Friday, August 27, 2010

New IRS Rules: Partial Releases of CMBS Debt

IRS REMIC rules require that certain tests be met with respect to changes to individual CMBS loans for a CMBS trust to retain its tax-free status. Failing these tests can result in the pool losing its status as a REMIC, which would have horrible consequences for the trust.

In the case of partial releases, the loan servicer has to date been put in a no-win situation: the borrower had a right to a partial lien release under the loan documents; yet doing so would violate REMIC rules and the servicer's agreement in its servicing agreement with the trust to comply with REMIC rules.

The IRS' new Revenue Procedure 2010-30 gives guidance on partial release of liens and details how the IRS will provide relief for loan modifications of CMBS loans that are “grandfathered qualified mortgages” and “qualified pay-down transactions.”

The Revenue Procedure provides that a partial lien release will be a "grandfathered modification" if:

  • It occurs by operation of the terms of the debt instrument, and
  • The terms providing for the lien release are contained in a contract that was executed no later than December 6, 2010.

The Revenue Procedure defines a "qualified pay-down transaction" as a transaction in which a lien is released on an interest in real property and which includes a payment by the borrower resulting in a reduction in the adjusted issue price of the loan by a qualified amount.

So, if the CMBS loan expressly permits a partial release of a portion of the property upon the payment of a partial release price (all as expressly specified in the loan documents), then the CMBS loan servicer may go forward with the partial release.

A Practical Observation on the Risks of Stupidity

Truppenführung ("Unit Command") was a German Army field manual issued to all commissioned and senior non-commissioned officers from its first publication in 1933 up to the end of World War II. It contained basic military doctrine for the German land forces during the war and a modified form is still in use today by the Federal German Army.

German General Kurt von Hammerstein-Equord observed in Truppenführung:
"I divide my officers into four classes; the clever, the lazy, the industrious, and the stupid. Each officer possesses at least two of these qualities. Those who are clever and industrious are fitted for the highest staff appointments. Use can be made of those who are stupid and lazy. The man who is clever and lazy however is for the very highest command; he has the temperament and nerves to deal with all situations. But whoever is stupid and industrious is a menace and must be removed immediately!"
What class is your loan servicer in? What class of real estate investor are you?
"The first criterion in war remains decisive action. Everyone from the highest commander down to the youngest soldier, must be constantly aware that inaction and neglect incriminate him more severely than any error in the choice of means." (emphasis in the original text)
Are you being proactive in restructuring your debt?

Sunday, August 22, 2010

The Art of The Pitch

When presenting to investors, the entire purpose is to convince them that YOU are the person they are going to invest their money and make money in return.

You have to convey 10 different characteristics:
  • Integrity
  • Passion
  • Experience
  • Knowledge
  • Skill
  • Leadership
  • Commitment
  • Vision
  • Realism
  • Coachability
Think about your pitch as a time-line, take them on an emotional journey:
  • Start like a rocket, you have 10 seconds to get their attention (story/experience)
  • Take them on a solid steady upward path
  • It’s got to get better and better and then at the very end you need to knock it out of the park
  • You want to get them on such an emotional high that they’re ready to write you a check right there before you leave
So how do you do that?
  • Logical progression – what is the market, what are you going to do, how are you going to do it etc.
  • Let them know that there are touchstones, you want to tie in the rest of the world out there
  • Outside validation – make sure somebody else out there says this makes sense
  • Believable upside which is 2 parts – upside, yet it’s got to be believable
  • Don’t tell any lies which will discount what you’re saying
  • Any typo or stupid mistake will show you can’t run this project
How to Give Power Point Presentations:
  • Short short bullet points, just the headlines, or even better just pictures
  • No long title slides, they know the date and who you are and why you’re presenting, just give them your company logo
  • Give a quick business overview – 2 sentences
  • Show who the management team is
  • Tell them about the market, why is this market worth getting into
  • Tell them about your product, what is it
  • How will you make money on it
  • Who are you selling this to?
  • Do you have any relationships that are going to be special to help you
  • Say exactly what your competition is and how you are special
  • Give a financial overview – project a few years out – what are the drivers
  • How is the money you get from them going to help you get there
  • How much money you actually want – what’s the money in so far? You must have invested personally
  • Then take it back to just the logo – give the final pitch that will put it over the top
Top 5 Power Point Presentation Tips:
  1. Never ever look at the screen
  2. Don’t read your speech
  3. Handouts are NOT your presentation
  4. Always use a remote control
  5. Always use presenter mode, it helps you pace yourself and lets you know where you’re going

Thursday, August 19, 2010

Moody’s CRE Aggregate Index Down 4% in June

It is important to remember that the number of transactions is very low and there are a large percentage of distressed sales.

According to Moody's, commercial real estate values are now down 41.3% from the peak in late 2007.

Wednesday, August 18, 2010

CRE Sales Prices Down 7.8% May to June

From CoStar Commercial Repeat-Sales Indices, July 2010:

The commercial real estate market’s pricing has been a tale of two worlds with the largest metro markets attracting significant institutional capital and forcing prices upward over the first two quarters of 2010, while the broader market has continued to soften.

This divergence of the two worlds may soon change as we are now witnessing a pause and softening even within the investment or institutional grade primary markets.

Over the past ten months we have seen the overall CCRSI oscillate from positive to negative and back again, with preliminary July figures very likely to be down for the investment grade property markets. From May to June, the overall CCRSI was down 7.78% with the investment grade property declining by 4.83%, reversing previous positive movement.

The CCRSI July report is based on data through the end of June. In June, 665 sales pairs were recorded, up significantly from May, during which 506 transactions occurred. Overall, there has been an upward trend in pair volume going back to 2009. February 2009 appears to have been the low point in the downturn in terms of pair volume, when 374 transactions were recorded.

Distress is also a factor in the mix of properties being traded. Since 2007, the ratio of distressed sales to overall sales has gone from around 1% to above 23% currently. Hospitality properties are seeing the highest ratio, with 35% of all sales occurring being distressed. Multifamily properties are seeing the next highest level of distress at 28%, followed by office properties at 21%, retail properties at 18%, and industrial properties at 17%.

Sunday, August 1, 2010

Record CMBS Losses

Realpoint reports total delinquent unpaid balance for CMBS increased by $3.1 billion to $60.5 billion, 111% higher than the $28.6 billion from a year ago, after deteriorations in 30, 90+ Day, Foreclosure and REO inventory. This represents a record 7.7% of total outstanding CMBS exposure.

Even worse, total Special Servicing exposure by unpaid balance has taken another major leg for the worse, jumping to $88.6 billion, or 11.3%, up 0.7% from the month before. And even as cumulative losses show no sign of abating, average loss severity on CMBS continues being sky high: June average losses came to 49.1%, a slight decline from the 53.6% in May, but well higher from the 39.6% a year earlier. Several properties reported loss % of 100%, and in some cases the loss came as high as 132.4% (presumably this accounts for unpaid accrued interest and liquidation costs).

Putting all this together leads Realpoint to reevaluate their year end forecast substantially lower: "With the combined potential for large-loan delinquency in the coming months and the recently experienced average growth month-over-month, Realpoint projects the delinquent unpaid CMBS balance to continue along its current trend and potentially grow to between $80 and $90 billion by year-end 2010. Based on an updated trend analysis, we now project the delinquency percentage to potentially grow to 11% to 12% under more heavily stressed scenarios through the year-end 2010."

And an even scarier dynamic is currently occurring in the Special Servicing space, where after a slight decline in the rate of deterioration, June once again saw a surge in this forward looking indicator.

Realpoint has this to share on the role of special servicing:

Special servicing exposure continues to rise dramatically on a monthly basis, having increased for the 26th straight month through June 2010. The unpaid balance for specially serviced CMBS under review in June 2010 increased on a net basis by $5.23 billion, up to a trailing 12-month high of $88.6 billion from $83.38 billion in May 2010 and $81.38 billion in April 2010. Special Servicers will play a key role in the level of delinquency reached in the next 12-24 months as large loan modifications, lender financing (through discounted assumptions and modifications prior to foreclosure), maturity extensions and approved forbearance have the potential toslow down or mitigate delinquency growth and delay losses. In addition, while vacancies across most if not all property types are near historic highs, optimism has recently surfaced regarding asking rents and vacancy across distressed loans. Some experts believe that increased interest for vacant retail space and pent-up demand may fuel a recovery for the sector.

We hope for the sake of all those value investors who have bought into the GGP resurrection story, that they are right, although if one actually goes by such things as fundamentals, which value investors presumably track as well, things are not looking good:

  • Special servicing exposure increased for the 26th straight month to approximately $88.6 billion across 4,830 loans in June 2010, up from $83.38 billion across 4,755 loans in May 2010 and $81.38 billion across 4,689 loans in April 2010.
  • For the 31st straight month, the total unpaid principal balance for specially-serviced CMBS when compared to 12 months prior increased, by a high $48.07 billion since June 2009. Such exposure is up over 119% in the trailing-12 months.
  • Conversely, for historical reference, special servicing exposure was below $4 billion for 11 straight months through October 2007.
  • Exposure by property type is now heavily weighted towards office collateral at 24%, followed by retail at 22% and multifamily at 21%.
  • Unpaid principal balance noted as current but specially-serviced decreased to a low of $1.44 billion in July 2007, but has since increased to $30.9 billion (up slightly from $29.73 billion a month prior).
  • Within the 3.9% of CMBS current but specially-serviced, we found 257 loans at $27.28 billion with an unpaid principal balance at or over $20 million, compared with 266 loans at $26.04 billion with an unpaid principal balance at or over $20 million a month prior.
  • Unpaid principal balance was at or above $50 million for 128 current but specially-serviced loans in June 2010, and was at or over $100 million for 68 loans.

The never ending deterioration has forced Realpoint to reduce its already bleak outlook for future delinquency trends, noting the following dynamics:

  • Balloon default risk remains an issue form both highly seasoned CMBS transactions as loans are unable to payoff as scheduled. In many cases, collateral properties that have otherwise generated adequate / stable cash flow results are not able to refinance their balloon payment at maturity, due mostly to a lack of refinance proceeds availability. This continues to add loans to those with distressed collateral performance in today’s credit climate.
  • Five-year and seven-year balloon maturity risk is growing for more recent vintage pools from 2003 through 2005 where little or no amortization has taken place due to interest-only payment requirements, while collateral values have also declined. Within this area of concern, large floating rate loan refinance and balloon default risk continues to grow, as many of such large loans are secured by un-stabilized or transitional properties reaching their final maturity extensions (if they have not done so already), or fail to meet debt service or cash flow covenants necessary to exercise in-place extension options.
  • Declined commercial real estate values and diminished equity in collateral properties continues to prompt more struggling borrowers with marginal collateral performance to claim imminent default and ask for debt relief.
  • The aggressive proforma underwriting on loans originated from 2005 through 2008 vintage transactions, commingled with extinguished debt service / interest reserves required at-issuance, has led to an increasing number of loans underwritten with DSCRs between 1.10 and 1.25 with an inability to meet debt service requirements. This is especially evident with the partial-term interest-only loans that will begin to amortize or those that have recently converted.
  • A cautious outlook for the hotel sector remains as many sizable hotel loans from 2005-2008 vintage pools have reported poor or declined results in 2009 (especially on the luxury side) and / or continue to be transferred to special servicing for imminent default. Many properties had to significantly lower rates to maintain an acceptable level of occupancy across the country and in some cases have experienced severely distressed net cash flow performance as a result. Our expectations are that more of these loans may be asking for debt relief in the near future and may ultimately default if a resolution is not reached.

The 5 and 7 Year cliff refinance issue is particularly notable in a delinquency exposure chart by vintage, where it is all too visible that 10 Year paper in need of rolling is going delinquent at an alarming rate: well over a quarter of all outstanding 1999 CMBS is in delinquency as there is nobody willing to fund a roll of the underlying debt:

And when looking at the most important category of all: liquidations and loss averages, these show no improvement either, as prevailing loss averages amount to about half of total outstanding principal:

  • Both liquidation activity and average loss severity for these liquidations has been on the rise over the trailing 12-months, especially in the past few months of 2010. An additional $762.9 million in loan workouts and liquidations were reported for June 2010 across 126 loans, at an average loss severity of 49%
  • Since January 2005, over $10.9 billion in CMBS liquidations have been realized, while only 48 of the last 61 months have reported average loss severities below 40%, including 21 below 30%.
  • Annual liquidations for 2009 totaled $2.18 billion, at an overall average severity of 42.1%. The overall average was clearly brought downward by the number of loans that experienced a minor loss via workout fees and / or sales or refinance proceeds being near total exposure, while the true loss severities by our definition averaged 62%.
  • Comparatively, annual liquidations for 2008 totaled $1.297 billion, at an overall average severity of only 24.9% while liquidations in 2007 totaled $1.094 billion at an average severity of 32.8%.
  • Liquidations in 2006 totaled $1.93 billion at an average severity of 30.2%, while 2005 had $3.097 billion in liquidations at an average severity of 34.2%.