REITs Living on a Wing and a Prayer
This is nothing more than the big boys' version of the "don't ask, don't tell" approach to home lending.
Considering the frustration percolating among commercial real estate bears, I'll risk beating the proverbial dead horse and re-repeat my thesis for stubbornly sticking with short positions in the iShares Dow Jones Real Estate (IYR) and its brethren, the ProShares UltraShort Real Estate (SRS), both of which would have destroyed my year's performance were it not for some decent risk management. Without much prose, here is my thinking:
- By now it's beyond dispute that commercial real estate loan defaults are going through the roof. If you enjoy gory stats read here and here.
- As shown by Vornado's (VNO) report, many investments in mezzanine debt tranches, i.e. second mortgages, are getting wiped out.
- Rents are falling and refinancing rates – for those who can refinance – are rising, killing cash flow. Again using VNO as an example, a recent refi in the Washington area cost them a rate of more than 7.5%, up from sub 5 levels, and that's for one of the best credits out there. Hence the cash flow crunch that's forcing REITs to pay net income in part or in whole using stock rather than cash.
- According to Jones Lang LaSalle (JLL) commentary, property values are down about 50% from the peak and it still does not seem to be enough since sizable transactions are few and far between.
- In the face of all of this the IYR is up close to 100% from the lows.
- There are two primary reasons why the equity value of properties – as reflected by the REIT stocks at least – are going up while mortgages on those same properties are growing increasingly impaired: First, banks have no desire to foreclose on the properties, so they roll defaulting mortgages into new restructured instruments and hope that time will cure all ills. Second, the REITs do not have to mark-to-market the value of their equity positions.
So here's how the game works:
1) REIT ABC owns a property purchased in a single asset entity for $200 mln with a $130 mln first lien, a $30 mln mezz loan, and $40 mln of equity.
2) The first lien, and often the second, are non-recourse to the parent REIT.
3) The REIT can't afford to pay the mezz loan and (a) the lender realizes that there would be no collateral value in a foreclosure so it simply walks away for nuisance money and make-up provisions that would make it whole if the property is one day resurrected. Or (b) the lender restructures the loan with terms which all but wipe out the equity value under any reasonable scenario.
Either way, at that point by all objective measures the value of the property is less than the debt, and the punitive terms of a restructuring have all but wiped the equity for good.
But the REIT does not have to mark-to-market its equity position, and since technically the lender has not foreclosed, the REIT keeps carrying the value of its equity at book, on a hope and a prayer that something unfathomable will restore equity value before the property is liquidated.
Hence, the magic of positive equity values while the underlying debt is not getting paid.
This is nothing more than the big boys version of the "don't ask, don't tell" approach to home lending that ultimately gave us Fannie Mae (FNM) and Freddie Mac (FRE). But what is even more maddening is that REITs management will tell us straight up on conference calls that property values are down 20%, 30%, 50%, but the same management will list asset value in public filings that have actually gone up in the last 18 months. Just look at the net real estate holding values for VNO, Boston Properties (BXP) and Simon Property Group (SPG) as shown in their 10-Q filings.
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In the words of Dana Carvey "well now, aren't they special?"
The end game will unfold when the properties must ultimately be sold – or when the regulators decide to see this bright red elephant in the room. At that point REITs investors will get nothing back, and we'll be subjected to another episode of the blame game for this outrageous scheme that everyone concerned has heretofore enabled.
And so the beat goes on.
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