There’s generally one item on a Buyer’s resume that matters.  They should be able to tell you what they’ve bought recently.  If they haven’t bought anything recently, they should be able to tell you the last thing they bought and why it’s been awhile since they bought anything.  For instance, if the Buyer acquired 10 deals in 2006, but didn’t buy anything in 2007-2009 because they didn’t see anything that made sense, I’m not going to hold that against them.  Their word that they are jumping back into the market will suffice.

But here’s a behavior that I see from time to time and is a huge red flag.  The Buyer hasn’t acquired anything recently, but has some story about access to a fund.  They have a company brochure that might look nice, but in reality probably cost a couple of hundred dollars to have designed and printed.  The story is too good to be true, and the cost to design the brochure is irrelevant when the offers they need to be submitting need to be in the millions.

Maybe you’re talking to someone and your antenna goes up because it seems like they’re trying to “overconvince” you of their capabilities as a Buyer (maybe they’re telling a story about their experience, maybe it’s a story about how they got access to a fund).  Whether you’re the Seller of the property, or a Broker representing the property, you’re wondering what all of the convincing is for.  Then the kicker comes.  They send an offer with a company brochure attached, a proposed earnest money deposit of $5,000, a purchase price that seems too good to be true, and 180 days of due diligence time.  The only question in your mind is whether you should actually light the offer on fire and watch it burn, or create a fake Wikipedia entry for “Total Waste of Time” and post the offer as an image on that page.

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I’m shooting from the hip here, but I suspect that industrial vacancies are probably highly correlated to the dropoff in imports (along with some fluff for overbuilding).  So getting back to 2008 import levels is probably pretty important for the recovery of the industrial property sector, and it’s important that it takes place without further deliveries impacting the supply/demand balance.  The interesting thing is that the recovery in imports is on a pretty aggressive trendline that matches the dropoff in imports that occurred at the end of 2008.

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Rule #1 – Don’t Screw Around With Buyers That Screw Around With Earnest Money

This is something you have to sort of play by feel.  If you are negotiating a transaction and it looks like the actual amount of the earnest money deposit is becoming important to the Buyer, look out.  Is the amount in the offer unusually low?  If the Seller proposes to increase the deposit, what is the Buyer’s reaction?  Does the earnest money deposit get adjusted in multiple iterations of the offer/counter-offer cycle?

In our typical deals the earnest money is refundable until the Buyer has approved feasibility.  So if the amount of a refundable deposit becomes an issue during negotiation it’s a red flag that something is going on.  A few potential explanations:

• The Buyer has limited funds and is going to try to flip the deal.  You can go ahead and set an Outlook reminder for the 4:45 call on the due diligence end date when the Buyer calls and asks for an extension to “wrap up their feasibility” when in reality they just haven’t found anybody to flip the deal to.
• The Buyer isn’t limited in funds, but they are out tying up 5 different deals and they’re going to choose the best deal to close on, so they have to conserve cash in order to be in 5 different escrows at the same time.  This is a huge waste of the Seller’s time.
• The Buyer doesn’t have the money and is going to try to syndicate the deal.  Slightly different than flipping, but the easy solution here is to force the Buyer to syndicate at their risk, not at the Seller’s.  So they should be prepared to close whether or not their syndication is complete.

I use a rule of thumb of +/-3% of the purchase price for the earnest money deposit.  So if the deposit is in that range, I’m good.  If it’s lower than that percent, but is still a substantial amount of money like over $100,000, then I’m also fine.

Rule #1 is first because it’s the most reliable.  Not because it’s the most important.  When doing repeat business, or dealing with Buyers that have already closed on deals, it’s not necessary to screen them based on this criteria, although I would offer that it still works.  For instance, if you get an offer through another Broker and the earnest money is light, but the Broker represents that the Buyer has multiple recent closings, it could be the case that the Buyer is using the “tie it up now and decide later” method of Buying.  In that case you’ve got some mitigating information to discuss with the Seller.

I’ll try to post a few more of these rules that are pretty straightforward and simple for anybody that has been doing this for longer than 10 minutes (although I see people who have been doing this for years somehow still miss warning signs).

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The Cliffs Notes version of the story is that a broker that represented Landlord #1 tried to keep a tenant of Landlord #1’s from relocating to a new space which the broker also represented, but which was owned by the less powerful Landlord #2.  There are all sorts of issues related to ethics, greed, legality, and in general just being kind of a jerk.

My take is probably a little bit different.  I see this not as an issue of greed (often thought to be the primary motivator of brokers) although it may be a simple as that.  I see this more as an issue of arrogance.  A good broker has to be naturally good at navigating complex situations and arriving at the brokers desired outcome (and for the avoidance of doubt I will say that the broker’s desired outcome should be in line with the principal’s desired outcome).  The broker needs to be good at essentially getting what he/she wants.  The better a broker is at this part of the business, the more successful they become, which only increases the confidence in being able to accomplish their goals.

The problem is that the line between confidence and arrogance isn’t just slim, it’s often non-existent.  It sounds like the broker in the story was sort of widely known to be a pretty effective broker, so it’s not a leap to assume that the broker probably ran into instances where the broker’s perception of his skills differed from reality (“Son, your ego is writing checks your body can’t cash” – to steal a line from Top Gun).  Or, if you’re a nerd like me, fastforward to about the 4:15 mark of this Star Wars clip to see an example of someone overestimating their abilities with a disastrous outcome.

So in the case of the broker acting dishonorably when the tenant wanted to relocate, it would have been an act of humility that would have saved the situation.  It would have required the broker to understand the limits of his powers to reach a successful outcome.  A simple “I am not good enough to navigate this complex situation, and I cannot make everyone happy here (or even mislead/confuse people into thinking they are happy) ” might have kept the broker out of a blog post that is now making its way around the industry (and when I say “the industry”, I mean “the biz”).

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This item from iStockAnalyst picks up on the theme and has a nice graph to illustrate the banking trend that would be personified by a boxer putting his gloves up and leaning against the ropes.  Since July of 2008, banks have been increasing excess reserves at a fairly consistent pace in anticipation of the beating they are going to take.

The article quotes Elizabeth Warren as follows:

"We’re seeing banks that don’t want to lend because they see every dollar that comes in the door and say I’ve got to hold on to it to try to fill my commercial real estate hole or else I will be gone."

So what can CRE participants do to counteract the cycle mentioned above?  Probably not much.  There is an unwinding that needs to happen and will likely take some time.  Because many of the loans in the marketplace aren’t due until 2012, the correction of the market will likely drag out for sometime.  Instead of being a sudden and intense sickness, the pain is likely to be of the consistent and dull variety.  This commentary comes with the usual caveats.  I suppose that if the economy suddenly caught fire (in a good way), it would bail out many CRE investors and lenders.

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Real estate related loan auctions for 2009 show that non-performing CRE debt traded at a premium to non-performing residential real estate debt.  Non-performing CRE debt sold for 37% of book value on average, while non-performing residential debt sold for 23% of book.

The thing that is striking though is that when both loan types are performing, there is no discount given for the residential debt.  Performing loans of both types sold for 57% of book value.  This seems odd to me and maybe a reader can tell me why it’s not odd.  But I would look at those breakdowns and say that either Buyers of non-performing CRE debt are overpaying, or Buyers of performing CRE debt are getting a relative bargain (you could also make the opposite case for Buyers of residential debt).

Taken another way, the graph below shows the performing/non-performing gap in loan prices.  The gap between performing and non-performing for residential loans is 35% of book value, while for CRE is just 20% of book value.

I have some theories on the difference in discount applied, but I’m not sure that the theories are coherent.  Some thoughts:

• The important difference might not be between the two types of loans at the non-performing level.  The important difference might be at the performing level.  Buyers of residential loans might be assuming that if the loan isn’t in default by 2009, it might hold up.  Whereas Buyers of CRE loans have to figure in a greater risk of future default (because the commercial market is lagging residential).
• The cost of foreclosure as a percent of book value is higher among residential loans, which means that you have to apply a formula like ((Loans In Default * Market Pullback) + (Loans in Default * Cost of Foreclosure)) * Average Hold Time * Required Return in order to arrive at the property discount.  Don’t quote me on that one – I’m getting an icecream headache just looking at it.  Anyway, the cost of foreclosure is likely to be similar for a house and a commercial property, though the loan amounts are quite different (the average residential loan sold had a book value of $167,000 and the average CRE loan had a book value of $466,000).

Again, any readers that have any relevant thoughts are encouraged to post them in the comments.

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In the clip Gross discusses the potential that the Fed might start to dispose of some of the MBS that it has acquired, a move that would be a 180 from current policy and would put further pressure on mortgage rates.

My general stance on the housing market for the past five or so months is that I would have preferred to see a stable real bottom form in the market before the bidding wars ensued.  I don’t think that happened.  There are about ten different things that could trip this market up and end the six month rally that we have seen.  Unemployment and further problems with the credit markets are probably the leaders.  I suppose REO inventory and expiration of the homebuyer tax credit have to be close behind.

Via Calculated Risk is this graph showing growth of the Fed’s MBS assets.

And then this graph showing new and existing home sales (incidentally, look at the right side of the existing home sales graph and tell me it doesn’t look like an energy graph for an 8 year old on Redbull!).

Like I said, I would have preferred to see a real bottom form in the housing market.  I’m not even saying that people shouldn’t be buying housing (or housing related investments) right now.  but I do think that in the next 18 months we will at some point see buying opportunities superior to those in the market right now.

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• “Thanks to City Center, MGM hasn’t made a profit for two years. The firm’s latest figures, for the final quarter of last year, show overall revenue fell 6% to $1.5 billion.” – Essentially CityCenter is part of a larger problem for MGM.  CityCenter shouldn’t have affected revenues yet.  So what’s happening is that CityCenter is finished as MGM is experiencing problems with their other businesses.
• “City Center is “an absolute catastrophe,” says America’s best-known developer, Donald Trump.” – Good point Donald.  It’s surely not as successful as the Las Vegas Trump.  That’s an absolute homerun.  By the way, are we still pretending that Trump is a developer?  He’s a brand, a reality TV star.  He lends his name to developments.  But is he still a developer?  Who knows?  Maybe.
• Even with its 6,300 new rooms, he predicted that City Center and other resorts in the MGM stable will be full most of the time by the end of this year. “All we need to fill the rooms is 4% growth in visitor numbers to Vegas this year to 36m-37m people. I think the actual figure will be over 38m.” He claims that Aria hotel, one of four in City Center, “is already generating positive cashflow”.  This is interesting.  Typically when you have a plan as aggressive as CityCenter, everything has to go right for it to work.  But MGM is saying that they have a little bit of breathing room.

I do think there is a larger issue at play here related to large scope development.  More often than not the really ambitious plans tend to fail.  Incrementalism in development can be hugely successful, while grandiosity is usually hugely unsuccessful.  Some might say that the development of the Wynn is an example that refutes my point, but I would say that it is in favor of my point.  From the development of the Mirage to the development of the Wynn, casino plans got slightly more aggressive (incrementalism) as each hotel was built.  The CityCenter however was orders of magnitude more ambitious and complex.  As a result, they had to reinvent the wheel and when you’re going to have to write $9B in checks to finish the project, reinventing the wheel is problematic.

The interesting thing is that in order to even begin construction, MGM needed a lot of really smart people to get caught up in the grandiosity of the plan and forget the tenets of prudent investing and lending.

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Image via Wikipedia

Buffett’s annual letter to shareholders has been making its way around the blogosphere for the past couple of days.  In addition to the usual great folksy one liners (like “Don’t ask the barber if you need a haircut”), Buffett also provides some thoughts on the housing market.

"Within a year or so, residential housing problems should largely be behind us," Buffett wrote in the letter. "Prices will remain far below ‘bubble’ levels, of course, but for every seller or lender hurt by this there will be a buyer who benefits. Indeed, many families that couldn’t afford to buy an appropriate home a few years ago now find it well within their means."

I think talk of the housing market and when the market will stabilize, or when the slump will be over usually says as much about the people reporting the story and reading the story, as it does about the subject persons in the story.

For instance, I know people (maybe even including me) that would see this story and forward it around in emails and say something similar to the headline of this post, like “Don’t bet against Warren Buffett.  He sees end to housing slump.”  But when you read the story, it’s actually very light on predictive material.  Buffett is saying that the problems will be behind us.  Which is no doubt true in some sense.  But what will not be behind us is the catastrophic loss of wealth in this country that accompanied the housing bust.  By 2011, we will not have made any of that money back.  More likely, we will have a housing market that is significantly more stable than it is today.

Today’s housing market, while resurgent in areas, looks to me like it has the kind of energy that an 8 year old would have after a can of Redbull.  Sure, there’s a lot of noise and activity, but there’s no real solid foundation for that energy, and a nap is probably on the way at some point.  The only question is whether we get to the nap with or without the temper tantrum and crying coming first.

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