Kevin Kleen has a very good blog titled Residential Property Analytics.  I’ve only been reading it for a short time, but already he has impressed me with the thoughtfulness of his posts.  He actually linked to a post of mine and he offered a pretty good rebuttal.  My original post had advised aggressive disposition strategies for banks in order to get as much out of the market before it slides further.

Here is an excerpt from Kevin’s post.

I agree, and disagree. When the banks dispose of their nonperforming assets, those assets become the comparables for and the new basis the remaining portfolio competes against, so those assets are now overleveraged and are disposed, and so it goes. An aggressive disposition strategy reinforces the downward spiral, so unless you get out of the asset class completely, you continue to suffer losses. A disposition strategy that looks smart for an individual asset can magnify your losses in the remaining portfolio. And remember, it’s not just you – the market won’t stabilize as long as other banks are making significant dispositions.

Also, an aggressive disposition strategy is smart, until it isn’t. If you sell an asset and the market continues to fall, you were smart, but if this downturn is like all the rest at some point the market will stabilize and values will start to rise. There is always someone selling at the bottom.

Game Theory

Kevin’s post got me thinking about the application of Prisoner’s Dilemma in real estate pricing.  Prisoner’s Dilemma is a game theory problem.  If anyone was interested in learning more about PD, they could check out Wikipedia page on Prisoner’s Dilemma.

I’m not a game theory expert, but I think PD would suggest that if Banks are given a choice between acting in concert to hold up asset prices by not selling, or having fire sales to avoid realizing further losses, that Sellers/Banks should have the fire sales if they are acting rationally.  I suspect that the theory would be that Banks should be fearful that their competitors are going to hold fire sales and send asset prices lower anyway, so it’s best to dump what they can before the competitors can negatively influence the market.  Again, I am not a game theory expert.  Also, if you wanted to argue that real estate investors (or Banks as real estate owners) do not act rationally, you would be preaching to the choir.  Real estate investors act emotionally.

The Lennar Model

Beyond the point related to game theory, I can think of some other reasons that I would respectfully disagree with Kevin’s post.  First, I think that recent history has shown that the advice offered in my original post has significant benefits for portfolio management.  In fact, Lennar followed a variation of the plan that I offered.  In 2007, Lennar sold a controlling interest in the massive Newhall Ranch project for $970mm to a JV that included CALPERS.  Lennar had already missed the market peak (peak land values were in early 2006), so they had to take a discount when they sold.  Some would have said that Lennar was selling into a down market, and should have just held the land until the market recovered.  But now Lennar is talking about buying the project back.  If the value of Newhall has followed other California land deals, it’s maybe worth $150mm today.  The cash they got from selling it the first time would probably allow them to buy it back 5 or 6 times over in today’s market.

I suspect that whether banks decide to get aggressive in disposing of their non-performing assets, or try to hold out for higher values, that the market is going to the same place regardless.  The only difference is how long it takes to get there, and how the decline treats individual sellers.  Banks have a choice to make.  They can either follow the model that Lennar used in disposing of the Newhall Ranch project (sell early), or they can wait around as so many sellers have done.

Stickiness Factor

Real estate prices are notoriously sticky.  They take time to get where they’re going.  The residential market has been in decline for two years.  But this stickiness presents opportunity for Sellers.  You have time to sell.  Sure, you have to aggressively price the asset in order to outrun the price decline that the market will see while you are in escrow.  But if you know that asset values are going lower, you know that there will still be buyers all the way to the bottom.  We’ve seen this for the past two years in the residential lot market.  Every time a Buyer thought they were getting a smoking deal, the market would go lower and the “vulture buyer” would be holding an asset that wasn’t worth the price paid for it.

Capital On the Sidelines

The other advantage in disposing of commercial assets now is that there is a lot of capital on the sidelines.  The chief reason there is a lot of capital on the sidelines is that there are a lot of investors who would like to be owners of new deals, if not for a disagreement over whether today’s asking prices are realistic.  But further deterioration in fundamentals will make commercial real estate investment less attractive.  It will get easier for investors to talk themselves out of doing deals.  Instead of “This is a great asset in a great location, in a great market”, it will be “This looked like a great asset, but now market-wide vacancy is 25%, several leases are expiring, and the remaining tenants aren’t bulletroof… do we really need to do this deal?”  Banks/Sellers should do whatever they can to get out of non-performing assets before this happens.  Investor psychology is cyclical.  Today’s CRE investors for the most part are still influenced by peak market psychology.  They’re still thinking about the huge scores they made.  But this won’t last forever.  Pretty soon all they’ll be able to think about is the deals they have in default, the disappearance of positive returns, and the continuing downward movement of the market.  Think capital is getting expensive now?  Wait until there isn’t nearly as much of it seeking commercial deals.

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