A wind blows against rental property.

Facebook is rumored to be trying to buy Sun Microsystems' 2.5 million square foot campus in East Menlo Park from Oracle. But the burning question among Bay Area commercial real estate circles is, why are companies building and buying campuses, instead of leasing some of the 40 million square feet of vacant space in Silicon Valley, even at historically attractive rental rates?
If you were to ask one of these campus builders or buyers, you might hear two answers, the business manager’s answer and the finance department’s answer.
Business Manager's answer:..today more than ever, the lifeblood of high-tech is attracting young talent that will create your next product, service or killer app. The 20 and 30-somethings do not want the suburban experience that was so comfortable for the baby-boom generation. No, the gold standard today is to grow your company in downtown Palo Alto with its youthful energy, restaurants, shopping and clubs. If you are too big for downtown Palo Alto, a company can build a campus to create its own amenity-rich experience, ala the Google campus in Mountain View.
Financial Manager's answer... the lease versus own scenario is going through a radical shift – making ownership more attractive.

Lease versus own going through radical shift?

Two fundamentals are changing. First, interest rates are so low that they are distorting the market. Companies can finance a purchase of a building with cash, (which is earning below 1% at the bank), debt (which is amazingly cheap; in September Microsoft sold 5-year bonds at 1.625%.) or equity (Facebook has a 165 P/E ratio = equals a cost of capital of 0.6%. Apple, Google, eBay have P/E ratios in the low to mid 20’s; still a relatively cheap 4% to 5% cost of equity capital.).
Even during these distressed times, no landlord will willingly accept a return of 2% to 5% for their office or R&D building. So owning is cheaper.
Second, The FASB and the IASB are moving to eliminate operating lease accounting entirely. And (at the risk of stating the obvious) if all leases are treated as capital leases then one of the main reasons for leasing versus buying disappears. The rule change also requires all probable rental increases for the base term and likely extension options be brought forward using straight-line accounting. Under the new rule, occupancy charges will be significantly more than the rent actually paid in the early years of a lease. So owning will look cheaper still, once this rule takes effect.
This accounting change would be retroactive to all leases. So, even though the elimination of operating leases is not yet required, companies should make decisions today as if this rule change is in effect. See the attached slide set from Deloitte explaining this pending change to FASB 13.

In a nutshell, the model may be changing from build-to-lease to build-to-sell; we'll watch how this plays out..
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Money is trying to flow to Commercial Real Estate again!

Each Fall Newmark’s correspondent lenders receive their production goals for their next year. How does next year look different to the past two?

• In 2009 it was: “No money to lend. Sell loans. Encourage payoffs. We want to shrink.” 
• In 2010 it was: “Here is a pittance. Put the feelers out there. Make a few loans. Take no risk.” 
• In 2011 it sounds to me like: “Get the money out the door. Here is a big allocation. But, again, take no risk. “ 

All our lenders are back in the market. Newmark's sweet spot tends to be loans in the $3 to $40 million range, though we have lenders able to lend up to a quarter of a billion dollars and others down to half a million.

Lending targets for all lenders are up compared to the last two years; click here to see the approximate production goals and loan strike-zone for the most active lenders represented by Newmark in our Northern California office. And I hear from our lenders that their 2011 targets on production are generally seen as minimums. The commercial loan departments are being told by their Chief Investment Officers, CIOs: “If they can double production over these goals without undue risk – please do it.”

Why the change? Life Insurance companies invest in fixed income assets in two areas, bonds and commercial mortgages. Basically, the returns from the bond market right now stink. This August IBM issued 3-year bonds with an interest rate of 1%! In September Microsoft sold 5-year bonds at 1.625%! So mortgages that are in the 4% range for 5-years fixed and 5% range for 10-year fixed seems pretty good to CIO’s hungry for yield.

As to the CIO’s order to take no risk? That will change slowly. There is too much money chasing too few risk-free deals. We are already starting to add risk-mitigation structures to mortgage transactions in ways we were not allowed to do 12 months ago. Compared to what went through for the last three years, 2011 will be a good year for commercial real estate – I think we should soon be able to call the bottom on commercial real estate values. When rates are low and money flows, values lift. Like the character in Pixar’s “UP!” our disposition may improve with a little upward momentum.

Great recession or a great bust?

I know a boom when I see one.
I was at ground-zero during the dot-com boom that ended in the tech-wreck of 2001 to 2003. It is my job to interpret local economic drivers for Newmark Realty Capital’s life insurance and pension fund mortgage lending clients. During the dot-com boom, we pointed out to our lenders that our local boom was unsustainable. They were cautious and Newmark’s commercial property loan servicing portfolio sailed through unscathed. I was happy the dot-com boom did not last any longer than it did. If it had, the damage in its wake to the Bay Area economy would have been worse.

In my opinion, the word “Recession” needs to be banished from the current debate. We are not going back to normal, or at least the “normal” of the last 10 years.  The seven years from 2000 to 2007 will someday be seen for what it was: a Great Debt-Driven Boom. 

What's a Debt-Driven Boom?

We had a number of unsustainable stimuli hyping the economy at the same time. Each of these stimuli created or encouraged excessive private and public borrowing. Between 2000 and 2009, the total annual increase to non‐financial debt averaged more than 11% of annual GDP. The result was similar to a family who lives the last 6 weeks of each year totally on credit cards and never pays off the bills; a nice life style that is not sustainable.

What will follow will not be a rebound.

It will not be a “V”, a “W” or even an extended “U” recovery. Because what we are experiencing is not the down-side of a business cycle. 
The USA and most of the developed world needs to prepare instead for a slow rebuilding. This time, hopefully, the economic rebuilding will be upon a sound foundation focused on investment and production versus on an economy built on finance and consumption as in the Great Debt-Driven Boom.
Faced with what will likely be a long recovery, my advice to investors is to stay conservative, de-lever and maintain cash reserves. Plan for a slow rebuild, not a quick rebound.

Click here to download Eric's article "the great recession is really the great bust", including his comparison of the debt-driven boom to the dot-com boom.

Bay Area Economic Engine - September 2010 Update

Each year at this time I make a comprehensive overview of the employment sectors that drive the Bay Area economy, as a tool to help predict the relative health of the local real estate sectors and locations.


Click to download

The picture looks a lot different to last year or even to six months ago. Profits are back, sales are up; these are leading indicators for employment and demand for space in these sectors in 2011.

The chart here gives a snapshot of my findings. Traffic light colors indicate status as we enter the last quarter of 2010; arrows indicate likely direction for next 12 months. You can download a complete copy of my 2010 Bay Area Economic Engine update, by clicking here.

The Bay Area... many diverse economic drivers, most on independent trajectories

The 7+ million people in the Bay Area are 19% of the State’s population and 2% of the Nation’s. The area’s $373 billion GDP in 2008 is 3% of the Nation’s.

The only major metropolitan area with more Fortune Global 1000 companies is NYC, with 69 vs. the Bay Area’s 54 which have sales of $957 billion vs. NYC’s $1,173 billion. Since the Bay Area outranks NYC in the number of fast growing companies NYC’s top share of large companies may not hold.

If the Bay Area were a country it would be ranked 25th behind Norway but in front of Austria and Taiwan. The Bay Area is second to the DC Metro Area and tied with Boston for the proportion of the population with 4-year or greater degrees.

And of course, the Bay Area’s infrastructure for innovation is second to none. It is always the “new new thing” that brings the Bay Area back from a downturn.

Rising above, leaping ahead...

This time last year we were in the brunt of the crash, wondering when we would see the end of the Great Recession. Commercial Property lending was largely shut down.

August 2009, the Newmark team joined many local businesses to run, jog, walk in the annual JPMorgan Chase Corporate Challenge; a 5K race around the San Francisco Embarcadero. We didn't expect to win alongside teams from Pixar, Wells Fargo, HP, Cisco and other Bay Area legends... but we were sure to have fun.

Sporting T-shirts that read "Goodyear? Not! But rising above!", our goal was simple; enjoy the day and stay in the race...

Here we are a year later, running in the 2010 5K Challenge which benefited the YMCA Kids for Camp Fund. It was a cold San Francisco summer evening as we made our way along the waterfront course past AT&T Park, but the Newmark team was running well and feeling optimistic.

The theme for the event was "green" and our Newmark team returned with T-shirts bearing a smiling cartoon frog, who is wearing Newmark logo running shorts and the mantra "Leaping ahead!".  

We know many of our borrower and some of our lender friends felt their lives were turned upside down during the crash. Commercial real estate is still struggling to recover. Hanging over us even now is the threat of a second recession that some economists give a 50-50 probability.

Newmark is still in the race. And as we prepare for the 2011 Challenge, perhaps our T-shirt design should include a cartoon bowl of chips and salsa, with the caption "Please! No double dipping!"

Lowest rate or best loan?

With interest rates nearing a 50-year low, common wisdom says get the lowest rate fixed for as long as possible – but what does capital wisdom say?

Rates nearing a Fifty-Year Low
Chart courtesy of Federal Reserve Bank of St.Louis

I work with a wide variety of lenders to get them to put forward the most competitive rates they can offer. But just as important, I work closely with my borrowers to explore their full range of requirements so that we can match the best fitting loan option to their unique situation.  The best match is not always the lowest interest rate.

Lowest rate may mean lowest payment, but may not always mean best deal.

Evaluating various loan quotes and selecting a lender can be a process of comparing apples and oranges and it’s tempting for borrowers to focus on two quantitative measures… the interest rate and the amount of the loan.  What other criteria should be weighed in selecting a lender?

Over the life of the loan other issues may represent additional costs, require extra borrower resources, cause delays or even introduce business risks. The list below is not exhaustive, but represents common questions we cover:

• Does the lender have a reputation of being reasonable and responsive?
• What flexibility can be built into the loan documents?
• Who will service the loan?
• Will the information you submit for the loan request be made public to potential CMBS bond buyers and thus potentially to your competitors?
• When in the closing process will the interest rate be locked in? 
• Is the loan assumable; if so can you cleanly get off of any guarantees? 
• How often will you need to give the loan servicer rent rolls, operating reports and financial statements?
• Will all or most leases need lender’s approval?
• What is the likelihood of being re-traded during the due diligence or closing process?

In a nutshell

As a borrower, look for a solution tailored to your needs. Calculating a loan payment may be simple math, but calculating its full cost can be a science and selecting the right lender, an art.

Financial Reform and the Real Estate Industry

The long-awaited financial regulatory reform bill cleared its final legislature hurdle late Thursday, passing the Senate 60-39. President Obama is expected to sign the bill into law this week

More than 2,300 pages long, the Dodd-Frank bill is intended to address the myriad of problems believed to have caused the financial crisis.

The Mortgage Bankers Association worked with lawmakers on issues impacting the real estate finance industry and has provided a summary report of the Dodd-Frank bill, highlighting areas of interest to our community. 

Below is an overview of key provisions in the Bill, extracted from the MBA report. Click here for full report with expanded summaries of provisions of particular interest to mortgage banking. 

The bill would:

• Establish Financial Stability Oversight Council to address systemic risks;
• Provide liquidation authority to permit orderly liquidation of systemically risky companies;
• Revise bank and bank holding company regulatory regime by transferring Office of Thrift Supervision functions to Office of Comptroller of Currency (OCC) and clarifying regulatory functions of Federal Deposit Insurance Corporation (FDIC) and Board of Governors of Federal Reserve (FRB);
• Establish regulation of investment advisers to hedge funds;
• Establish a new Federal Insurance Office to monitor the insurance industry including regulatory gaps that could contribute to systemic risk;
• Restrict banks, bank affiliates and bank holding companies from proprietary trading or investing in a hedge fund or private equity fund;
• Increase regulation and transparency of the over-the-counter derivatives markets;
• Establish new regulation of credit rating agencies;
• Establish new requirements regarding executive compensation including shareholder “say on pay;”
• Require securitizers to retain economic interest in assets they securitize;
• Empower new CFPB as an independent office in FRB with broad new authorities and functions and responsibilities under wide range of current consumer financial protection laws;
• Establish extensive requirements applicable to mortgage lending industry, including detailed requirements concerning mortgage originator compensation and underwriting, high cost mortgages, servicing, appraisals, counseling and other matters; and
• Preserve enforcement powers of states respecting financial institutions and restrict preemption of state laws by federal banking regulators.

back to capitalwisdom blog...

Financial Reform - can we keep it simple?

Finance reform is on hold, waiting for the successor to Senator Robert Byrd to vote it through. Will the new Bill do the trick though? Harvey Pitt, former chairman of the SEC, tells StreetWise columnist Suzanne McGee he's not happy with it.

We’ve got 2,500 pages, which ensures that pretty much no one in Congress has actually read it.

Ouch! Harvey Pitt would like to see three very simple elements:

First, a provision that anyone whose business or dealings have a significant impact on financial markets should be forced to supply significant data on their products and services, their liquidity and leverage, and so on to regulators.Secondly, we need to impose an obligation on government to analyze all this data and disseminate it... Finally, we need to set circuit breakers, something that will give government the ability to stop, look, listen... and identify any systemic threats.

A number of analysts are comparing Wall Street and BP. In his Global Research article, Can We Fix the Oil and Financial Crisis Before It's Too Late? Danny Schechter points to BP's frequent full-page ad “We may not always be perfect, but we will make this right” then asks "and who will make our economy right?"
I've been broadly quoted as saying finance is not that complicated and financial reform should not be that difficult. And yes, I do think you can explain it to a kindergartner (read my Mad Meat !). It should not be that hard to regulate

Pretty pigs and falling rates. What next?

Rates did not rise.

At the end of last year, with the 10-Year Treasury yield bouncing between 3.7% and 3.9%, experts agreed it was an artificial low created by the Federal Reserve purchases of long term Treasuries.

Anticipating the selling-off of this large horde, Bank of America, Merrill, Goldman Sachs, J P Morgan and Morgan Stanley were forecasting rate increases, by now to the 4.25% to 5.5% range.

The 10-year Treasury is currently trading in the low 3% range.

What happened?

P-ortugal, I-reland, G-reece, S-pain?

The Euro sovereign debt crises and the lack of anywhere else besides gold as a store of value, makes the dollar the best of the bad.

What next?

This will not last. If you can get a loan, lock in these low rates for as long as possible.

Easy Money, Hard Truths - NY Times

Great opinion piece in the New York Times from David Einhorn, who begins with the question... are you worried that we are passing our debt on to future generations? And follows with the "reassurance" the recession has created budgetary stress sufficient to bring about the crisis much sooner then that...

"If we don’t change direction, how long can we travel down this path without having a crisis? The answer lies in two critical issues. First, how long will the capital markets continue to finance government borrowings... and second, to what extent can obligations that are not financed through traditional fiscal means be satisfied... by the printing of money?"

http://www.nytimes.com/2010/05/27/opinion/27einhorn.html?hp#

Good reading.

The San Francisco Bay Area Economic Engine

Just like the weather, a local economy is driven as much by micro-climate swings as it is by seasons and global climate changes. The SF bay area is especially influenced by its local economy, which can move in polar opposite directions to the economy of the rest of the country.

Here's my assessment from 2009, I'll be publishing the 2010 assessment here soon:

http://www.e-newmark.com/e-newmark/newsletters/BA_Economic_engine-update-Fall09.pdf

Stamping out AAA ratings?

It's been three years since the securitized debt plane began its crashing descent. Crash investigations continue with the hope that findings will prevent future failures. Last week the Fiscal Crisis Inquiry Commission, chaired by Phil Angelides focused on the credit rating agencies.
Rating agencies may not have been the root cause of our financial crash, but Angelides points out they did play a fundamental role in accelerating the securitization and therefore the origination of products that were highly deficient... such a low teaser rates, negative amortization and an epidemic of mortgage fraud. Warren Buffet points out the entire American public was caught up in the belief that housing prices could not fall dramatically, what he calls a mass-delusion.
If there's a lesson to be learned it's don't believe everything you read on a label, take a good look inside the package.

Phil Angelides to Moody's "did you ever feel like Lucy on the assembly line?" Great video of the hearing if you have a few hours to spare... http://www.c-spanvideo.org/program/293839-2

Concrete lessons from Haiti and Chile

It's not hard to spot the risky buildings. Is it time to provide full disclosure of seismic risks similar to what we do today with other environmental risks?

The concrete coalition is a group to which I am lending my support. Their cause could save many lives. Here's an extract from their website, check it out...

http://www.concretecoalition.org/

The potential safety problems posed by some concrete buildings constructed in the U.S. west coast prior to the 1970’s are generally well known among structural engineers and building officials practicing in seismically active areas. Public policy makers are somewhat less aware and the general public is not informed adequately of the potential risks.

These buildings are widespread. They were a prevalent construction type in the western U.S. prior to enforcement of codes for ductile concrete in the mid-1970s. The exposure to life and property loss in a major earthquake is immense. Many nonductile concrete buildings have high occupancies, including residential, commercial, and critical services. Severe damage can lead to critical loss of building contents and risk of ruin for business occupants and partial or complete collapse can result in large numbers of casualties.

The Concrete Coalition will generate a concerted effort to advocate the identification of these dangerous concrete buildings and the development of sensible solutions to reduce risks associated with these buildings.