Property News as saying that Merrill Lynch’s sale of $30 billion of CDOs to Lone Star Funds “broke the ice” and unstuck prices for this kind of portfolio sale. Mr. Longua failed to mention that Merrill was in a position to offer 75% LTV financing to Lone Star to facilitate the transaction. It is unlikely that Lehman is now in any position to offer such generous terms to bidders on its CRE portfolio.

Mid September marks the end of Lehman’s third quarter, and rather than the modest profits they had hoped to report, analysts estimate that actual losses will range from $1.8 to $2.6 billion. Losses of this magnitude may necessitate further capital raising in their race against real estate write downs.

Dealbreaker.com cites anonymous sources privy to the portfolio sale who say that there is a wide price gap between Lehman and potential buyers and that negotiations have stalled out. It has been widely reported that Blackstone and Blackrock are the two most viable buyers, but other contenders include Colony Capital, and J.E. Robert Companies.

The problem is the wide spread between Lehman’s pricing and buyer’s expected discount, in spite of the fact that FT.com has reported that “Lehman has offered to shoulder the first $5bn of any losses suffered on the portfolio’s assets following a sale”.

Reports vary as to the size of the portfolio: Lehman may be offering $14 billion of their CRE assets (Bloomberg) or $40 billion (FT.com). What is clear is that Lehman valued its CRE portfolio at $52 billion in November, and as of May it was written down to $40 billion. Since May, Lehman’s stock is down 72%. If quarterly losses continue, Lehman will be forced to raise more than the $13 billion thus far to support itself against the $8 billion of its  cumulative write downs.

FT.com | Henny Sender | August 16, 2008

“If the sale talks fail, Lehman is believed to be considering spinning off the entire commercial property division and listing it separately, people close to the discussions said. Such a move might not raise much fresh capital but could help Lehman to dispel the concerns over its balance sheet and financial health that have dogged it for the past few months.”

Bloomberg | Jonathan Keehner and Sree Vidya Bhaktavatsalam | August 13, 2008

“Bove expects Lehman to sell its entire $29.4 billion commercial mortgage portfolio. The firm also owns $10.4 billion of property. It may record a loss of $4.9 billion on the sale of the commercial mortgages, Sanford C. Bernstein & Co. analyst Brad Hintz estimated in a report last week.”

The Wall Street Journal |Randall Smith and Susanne Craig |August 18, 2008 |

“In the past few months, Lehman officials have examined an array of options to bolster the company’s financial position, ranging from selling troubled real-estate assets at a discount to divesting a piece of profitable asset-management unit Neuberger Berman, according to people familiar with the matter.”

“Another stock offering would be hard to pull off without angering existing shareholders, largely because the tidal wave of common shares floated in June has since plunged in value by 42%. Lehman shares slipped three cents, or 0.2%, to $16.17 each in New York Stock Exchange composite trading at 4 p.m. Friday.”

Dealbreaker | John Carney | August 18, 2008

“The speculation is that Lehman may simply try to spin off the assets into a separate entity, in a Good Bank-Bad Bank scenario. But that move is also being criticized. “A spin-off could meanwhile mean taking an upfront hit to capitalise the newly formed entity, without raising funds for the core business,” Lex writes in their cutie-pie British way.”