Published February 15th, 2011

"Price is what you pay.  Value is what you get."
- Warren Buffett

While this may seem obvious there is concern that the lines may be blurring in today's real estate markets.  A lot of money has been sidelined since the market crashed three years ago, and it's getting impatient.  Seemingly distressed assets can get bid up to close to pre-crash values, while the truly discounted properties (and real values) are mostly passed over as too risky.  The challenge, of course, is how to assess value and over what time period.  Too many investors are using bubble era valuations as the benchmark without taking into consideration the fundamental economic outlook.  While the economy may be out of the ICU it is still hooked on a lot of life saving measures.  True value judgments in real estate today must be forward-looking and long-term. This is where real patience will pay off.

Commercial Real Estate

Commercial Real Estate's Uneven Return
Commercial property took less of a drubbing than residential real estate in the recession but still faces a long and painful recovery. Banks have already taken $80 billion in commercial-real-estate losses—about half of what they are expected to take as a result of the recession, according to the Federal Reserve. But in some markets, commercial-property values have soared more than 30% from their lows in 2009, according to one industry gauge. For properties such as marquee apartment buildings in New York City and office buildings in Washington, D.C., values are even approaching pre-crash levels.
Full Story (WSJ)

Office Vacancy Drops, Lease Rates Languish
According to a new report by Colliers International, the U.S. office market entered the year on a relatively strong note after the fourth quarter, with a sharp drop in vacancy and a healthy increase in occupied space. But rents continue to languish, according to Ross Moore, chief economist at Colliers International and author of the report. The fourth quarter marked a key turning point toward recovery, he says. “With the economy now posting robust growth, all that is needed for a full recovery is a surge in employment.”  With the economy making strides, and the addition of private sector jobs, leasing markets are expected to continue improving as 2011 unfolds.
Full Story (NREI)

To Default Or Not To Default
Borrowers in today’s commercial real estate market face the daunting dilemma of deciding whether to default on their loans as a way to secure discounts in a struggling economy. According to “To Default or Not Default? That Is the Question,” the latest podcast by John B. Levy & Co., commercial real estate owners are considering loan default as a viable strategy for managing troubled debt at a time when access to money has become tight.
Full Story (NREI)

Residential Real Estate

Crash Hitting Cities Thought To Be Stable
Few believed the housing market here would ever collapse. Now they wonder if it will ever stop slumping. The rolling real estate crash that ravaged Florida and the Southwest is delivering a new wave of distress to communities once thought to be immune — economically diversified cities where the boom was relatively restrained.
Full Story (NYT)

Finance & Economy

Outlook Turns Bullish For Capital Flows
Despite risks that can't be ignored, experts foresee bright times ahead for the already much-improved debt markets in 2011. Commercial mortgage markets improved dramatically in 2010, observers say, and that improvement is expected to continue throughout this year.
Full Story (GlobeSt.)

Securitization Market Still Dormant
The securitization market is slowly awakening. So says Tom Muller, real estate & land use partner at law firm Manatt, Phelps & Phillips in Los Angeles. Smaller, specialized securitizations have been placed in the last two years and we're beginning to see some initial interest in larger, more diversified offerings. 
Full Story (GlobeSt.)

Imagining Life Without Fannie And Freddie
A report to Congress from the Treasury and the Department of Housing and Urban Development, published on Friday, provided some long-awaited analysis by the Obama administration about what went wrong in housing finance — and how to fix it. The report, entitled “Reforming America’s Housing Finance Market,” zeros in on the perverse incentives created by the nation’s mortgage complex during the years leading up to the panic of 2008. The Treasury’s recommendation that we wind down Fannie Mae and Freddie Mac and let the private mortgage market step in is spot on.
Full Story (NYT)

What Is The New Normal Unemployment Rate?
In the past, the U.S. labor market has proven to be very flexible and recessions have not usually been followed by long-lasting increases in the unemployment rate. But, in the wake of the most recent recession, many economists are concerned that developments such as mismatches in the skills of workers and jobs, extended unemployment benefits, and a rise in long-term joblessness may have raised the “normal” or “natural” rate of unemployment above the 5% level that was thought to be typical before the downturn. Indeed, a few economists have gone so far as to argue that the rise in the unemployment rate to its current level of 9% primarily reflects an increase in the natural rate, implying there is little slack in labor markets and therefore little downward pressure on inflation. This Economic Letter examines evidence regarding changes in the natural rate of unemployment in the United States since the recession began.
Full Story (FRBSF)

Published January 31, 2011

Uncertainty. There is nothing worse for sound business and investment decisions than an uncertain economic environment.  As the recovery, however tepid, takes hold, we continue to operate with mixed signals and conflicting data.  While there is much talk of a turn around in real estate and a thawing of the credit markets, it is the Shepherd Perspective that only the very top quality properties and sponsors are enjoying these sunnier climes.  The market is bifurcating into haves and have-nots, with most of the market settling into the latter.

Commercial Real Estate

Calpers, After Losses, Plays It Safe

After losing more than $10 billion on real-estate investments, Calpers, the giant California pension fund, is returning to the property market with a new strategy and fewer investment managers, seeking steady, modest gains rather than blockbuster returns. Calpers will be making those investments with less help from some big-name managers, including Black Rock Inc., Hines Interests and Jones Lang LaSalle Inc.

Full Story (WSJ)

Multi-Family Performance May Not Be What It Seems

The year-end data are in, and it turns out the CMBS market isn’t improving, after all. In fact, the delinquency rate hit its all-time high in December, 9.2%, according to a report on GlobeSt.com late last week. And in an interesting turn of events, it’s multifamily that’s seeing the worst of it.

Full Story (GlobeSt.)

Shadow Space Hampers U.S. Office Recovery

The U.S. office market continues to recover at a snail’s pace in large part because of an overhang of shadow space, according to a newly released forecast from brokerage firm Grubb & Ellis. Shadow space — leased but empty office cubes, floors and wings — vacated during the recession will accommodate about one-third of all net new demand in 2011 and about one-fourth in 2012, predicts Bob Bach, chief economist with Grubb & Ellis. This activity will not be reflected in the published statistics.

Full Story (NRE Investor)

Residential Real Estate

Housing Numbers To Be Revised Down

The NAR is planning on releasing revisions for the past three years (2008 through 2010) on February 23rd along with the January existing home sales report. Many housing analysts expect these revisions to be significant – and to be down. Assuming the revisions are down, this will also reduce the “distressing gap” between existing and new home sales.

Full Story (CR)

Finance & Economy

CMBS Delinquency Rate Hits Record High

The CMBS delinquency rate hit 9.2% in December, the highest in history for U.S. commercial real estate loans in CMBS, reports analytics firm Trepp LLC.That includes loans 30 or more days delinquent, in foreclosure or real estate owned. The new delinquency rate represents a jump of 27 basis points in December. The value of delinquent loans now exceeds $61.5 billion, according to Trepp.

Full Story (NRE Investor)

CMBS Payoffs Best In Two Years

Borrowers paid off more than half of the securitized commercial real estate loans reaching maturity in December 2010, marking the highest monthly payoff rate in two years, according to Trepp LLC. The uptick suggests that replacement financing is growing more accessible to borrowers.

Full Story (NRE Investor)

Employment Data Tempers Outlook

For investors eager to embrace recent affirmations of a turnaround in commercial property fundamentals, Friday’s labor report should offer a modest check on their rising sense of optimism. One and a half years following the official end of the recession, US employers added just 103,000 jobs to national payrolls in December. While the unemployment rate dropped to its lowest level in 19 months, that decline reflects a large number of discouraged Americans giving up on their job search and a corresponding decline in the labor participation rate. Neither one of these outcomes is consistent with a robust improvement in the health of the US labor market.

Full Story (GlobeSt.)

 

I get this questions a lot, so I figure it’s time to try to answer it. Why it’s called hard money is another story.

Hard money lending is also sometimes called private lending, equity lending, or trust deed investing. (I use these terms interchangeably.) In its simplest form it is generally short-term, low-leverage loans with relatively high interest rates, made by private individuals, groups or institutions, backed by equity in hard assets. The most common asset being real estate, of course.

This is a brief overview but hard money lending is distinguished from conventional lending in the following way:

Conventional (bank) loans are what I call cash flow lending. The primary underwriting factors involve the borrower’s credit worthiness: willingness and ability to pay. The value of the actual property–the collateral–is an important but secondary consideration. For a residential borrower this means your credit history, and income level and stability is all important. In the commercial realm it means the property’s ability to cover the debt, as well as the sponsors financial condition. In short, the primary issue is the ability to make monthly loan payments.

Hard money loans flip this around. The single most important factor is the collateral itself: how much is the property realistically worth and how much equity cushion does it provide to protect the loan. The lender’s primary concern is, if the borrower defaults and he has to foreclose, can he quickly and easily dump the property and recover all of his principal and (hopefully) interest and fees.

The second critical factor in hard money underwriting is exit strategy, or how will the borrower repay the loan at the end of the term. Since most of these loans are short-term–1 to 5 years–there has to be a clear and plausible strategy for repayment.

Below these factors comes the borrower’s credit worthiness: ability and willingness to make monthly loan payments. Before the credit crisis this was barely a consideration at all. Since 2007 even hard money is looking a little more carefully at a borrower’s ability to service the debt.

Hard money lending (as we call it today) has been around for decades and until 20 years ago or so had a pretty seedy reputation as being not much different than loan sharking. While there are still unsavory characters in the lending business, the hard money profession has, overall, become quite professionalized. There are lenders that specialize in all types of assets and transaction types, and that provide outstanding and highly professional customer service. It is also a common misunderstanding that all hard money borrowers are financial hardship cases. This is simply not true. Private money provides a speed and flexibility that conventional, “check the box” lenders simply can not match. Many, if not most, hard money borrowers understand the strategic value that it provides in the appropriate situations.

 

In previous posts we’ve described what trust deed investing is and how it compares to other readily available investment options. Now we want to tackle exactly how one goes about investing in trust deeds. Well, I’m glad you asked.

There are three basic methods of trust deed investing:

• Direct investment.
• Fractionalized investment.
• A pooled fund.

Direct Investment

The oldest and most labor intensive method is for you, the investor, to put together the investment yourself. This entails you going out to find prospective borrowers, underwriting the properties, doing your due diligence and assessing the risk, preparing the documentation and, once funded, servicing the loan yourself. In this scenario the investor makes all the decisions, does all the work, and generally concentrates all the risk on one loan and one property. If you have enough money risk can be somewhat diversified by repeating the process multiple time and making loans on several properties.

A variation on this approach is to have a broker find the loan for you. In this case you are still making all the decisions and generally concentrating your risk, but the broker can absorb some of the work by prospecting for borrowers and preparing the documentation. Of course the broker gets paid a commission for this work. However, you must still perform your own due diligence. A broker can be very helpful in this regard but it is up to you decide if it’s a good deal.

Fractionalized Trust Deeds

A fractionalized trust deed is basically a brokered investment but with multiple investors taking a piece of the deal. For example, if it’s a $1 million loan you could provide 10% of the capital required and let other investors take the balance. You would then receive your proportionate share of interest payments. The advantage of fractionalized trust deed investments is that you can participate in larger loans, which are often of better quality, and/or diversify your capital further by investing in small portions of a variety of properties. As in the direct investment method you are a named note holder and recorded on the deed of trust. Although the investor makes the ultimate decision in both these methods, this level of involvement has a price.

Unless you have unlimited capital your investments will still be relatively concentrated in a small number of loans. And each of these loans will require you to review 2 to 3 inches of loan documentation. There is no anonymity as you are named on the deed of trust and, with fractional deals, there is no autonomy in decision making. If there is a problem with the loan you may be required to contribute additional capital. And once your loan pays off your capital will likely sit idle until you locate another qualified deal. The simple interest you earn would make Albert Einstein turn over in his grave. Finally, in some states there may be licensing issues for acting as a lender.

Pool Trust Deed Funds

These funds are essentially private mutual funds for trust deed investments. Investors place their capital in a fund managed by a professional lender. The manager does all the work of finding good loans, underwriting the deals and performing due diligence, assessing risk, preparing all the necessary legal documentation, servicing the closed loans and distributing payments to investors. In additional to assessing risk on each loan the manager manages the risk on the overall portfolio, ensuring that the fund’s capital is diversified across property types and markets. Loans are closed in the name of the fund, rather than the individual names of the investors.

The fund manager makes the decisions as to what loans to make, but investors know the criteria up front as it should be clearly defined in an offering memorandum. The advantages to the investor are:

• Immediate diversification of investment.
• Simplicity: little to no involvement with individual borrowers or brokers.
• Your money is working for you every day of the year.
• You maintain your anonymity and are shielded from personal liabilty.
• You can reinvest your dividends to earn compound interest.
• And you’ll generally get higher yields and improved liquidity.

Ultimately you as the investor must evaluate which method works best for you. For the majority of non-real estate or finance professionals a professionally managed trust deed fund would be the way to go.

 
Trust deed investing has been around for many generations, yet today it seems few people are familiar with how it works or how it compares to other investment options. The economic signals today are mixed and confusing, and investors are understandably unsure about what to do. Invest or sit on cash? Invest in what? Trust deed investments offer one of the best opportunities, and risk-adjusted yields, available today when compared to the other major alternatives: stocks and private equities.

First let’s understand the inherent value of risk-adjusted yield. Simply put it is the return potential of a given investment relative to its risk, where the risk is generally measured by volatility. Commercial trust deed funds historically yield consistent returns in the 9%-12% range annually, with very little volatility. Other assets, say small cap stocks or funds for example, have the potential for much higher returns but with much greater chance of loss as well. So the commercial trust deed fund would have a higher risk-adjusted yield.

Stock Market

Commercial trust deeds funds show much less volatility than stocks.

If we now look at the major stock market indexes and compare them to commercial mortgage funds we see how this pattern plays out. The chart shows three major stock market indexes versus the lower end average of commercial trust deed funds. While there are slight variations among the indexes they all follow a similar path, and all show a lot of volatility. It’s interesting to note that this particular chart shows the stock market during the best part of the recent economic bubble, and stops before the market imploded in August of 2008. While there are periods where the market outperforms trust deeds it is impossible to time the market perfectly, and as we’ve all painfully learned recently those profits can disappear quite literally overnight.

Another important distinction is the collateral behind the investment. Theoretically an equity holder’s investment is backed by the company’s assets, but in reality your capital can disappear into the wind. (Just ask shareholders of Lehman Brothers or the Madoff funds.) Trust deeds are backed by valuable, and tangible hard assets: real estate. While real property can and does drop in value it is not subject to the minute-by-minute trading of wall street, and most real estate will always have some economic value. If the private money lenders do their job right there is ample collateral backing every trust deed investment. And don’t forget, when things go bad the lender (trust deed holder) is first to get paid, but the equity holder stands at the back of the line.

Private Equity
Private equity is exactly what it sounds like: investing money directly into a private company in exchange for an ownership stake. The attraction, of course, is that these mostly smaller, early stage companies offer the chance for eye-popping profits if and when they become successful.

Trust deed funds provide a better, more accessible option for most investors.

Of course, that’s a big IF. Truth is most of these companies fail, or at least fail to achieve any sort of real value. On top of which investing in private companies is a tremendous amount of work and generally requires significant expertise. This is why it is mostly done through private equity or venture capital funds. (We’ll ignore Angel investing for the time being.)

So what about those eye-popping returns? Well, private equity and venture funds operate on basic portfolio theory. That is, out of every 10 investment about 6 will go completely bust, 4 or 5 will do ok and 1 or 2 will knock it so far out of the park that the fund overall provides a decent return. Nothing wrong with that if you have the stomach for that level of risk. Think of it as the extreme sports of the investing world. In fact, the amount of money required is so high and the risk so great that this is generally an investment class relegated to institutions and the extremely rich.

Stocks, bonds, mutual funds, and even private equity can be valuable tools in your investment toolbox. But the familiar, understandable, reliable and secure commercial trust deed fund should hold a prominent role in most investor’s portfolios.