Public Debt and Financial Overhaul

I normally do not post on issues in the political realm, but what I hope to do here is make clear the dangers that lie hidden in the current financial overhaul bill recently passed by the Senate. With the rhetoric around the bill giving away nothing and being spun around preventing financial catastrophe, I think it useful to put the bill in the proper context of the current fiscal climate of the country. I then explain one provision I know something about impacting the commercial real estate sector: the carried interest provision. Simply put my argument is that :

1. Our nation does not have the luxury to live off of borrowed money for much longer.
2. In order to face the very real problems relating to fiscal imbalances and public debt, we must do all we can to grow the economy through promoting entrepreneurial activities.
3. The carried interest provision will serve the opposite purpose by disincentivizing capital to back entrepreneurial activity in the commercial real estate sector.

I am not going to take much space expousing on 1 above as I think this is obvious to most people. For some perspective on the magnitude of the issue please see the below video I produced from a recent lecture from the introduction to macroeconomics given by Kenan-Flagler Business school professor Christian T. Lundblad.

2. In order to face the problems relating to fiscal imbalances and public debt, the economy must grow through incentivizing entrepreneurial activities.

Peter Drucker, in his 1985 book Innovation and Entrepreneurship: Practice and Principles (1985), (yes 25 years ago) articulates why an entrepreneurial society and tax structure promoting entrepreneurship was needed then in America. He foresaw the worker skill gap created by the decline of smokestack industries due to the forces of globalization, and proposed that innovation and entrepreneurship would be our route to staying competitive in the global economy. Here are a few quotes: "........an entrepreneurial society and economy require tax policies that encourage the formation of capital." and "just as important......is protection of the new venture against the growing burden of government regulation, reports, and paperwork".

Why is this even more important today than 25 years ago? If we as a nation are to have any chance of avoiding the true financial catastrophe looming do to unprecedented imbalances based on unfunded liabilities then we must do all we can do to promote the economic growth that will provide the tax base to deal with the situation without the burden of additional taxation.

I speculate that the future obligations are too large to expect that taxation alone can fund them as levels will need to be far too high to have a positive net impact. By this I mean that we will cross the point where tax revenues will actually be less due to the negative impact the tax burden will place on the economy.

3. Now, to the current bill on the table (and just signed I see). The "carried interest provision" is inserted evidently for the express purpose of limiting profits made by hedge fund operators and other investment partnerships. Most private real estate investment partnerships utilize structures whereby the sponsor or developer gets a profit share after a target return has been paid to investors. This happens because the sponsor takes on the burden of guaranteeing  the debt in a project and taking on inordinate risk as a result, and because of the fact that the sponsor is the party utilizing their expertise  to create value. The carried interest provision as it is written will increase operating taxes on the sponsors interest by 21% and more importantly, on the profit or capital gain by up to 150%. If this is not bad enough, it will also disallow the sponsor to claim any losses on the carried interest. This fact is important because the underlying assumption the bill is trying to establish is that the carried interest is compensation income and shouldn't be treated like investment income. How many workers do you know that guarantee the debt of their employers for the right to receive a paycheck? Below is a more detailed discussion of the impact from a recent webinar I participated in from ICSC. A copy of the complete presentation along with speaker bios can be found at http://www.icsc.org/

This provision of the new bill will only discourage the formation of capital in commercial real estate, add to the devaluation problems already occuring, and ultimately add to the larger problems of fiscal imbalances in our country while doing nothing productive to safeguard the financial system.

The $30M Scapegoat

While I do not normally comment on the news, a recent article in The WallStreet Journal caught my attention as it relates to the CRE market. In - Examnier: Lehman Torpedoed Lehman- the Journal reports among other things that a court appointed examiner found that  "Lehman improperly valued its real-estate assets". What makes me shake my head about this is that so was everyone else and by the way, they still are. Not only this, but the FDIC is enabling and encouraging the practice among community banks holding real assets. I cannot comment on the other allegations in the article, but it appears that the $30m report provided a nice scapegoat for the crisis.

How can this be:
 It is based in the fact that the industry is reliant upon appraisals for valuations of underlying hard assets. It is the classic social psychological phenomena that occurs when no one knows the value so what do they do but ask the expert. Where does the expert get their value. there are three methods, income approach, comparable approach, and replacement approach, which are then reconciled. For income producing assets the income approach is given the most weight and so this is where I will focus. I will briefly point out that the comparable approach is simply looking at what everyone else has done in the past. In a dislocated market, where there are very limited comparables to choose from and the past comparables are from an overheated market, there is very limited relevant usefulness. The replacement approach is a straightforward approach to what it would cost to rebuild a structure today, but it will not give an acurate market valuation. Please note that I have nothing against appraisers or appraisals under normal market conditions. I am simply pointing out that their are serious limitations to their usefulness in dislocated markets.

The income approach:
The income approach relies heavily on on picking the right capitalization rate. Many appraisers construct their cap rate based on formulas utilizing current interest rates and other factors. The problem in a dislocated market is the fact that most will not go far enough in their assumptions and will overvalue properties.

The result:
Anecdotally, I am seeing banks taking properties they own to market based on appraisals and being unable to sell because the 7 offers they receive are well below that number. Basically, the market is telling us what the value is but we do not want to hear it, so if we ignore it it will go away. In many cases the banks are upset at the appraisers because they would be leaving themselves open to regulatory and shareholder scrutiny if they actually sold at the market value.  In steps the FDIC. If the FDIC takes over a failed bank that currently has property on their books at appraised value X but the market values it at X-100, then the FDIC is shouldering the liability and allowing the bank to hold the property at appraisal value X on the books. The bank has less incentive to liquidate the asset due to the backstop, and holds it on its books at an inflated valuation.

2010 - Year of the Sale Leaseback?

Briefly, a sale leaseback transaction occurs when an owner and user of the same property decides to sell the property while maintaining the use of the property through a lease.  Essentially  the transaction provides more liquidity to the business owner as equity requirements of a refinance are freed up. A seller/lessee (tenant) looking to build does not have to tie up cash in the form of a down payment required by conventional banks. A seller/lessee who already owns the property can unlock the equity in the real estate and turn that equity into cash. For a corporation the added benefits include improved debt-to-equity, current , and return-on-assets-ratios when structured properly.

The dynamics of the current real estate environment set up well for these type of transactions:

Fundamental valuations are low:  Appraisers should be using discounts of 30 to 40% over 2007 peaks with further to go if they are using recent comparables and assessing  fundamentals in arriving at their valuations. Why does this matter to the user? It matters because valuations are not going to come back expediently and assets with leases are valued differently than vacant assets.

Credit is tight: The fact is that the terms are much tighter than in the recent past, and somewhat tighter than historical norms as a reaction to the credit crisis.  This means Loan to Value Ratios are lower and proceeds from refinancing will be lower on top of the lower valuations banks will get from appraisers.

Investors still chase yield:  Valuing a lease based on the yield to the investor as opposed to fundamental metrics will yield the seller/lessee much more than they would receive on a fundamental real estate valuation.

Interest rates are low (but for how long): Interest rates  are as low as they can go yet  recent comments by Fed official Thomas Hoenig  (see WSJ article here) suggest that they will not wait too long to begin raising interest rates. We know that rates cannot go lower, so when they do start to rise valuations will be impacted in sale/leaseback transactions due to investors yield requirements going up as well.

To understand the implications of the above consider the following example. A 50,000 office building that was appraised in 2007 for $10M and refinanced then at an 80% LTV would have yielded $8M to the owner. That same building today will appraise for $7M and only be provided a 65% LTV yielding $4,555,000. The asset will still be on the books at book value and artificially deflate Return on Assets.

By contrast, the business can sell the asset for closer to the appraised value and lease it back under a triple net lease. If structured properly, the company will net more cash and be able to have similar occupancy costs, thereby enhancing return on assets, and freeing up capital to put to use in its core business.

 2010 will be a good year for sale leaseback transactions to occur for companies looking to free up liquidity, reduce liability, and enhance long term operating performance.

Postscript: As a case in point Novant Health recently completed a $122 million sale-leaseback of a 22-building medical office portfolio in Winston-Salem and Charlotte, N.C.