Archive Page 2

Appraisals Are Deeply Flawed

Appraisals Are Deeply Flawed

I recently wrote a column on HotelNewsNow stating that appraisal methodology was deeply flawed and that appraisals are essentially fairy tales based on a bunch of unsupported wild guesses by appraisers. They claim to be able to project cash flow, interest rates, discount rates, terminal value cap rates, and renovation requirements for 10 years and then they use some unsupportable discount rate to determine present value. It is all nothing more than wild guess compounded by more wild and unsupportable wild guesses. It short, appraisals to me, have no value, and were clearly proven to be nothing more than propaganda to support unrealistic loans in the 05-07 period.

In response to the column two appraisers commented that”appraisers are required by our standards and regulations to reflect the market. If the market is being optimistic we are required to reflect that. It is not the appraisers role to adjust projections or cap rates or values or opine if anticipated net income is not sustainable. We are merely reporters on the sidelines. If you want us to tell you what we really think then have us put our consulting hat on instead of asking us to do an appraisal.”  Another appraiser said “we are required to reflect the froth”.

That says it clearly. Even the appraisers say their appraisals are nothing more than make believe to reflect what the clients wants them to say. In fact one appraiser responded to my column by saying “who are we to question the view of the borrower or the lender”.  

Why do appraisers even bother with the make believe of 10 year cash flows, alleged terminal cap rates and all the rest. What they are admitting finally is they are merely making all that up in order to get the answer their client wanted in the first place. This is why when I created the first hotel CMBS programs in 1993 we refused in our underwriting to use any numbers or values the appraisers came with. We got appraisals just to fill the rating agency file folder.

Everyone would be much better to ask appraisers to provide real numbers and projections as the appraiser I quote above has suggested. Phony appraisals was one of the contributors to how we had the crash. They were used as excuses to make stupid loans. The rating agencies are the ones to drive this change. The servicers tell me they are relying much more on broker opinions of value than appraisals and they only get appraisals because they are required to by the PSA docs.

In 1993, our underwriting manual required the use of historic cash flows and then current cap rates to determine loan proceeds. Loan to value was only used to make sure we did not exceed a percent of the appraised value since we knew the appraised value was in excess of reality, we always wanted to below that test.

My intent here is to get the capital markets, the rating agencies, and the real estate industry to start to use appraisers properly, and to use their knowledge in a way that is helpful, and not to support excessive lending and stupidity.  If the truth hurts as to projections and value, then loan proceeds should reflect truth and not bull.  If we redo how loans are underwritten, and if we use the talents of the appraisers properly, we may just help save ourselves from the next crisis in the capital markets.  Excessive lending and over inflated values always lead to a crash-that is reality, so let’s not repeat this costly history.

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The Next Crisis Is Here

The Next Crisis Is Here

The city of Vallejo is in bankruptcy due to excessive pensions and other benefits given to its municipal unions. This practice of granting huge pay increases and benefits to unionized municipal and other government workers is the crisis that has not yet hit the media but which is severely harming the economic recovery. Many government workers now earn considerably more than private sector counterparts performing the same work. Vallejo is simply the canary in the coal mine. A fireman earns $171,000. He also has a pension based on his last year of wages and a healthcare program for life. Yet if you listen to the unions and politicians we are supposed to help the poor municipal workers like teachers and firemen. Where I have my beach house school teachers earn $95,000 for 9 months of 8-4:00 hours. They also have pensions and healthcare.

The result of all this is that local and state taxes have to rise, services have to be reduced, and the local economy is badly harmed because there is no money for infrastructure, better services or economic development. Towns like Vallejo cut back, raise taxes and deteriorate further in a death spiral. Police jobs are reduced and crime rises, further discouraging business and economic growth.

New York City and Times Sq proved that by adding cops, reducing crime and revitalizing the area, business flocks in, tax revenue is generated and people return to retailers and entertainment. This demonstrates how these excessive pensions and other union benefits and wages negatively affect real estate values and development in places like Vallejo and many towns across America.

Whatever good may be done by the Fed and  other steps to generally try to improve the economy is being severely restrained at the local level by the unions greed and power. They payoff the politicians with campaign contributions, free campaign workers and publicity, and in other ways. Yet when developers or corporations undertake similar efforts to influence political outcomes or real estate development, it is considered by the media to be undue influence and corruption. The unions are protected by Congress and Obama who took over $400 million of union payoffs for his campaign. Now we see how they were protected in the healthcare bill along with the tort lawyers.

More towns and cities will be filing bankruptcy over the next two years, more taxes will be raised, and your real estate projects will suffer more harm along with the economy. The big pension funds like Calpers are not going to be able to cover the liabilities to workers. The result is going to be higher taxes to help pay to cover these obligations. Less capital will be made available to invest in real estate. There is a massive transfer of wealth form the earners to the unions and Obama and Pelosi are doing all they can to encourage and protect the unions. If we do not push for major reform of the municipal employee pensions and other benefits, it will do severe harm to the real estate recovery.

The Hotel Industry Is Finally Stabilizing

The Hotel Industry Is Finally Stabilizing

There is growing evidence from many of the people I speak to in the hotel industry that revpar is beginning to stabilize. By late this year it is highly likely there will start to be some signs of small improvement, although for the full year the numbers will still be slightly down or flat at best. Next year will start to see some improvement and 2012 will be a good year for revpar growth.

However, some appraisers are already going way over board projecting over optimistic value increases and revpar growth that has no connection to reality. I have written other articles which demonstrate why hotel appraisals usually have no connection to reality and the methodology is totally flawed. They make assumptions that things only go up and at growth rates and to levels that are silly. One major appraiser now assumes that there will be 7% debt at 70% of some make believe value in 2012 and he uses this to justify a refi at excessive levels in order to make the cash flows unrealistically high in the early years.

Hotels will do better over the next several years, and values will improve, but we need to be realistic and not get carried away with euphoria. Buying hotels or lending to hotels now will prove to be very good, and profitable so long as the going in value is realistic and you do not assume wild increases as some appraisers and brokers project. If there was ever a time to lend on hotels it is now. If well underwritten, and properly levered, you cannot lose on loaning to hotels now.  I do believe there will be debt available in 2012 and sooner in some cases, but it will be carefully underwritten and no more than 65% on the A piece portion. There will be higher leverage available, but only in the form of a B piece at far higher spreads. The source of funding for many smaller deals was always the local and regional banks. Those sources are now very restricted due to many are out of business or severely restricted by regulators. There will simply not be the ready availability of loans for the smaller- under $15 million deal.

There will be a lot of hotels coming out of banks and servicers over the next two to three years. They are buried in defaulted and foreclosed properties. It will simply take time for these to show up in the market, but when they do cap rates will likely rise due to a far greater supply and higher interest rates. The frenzy right now to buy hotels is over blown due to the tiny number of properties offered and too much money chasing them.

As a totally side note, the obscene activities of bribery, corruption and outright lying on the part of Pelosi and the administration regarding health care has sunk Washington to a new low in our history. This is a new entitlement we cannot afford, and it will add to the deficit which is already way out of control. The whole concept that they know better despite clear polling against the bill, and no bipartisan support, defies everything this country is about. Whatever happened to the voters get to have their say. Nancy Pelosi knows better than we do what our healthcare should be, and it is OK because we will learn to love it after they shove it down our throat. Medicare has proven that the country is not able to afford these mass spending programs and we are headed to the cliff in ten years or less.

This Time Is Different

This Time Is Different

Having lived through several major downturns, including the eighties interest rates of over 20%, it is instructive to compare and contrast. This time is very different. While the S&L industry imploded in 1989, the rest of the world was not so affected, nor did the US financial system collapse. The S&L’s were a small sector in terms of dollar impact. This time we have the entire world financial system nearly ceasing to function and suffering enormous long term damage. Foreclosures will not be mitigated by the modification plans and it is entirely possible that the problem will be with us for a considerable time. Home equity lines are mainly a thing of the past. Unemployment will take 4-5 years  to recover to more normal levels of 5.5%, and real estate loans will not permit high leverage on inflated projected values.

All of this indicates that the over inflated values of 2007 will not possibly be recaptured for probably at least a decade on an inflation adjusted basis. There will not be the ability of consumers to over leverage to buy things they can’t afford including homes, take trips they can’t pay for, and speculators will not get the absurd funding to take what amounted to options on assets they intended to flip.

Just because the 1990 and 2001 recessions happened does not mean they are relevant to this time. Almost all the metrics are different. The politics are very different, the regulations will be different, and the risk officers and auditors will be under enormous pressure to restrain the free wheeling over leverage of investment banks and others. Real estate has returned to fundamentals finally, and it will not be the trading vehicle it had become over the past 15 years.

What does this mean. You need to be a lot more careful on the buy this time. Values are not going to take off. Net effective rents will remain constrained for many years. Leverage will remain constrained. In about two years inflation will begin to drive up operating costs but leases signed in 2009-2011 will be at lower rates than had been the case in 2007-8. Interest rates will go up. Most importantly, property taxes will have to rise to cover the massive deficits at the local and state levels where the budgets of these levels of government are simply unable to pay the bills. The federal budget will continue to rise unrestrained to dangerous levels. It is clear Pelosi cares nothing about fiscal responsibility and neither does Obama. They will do anything to pass healthcare and all of their agenda no matter the damage it is doing. That has to mean higher taxes for all of us who actually still pay taxes-which is just a little over 50% of the population. Those of us who are able to earn high incomes will be paying far more.

The bottom line is you need to take all of these issues into consideration when pricing an asset for acquisition. Discount rates and terminal values need to be adjusted to take these metrics into consideration. Your risk adjustment when making assumptions about discount rates and cap rates need to be cognizant of these future restraints on value over the next 5 years. It is all in the buy. Don’t let a few recent deals where too much money was bidding on just a couple of properties let you get lulled into making a mistake that cap rates are low again. They are not indicative. When a lot of assets are finally put to market, so supply of deals is again normal, cap rates are likely to rise a little at that time. Don’t buy at any price just to spend those available funds- you could regret it later. Stick to old time fundamentals.

Silverton And FDIC Bids

Silverton And FDIC Bids

The bids are due in about 30 days on the Silverton portfolio. It is mainly hotel loans, and it is only a portion of the hotel portfolio. It consists of whole loans and loans participated out to small community banks. The whole loans are probably reasonable properties with mostly decent borrowers. There are supposedly 65 bidders for everything from the entire portfolio of $416 million face amount of which $254 million is participated loans, down to individual borrowers bidding for their own loan.  It is highly likely the winner will be a bidder for the whole portfolio, but politics will possibly interfere with the bid process, and they may sell some loans to the borrowers.  FDIC will retain a 60% interest in the buying entity, so it will have substantial control rights over how the workouts are handled. The confi required was so onerous some potential bidders backed away.

Here is one major issue. The participating loans are held by tiny banks who have essentially no capital if their assets were written to true value. Whoever buys the loans from Silverton will be faced with the FDIC likely interfering with normal restructures so that the little banks do not take the hit to capital. This is very bad policy and will not allow borrowers to get the restructures they need. It also means many bidders will not bid this part of the portfolio, and those who do, will way underbid due to the FDIC interference. FDIC is likely to require more extend and pretend, and a lot of little banks who do not deserve to exist, will be kept alive by FDIC only to die another day.

Now we have already seen a whole host of people involved with these banks screaming that it is unfair to recognize truth and the FDIC is already under huge pressure to lie about the true value of these loans. If reality would be permitted, then we could have a true arms length bid for these assets which would set the market value in a proper way. Then all banks would be forced to recognize reality and the bad loans would be forced to come to market. That would start the loan sales which we have all been waiting for and begin the healing of the banking sector by closing all the small, poorly run banks across the country that should never have been allowed to exist in the first place. They made real estate loans they were not qualified to underwrite, and they have no idea even now what these assets are worth.

The politicians and media love to blast the big banks who made many bad decisions as well, but the real problem today lies at the regional and small bank level where all of these small loans still reside, and will continue to reside for several more years so long as FDIC insists on hiding the truth. The Silverton auction is not going to reveal true market values due to this misdirected politicized policy.

Government Interference Delays Solviong The Problems

Government Interference Delays Solving The Problems  

In his latest misguided proposal, Obama wants to halt all home foreclosures until the borrowers have been afforded 5 chances to get a modification. 1. Government interference in the sorting out of distressed markets is never good unless it is in the form of the RTC which was able to simply seize assets and resell them to the highest bidder. The Japanese have painfully learned that the market needs to clear itself at whatever the market clearing price is. 2. The proposed program is nothing but price fixing. 3 The program assumes borrowers are all responsible and well meaning, and they want to have a modification. 4. This is another example of the Democrats thinking they know better than the market and the rest of us.

Reality is most troubled loans are held by homeowners who are either speculators, or by irresponsible borrowers who were simply greedy and did not care if they lied on their application or that they knew they could not afford the house. I have been in the business of buying residential mortgages. The entire culture of borrowers has changed. Even those who are true homeowners, and not speculators, have no sense that it matters to keep your mortgage current. Such thinking is further encouraged by the liberals who think it is the big bad banks who are wrong and not the borrowers.

When we tried to modify loans we found it was often impossible to communicate with the borrower. They did not answer calls or letters. It was often necessary to send a person to the house to make contact and then it was usually a waste of time. People  at the low end of the income ladder have generally low credit scores and so it does not seem to bother them that a default on their mortgage will hurt their FICO score. After all, Obama and Pelosi tell them they are not at fault and then the government offers to help them in their defaulting behavior by telling the banks they can’t act. What message does that send. In many states now the local courts are as bad and it is very hard to foreclose. This just reinforces the concept that as a borrower I can do as I please and they can’t bother me. Borrowers view is this is a way to live in the house rent free for a year or more, no mortgage payments, no rent, and when they finally throw me out I rip out the appliances and sell them for a couple of thousand dollars. In short, the government has created a whole new culture that there are no bad consequences to default and be irresponsible.

All they have done is delay the inevitable, cost the banks millions of wasted dollars chasing ghosts, and they keep house prices artificially high by not letting the defaulted inventory reach the market quickly to once and for all set a real price. This keeps poorly maintained houses in the neighborhood and hurts everyone. Investors who buy foreclosed houses generally spend $8,000-$12,000 per house to paint, re-appliance and fix it for new tenants or owners. This upgrades the area and the overall quality of low cost housing. It resets the pricing to where it belongs. That helps everyone.

In addition, just as they did in Chrysler, the government is proposing to interfere in contract rights which will have substantial negative consequences on future pricing and credit approvals, thereby hurting the very people they claim to be helping.

If Obama, Barney and Pelosi keep this trend of blame the banks, interfere with contract law, and protect the irresponsible borrowers, then we will have unintended consequences for many years to come which will grow to a problem of major proportions.

New Lending Platforms

New Lending Platforms

There is wide recognition that the demand for refinancing and for acquisition debt funding is very large and unmet. It is highly likely that there will not be a large scale securitized lending market again for at least 2-3 years, until a variety of regulatory and legal issues are resolved, and until the bond buyers are comfortable the underwriting is back to 1993-94 rules, and the rating agencies have materially amended how they analyze risk. All of this is going to take time.  While there will be a few large securitized offerings that make news, there will be a long wait for the ordinary mid size to small property to get conduit funding again.

To fill that demand there are various groups who are setting up, or have already set up lending platforms.  I have spoken to several and am involved in working with a few. The issues are quite interesting. None are very large since funding for them is limited and warehouse lines are not yet readily available. The ones that have been or are formed rely on equity investors to provide the funds. Those investors are generally seeking a 15% yield-part current and part PIK.  They generally are not interested in pure equity participations, but do want equity like returns through the PIK interest.

The other issue is the investors want relatively lower risk than is required to obtain equity like returns. There in lies the rub. This has hampered some of the fund raising that is underway. It is why some of the proposed mortgage REITs have not been successful. It is also why some that have been raised are buying paper in the hope of higher returns.

Buying existing paper, depending on vintage and originator, can be deeply flawed, and so may or may not turn out the returns intended if one is not careful what is being bought. Originating new paper for refi may also not drive the returns since a lot of better borrowers simply will not pay the price and will use extend and pretend for now. The main market is more likely the acquirer who will look at the PIK or participation as bridge equity. The issue there is the borrower will want short call protection so he can refi this loan as soon as there is a revitalized lending market at more normalized pricing- likely in 2-3 years.

The groups now forming are likely to offer 80% -85% leverage on cost to acquire or current value, on the very reasonable bet that we have hit bottom and values will only rise from here ., making the leverage in 3 years more conservative and thereby refinancable.  The issue is that the investors who provide the capital to the lending platform are risk averse and view 85% leverage as too risky even though is probably is not if well underwritten under today’s numbers.

Having created a lending platform myself in 1993, I have always believed that the exact right time to lend is at the very bottom of the cycle, like now, and to then stop lending 5-7 years into the upturn. That is when everyone else is lending and margins are squeezed, and underwriting and covenants start to get too easy.  When securitization is back in a sizable way, it is time to get out. In the meantime, high leverage lending if underwritten right, and priced to fully reflect the equity component risk of the B piece can be safe and very lucrative.