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.

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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