August 22, 2008

Commercial Real Estate: The lost Cycle

If you read some of my posts and tracked some of my investments you will notice that I am betting on Commercial Real Estate. Commercial real estate (CRE), I mainly focus on retail and office spaces, cycle has been lost amid the residential housing crash. In this post I want to look more closely to the CRE sector and outline my investment thesis that will assist me in picking and assessing investment opportunities.

Along with general economic conditions, valuations in commercial real estate are driven by the following factors:
  1. Capital availability: Real estate is a capital-intensive industry, and its health rises and falls with capital availability. Capital, relatively cheap, fuels investors demand for CRE projects in the hope of earning future cash flows.
  2. Supply: Boom times typically engender oversupply of product.
  3. Interest rates and the economy: The lone head wind for commercial real estate is higher interest rates and their potentially negative effect on economic growth.
Actually the factors move in cycle and it goes something like this:
  1. Tenant's demand in good economic times for CRE will drive rent prices up making yields very attractive, as a result CRE prices start to go up.
  2. builders start increasing their investment in new developments therefore flooding the market with more supply that demand can absorb causing rent prices to start dropping due to competition over tenants. Please note that this takes few years as new supply do not materialize suddenly as projects take few years to complete.
  3. CRE prices start to decline as a result of the new supply.
  4. Lenders panic and put the breaks on loan refinancing and originations as their collateral is being devalued and realize they are heavily exposed to commercial lending.
  5. Developers can't get new financing to finish their projects or refinance existing properties so they default causing banks to take title and liquidate their holding causing more decline in CRE prices.
  6. Recovery begins when excess inventory is cleared and rents start to stabilize.
The previous steps are present in almost every real estate boom and bust. But the universal truth in every CRE bust is overbuilding. Then it is followed by system deleveraging of some sort. Currently, residential overbuilding has caused severe price drops followed by a liquidity crises as banks try to clean their balance sheets from bad loans and defaults as result of overzealous lending.

The slow economic environment, the disruption in capital markets and the shutdown of CMBS market will no doubt weight on CRE prices, no questions about it, prices have to come down. Owners have to refinance at some point and when they can't they have to sell at any price to allow them to repay their loans. However will CRE go by the same way as housing and suffer a collapse in pricing? That question can be answered by finding out: if developers overbuild in this CRE cycle. Answering this question have many implications to banking write offs and the severity of CRE price decline.

In the late 80s and early 90s CRE has endured a similar fate to what housing is going through right now. You can argue it was exactly the same but the current crises is much more severe due to the large size of residential mortgages and housing construction compared to commercial lending and construction.

  • The amount of investment in CRE the current cycle is mundane compared to the late 80s and early 90s as percentage of GDP. That suggest that the current cycle of CRE did not terribly overbuild to create excess supply that could lead to a bubble like environment, however still since 2003 non residential investment has picked up a bit, see chart 1 from Wall Street Journal.
  • Most of the construction investment happened in secondary markets, take the example of office construction as in the graph 2, courtesy of CB Richard Ellis research.
  • Construction prices have skyrocketed due to natural disasters and rising commodity prices, which has tempered new building in all property types. That lack of new supply increases rental pricing power and occupancy levels in existing properties. New developments will incur higher costs so they have to charge higher rents to earn good returns giving an advantage for existing buildings to charge less rent. That dynamic will limit new developments and construction a bullish sign for CRE valuation.
  • Most recent construction happened in suburban locations or B and C locations. Downtown real estate saw little change in construction levels over the past few years as you can see in chart labeled office construction. Further evidence is the available sublease space is also low compared to previous cycles as seen in chart labeled available sublease space. The limited construction and further decline in construction in the downtown office market will lead to higher rent growth once the US comes out of this rescission and employment starts to grow again.
  • Real estate funds are flushed with cash and new ones are being formed to take advantage of the dislocation in capital markets
  • Retail space will face tougher outlook than office due to retailers bankruptcies and slow down in consumer spending. Space vacancy is highest in retail space in a decade. Take for example some of the recent events for retailers:Two retailers on the brink of collapse with strong potential to announce major store closings over the next six months include Steve & Barry's, which operates 276 stores, and Circuit City, which operates 696 U.S. stores. Add to this the likelihood that Linens 'N Things will liquidate the remainder of its store fleet (382 stores, as it already announced 120 closings in May and another 87 this week) and Whitehall Jewelers, which just filed bankruptcy, will liquidate its 373 stores, and there is already another 1,721 possible closing announcements over the next six months. Foot Locker is closing 140 stores; Wilson's Leather is closing 160; Ann Taylor, 117; and jeweler Zales has closed 105.
  • For some chains, times are even more desperate, and the drumbeat of retail bankruptcies grows louder by the day. So far this year, 15 retailers with assets of $100 million or more have filed for Chapter 11 bankruptcy, up from seven for all of 2007, according to, which tracks such filings.
  • Property & Portfolio Research expects the final tally of store closings for the year to climb to more than 6,000, compared with 4,600 closings in 2007. As of mid-August, Boston-based PPR reports 5,300 closings. Of the store closings tracked by PPR, 46% are located in malls and about 43% in strip centers, with the remaining stores tied to big-box retailers. The current retail vacancy rate nationally is 11.8%, according to PPR. The firm forecasts the vacancy rate to rise to approximately 13% by the end of 2008 and 14% by late 2009. Apparel stores accounted for about 35% of the 2,831 store closings tracked by the International Council of Shopping Centers (ICSC) in the first half of 2008. About 6.5% of the store closings through the first half of 2008 tracked by the retail industry trade group were in the home furniture and furnishings niche, one that moves in tandem with the housing market. However, this is an improvement considering that this niche accounted for more than 14% of store closings in the first half of 2007, and about 34% of the closings in the second half of 2007, according to ICSC.
  • Lack of liquidity: CRE market still have good fundamentals as no overbuilding occurred in this cycle, but distress in CRE will come from lack of financing. Owners have refused to sell in the last 2 quarters due to low prices but they have to sell some time if they can't refinance. My thesis is condos and single home developers will be the one doing most of the selling but income producing properties like offices and retail are in a better situation completely. Banks have been reducing commercial loans and taking reserves against commercial loans because they lump single home and condo development loans with all commercial real estate loans. Financing for this type of assets have dried up but for an owner of an office building that have available property will be able to get refinancing.
Conclusion and CRE investment thesis
One of the good things about the recent economy is that in most sectors--excluding the residential sectors--there was relatively little overbuilding. High oil prices, high commodity prices and fierce competition for construction equipment and material in other parts of the world--China, India, and the Middle East--tempered the market's tendency to overbuild and will make new space less competitive. The lack of over-supply in the US commercial real estate market will help to support and speed the recovery in the market. I will focus on companies with portfolios of downtown office space like Brookfiled Properties and Boston Properties as they own unique assets with high barrier to entry. The slowdown in lending and capital market activities has put the breaks on new developments making new supply in the future virtually non existent therefore allowing existing office space to command higher rent due to limited supply in the future. I will avoid companies with large development business or pipeline as they will get chocked in this current environment and their prospect of earning good return is outweighed by risks involved. I will avoid retail properties due to significant risks to their ability to increase cash flows. Supply in retail properties is abundant at the moment due to string of bankruptcies. But in general these vacancies are a function of economic slowdown and the same thesis for office space applies to retail. unique assets will command a premium due to higher replacement cost and the drying up of financing for new developments.

Pepsi Bottling to Distribute Dr Pepper's Crush Sodas -

Pepsi Bottling to Distribute Dr Pepper's Crush Sodas -

Dr pepper is making nice moves in their distribution and marketing. Also they have improved their supply chain structure by adding regional distribution and optimizing their warehouse facilities. All good moves to improve the bottom line.

In addition, some high level value investors have moved into the stock among them Ackman, Einhorn and Pitz. I guess those only serve as a confirmation of the value in Dr pepper.

I have been adding to Dr Pepper in the past little while averaging down on my position and still think it is a very attractive company to own.

August 21, 2008

IAC Interactive now 5 companies

IAC completed a stock spin-off of four separate businesses today leaving shareholders with five separate holdings. Will any of these spin offs be worth more as a separate company than a part of conglomerate?

The businesses now are as follows: Home Shopping Network (HSNI), Ticketmaster (TKTM), (TREE), International Leisure Group (IILG), and the parent IAC/Interactive Corp. (IACI).

All of 5 stocks got a good pop today except one Lending for obvious reasons. To me Lending tree is the most interesting business. It is in economic sector that no one wants however most the bad news and losses have been sustained already and they are reflected in their results. The company is strongly capitalized with $110 million of cash on hand. The company has a market cap just under $70 million. So the company is trading less than cash on hand makes it a candidate for "net net" business as defined by Graham. A further analysis and look into its business is in order.

I am not so excited about the other businesses. TicketMaster is a business that a lot of investors are falling heads over heals for due to its "monopoly" on ticket sales and distribution, so lets look at that for a second. TicketMaster built that monopoly at a time when Internet was absent so it had a technological and economies of scale advantages over separate venues because it was more ubiquitous. Now any venue can sell its tickets itself online and users can easily access their sites and venues do not need any scale to accomplish that.

LiveNation is concert promoter and constitute a significant portion of TicketMaster business, now its taking its business in house. Others can and will follow suit. So its monopoly is weak and could disappear quickly so I am not excited.

IACI the original business is headed by Diller and has tons of cash on hand due to the recapitalization. Mr Diller has bought any company with .com in its title over the past few years and now he is "unlocking value" by spinning them off. I am not sure I want to go through the same ride again. The remaining business of IAC Interactive is online advertising business that competes against the likes of Google and Microsoft. Those are very formidable competitors so the prospect of owning a business against those competitors do not excite me.

I have not looked too much at the Home Shopping network and the Interval Leisure Group to make any educated guess. So for the time being I want to look closer at Lending tree business and see if it worth buying.

August 19, 2008

Value Idea: NorthStar Realty- part 2- Risks

Part 1 can be found here.

Investing in what is called mortgage REIT is very risky and not for the faint of heart. Mortgage REITS market caps can be cut in half within few hours, and some actually have evaporated into bankruptcy heaven, hell is more like it. So it is important to list my risks and look down rather than up on this one. Actually if you read their quarterly or annual SEC filings you will be reading 3-4 times the number of pages of any other company. So here goes:
  • Liquidity: NRF has a good liquidity profile with some $296 million in cash and liquid securities.
  • Exposure to retail: Retail commercial real estate might be a sour spot and in a weaker position compared to other CRE properties and run the risk to suffer more defaults and losses. NRF has 8% mundane exposure to this retail properties.
  • Leverage: conservative leverage running about 3:1 compared to others with leverage that reaches up to 30:1.
  • origination discipline: management is very conservative in its risk management program. They avoided all of the residential fiasco by not buying intosubprime . They also originate their own loans rather than buying on the market so their have fist hand due diligence on borrowers and most importantly in most cases they have recourse on borrowers to recover their investment, if the loans go south.
  • no delinquencies in their portfolio so far and do not expect significant delinquencies in their CRE asset backed securities (CMBS) as most of their portfolio in CMBS have been accumulated prior to 2004 avoiding aggressive lending practices in the peak of the credit bubble from 2005 to mid 2007, see distribution of theirCMBS portfolio by vintage year.
  • with respect to risks associated with their CMBS portfolio: A 15% drop in property values will do relatively little to adversely impact the credit ratings of older vintage U.S.CMBS , even those tranches that are deemed impaired, according to Fitch Ratings in a new report titled '98% of Seasoned Deals Pass Stress Tests'. Other findings from the report:
    • Fitch stress tested its rated U.S. CMBS portfolio with significant exposure to near term maturities in order to address concerns about the stability of ratings. Tests were performed on loans maturing through 2012 and the results were evaluated on each transaction tested. Fitch concluded that these older vintages inCMBS were well-insulated in the event of a sizable drop (15%) in property value. Of the 1,381 total classes stress tested, only 138 were considered 'impaired', with only 20 of those tranches at the investment grade level. By class balance, 97.8% were considered not impaired, or $74.1 billion of the $75.8 billion tested. Classes that were determined to be impaired either incurred a hypothetical loss in the stress scenario, or the resulting credit enhancement deemed too low to support the current rating.
    • How bad can it get for commercial mortgage-backed securities in the event of a recession in the U.S.? A stress test on commercial mortgage-backed securities (CMBS) in 675 CMBS bonds, finds that CMBS securities rated BB have as high as a 63% chance of downgrade in a recession scenario, according to a recent Fitch study commissioned by industry trade group, Commercial Mortgage Securities Association, so you may want take that conclusion carefully. Moving up the investment spectrum, the odds against downgrading improve. Bonds rated BBB- have only a 47% chance of downgrade, while those rated BBB face a 31% chance of downgrade. AA-rated bonds face a low 2% chance of downgrade and A-rated bonds face a 6% risk. AAA-rated bonds in the stress test showed a 2% risk of being downgraded.
    • Expected losses could reach as high as 46% in the case of BB-rated bonds and as low as 1% for A-rated bonds. In the case of BBB- bonds, expected loss is more than 17%, and investors in BBB bonds could see more than a 9% loss. HoweverNRF portfolio is investment grade only and do not have any of BBB- assets.
  • Match funding: 91% of NRF capitalization comes from long term debt the balance is from short-term credit facilities provided by JP Morgan
  • CRE market still have good fundamentals as no overbuilding occurred in this cycle, but distress in CRE will come from lack of financing. Owners have refused to sell in the last 2 quarters due to low prices but they have to sell some time if they can't refinance. My thesis is condos and single home developers will be the one doing most of the selling but income producing properties like offices and retail are in a better situation completely. Banks have been reducing commercial loans and taking reserves against commercial loans because they lump single home and condo development loans with all commercial real estate loans. Financing for this type of assets have dried up but for an owner of an office building that have a viable property will be able to get refinancing.
  • No exposure to residential or sub prime and thus they are in better shape and their portfolio did not take a big hit.
  • Retail properties exposure: Retail CRE is one of the most problematic segments in CRE with many retailers under pressure due to consumer cut back on spending. NRF exposure to this sector is a mundane 8%
  • interest rate risk: NRF earns a spread between borrowing and lending rates so if borrowing and lending rates converge earnings will vanish and the company will be under pressure.

continued credit market instability, poor visibility on commercial real estate valuations, and a continued lack of liquidity in the CRE market are all uncertainties surrounding this type of business but I will buy those risk in the face of these uncertainties.
The book value is $12.5 which give me a 43% discount from its recent trading price.

This is a position to capitalize on irrational fear of all thing real estate. According to my thesis CRE have been thrown out with the bath water.

NorthStar realty presentations and SEC filings
CB Richard Ellis various research
Fitch research

August 11, 2008

Value Idea: NorthStar Realty

I have talked a lot about Commercial Real Estate (CRE) debt market in the past, see here, here, and here , and how pricing really do not reflect its economic reality. Mainstream media superficial analysis and reporting and fear from a repeat of the housing collapse have put downward pressure on all things real estate and CRE was not spared. I have also noted that CMBS debt have took a steep hair cut along with residential debt and now their pricing are attractive given their risk/ reward profile, see chart for spread over 10 year Treasuries. To be clear, I do not think this distress debt thesis will yield as a good of a result, if any, as in the previous crashes of CRE in early 1990s and 2000 downturn. There are just too many funds chasing these securities and crowding the market, keeping prices up. But still the returns can be worth while. I want to take advantage of this opportunity and place my bet, but what eluded me is how?

Then, I found NorthStar Realty Finance (NRF), the idea came thanks to NRF is ...

... an internally managed real estate finance company that focuses primarily on
originating and acquiring commercial real estate debt, commercial real estate
securities and net lease properties. The Company conducts its operations so as
to qualify as a real estate investment trust (REIT) for federal income tax

I bought into NRF at $8.6 on August 11 and it comes with a dividend yield of 16%, lets hope that I can see some of this yield this year!

Investment rationale:

  1. CRE Economics are OK: CMBS underlying market have relatively good fundamentals but they are priced for disaster defaults, which I do not think will happen. I have made this case before in various posts.
  2. Growth potential: I see several trends and reasons for increased business pipeline for NRF:
  • The tight credit environment offer opportunity to NRF to extend and originate loans and/ or buy discounted assets and debt. The CMBS market along with structured debt have evaporated overnight with the credit crises. It may be resurrected in the future but it won't be in the near term. Banks and traditional lenders are grasping for capital and as a result have tightened lending so much. However, there has to be a credit provider alternative for businesses and CRE and even individuals. There has to be some entity to fill the void for the market to function smoothly, albeit maybe at a higher interest rates, equity like rates of return maybe. I think private equity and companies like NRF will fill that void. It won't be cheap but I think they will price risk better than the banks did over the last 5 years. I think the growth potential here for NRF is absolutely terrific.
  • As Banks try to deleverge their balance sheets by selling loan portfolios. NRF will buy at steep discounts such portfolios and can earn high return on equity invested.
  • Another area of growth opened for NRF is sale-and-leaseback transactions, where corporations that own their offices sell them to raise capital and then lease them back from the new owners. Banks are engaging in these transaction at feverish pace; Citi bank, BofA, and many others are doing these transactions more and more. NRF has already done a number of them to Fortune 1000 corporations and will do more as corporate America tries to raise capital.
  • Mezzanine loans to owners is another growth area for NRF. Those loans provide equity like returns to originators and the dislocation in the credit markets makes the returns more attractive. Private equity outfits like KKR and Blackstone have been raising funds to take advantage of this segment, see story here. Distressed debt funds raised 38% more capital globally, raking in a total $33 billion in the first half of this year according to Private Equity Intelligence Ltd. The global pool of mezzanine capital doubled to $20 billion. The top three U.S. funds raised so far this year are: the $15 billion Warburg Pincus Private Equity X; Goldman Sachs Private Equity Group's $13 billion GS Mezzanine Partners V; and Oaktree Capital Management's $10.9 billion distressed vehicle, OCM Opportunities Fund VIIB. All this capital raising validate the thesis for NRF business model right now.
  • Liquidity is king: NRF has about $295 M in cash to deploy and in a time where liquidity is in short supply, those funds will earn excess returns. As I said above they can deploy these funds into areas of opportunities with high return on equity.
  • Experienced Management: good quality and accomplished management in the real estate and investment world. Moreover they own about 10% of outstanding shares and have been buying recently, always a good sign. NRF is internally managed that means that no asset manager is hired to mange the fund and carry the mandate. It is set up as a corporation that have employees and they make the investment decision rather an externally hired asset manager and in this case they have skin in the game through their ownership.

In the next post i will detail risks and valuation.

August 7, 2008

United Rentals: update

The tender offer has been oversubscribed and as a result the company prorated the buyout to all tendered shares, so each investor who tendered their shares sold a prorated 37.5% of tendered quantity. They have purchase 37.5% of my shares at the minimum auction price of $22.

Lesson for tender offers: always trade in odd lot quantities, i.e, less than 99 shares. This way your are guaranteed to get bought out by the company. You can buy different odd lot quantities in different accounts in your kids, spouse..etc name and tender it that way. In the future I will always by an odd lot quantity to participate in this type of trade. I have not bet any significant amount on the position and I will never do for these type of special situations and I do not advise of risking more than 1% of the portfolio on such trade as the upside is limited while the downside can be significant.

Currently I am waiting for an opportune time to sell the remaining shares and close my position in United rentals. It will be at loss of about 14% if I sell now.

new position added

I have purchase CB Richard Ellis (CBG) two days ago at $13.50 per share. I will post a complete write up on this opportunity, but highlight for my purchase:

  1. Premier real estate service company in the world.
  2. Commercial real estate fundamentals are deteriorating but will crash as many expect and therefore many real estate operation prices are selling at steep discount to net asset value.
  3. the outsourcing segment, which have recurring revenue and is not affected by occupancy as maintenance has to performed on a building if it is empty or not, valuation alone equals to market cap of CBG and you get other segments for free.
  4. The company has an international network of services in growing markets.
  5. Top skilled management that can navigate difficult market conditions.
  6. Commercial real estate prices do not affect their results as much as lack of transactions. Transactions over the last 6 months have been almost non existent but that is a temporary event that can reverse quickly.

The valuation of CBG has gotten really attractive after their earnings release, which has declined by some 80%. The company represent good value at these levels for the long term holding.

August 5, 2008

Merrill Lynch Deal with the devil

I have not written for awhile , life is busy on personal and business fronts. But I have few posts in the works about couple of investments I made or will be making shortly.

For the time being I want to share with you a write up by HCM on Merrill Lynch deal to sell some of its assets. I am in disbelief that investors are still bidding their stock up or still holding a position in this company.

Merrill Lynch & Co. Inc.'s decision to dump $30.6 billion of mortgage securities at an average price of $0.22 on the dollar barely a week after its quarterly earnings announcement (which itself included a $10 billion write-down on such securities!) raises more questions than answers about the firm and the prospects for credit markets to recover from their current crisis. Merrill Lynch agreed to sell these securities to Lone Star Funds for $6.2 billion, yet barely two weeks earlier the sale the firm had valued those identical securities at $11.1 billion. Moreover, the sale is structured in such a way that Merrill Lynch is financing 75 percent of the transaction. This means that Lone Star is on the hook for the first $1.7 billion of losses, and then Merrill Lynch will eat any losses beyond that. In other words, another $0.05 drop in the value of these securities would leave Merrill Lynch back on the hook for more losses. Either this will prove to be one of the most desperate transactions done in the annals of the current credit crisis, or John Thain knows something the rest of us don't want to know about the real value of the toxic waste he just sold to Lone Star. At the same time, Mother Merrill announced the sale of 380 milion new shares of stock to raise $8.5 billion in new equity capital. The issuance of additional shares at current prices triggered a make-whole provision in an earlier share sale to Singapore's state investment agency, Temasek that cost Merrill Lynch $2.5 billion. Temasek, the firm's largest shareholder, turned around and reinvested this $2.5 billion in Merrill's new share offering along with an addition $900 million. These announcements not only left Merrill Lynch shareholders severely diluted but, if they had been paying attention to the quarterly earnings call, deluded.

This transaction may constitute one of the oddest corporate announcements in recent memory.6 First, it suggests that Merrill Lynch's quarterly earnings announcement was grossly inaccurate since, with respect to these assets alone, the firm's valuation was apparently off by a factor of 40 percent. Second, it raises serious questions about the values all financial firms are placing on their mortgage securities. Either Merrill is alone in mis-marking its book by 40 percent, or other firms are grossly over-valuing their holdings and will be forced to report large write-offs in the third quarter. What is particularly troubling (but gives the anti-quantitative HCM a wonderful dose of schadenfreude) is the enormous gap in valuations that different firms (i.e. Lone Star and Merrill Lynch) can apparently derive from securities that are allegedly valued according to mathematical models whose precision is such that they would have problems hitting the side of a barn.

And naturally Merrill Lynch's announcement, which included a highly dilutive share sale to compensate for the multi-billion capital loss suffered by the firm, led to a rally in the firm's stock price. Let us get this straight - the firm admits that it grossly mis-marked its book, reports a(nother) multi-billion dollar loss, announces a hugely dilutive stock offering, and the stock rallies? Makes perfect sense to us. And people wonder how and why the financial markets continually fall into crisis!