Vornado Realty attempts to breathe life into CMBS

Another large REIT is tapping into government money and at the same time, trying to restart the CMBS engine that drove the commercial real estate industry through the last cycle.

Keep your fingers crossed.

Read the whole article here: http://online.wsj.com/article/SB124880426449487319.html

Forbes: Making a Case for Real Estate (Sort of)

Just got done reading the latest issue of Forbes - and I was excited to see a whole section on real estate investing. Unfortunately, I was disappointed once again by the mass-medias complete misunderstanding (maybe thats too harsh) of Commercial Real Estate. We'll correct some of the errors here, then its good reading.

Art. #1: Why REITS Make Sense:

http://www.forbes.com/forbes/2009/0803/real-estate-commerical-property-why-reits-make-sense.html

This isn't a bad article, only it fails to bifurcate real estate into its two components: residential v. commercial. They are not the same, not even close. So when the author states "[he] chuckles at how poorly he fared in his only direct property investments. He recently lowered the asking price on his four-bedroom Tudor house, which he built on 1.5 acres in 1983. If he manages to get the $385,000 he's now listing it at, the house will have returned 1.5% a year, not even keeping up with inflation. REITs generated average annual total returns of 9% over the same period" it's misleading. You can't compare the two, they operate on totally different fundamentals. Commercial real estate will outperform residential over every time period, simply because it is built to. People buy homes to live in them, not as an investment. The Author makes this mistake again in saying "Buy a $100,000 property and closing costs can easily run $3,000. Assuming you put down $20,000, that represents a one-way drag of 15%. Sell and your Realtor is likely to skim off a 6% commission. REIT operators absorb some of these same costs, but at least you can get in and out of their shares at their prevailing market value. The Simon REIT runs up overhead of 0.8% of assets annually; this is on top of operating costs (like janitors' salaries) of the sort that any property owner incurs." Again, this isn't apples to apples. I would think it would be more compelling to compare net lease investments (single tenant stores, etc.) to REIT investments if you want to compare direct investment to REIT investing.

The author also misses out on another key component of REITs versus direct real estate investing: REITs are invested in pools of properties. This diversification is a HUGE advantge. It means the investor is less exposed to a particular region, sub-market, tenant, or a number of other factors that can be road hazards to investors building their own portfolios.

I like the remainder of the article, it is compelling. Worth printing out and saving.

Art. #2: Rent Out Your Home. Cut Your Taxes:

http://www.forbes.com/forbes/2009/0803/real-estate-rent-residential-home-sweet-tax-break.html

This is a good article for people (like me) who decide not to sell a home they used to live in and instead rent it out. It cites the tax reasons for doing so, and albeit there are a couple of minor errors, it is a good representation. What I think readers need to keep in mind is that the changes to the tax code in 1986 were specifically geared toward thwarting the abuse of real estate tax benefits. Congress left many of the tax benefits for real estate professionals (like me), but put significant restrictions on passive investors. So, reader beware: Unless you make LESS THAN $100,000 per year, joint with your spouse, OR you are a real estate professional, your tax benefits will be significantly limited, most likely to zero. In my prior life as a CPA, I can't count the number of people I had to break this news to. I repeat, reader beware. Renting your house better make sense when comparing your rental income to your mortgage, or it's not worth it.

Art. #3 (my favorite) How Much Real Estate Should You Own

http://www.forbes.com/forbes/2009/0803/real-estate-reit-housing-dividend-property-poor.html

This article hits the nail on the head when it comes to the 'my house is a real estate investment' argument. It's not. End of Argument. The author also makes a case for allocating 20% or more of an investment portfolio to commercial real estate. I agree. In studies I will address here later, you will see that adding real estate (especially private, low-leveraged real estate) reduces volatility and increases returns over nearly every time period since the industry began tracking those yields.

Here is the trick to interpreting the authors suggestion that you increase your exposure to real estate: you HAVE to do it right. If the vehicle (REIT) you are investing in has legacy assets (those it purchased between 2001 and 2007) you need to verify that those are priced to market, or reasonably close to it. In addition, not every REIT or syndicator will have the capital to take advantage of the current buying market, nor do all of them have the expertise. Yes, fortunes will be made by buying today, but only by those with the capital AND the experience to play the market right. A very wise person told me early in my career: 'Real Estate is a street game, either you can play it or you can't; you're either in, or your out'. I have spent the entirety of my career since then staying close to people that are 'in'.

Todd

REIT Equity Offerings Strong in 2009

Found a REIT.com link that shows capital raised by public REITs since 2001. The numbers are interesting. IPO's are down in 2009, but the year is on pace to have the largest capital raised through secondary (follow-on) offerings in the past 8 years. Seems the REIT space is a good place to be.

http://www.reit.com/portals/0/files/nareit/htdocs/library/industry/HistOff0906.pdf

Developers Diversified to Sell TALF-Backed Bonds

By LINGLING WEI - wsj.com

Shopping center giant Developers Diversified Realty Corp. is working on raising $600 million through two bond sales that promise to be a litmus test for one of the government's key economic rescue programs.

Those deals are on track to be the first major offerings of commercial-mortgage-backed securities that will take advantage of the Term Asset-Backed Securities Loan Facility, or TALF, program. TALF is designed to jump-start lending by increasing investor demand for securities tied to all kinds of assets, including consumer and commercial loans. As long as banks can move loans off their books by repackaging and selling them as bonds, they will be able to make more loans.

Read more on www.wsj.com

Let's cross our fingers and hope this grows into something more owners can benefit from (other than just the giants).

S&P Changes mind on CMBS Rating?

What in the world is going on here:

By Sarah Mulholland - from Bloomberg.com

July 21 (Bloomberg) -- Standard & Poor’s backtracked on ratings cuts issued last week and raised the ranking on commercial mortgage-backed debt from three bonds sold in 2007.

The securities, restored to top-ranked status, had been downgraded as recently as last week, making them ineligible for the Federal Reserve’s Term Asset-Backed Securities Loan Facility to jumpstart lending.

S&P lowered the ratings on a class of a commercial mortgage-backed bond offering from AAA to BBB-, the lowest investment-grade ranking, on July 14. The New York-based rating company reversed the cut today, S&P said in a statement. In a related report, S&P said it adjusted assumptions on the timing of projected losses on the mortgages.

“It is a stunning reversal and certainly raises questions concerning the robustness of their revised model,” said Christopher Sullivan, chief investment officer at United Nations Federal Credit Union in New York. “It may engender further uncertainty with respect to ratings outlooks.”

Debt rated below AAA isn’t eligible for the Federal Reserve’s TALF. Investors sought $668.9 million in loans from the Fed to purchase so-called legacy commercial mortgage-backed bonds on July 16, the first monthly deadline to finance the purchase of the securities.

- Again, stay tuned, not sure what is going to happen next...

TALF

Paul Bunby gave us a TALF update on GlobeSt.com.

See the article here: http://www.globest.com/news/1454_1454/newyork/179891-1.html

From this and a bunch of reporting I saw on Bloomberg tv over the week, it looks as though the market for existing CMBS issuances has stabilized. According to Bunby, it has not affected new issues to date, but it appears as though we may see a break in that iceberg soon.

"Earlier this week, CMBS experts told GlobeSt.com that the TALF program stood a chance of succeeding if the pieces fall into place. 'The reason no one applied for the first round is that there simply was no new product in the marketplace,' Spencer Levy, senior managing director with CB Richard Ellis, told GlobeSt.com on Tuesday. 'The view I’ve gotten from the marketplace has been a bit warmer than what some suggest, particularly from some of the originators,' because 'they see some purchasers of their CMBS securities are going to be able leverage it up using TALF capital.'"

Stay tuned, this could change everything.

Todd

Commercial Real Estate Investment Handbook

I am writing a book on commercial real estate investment for the benefit of passive real estate investors to better understand commercial real estate fundamentals, metrics and trends.

I plan to post sections here for comment. Thanks for your help!

CHAPTER 1

Why Invest in Real Estate?

Real estate is a gripping investment. Many individuals, families, and institutions have created and sustained generations of wealth from real estate. Real estate has created icon’s like Donald Trump, it has been featured in numerous Hollywood hits like Glengarry Glen Ross. Real estate has been given credit in many clichés “Buy land son, they aint makin’ any more of it.” But in today’s fast paced environment, we have to elaborate beyond that. There must be something compelling about real estate; something that drives its value up. Over my career, I have narrowed it down to four main factors: (1) attractive yields, (2) relatively stabile value, (3) non-correlation to other assets classes, and (4) income tax benefits.

Yield

Yield is probably the main driver for most investors. Real estate is rented to third parties through leases, creating a stream of rental income. Real estate also tends to increase in value over time, tied for the most part to inflation. That is, rents tend to increase over time and thus the value of the property increases generally as the rental income increases. When underwriting properties, it is a mistake to include growth in value from increasing rents and add to it an additional growth factor for inflation, however, they are tied together through rents.

Real estate also provides yield from the repayment of debt. Most mortgages require debt be repaid (amortized) over a set time period. When an investor sells a property, the amount due on the loan is often lower than the amount borrowed. It is somewhat like a forced savings account.

Yields over time have fluctuated, but annual real estate yields tend to be higher than both public stock dividends and most investment-grade bond rates. Total yield on the realizations of gains tends to be 1.5 times to 2 times the annual yield on the property. For example, a typical investment in 2005 was projected to yield an annual cash return of 8% and yield upon sale of 12% to 16%. This is higher than expected return on stocks and significantly higher than historical bond returns.

Several groups have set out to track values of commercial real estate and have created tracking mechanisms and valuation models. One of those groups, the National Council for Real Estate Investment Fiduciaries, “NCREIF”, has created the NCREIF index. A ten-year example is illustrated in table 1.1 Table 1.2 on the other hand, shows the S&P 500, an index of the 500 largest companies in the US over the same time period.

As an investor, these numbers can be verified and are widely available on the internet. A researcher can play around with them and come up with different results over different time periods, or use averages, moving averages, returns on $100 over time, or any number of other techniques, but most of the time investors will find real estate yields are attractive when compared to other asset classes.

Stabile Value

Commercial real estate values tend to remain relatively stable over time. Another quick look at the NCREIF (table 1.1) quickly verifies this. There are several reasons for this but two really stand out as the cornerstones. First, most buildings have long-term tenants and rollover is infrequent. Second, investors tend to buy and sell commercial real estate much less frequently than investors buy and sell stocks.

Rents, in essence, represent a historical moving average. That is, they are historical because the leases were signed in the past and represent the market leasing rates at that time and they are a moving average because tenant rollover happens at intervals. The result is similar to dollar-cost-averaging when investing in stocks or mutual funds. Landlords keep a snapshot of their leases in a file commonly called the ‘rent roll’ (see example). A good rent-roll is one that is staggered with leases expiring in different years, so the investments is exposed to multiple points in the cycle.

Investors also tend to hold on to real estate given high transaction costs and the lead times it takes to sell a building. Costs of sale can be disposition fees, selling broker fees, title costs, shoring up deferred maintenance, etc. Selling fees can often be five percent (5%) of the value of the building or higher. Acquisition costs can include acquisition fees, buyer broker fees, legal costs, title examination, survey, structural reports, appraisal, loan origination fees, etc. and can likewise be as much as three to four percent of higher. All considered the cost to both parties can be as high as ten percent, which is a significant deterrent to frequently buying and selling real estate.

---

Non-Correlation to Other Investments

This book will describe real estate cycles in more detail in later chapters, but for the purposes of correlation, commercial real estate has a relatively low correlation to other traditional investment asset classes such as stocks and bonds. Readily tradable instruments tend to fluxuate, sometime wildly, in value. This leads to low correlation in some respects. Add to that, however, that real estate cycles are often not in direct correlation with general business cycles. Real estate cycles are driven by the rental income an individual property can generate. Rental rates in turn are driven by the supply and demand of tenants and leasable space in the immediate sub-market.

When it comes to correlation to general economic cycles, things get a little muddier. In normal times, I would still say being in the right submarket at the right time with a good location will trump economic cycles, however, this latest economic disaster has proven otherwise. Many well-located, well-leased buildings are going to suffer in a deep enough economic recessions. The perhaps over-simplified reason is jobs. Jobs affect tenant demand for leasable space. When jobs fluxuate in the overall economy by 1-2%, sub-market demographics play a far greater role in determining rents, but a wild fluxuation in unemployment will inevitably affect all rents.

Income Tax Benefits

Most tax experts will tell you real estate is one of the last bastions of tax shelters. Depreciation is the key. The US tax code allows taxpayers to take an allowance for the depreciation of an asset whether or not the value actually went down. This allows taxpayers to essentially write-off the cost of the investment against the income received. If the asset is later sold for greater than the cost less any depreciation, then the depreciation taken earlier is simply recaptured. This book will go into further detail on the tax benefits, how to take advantage of them and how to avoid potential pitfall in a later chapter. For now, suffice to say that many investors are attracted to real estate by the potential for partially (or totally) tax-free cash distributions. This puts real estate in a small class of investments that allows individuals living on the cash flow from their investments to live with relatively low income taxes, thus maximizing their lifestyle.

Join My Group on LinkedIn

My group on LinkedIn, Commercial Real Estate Investment Professionals has more than 7,900 members who are linked to the commercial real estate investment industry. Members are from all over the world. Make use of news feeds, discussions, and postings. I am planning to add new features to the group in coming months that will benefit you as a professional.

Go to LinkedIn.com and start networking with me. Lets create our futures together!

Todd

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The Eggheads Were Right After All - maybe...

Jon Fosheim, formerly of Greenstreet, argues that REITs should not have taken on any debt and that debt to a REIT is nuetral to their value.

Read the article at: http://www.realestateportfolio-digital.com/reportfolio/20090708/?pg=46&pm=2&u1=friend

Fosheim's conclusion may well prove correct, but his argument is flawed. Hindsight is easy in economics and he argues that he and his former cohorts at Green Street got it right. We shouldn't be so quick to pat him on the back. He makes the point that as REITs add debt, their equity multiples (similar to cap rates for the real estate folks) adjust to meet the new risk. What this article fails to explore, however, is a very important point. Adding debt to a REITs balance sheet, whether at the property level or at the entity level, is simply a bifurcation of risk. That is, a lender takes on the least risk, but in return gives up yield and control. The equity holder increases its risk, but retains control and increases its yield potential (it also gets ALL the tax benefits for less capital in the case of privately held RE).

This is an important distinction, because it doesn't mean that REIT CEO instincts were wrong, it simply means they took on more risk for their equity stakeholders. Unfortunately, I don't think anyone saw this type of a recession coming. In many property types, fundamentals were still improving. Real estate equity holders simply got caught in a horrible market decline. Real estate debt holders, who were transferred the least risky part in the bifucation, will ultimately not be hurt as badly. In essence, the market worked as it should have.

Don't belive me? Try this example: An extremely conservative invstor buys all debt, no equity. He got hurt in 2008, but didn't lose everything. An agressive investor bought all equity, no debt. He got hurt, badly, maybe lost everything. On the other hand, assuming most properties were leveraged at 75%, a market neutral investor would have bought 75% debt and 25% equity. His returns would be market neutral.

So please don't discount debt, Mr. Fosheim. Without it, we would all be market-neutral and none of us would have anything to talk about.