Silicon Valley in Transition

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An interesting study was published this month on the workforce implications of the renewed growth of Silicon Valley’s cluster of IT industries, the Information and Communications Technology (ICT) cluster; networks, computers, chips, telecom, software, hosting, social media, etc.
For a copy of “Silicon Valley in Transition” go to  http://connect.one-stop.org/lmi/TechStudyFullReport_03.pdf

Here are the highlights:

• The ICT sector added 13,000 jobs in greater Silicon Valley (now defined to include San Mateo, San Francisco and southern Alameda counties) since 2009.

• The ICT sector is conservatively estimated to grow 15% over the next two years, adding around 20,000 new jobs.

• Companies are already finding it hard to recruit in certain engineering fields.

• Average salaries in the ICT cluster are growing again and now exceed $150,000/year.

• Silicon Valley is a magnet for start-ups and venture capital because of its deep pool of highly skilled talent. This talent in Silicon Valley is seen as more flexible and willing to adopt and learn the new technologies that cannibalize the old. Without “positive destruction” Silicon Valley would not be what it is today.

• Even as other tech centers have proliferated, Silicon Valley share of total US venture capital investment has steadily grown, now exceeding 40% of the nation’s total VC funding. The Valley’s “infrastructure for innovation” attracts companies such as Facebook to relocate here and companies such as Groupon and Wal-Mart Online to move engineering here.

• The reviving IPO market (Pandora, LinkedIn, and soon Twitter and Zinga will go public), is letting the local VC players cash-in, so Silicon Valley’s share of the VC pie is likely to grow further.

 

Dear Amazon, you have to be kidding!

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This just in....
Amazon has filed a petition in California for a ballot measure asking voters to repeal the law passed in late June that was designed to force online retailers like Amazon to collect sales tax. Amazon will hire the firms that will collect over 430,000 signatures by late September to qualify the referendum for a statewide ballot on Feb. 7, 2012.

Paul Misener, vice president of public policy at Amazon, in a statement sent to journalists claims "This is a referendum on jobs and investment in California...."

Mr. Misener is correct. It is a referendum on jobs in California. Giving online sellers a 7-9% price-advantage over local California businesses, will shut down local businesses and will drive jobs out of California. If you need evidence, ask the19,000 employees at Borders. Borders was driven into bankruptcy largely due to this uneven playing field.

“It is in every Californian’s interest for online and store front businesses to play by the same rules," Betty Yee, first district member of the California Board of Equalization, said in a statement. "I strongly doubt Californians will support a loophole promoting out-of-state jobs, when holding Amazon.com accountable to the same rules as everyone else protects California’s economy.”

Let's hope so.  Support your local retailers who pay real estate taxes to our cities and collect sales taxes for both our state and cities.  Boycott Amazon.com.

See http://www.bizjournals.com/mobile/sanfrancisco/blog/2011/07/amazon-strategy-fight-california-tax-law.html

Time to boycott Amazon.com?

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A key component of California’s 2011-2012 budget is to require online retailers to collect sales tax. Amazon is not taking this lying down and sent an email June 29th, 2011 severing ties with all its California affiliates (not me - "Capital Wisdom” has no sponsors or advertisers). Amazon is refusing to pay the tax and is preparing a legal challenge.

It is time for us to say, “Enough!”  And, we in the commercial real estate industry need to be the loudest voice. 

We, who make our living from the bricks-and-mortar industry, see the effects of an uneven playing field on retail tenants.  Our bookstore chains are dead or dying and our electronics stores are sick.  You can download a bar-code-reader app to your smart phone, stand in the aisle at Best Buy and with a few clicks, order that exact model flat-screen TV from Amazon, delivered to your front door and save tens or hundreds of dollars in taxes. 

Competition is great, but true competition requires a level playing field. 
Bricks-and mortar retail stores pay rent to our industry.  But more than that, they pay sales tax and property taxes to our States and local communities; they hire our young people; they sponsor our little league teams and support local causes and charities. 

You might think a bricks-and-mortar retailer could open its own on-line outlet and achieve the same benefit as Amazon.  No; they can only avoid collecting sales tax if they have no stores in that state. 

The consumer is responsible for paying its own sales taxes on on-line purchases.  A system that requires people to voluntarily tax themselves: How stupid is that?

Write to your Congress person
Tell them to pass legislation to require all on-line retailers to collect sales tax based upon the sales tax-rate for the zip code where the goods are to be delivered.   Tell Congress to ignore the screaming that “This is too difficult!” These are automated systems – it's not that hard to do.

When dot.com retailing started, the San Francisco Bay Area was a center of this activity.  At that time I supported a special status for these retailers.  Ignoring sales tax was a way to get this fledgling industry born.  

Amazon.com went live in 1995; it is now a 16-year old:  We have a powerful, self-centered and headstrong teenager on our hands. Time to grow-up.  Time to shop local. Time to boycott Amazon.com.

Why We Do Not Want Two Classes of CMBS

The multitude of Dodd-Frank regulators are working on the new rules for CMBS 2.0.  Built into the Dodd-Frank legislation is the concept of a Qualified Commercial Mortgage (QCM) - a mortgage considered conservative enough that no risk retention (aka Skin in the Game) will be required.  QCM Pools will have different players, different subordination levels and better pricing than CMBS bonds made up of loans that do not qualify as Qualified Commercial Mortgages.

I would like Congress and the Regulators to look at the QCM issue from 30,000 feet.   If they do, I am hoping they will agree with me that creating two classes of CMBS will cause more harm than good.

What is being proposed are two classes of CMBS “Prime” and “Less than Prime.” (Let's not use the phrase "Sub-Prime")
You may feel a sense of déjà vu: We saw this before in residential.

Two classes of CMBS is a mistake for three reasons:
1. It is not good for commercial real estate.
2. It is not good for portfolio lenders.
3. It is not good for the CMBS industry.

Let me take these in order:

1. Threat to Commercial Real Estate
Quality commercial real estate is not suffering from a lack of capital. Quite the contrary, we are hearing the word “Bubble” being thrown around again. Life Companies are slugging it out to win the conservative loan business.  What is lacking is capital for properties that, for reasons of location, product type or leverage, are not targeted by the portfolio lending industry. This is why we need CMBS to come back. QCM pools are a distraction for the CMBS industry. Creating a “Less than Prime” second category of CMBS will discourage funds flowing to where it is desperately needed. And when these funds do flow it will increase the cost of borrowing for owners of real estate largely ignored by the portfolio lending industry

2. Threat to Portfolio Lenders
When Ronald Regan was in office there were two classes of commercial real estate and commercial loans; life insurance quality deals, and S&L Quality Deals. Things have not changed. The life insurance companies are lending on the same quality deals. CMBS came in in the 1990's to fill the void the S&L's left. Having the CMBS industry now target Life Company quality business with a source of very cheap capital is an unneeded threat to a vital portfolio lending industry.  A low cost of capital killed the residential portfolio lending industry and could do so again in commercial lending.

3. Threat to the CMBS Industry
What we had in CMBS 1.0 was pretty much an undifferentiated securities product, with mortgage pools containing both the diamonds and the dreck. Removing the diamonds will not make for better mortgage pools. This new two tier CMBS system is not in the interest of the bond investors. The QCM pools will lack risk retention and will be created with very high incentives to force deals to be qualified as QCM. Subordination levels on QCM pools will be minuscule. I think that time will show that QCM pools will be anything but risk-less.

CMBS bonds made for Less than Prime pools will be penalized in pricing:  By removing the diamonds from the dreck the cost of mortgage loans for non-QCM product will be high and financing for this class of property might not be very plentiful.

Lenders' Views

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Once a rising tide lifted all boats, but now lenders are looking for what they perceive are sure bets. So what are lender's current preferences? Apartments stay on top, with office bringing up the rear.

Apartments

Life Insurance lenders are beating the GSA's on good quality infill apartments. This could be because of where spreads are right now, but it could also be a political move on the part of the agencies. If the Tea Party wants to privatize FNMA-Fannie and FHLMC-Freddie, the best way to show a need for taxpayer support is for the agencies to be active where the private sector refuses to go, rural communities and C-Quality urban product. On the borrower side we are seeing active apartment owners rebuilding relationships with the life companies just in case the agencies are curtailed.

Retail

Lease provisions besides rent are more important than ever, effecting mortgage rates and property values. If owners are signing new or reworking old leases, they need to fight to get rid of co-tenancy clauses and to get annual reporting of retail sales. A mortgage rate might be 100 BP more for a big-box retailer without sales data versus a similar store where the owner can show the tenant has good sales performance.

Industrial
Lenders' adversity to single tenant deals is creating a big advantage for those owners who can do portfolio financings. Newmark Realty Capital has been able to get major discounts in interest rates for large industrial portfolios, say a single loan against 10 properties. With cheaper financing these larger players can bid higher for property to buy and bid lower rent to attract tenants to fill their buildings.
Office
Why, with 40+ million square feet of vacant office and R&D space in Silicon Valley, do we see major users designing campuses and leasing new buildings at twice the rent they would pay for a 1980's vintage R&D building? Partly tenants want safer more resilient buildings. To meet this resiliency demand from users the structural engineering profession is working on standards that will estimate a building's downtime after a major quake. ATC58 is in draft and should be issued in 2011. Just as important, tenants want spaces that can layout for the "office of the future", see my April posting.
Other Product Types
Newmark remains active in the outlying product types; self-storage, mobile home parks, data centers, hotels. If it generates income we can find a financing source, working with a wide range of lenders with a broad spectrunm of interests. We have a long list of life insurance correspondent lenders, are active in CMBS 2.0 and are also working with those banks that are back in the market.

To see the office of the future, watch how Tech does it

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Micro cubes & bull-pens requiring multiple break-out rooms. 5.7 employees/1,000 SF and growing. A negative trend for office buildings – especially suburban stock.

San Francisco’s tech sector employment is approaching the highs of the dot-com era. See the excellent article by Casey Newton in the SF Chronicle.

But don’t throw a party quite yet
What strikes me is the shrinking use of office space on a per employee basis is erasing the growth in employment. San Francisco’s Tech sector is now down to an average of 175 square feet per employee or 5.7 employees per 1,000 square feet, with many companies cramming 10 employees into 1,000 square feet.

Why is this important?
The tech sector is the harbinger of trends in office use. This makes sense: Tech companies refresh their build-outs often, because they are either growing or collapsing. Tech employees are generally younger and more willing to accept change. These companies have already adopted the latest technology, so their office layouts show what is coming next.


 Zynga’s space (Desks 2’x6’, Cubes 3’x6’):

Photo: Liz Hafalia / The Chronicle

Take a good look at the photo of Zynga's office space...

What is making this possible?

Changes in Work Style
If you want to get a hold of a baby boomer, pick up the phone. If you want to talk to a Y-gen, send them an IM. In a phone-based corporate culture, 175 feet per employee would sound like a call center. These densities only work when people communicate electronically.
Richard Pollack, principal architect for the office interiors firm, POLLACK architecture, comments; “It’s becoming more prevalent in the young-person tech world that you shouldn’t even expect to get a quick response if you send an email to them! In fact, the current electronic communication approach is centered on social networking, even within companies. Salesforce.com released Chatter in 2010 which is their social networking tool for use by their clients and staff, and Google relies strongly on their multi-user collaboration tools known as Google Apps. Both companies are POLLACK architecture clients.”

Changes in Design of the Work Place
John Able, a prominent office leasing broker in San Francisco, told me the secret to maintaining employee satisfaction, with bull-pens and micro-cubes, is the provision of ample “Break-Out Rooms” available on an unscheduled basis. Densities of up to 10 employees per 1,000 square foot can only work by providing unassigned private break-out rooms, available when an employee needs to harangue a supplier, pitch a potential big customer, meet with a colleague or set up a date for the weekend, i.e. If you are going to have an extended conversation you head to the break-out room.
Richard Pollack also notes that beyond the Break-Out Rooms, a current design focus is to provide significant open collaboration space, with massage chairs, foosball, ping pong, etc. These spaces often incorporate white board walls (sometimes using special “white board paint”). Other trends are a lot of glass, and all the perks that we hear about – dry cleaning, dental vans (the equivalent of a food truck), etc.


Tech jobs up; space per tech worker down

Changes in Corporate Priorities

Rent used to be the top expense after salaries for the most office users. No longer - many modern companies are now spending more on IT than rent. According to the Corporate Executive Board benchmarks, the average company spent $8,910 per employee per year on IT in 2010. Software and Tech companies spent slightly more at $11,470 per employee per year. If a typical Tech company finds space today at $35/sf/yr full service in San Francisco, with only 175 square foot per employee, their rent is only $6,125 per employee per year, little over half of their IT budget.

What does this mean for office buildings in the future?

Clearly the design of office interiors is changing. But what is also changing are the metrics – Companies are focused less on rent per square foot and more on rent per employee. This change in metrics effects tenants’ location decisions. If you want to cram 10 employees in 1,000 sf then a typical suburban office building in a business park is less appealing. A tenant will accept a higher rent if that location allows them to achieve a high employee density. The typical suburban inhabitant is not going to tolerate this cutting-edge work-style, which is more akin to a college study hall or university library then the office environment of the baby-boomer generation. If you want to lower your rent per employee you need to be near Generation Y , i.e. hip and urban areas. You will also need a location where much of your workforce can come by public transit because the typical suburban office parking lot with a parking ratio of 4 cars per 1,000 sf of office space will be overburdened.



What does this mean for the recovery in the office sector?



As employment picks up, we will be fighting a trend toward less office space per employee. The recovery of the office sector will be delayed unless your office building happens to be in a Generation Y hot-spot: In my mortgage banking territory that is Palo Alto-Mountain View, Berkeley, or San Francisco.

The graphs and pictures for this blog posting came from the San Francisco Chronicle;  click here to read the article



Some good news for commercial real estate landlords and lenders

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The Financial Accounting Standards Board and the International Accounting Standards Board have agreed to modify their proposed accounting rule changes that would have required balance sheet treatment for all commercial real estate leases.

The Incentive for Commercial Property Users to Lease-versus-Own Stays Intact.

The proposed changes to the FASB13 accounting rules would have jeopardized the current accounting treatment of operating leases by requiring all leases to be treated as capital leases, i.e. a lease obligation would show up as a liability on a tenant’s balance sheet. Read my blog post of December 22, 2010 for more details.
The real estate industry lobbied hard against this accounting rule change, with the ICSC (International Council of Shopping Centers) being especially active. The Mortgage Bankers Association (MBA) also weighed in heavily – and successfully turned around this controversial proposal.

Here’s the MBA’s recent report on the topic:

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (collectively, the Boards) have agreed to modify their controversial proposed accounting rules that would have required balance sheet treatment for all commercial real estate leases. The Boards have agreed to consider separating leases into two categories: financial leases and other-than-finance leases. Financial leases would be put on the balance sheet as an asset and liability and paid down over time. However, other-than-financial leases would be considered operating leases and would not have to be capitalized, which is the current accounting treatment for commercial real estate leases. MBA strongly supports the other-than-financial accounting treatment of commercial real estate leases. In addition, the Boards eased the standard for when lease option periods would have to be included in the lease value from “more likely than not” (over a 50 percent probability) to a much higher threshold.

Rebuttal to the Rebuttals to the Financial Crises Inquiry Commission Final Report

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The Financial Crises Inquiry Commission issued its final report at the end of January. The commission split along party lines with the Republicans offering two dissenting opinions.
The dissenting reports do not dispute the facts of the crises. The key points of dissent boil down to how to answer these two questions:
1. Could knowledgeable people have foreseen the financial crises?
2. Could regulators have played an active role in heading off the crises or limiting its damage?
The Democratic members answer “YES”; the Republicans answer “NO”.
(The second dissent pins most of the blame on the government itself not for lax regulation but for its jiggering of the free market with government incentives for home ownership).
The Republican dissent casts doubt on the efficacy of regulation, i.e. Regulation only slows the economy and can have unforeseen consequences. No one saw this coming.
“Pro-Business” legislators tend to have a reflexive response, “Get the government as far away as possible and the free market will function best”. But are these pro-business politicians defending 0% - down, liar loans? That is the equivalent of advocating an unlimited speed limit on Highway 1 along the coast of Big Sur. People drove off the cliff? Really? No one saw that coming.

Support of free Capital Markets does not mean “no law” and does not mean “no policeman”
I am a great believer in free markets. As a young man (with hair), I was a big fan of Alfred Kahn and was able to meet with him in 1978 when he was deregulating the airline industry through the Civil Aeronautics Board. He is still a hero of mine. But, as a business person I quickly learned that market participants often conspire to keep their market from being anything but free and fair.

I respectfully dissent from the dissenting opinions.For some reason we feel that regulators must stay far away from financial markets. I disagree. If any other industry sold products known to be dangerous, that cost the public their fortunes, jobs and dreams – people would demand to see indictments and prosecutions and, if not, we would see public outrage and new laws. Yet, at this time, three years after Lehman’s demise – VERY LITTLE NEW REGULATION IS IN PLACE! The too-big-to-fail banks are even bigger.
The wisdom of our forefathers that separated depository institutions and investment banks was proven to be correct, yet in order to save the Investment Banks our government merged the two industries. “Financial Reform” has been kicked down the road by Congress to the regulatory arena – an arena dominated by the lobbyist of the Big Banks and Wall Street.

Many Cultural Myths about “free” financial markets need to be deflated...

“The Free Market Knows Best.” In our minds the free market is a buyer and seller each knowing the product, facing each other haggling over price: If a market is this direct and open, it works. To try to regulate it would allow either side to attempt to game the system. But, when the market is controlled by a re-packager and re-labeler of the product, who keeps buyer and seller apart so risks are hidden, watch out! IT IS NOT A FREE MARKET. It is a license to disorient and game both buyer and seller.

“In Time the Just Will Prevail.” The Wall Street vendors of CDO and Subprime-backed securities knew they were selling unsafe, if not poisonous, investments. The investment banks that survived were those who kept the least inventory or who bought more of the antidote (credit default swaps) than the companies that went toes up. The most cynical investment banks survived.
Why was AIG bailed out in the blink of an eye? They sold the antidote! Credit default swaps against these toxic pools of mortgage bonds.
Goldman Sachs, the clear winner in this debacle, designed and sold several CDO’s, in fact, 3 are within the top 5 highest default ratios. Goldman established a book-making operation taking bets on whether these products would default. They convinced their own clients to buy positions betting the bonds would perform. Goldman then reaped huge profits betting against their own bonds. Given how the mortgage pools were picked, a sure outcome. The SEC $500 million fine is a minor slap on the wrist given the magnitude of the profits made. (Goldman bet against the housing bubble, $21 Billion on Credit Default Swaps with AIG alone. We taxpayers made good on Goldman’s bet with AIG.)
When purveyors of dried milk added melamine and knowingly sold dangerous products to the people of China and the world – they paid the ultimate price – summary execution. And what happened to those who knowingly polluted our financial markets.

“These were Sophisticated Buyers Who Knew the Risks.” Who runs the investment desk at a company’s pension plan, union or government retirement fund? Generally not a sophisticated buyer. In the face of a commission-incentivized Wall Street Investment Banker that pension investor is cannon-fodder
“Only Fat Cats are harmed by Wall Street.” We know today, this is not true. We are all victims. This is everyman’s retirement money. Dreams melted into despair. We will each be working 5 to 10 years longer because our Government let this happen.
“All it takes is Full Disclosure.” So you read those inserts with your prescription medicine in 4 point type? They’re about the same. Wall Street lawyers are artists of obfuscation. With hundreds of pages of red herrings no wonder it is so hard to sniff out the real deal.
“The rating agencies are watching the store.” This myth needs no further deflation.

“The World of Finance is too complicated to regulate.” I’ve said before, nuclear power is complicated and we regulate that. Why? Because it can blow up in OUR FACES!
But finance is not that complicated. Ask a kindergartner:
What is a loan? If you lend a classmate a dollar, you expect him to pay it back.
What is loan underwriting? If that classmate is unlikely to pay it back, do not lend him the dollar.
Explain a credit default swap to a kindergartner? You offer a quarter to the friend of the kid to whom you lent the dollar, if he guarantees his friend will pay you back.
A derivatives’ market? You go to your fellow kindergartners and take bets on whether the borrower-classmate will or won’t pay his debt.

It is not that complicated. We need some common sense laws. And we need the government to police these laws.

Summary of the conclusions of the Financial Crisis Inquiry Commission:
http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_conclusions.pdf
Dissent Joined by Keith Hennessey, Douglas Holtz-Eakin, and Bill Thomas: http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_hennessey_holtz-eakin_thomas_dissent.pdf
Dissent by Peter J. Wallison: http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_wallison_dissent.pdf

For a lighter version the meltdown download my cartoon parable about the financial crises,” Mad Meat!”: http://www.scribd.com/doc/40224496/MAD-MEAT-September-2010

Scene and heard at CRE Finance Council Conference in Washington DC

View from the (departure lounge) bench
Stranded overnight at Dulles Airport in a snowstorm may not have been the ideal end to the CREF Finance Council January conference, but it left me plenty of time to contemplate the (other) memorable moments from this year’s January CREFC Conference.  Here's my summary of the event. For a selection of slides from the event click here.

Rational Exuberance?
The mood at the CREFC January 2011 event was near giddy.  CREFC’s events are attended heavily by Wall Street-oriented players; CMBS conduits, issuers, rating agencies, securities lawyers and bond investors.  I've said it before... what a difference a year makes.  Michael Heagerty, Newmark’s CFO, described the mood at last year’s conference as desperate to suicidal; in January 2010 conference speakers were predicting health would not return to the CMBS new issue-market for many years, if ever.  This year’s CREFC participants seemed to be shifting their outlook from relief at having survived to fully-pumped and ready for action.

2011 Likely Lending Volumes
Banks: Larger banks have worked through or written down much of their CRE loan problems and are coming in to 2011 pushing for resolution of distressed loans now that the real estate markets are seen to have stabilized.  As a result, banks are making noises about making new commercial real estate loans in 2011, maybe even making a construction loan here and there.
Life Companies: The life companies as an industry will increase volumes moderately in 2011 over 2010 levels of roughly $30 billion.  Life Companies generally increased their production targets for the coming year, but will face a lot more competition in 2011.
Wall Street:  CMBS loan production may exceed life company volumes in 2011.  In 2010 the industry did about $11.6 billion of new CMBS issuance.  However, in the first quarter of 2011 $11.3 +/- billion of CMBS are scheduled to come to market.  Various industry estimates for the 2011 full year range from $30 to $60 billion of new CMBS issuance.

2011 Rates and Spreads
Rates:  The conference saw a fairly universal prediction that long term interest rates will increase as the economy strengthens.  If you want low rates, root for a double-dip recession. Some speakers felt that with a full-paced recovery we could see a 5.5% yield on the 10-year T-Bill within a year.
Spreads:  Spreads are already down but might have 20 to 25 BP left to tighten.  Many CMBS investors have AAA bonds that were valued not long ago at 70 cents on the dollar, now find these same CMB Securities are valued at 105 cents on the dollar.   The managers in an investor’s CMBS department look like heroes even if they did nothing all year.  Investors are hungry for new issues and the 20 or so conduits that are now in the market are chasing the few good loans in the market.  The issuers are holding firm at making 4% to 5% in profit on each new issue brought to market.  So spreads will only tighten if the bond buyers are more comfortable and strongly bid for the bonds.

Hot topic - CMBS 2.0 vs. a rebooting of CMBS 1.2
There was much talk at the conference about the attempt to totally re-write the rules of engagement for CMBS under Dodd-Frank, an effort labeled CMBS 2.0.  Many felt that the crafting of new regulations is turning into a jump-ball where Big Banks have an unfair advantage.  The players at either end of the CMBS process, at the front borrowers and mortgage bankers and at the back bond investors and B Piece buyers, feel strong-armed by the dominant issuers of CMBS.
Each of the Big Four Banks (Chase, Wells, Citibank and BofA) plus Goldman Sachs and Morgan Stanley has more lobbyists in DC than any single trade association.  These banks are pushing for and likely to get new rules that will limit competition, protect their securitization profits and maximize their control of the process.  For example, the CMBS bond investors question the banks pushing for a vertical slice retention policy (a slice of each level of security from AAA to first-loss) to meet the 5% risk retention required by Dodd-Frank.  As an alternative, the bond-investors are calling for a return to the olden days of CMBS, say the 1999 to 2003 playbook - what people are calling CMBS 1.2, when there were strong B-Piece buyers who actually held the first-loss risk in the mortgage pools and actively kicked-out bad loans from the pools.
The banks have the balance sheet to meet the 5% retention requirements, which today basically means leaving in their securitization profits.  With a vertical slice the Big Bank’s retained profits will not be at risk – if the first loss piece is say 4% of the pool, 5% of that 4% is only 0.2% - a negligible amount of the Big Bank’s securitization profits.
Other Dodd-Frank regulations favoring the Big Banks: (a) Loan buy-back requirements in the proposed loan originator’s reps and warranties. (b) Planned Regulation AB changes making it hard for loan servicers with smaller balance sheets to stay in the game.

Competitive Landscape
JP Morgan/Chase had a 50%+ market share of the CMBS new issue volume in 2010.  Nothing speaks louder about the loss of competition than a single player achieving a 50%+ market share.  The Big Four US Banks, a few European Banks plus Goldman Sachs and Morgan Stanley will dominate the new CMBS world.  Many of the 20+ conduits who say they are in the market are really planning to feed loans into pools led by these few big players.

So is exuberance warranted? Does a middle seat in Economy look great after a night on a bench at Dulles Airport? You betcha.

Commercial mortgage loan restructuring - old skills, new toolbox

Standard & Poor’s reports that 354 securitized commercial real estate loans with a principal balance $15.6 billion were modified from January through November of 2010, up from 216 loans valued at $7.06 billion for all of 2009.

We can work it out…
Newmark’s Debt Advisory Group is very active working with borrowers who have existing CMBS loans that are underwater, i.e. where value < loan amount.  Since its formation in 2009, the group has achieved significant discounted pay offs (DPO’s) that have allowed properties to be recapitalized, achieving a better outcome than would have been achieved through foreclosure - for both the borrower and for the CMBS trust.

The three R’s still apply
Debt Advisory is a highly specialized area; even Newmark’s most experienced mortgage bankers do not attempt it on their own. But while the toolbox is completely different, debt advisory uses the same skills and strengths that are the foundation of a successful mortgage banker; what I call the three R’s:

1. Relationships
On the new loan production side, commercial property finance is a small community.  On the Special Servicing side it is a different and much smaller community.  There are very few Special Servicing firms and they are understaffed.  The asset managers for Special Servicers are deluged with calls from developers, brokers, and mortgage bankers all trying to get in the door to pitch their services and/or get an inside track on distressed notes and assets.  Most of these calls go unanswered and unreturned!
Ted Norman who heads Newmark’s Debt Advisory Group worked for two firms that are major special servicers and before that he ran a CMBS production shop for TIAA-CREF.  Newmarks contacts with the special servicers run through one person, so relationships build with each assignment. Ted gets his calls returned!

2. Reputation.
It is one thing to be known and another thing to be respected.  A stellar reputation is built upon years of doing business fairly, adding value for the fees earned and being reasonable.  And remember, Special Servicers are just doing their job, they want to deal with reasonable people; table pounders or those who use legal threats are best dealt with through foreclosure.  Ted gained his reputation through working to achieve and document a win-win result. He’s learned that presetting a borrower’s expectations to a realistic outcome is greatly appreciated by the Special Servicer.

3. Real Estate Knowledge.
What distinguishes top mortgage bankers is the depth and breadth of their knowledge of commercial real estate.  A gut-level knowledge of real estate values with the ability to back up these assessments with data is the most important value-add for commercial property mortgage banking.
The difference in loan workouts is that the mortgage banker is focused on distressed real estate vs. stabilized assets,   Instead of collecting the highest rent and value comps, the work-out specialist is collecting the lowest.  This glass-half-empty mind set is completely different than what is needed for new loan production, another reason Newmark created a specialized group to handle debt restructuring.

For an on-topic article by Ted Norman for the California Mortgage Bankers Association click here. 
Download Eric's CMBS workout's worksheet.

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.