PROJECTIONS

It is a given that you cannot have Reward without Risk. The conventional wisdom is that when evaluating the Risk/Reward of a prospective (ie real estate) investment, you calculate the potential dollars of Reward for every dollar at Risk. You do this by analyzing myriad potential investment outcomes and the likelihood – the odds – of each one coming to pass. It usually requires contemplating of a wide array of fluctuating variables, which makes it difficult to accomplish with precision, even within a liberal coefficient of variation (margin of error).

Imperfections notwithstanding, with strategic thinking and sound modelling tools, we can make reasonable and often quite accurate projections – provided that we use objective, relevant variables and reliable economic indicators.  Creating projections is making use of experience – the past, to presuppose likely outcomes – the future.  That said, the future is stubbornly elusive and fickle. Financial offerings contain that ubiquitous phrase “past performance is no guarantee of future results” for good reason. Moreover, the further into the future we try to forecast, the less reliable our projections are destined to be. To illustrate the point, if SpaceX were sending a spaceship from the earth to the moon and its guidance was off by just 1 one-hundredth of 1 inch after 1 foot (the near future), it would miss the moon (the distant future) by a distance wider than the state of Michigan. Fortunately, in real estate investing, as with the ship headed for the moon, we often have time to course-correct – influence the direction of an investment – but that’s a topic we’ll discuss in the future.

THE GREAT UNKNOWNS

When I analyze an investment for a client, the templates I use employ use as wide an array of variables as I believe to be practical for the given asset, which can be copious in some cases. In the end, I feel pretty good that I have a clear picture of the opportunities and threats. I’ll run multiple scenarios to identify best- and worst-case scenarios. Most importantly, the worst-case scenarios seek to contemplate “future unknowns,” which is redundant, because the future doesn’t exist yet and by definition is unknown. As former Secretary of Defense Donald Rumsfeld famously obfuscated “…there are ‘known knowns’; these are things we know we know. We also know there are ‘known unknowns’; that is to say, we know there are some things we do not know. But there are also ‘unknown unknowns’—the ones we don’t know we don’t know …it’s the latter category that tend to be the difficult ones.” Well that certainly covers everything!

Even that enigmatic quote misses the point that the future is more than unknown – it is unknowable, and yet, business requires that we make projections. Coronavirus puts in stark relief just how much “future unknowns” are something to be reckoned with. They can be estimated and projected (all euphemisms for “guessed”), but ultimately, they are not knowable. Meanwhile, my clients don’t want to hear “…but no one could have predicted…” so I must contemplate both the knowns and the unknowns and advise accordingly.

CAN YOU HANDLE IT?

OK, but then isn’t “planning for the unknown” a contradiction in terms; and what the hell does this all have to do with Risk vs Reward?  As stated earlier, the prevailing interpretation emphasizes probability: comparing the cost with the potential income; if and when you are comfortable with that ratio, you move forward with an investment. The problem with this reasoning is that it conflates risk with ROI, which it is not.

I see risk differently: Risk vs Reward should be governed by the rule that “when the unknown becomes known and it ain’t good, when that “can’t-miss” misses, can you handle it?”  This relegates probability to a subordinate position; meaning threat is the primary focus. This is because if the “miss” is catastrophic, whatever the odds were and whatever the reward might have otherwise been, it’s game-over.  So while it is true that you can’t predict the unknown, you must be plan for it.

THEORY OF RELATIVITY

From this point of view we recognize that a “good investment” is relative, it is not absolute. For example, I might not risk $100,000 on a given investment for which Amazon founder Jeff Bezos would comfortably risk $1,000,000; simply because losing a million dollars is a rounding error for him, whereas losing a hundred thousand dollars would be impactful to me.

Same investment, different risk.

This is a key part of the axiom that “money makes money”: statistically, “safe bets” will in fact prevail across multiple events; however, you need the opportunity to engage in multiple events. Think of the Hundred-year flood, where the potential of a flooding is very low statistical threat; unless, however, if that one-year is this year, and you just bought a property and saved money on flood insurance.  Las Vegas casinos are a ten-billion-dollar industry built on millions of relatively small transactions, winners beating losers over time, based on the thinnest of margins. Properly managing risk means staying at the table and prepared for the hands where reward is most likely.

“Odds are” you have a different take on the subject. I’d be glad to hear what you think as well.

As they try to intertwine these two stories to gin up some kind of apocalypse, an important distinction between the “banking crisis“ (aagh!), a term which has already lost its mojo, and the “Demise of CRE“ (aagh!) story is this:

Office properties which are financed by Wall Street, vis-a-vis REITs and CMBS debt, (or Sovereign wealth funds and family offices) are typically high profile trophy assets (ie  777 Figueroa St in Los Angeles, 660 Fifth Avenue in New York, 650 California Street, San Francisco), and are a different risk class, being funded by investors who are – or should be – prepared to absorb a high amount of potential loss (see my blog on “Risk vs Reward“). Moreover, 401ks and other pension funds are typically not overweight in either of these products, so while the “man on the street” may see some drag from whatever percentage of their retirement accounts are invested there, don’t expect it to be impactful beyond the ups and downs the market regularly imposes on these funds.

On the other hand, as mentioned in my original posting, regional banks are the overwhelming source of debt for the entire basket of CRE assets – not just office buildings – most of which are doing quite well, it is worth noting. Per that narrative, the RBCCs of the world are closely monitored and have engaged in responsible lending practices. They also are the grist for local investors; making loans against assets that they understand in their own backyards. And because most of that debt has stayed on the bank’s books and was not sold up to Fannie and Freddie like residential mortgages, they will have been judicious about both the properties and borrowers that they financed.

So as the Will Robinsons across America are lining up to refinance their commercial loans, I predict that the overwhelming majority of them will walk out of their banks, hop back into their Jupiter 2s, and zip happily off back into space for the next ten years.

———-

March 31 2023:  The financial news channels have had the Commercial Real Estate doom & gloom story on the back burner for a couple of weeks now.  Soon they’ll be zipping around like Robot on Lost in Space, flailing their arms and shouting “Danger! Danger!”

Let’s look at some numbers and check what does, or “does not compute.”

Scott Rechler and Neel Kashkari weighed in on it over the weekend (which officially moved the story to the front burner). The basic area of concern is regional banks, and refinancing loans that are ballooning after 10 years. Mr. Kashkari was interviewed on Face the Nation, and one sentence in that interview which stood out to me was “…fundamentally, the banking system has a lot of capital to be able to withstand those pressures.”

This sentence was not a blithe attempt to calm the public, but is in fact an extremely important consideration to recognize. To analyze this objectively, to wit, dispassionately, I built a simple algorithm to evaluate what happens when a balloon payment hits a typical “Main Street” office property – call it the Camden Canyon Professional Center, which our investor, Will Robinson, bought ten years ago. This analysis focuses on conventional debt financing, which according to Mr. Rechler represents nearly 80% of debt used to finance CRE, and is employed overwhelmingly by regional banks for investment properties (vs user occupied properties):

In April 2013, Will purchased the CCPC, with 10 units and a $200,000 NOI.  He paid $3,134,000, borrowing $2,193,770, with a 20-year amortization schedule and a 10-year balloon. The loan was based on a 70% LTV / 1.25 DSCR, imputing a 5% vacancy factor. In April 2013 a 5-year T-Note was at about 0.7%; assuming a 275 bps spread, the borrowing rate was 3.45%; five years later the rate would reset at about 5.50%.

Since Covid, the property has lost three tenants on the end of the building and the rent is down 30%.  By 2019 the NOI had grown to $226,900; by the end of 2020 it dropped like a rock to $163,500. While those 3 spaces haven’t re-rented, the NOI has crept back up to $173,500; but it is still some $27,000 less than when he purchased the building a decade ago!

It is now April 2023 and Will needs to refinance the debt or sell the building. At his preferred lender, Regional Bank of Camden Canyon, borrowing costs are running about 7.00% – double the original rate – and to make matters even more challenging, RBCC is playing it safe by raising the DSCR to 1.35 and applying a 7% vacancy factor.

Will is lost in space.

Will walks into RBCC, ready to hand over the keys. Its 2008 all over again. How is he going to survive those astronomical lending terms?  A little while later, somehow Will walks out of RBCC with his debt refinanced, plus a check in his hand for $22,000; He still has the upside potential of renting those 3 “outer-spaces” (ouch).

What happened?

Instead of listening to whining Dr Smith and getting freaked out, Will could have asked Robot to crunch the numbers:  After paying down the principal over 10 years, Will’s original loan has a balance of $1,321,570. Adding some settlement costs, Will needs a new mortgage of $1,360,000. At 7% interest with a 20-year amortization and the 1.35 DSCR, his current $173,500 NOI qualifies his property for a new loan of $1,381,700.  Cross-check this with a 70% LTV, and we find the loan would qualify using a valuation obtained by employing a cap rate of up to 8.9%.

Even taking into account the 2018 EGRRCPA banking regulation amendments which only affected a limited number of relatively large banks, RBCC is well regulated, and as Neel Kashkari pointed out, is adequately capitalized. Moreover, RBCC has to continue to place debt, since that’s how they make money.

And lest we forget, including the rent shortfall since Covid, (for now we’ll put aside the forbearance he got when he was dipping below his DSCR minimums), Will’s cumulative Cash Flow After Debt Service over those 10 years was $295,000.

That’s not to say it was not a close call. For example, if the NOI had dropped 40%, Will would have had to infused $176,000 to support his refinancing. Nevertheless, even at that drastically reduced income, he would still have $807,000 equity in the investment; and with the $2,600,000 in principal and interest payments he made over the previous ten years, Will isn’t walking away over $176,000.  (What if Will doesn’t have the $176,000?  He could simply sell the asset; even at ie an 8% cap rate vs the in-place NOI, he would still realize a profit of $540,000).

As is evidenced by this forensic review of a very conceivable scenario, the CCPC is able to withstand some extremely challenging economic and financial weather.  The loan structures, capital requirements and hard lessons learned since ’08 have helped create a very solid foundation in the CRE industry.

Next time I will review a small retail strip center Will bought in 2018, with his 5-year Rate Reset which will be hitting next month

A quick glance at two random properties recently posted on LoopNet in my region include a mixed-use property and a STNL medical building – offering cap rates of 4.4% and 3.8% respectively. One promises upside through leasing vacant units and the other offers a long-term guarantee with a couple of modest rent bumps.

Among the myriad considerations (to be discussed in future installments), there are two obvious and interrelated issues at work here:

Firstly, be it a large fund manager or a private individual, when an investor is deciding where to allocate capital, is the industry incentivizing them toward real estate or pushing them elsewhere? On one hand there is a hassle-free return backed by the Full Faith and Credit of the United States Government, on the other hand is the risk, costs, effort and illiquidity of real estate for a comparable or even lower return. Hello? Anybody home, think, McFly, think!

Secondly is the cost of the funds that many investors need to borrow to acquire real estate (or those who responsibly use debt as a tool to leverage up yields), which, at a few hundred bps spread, can now cost upwards of 7% and heading north. That’s ~7% dollars to buy ~4% dollars.  How’s that loan working for you? It isn’t. Increasing rental used to be an argument for income properties, now you depend on it just to tread water? Hmm. Back to “Firstly”

So, maybe I’m missing something, but my Venn Diagram says that when the I-need-debt investors are removed from the large circle of all investors, all that is left is that smaller circle of all-cash investors.  And if the Invisible Hand does its invisible thing, fewer buyers mean lower prices; ipso facto (yes, I just wrote “ipso facto”), higher cap rates.

This is good. Balance is always good. The world could use a lot more of it. Supply and demand will replace artificially low interest rates in driving the market, as it should. Sellers will soon have to pull their heads out of their assets and respond accordingly or wait until such time as – were it to be in this lifetime – interest rates revert to the “norm.” Or is it more likely rates are now actually finding their norm?

Next time: the Great Reset (the not as good part)

Every aspect of society has been affected and we in the real estate industry are no exception. Fundamentally, the story of the virus is about contact, which means that it is related to place, and by definition, real estate is place.  Real estate is also, literally, the foundation on which every other brick in the economy is laid, and no sector of the industry is “immune” to the discussion: user, investor; office, retail, industrial, multifamily, residential sales & rentals, relief and forbearance… one way or another, both how we conduct business and values across the board are being affected. Each segment itself is a plethora of whitepapers, books and articles just waiting to be written.

For a moment let’s just take a beat. When listening to the daily barrage of data and conflicting information, accept that the future is unknowable and we are wise to be restrained when predicting it (as I write about in my recent blog, “Another Look at Risk vs Reward”). However, to the extent that we may see the past as prologue, the big picture view is encouraging, so it is important we try to take a step back and see forest for the trees.  And with that perfect segue…

A TALE OF TWO FORESTS

This metaphor needs no interpretation: The Jack Pine tree, covering millions of acres of northern United States and Canada, has pinecones which hold their seeds fast for dozens of years. What opens them up is the heat of a forest fire, which melts the sap in the cone and allows the seeds drop and grow a new Jack Pine in the ashes of its progenitor.

It is through this lens that we can view and gain perspective into our current situation, from the “trees” which grew out of two “forest fires” in our past; one being 9/11, the other being the 1918 Pandemic.

The 911 Forest Fire: In a few ill-fated hours on the morning of September 11, 2001, the world changed. It was sudden, unfathomable and painful, touching people in every corner of the planet. We all remember where we were that day. For me it was Warsaw at the Marriott when the office called from New York – turn on the TV.  Then the calls came from friends and colleagues from around Europe expressing sympathy, solidarity and disbelief. Sitting in the hotel lobby, reporters were questioning our plans: were we going to continue with our developments?  Was I going to keep flying to Europe?  and so on.  We had just inked the lease for the first anchor for our first project, so I couldn’t imagine we wouldn’t move forward… but then again, it was only September 12th and I didn’t even know what I’d be doing on September 13th.

For a long time afterward, airlines, airports and the government had quite a needle to thread.  Getting on a plane was a protracted, inconvenient and chaotic mess as they tried to figure out protocols that would keep people safe while not discouraging them from flying.  This was the “New Normal” of air travel.

Regrowth: As you might guess, the following year air travel worldwide plummeted. You would also be guessing incorrectly.  In 2002 global air travel dipped less than 2% and by 2019, grew 262% to nearly 4.4 billion travelers.  In America, the epicenter of the disaster, it took the industry a little more time to recover to 2001 levels. After a few minor annual declines (-6.5%, -3.8%, -1.6%), airline ticket sales jumped by more than 15% in 2004, erasing the declines of the previous three years plus a 20% jump in sales. Moreover, excepting a short period of decline after the ‘08 financial crises, air travel in the U.S. has increased steadily, overall averaging nearly 10% annual growth.  The industry figured it out, despite the increased costs, security challenges and lingering memories of that tragic day in 2001.

The 1918 Forest Fire: 1918 saw a pandemic that was not only worldwide, it took place during a World War. The “war to end all wars” was a devastating, horrific, miserable slog; and yet, ten times more American soldiers were killed by the “Spanish Flu” than were killed fighting the enemy. They were among some 675,000 Americans who died from the virus, which also happened to cause respiratory failure. Estimates are that between 50 and 100 million people died worldwide, at a time when the world population was 75% smaller than it is today. These statistics stagger the imagination. The first flu vaccines were still 25 years away, so the virus and the war carved a chasm of destruction and both disappeared later that year.

Regrowth:  Just a couple of years after this global trauma ended, the “Roaring Twenties” began. (Now could be a good time to add F Scott Fitzgerald’s “The Great Gatsby” to your read-it-again list). It was one of the most prosperous and madcap periods in modern history, only to end in a market crash and economic depression unrelated to any pandemic or war. Well before that macabre historical episode began and ever since it ended, real estate developers and brokers have been busy building, selling and leasing downtown shops, retail centers, industrial parks, apartment buildings, ever taller skyscrapers and gigantic sports complexes.  People in those buildings have been getting on elevators and going to bustling restaurants with waiters who weren’t wearing face masks and riding home on crowded trains. All after a ruthless, medieval-like plague of biblical proportions became – I’ll submit consciously – all but forgotten. Until now.

Just a quick aside… isn’t it curious how they called everything “great” back then, even when they actually sucked?  The Great War, The Great Depression, The Great Gatsby… what’s up with that?

NO MORE ZOOM & GLOOM

IM not so H.O., what is likely to be different in the pending New Normal will be vestiges of the virus, not a sea-change in our industry or way of life. It will include hard changes that we put in place while developing solutions to deal with immediate issues; ie germ-lights and air filters installed in office buildings are likely to become construction standards which be ubiquitous because their efficacy is obvious. On the other hand, I have little doubt that my Jesse James face mask, wiping doorknobs, elbow-bumping, directional aisles in supermarkets and other such conventions will linger by habit for a while and then fade away unceremoniously.

And thank you video conferencing, you’ve been a lifeline!  But as the-future-is-already-here as it has been, is just as so yesterday as it has already become… Will it become an unwelcome reminder of these unpleasant times? Temporarily, yes – long term, no; though it will remain a tool in my toolbox and I will use it to expand my business. Right now, I’m getting just a little zoomed & webinarred out. The sooner I have an up close and personal alternative to a video conference the better. To paraphrase the great scriptwriter Aaron Sorkin, “a video meeting is to meeting what reality TV is to reality.”  I look forward to actually meeting my clients and colleagues in their shop or office, not pixelated in their pajamas in their living room.

Collectively, just as the 20’s “roared in” after 1918, society and the economy will move boldly into the future. Individually, as the airlines on the brink of failure in 2002 figured out how to turn record profits, we’ll innovate and re-imagine our businesses. We’ll add the pluses and forget the minuses. We’ll surprise ourselves at our resilience, and for what are able to accomplish.

MEET THE NEW NORMAL, SAME AS THE OLD NORMAL

In fits and starts, without remembering when it began, we will be fist-bumping, hand shaking, elevator riding and hot-dog passing from the vendor to that loud guy sitting next to us at a ballgame, like… didn’t we always do that?  And whatever the New Normal is that comes tomorrow, it’ll be more like the Old Normal than we might imagine today.

It would be very Normal for you to completely disagree – please weigh in with your thoughts as well.