Commercial Real Estate Won’t Blow Off Leverage

Felix Salmon has a post up tonight along the same lines of one I put up earlier today (link). He talks about the currently in vogue investment idea of raising money for REIT’s to invest in distressed real estate.

You can check back on my blog post for the details or go to Felix’s and see his citations, but since we both quote the same Reuters source, you’re going to get the same basic story. Felix has a take on what’s going on that I have to quibble with a bit.

Here is what he has to say:

Essentially what’s happening here is that debt (in the form of CMBS) is being rolled over into equity (in the form of REITs). This is a good thing, and I hope we see much more of it.

This is a two-stage process, I think: first the REITs will buy up distressed CMBS at a discount, then they will wait for those CMBS to default, at which time the REITs will take possession of the collateral — the commercial real-estate securing the CMBS. In other words, the REITs — and the REIT investors — aren’t looking at yields, they are looking at property values.

It’s an open question, of course, how much leverage these new REITs will be able to use, and also whether the kind of institutional investors who used to invest in CMBS will ever have any interest investing in REITs instead. But I hope that the answers are “very little” and “yes” respectively. It’s a good idea for an investor to accept a bit of short-term equity market volatility if it means losing a lot of long-term tail risk.

Let’s look a little closer at this.

First, the article doesn’t mention the financing techniques that these new REITs intend to employ. Historically, most REITs have made use of leverage every bit as much as private investors and there is no reason to assume that this time around it will be any different. In fact, there are REITs that invest solely in the debt of commercial real estate projects and I suspect we may see some of them eventually, though they will probably employ more conservative structures than in the past.

So effectively, there is no reason to assume that these new REITs are not going to use leverage which is what Felix implies.

Second, Felix assumes that these REITs are going to buy CMBS debt at a discount and then foreclose. Why bother? These projects are dead men walking and will go back to the lenders soon enough. The REITs will wait for someone else to fight the foreclosure battle and incur the embedded legal expenses and then pick up the properties from the desperate sellers. Ain’t no reason to buy paper when you can get it free and clear of any contingent liabilities in a few months.

Finally, he asks if investors in CMBS will invest in REITs and says he hopes not. Of course, they will. Investing isn’t about winning all the time and you take some hits along the way. Felix, trace the history of investors that bought into commercial real estate in, say, around 1991 and by the way leveraged it. The returns have been spectacular. The tail risk on commercial real estate isn’t that long. This time it’s been really short simply because the world went crazy for a couple of years.

The reality is that there are a lot of people sitting on commercial real estate they bought long ago at fire sale prices. They leveraged it appropriately to the cash flows and rent inflation is seeing them through even now. The losers are all of the real estate PE firms that sprang up in the early years of this century and thought there was no end to increasing rents. Proforma underwriting on the banks’ part sealed the deal and those are the disasters that the market has to work through.

If the argument is that too much leverage was employed originally, then I can buy off on that. If the argument is that leverage is inappropriate to commercial real estate investment then I differ. The critical point is price and valuation. Buy at a decent cap rate and leverage within reason and commercial real estate will always work. Don’t follow those dictates and you end up selling on the cheap to someone who will reap a fortune on your mistakes.

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