Lloyd Hanford

A few days ago, while eating lunch, I caught an “infomercial” on television sponsored by Armando Montelongo of “Flip This House” fame. Armando was promoting his course that is described as teaching how to make millions in the residential foreclosure market. He refers to his list of bankers who will lend money for transactions and suggests that it can be done without having any money of your own. He refers to his sources for finding foreclosure sales that are not generally available to the public. These claims are supported by a cast of people purporting to have made tons of money, on a repetitive basis, following his teachings, including people who were involved in multiple deals simultaneously.

The fact that people pay good money to attend these courses is a testimonial to the belief of gullible people that there is really a “tooth fairy” and that taking a “smart pill” is all that is necessary to unleash riches. Teaching people “how to get rich quick” has been around forever. What is absolutely astounding is the fact that people are willing to pay money to attend these kinds of courses without undertaking any kind of research to find out whether or not what is being advertised has a reasonable chance of working.

The first “red flag” is the inference that the strategy can be implemented without using ones own money. That may have worked in the years leading up to 2006 when zero” down payments, liberal loan terms, no-document loans and relaxed loan underwriting standards were in vogue. But, since he collapse of the mortgage market it is general knowledge that lending standards have changed and zero down – no-doc loans are no longer de rigueur. So, question number one, before paying money for a course, should be to ones banker asking if these claims are reasonable.

The next question should be addressed to an experienced residential real estate broker to ask if the market is such that it is easy to identify and buy foreclosed properties with little or no down payment as well as to find out if the broker (brokers) had any knowledge of the “Flip This House” strategy working in the present market.

Finally, research needs to be done to determine whether lenders selling foreclosed properties are required to make the same disclosures relative to condition that a typical seller is required to make or whether a sale would be “as is”. Anyone buying homes in California, with the intention of “flipping” should be aware of the disclosure required of sellers and their brokers. Failure to disclose could result in costly remedies after the sale has closed. Buying “as is” becomes a very dangerous undertaking for the inexperienced buyer. Before buying “as is” a purchaser should have a thorough home inspection to identify any serious problems like mold, lead paint, termites, and wood destroying organisms, as well as structural problems, major deferred maintenance (like roofs) etc. The cost of putting the home in salable condition may erase any potential profit. “Fixing” the home to “flip” it may well involve much more than just a coat of paint. When purchasing foreclosed property, the buyer should assume that the foreclosed owner who couldn’t meet the required debt service payments also couldn’t afford to take care of any maintenance problems.

Going into the business of buying foreclosed properties should be approached in the same manner as going into any other business. First and foremost the buyer must learn the business. Learning the residential real estate business can not be done in a short “get smart quick” course. There are capital needs. The money to make the initial purchase, the money to ready the property for re-sale and the money to hold the property during the time between acquisition and final re- sale. It may be possible to buy with nothing down and, if so, what about the rest of the capital needs? Next, how does one learn the market? It can not be learned in a short course. What is needed is a fairly intensive study of neighborhoods and recent sales within those neighborhoods in order to develop the necessary judgment that will allow identifying a “bargain”. This takes a lot of perusing of “For Sale” ads, visits to “Open Houses” and follow up on closed sales. There is no “smart pill” for this.

When one sees a picture of a classroom full of budding real estate speculators one should consider what will happen if all of these people go out into the market at the same time and are ready, willing and able to buy. That amount of activity would cause at least a temporary excess of demand over supply which in turn would tend to destroy bargain prices. The answer is that the strategy most probably can not be implemented by everyone for one reason or another.

Before spending hard earned money on a “get rich quick” promise be very skeptical that the “promise” may be nothing more than to induce the spending of money to register for a course and may lead to nothing more than a few interesting lectures that may resonate like the selling of “snake oil”. There is no quick way to riches other than lots of luck. Otherwise becoming rich takes a long time and much hard work and study. Buying and fixing homes for re-sale should not be expected to be done on a part-time basis and successfully implementing a strategy is a time consuming process. That is not to say that someone couldn’t start from scratch and buy foreclosed property and successfully “flip” the property. It is just very unlikely that lots of people could do it without substantial training. Just ask – if it were so easy why wouldn’t every real estate broker who spends 40-60 hours a week in the market be doing it too, in competition with the inexperienced buyers? If you feel lucky and want to get rich quick – buy a lottery ticket but don’t quit your day job.

On April 2, 2010 the Wall Street Journal ran an article by Peter Latman and Anton Troianovski reporting on the vacancies in the office building known as 9 West. The fact that there are vacancies in one of the premier New York office buildings is not surprising because many prime building across America have vacancies. But, the interesting information in the report is found in the statement “Brokers and tenants trace the vacancies to Sheldon Solow, 9 West’s billionaire owner. Mr. Solow has declined to reduce rents in the building, where the highest floors go for roughly $200 a square foot. The average asking rent of 9 West’s neighborhood, the Plaza district: $79 per square foot down 18% from a year ago…” The article also contains a quote from a large brokerage firm saying “I think that there’s been a perception in the marketplace that doing business with the Solow’s is difficult”.

These observations raise the question as to how much of the current office vacancy around the nation is just the result of an adverse market and how much is self inflicted by unrealistic ownership or management. Any real estate broker can tell you that there are property owners and managers that are just difficult, if not impossible, to deal with. Any tenant can tell you that there are owners and managers that just will not recognize the fact of competitive market rents harboring their own views as to what rents should be. Both of these situations can lead to self inflicted vacancy.

Too often, property owners (managers) look at tenants as an “evil necessity” to their business instead of recognizing that tenants are their good customers. Successful, sophisticated owners and managers deal with tenant prospects and existing tenants as very important customers and bend over backwards to do all reasonable to keep their customer happy. This doesn’t mean that successful owners do not experience vacancies but, through well articulated tenant retention programs there vacancy exposure is reduced. Successful owners and managers, recognizing rising vacancies also recognize that when there is substantial vacant space on the market, their tenants are targets for the competing buildings that will do all in their power to lure their tenants away. So, instead of waiting they will be pro-active in approaching their tenants with expirations looming in the future and immediately renegotiating their leases as a strategy to make them unattractive targets of a competitor. Yet, there are owners like Solow who, instead of letting the market dictate decisions, believe that they can get away with whatever they want. Being difficult to deal with only causes leasing brokers and tenants to avoid them except when there are no other alternatives. That is not smart or sophisticated.

There are too many examples of difficult owners or managers and there a variety of reasons for being difficult. In the case of corporate or institutional ownership, failure to be progressive in dealing with tenants often stems from the desire of the decision maker to avoid leaving their “fingerprints” on any decision that, in light of history, may prove to have been a good deal for the tenant. This most often happens at times of rent resetting under leases calling for adjustment of rent after a certain period of time and providing that adjusted rent would be decided by agreement and if no agreement is reached than decided by arbitration. Too often the decision maker seeks a rent that is too high and, rather than going with the market information, decides to arbitrate so that any decision at a lower amount will not bear their fingerprint”. Too often this process leads to substantial friction between landlord and tenant resulting in the tenant making decision to move out at the end of their lease no matter what. But, there are too many landlords like the Solow’s who just refuse to negotiate based on what the market dictates and, rather view the negotiation as a test of “power”. By being “difficult” one exhibits “power” or so they may think. If one wants to use power, it should be in the context of reality. When vacancy rates are at 10% and above, as is the case in so many markets power ploys do not usually succeed so they should be used cautiously.

Property owners and managers should be, at all times, completely in tune with what is going on in the market. To obtain and retain tenants they should recognize the dictates of the market and, most importantly, in difficult times they should avoid using the weak market as an excuse for deferring needed maintenance and postponing necessary upgrades since that strategy will lead to reduced occupancy on its own..

An article in the Wall Street Journal on March 31, 2010 suggested that Real Estate stocks are set to have their best quarter since 2006. The article suggested that REITs are attracting new groups of investors who normally invest in high yield junk bonds, lured by the yield. The article pointed out that investors are banking on a strong recovery in real estate in 2011. Among other things the article pointed out that many REITs that changed their dividend policy will return to the all cash dividend. The average dividend for REIT stocks was 3.4%.

Is this investor optimism supported by the facts? A yield of 3.4% is not an attractive yield from real estate when measured against the risks and can only be justified by the conviction that dividends will rise in the near 12-18 month term. That, in and of itself, may be asking too much. For most of the country, vacancies remain high with no sign that leasing activity is adequate to trigger an upward move in rental rates. Hotels continue to be plagued by relatively low occupancies so their recovery outlook should not be optimistic particularly where many businesses are curtailing travel and meetings. It is impossible to generalize about the direction of income for any specific REIT without access to their current income schedules, square foot rents and lease roll over dates. Many properties are operating on leases that are at over market rates and will be renegotiated at lower rents in the near term. Business failures have not ended so space could continue to be placed on the market. None of these risks auger well for optimism relative to increasing occupancies and rents. Before investing in any REIT it would be important tot ascertain the sustainability of the current dividend based on lease schedules.

Opinions are mixed about the future with many experts anticipating continued fall out attributable to debt problems because either properties can not be re-financed or the outstanding loan balance exceeds the value of the property. Until these issues are behind us, the recovery will remain illusive.

Many managers have raised money anticipating that there will be great buying opportunities because of the troubles of others. But, that has not yet come to pass. Strong owners (those who hold prime properties with adequate cash flow to service debt) are not wiling sellers in a down market. Lenders who have foreclosed properties face a loss and are very slow to sell without trying to re-position the properties for a more beneficial sale. Thus, the opportunities that do exist may be confined to “problem properties” (those without adequate occupancy to service debt or provide an adequate return. These types of properties are not accretive to REIT earnings.

The published statistics and reports indicating a turnaround may be reporting a “mirage”. This is a good time to be extra cautious, particularly when looking at 4.3% yields.

April 8, 2010:

After posting this piece, three articles of interest appeared in the financial press. The first one reported that office rents declined in the majority of the market areas during the first quarter of 2010. That doesn’t provide much confidence relative to forecasts of a bottom. The second article indicated that hotel revenues are down in most market areas. And, the third article discussed the probability of increasing vacancies and declining rents in shopping centers. None of this information suggests any reason for optomism relative to a real estate recovery any time soon.

Ever since the commercial real estate (CRE) market began its decline in 2008 there have been all manner of reports indicating the level of decline. At the outset, market makers generally did not foresee a decline of the magnitude now being reported. However, there have been transactions (or foreclosures) evidencing value declines in excess of 50% or more from the market high in 2006. And, it isn’t only the small, unsophisticated investor being subjected to losses but, rather includes a host of very large, real estate “movers and shakers” like Tishman, Morgan Stanley, General Growth etc. All of this raises the question of the real worth of CRE today. The answer is that no one really knows with any great degree of certainty for a variety of reasons.

In stable markets, real estate appraisers and market makers, among other things, rely on a volume of transactions to provide the market information leading to estimating value. A problem arises when there has been a major economic change that, in effect, causes a disconnect between a past market and the current market. Previous transactions, under these conditions, fail to provide reliable views of current market anticipations. Further, when markets change radically transaction volume slows down substantially as buyers want to pay “tomorrow’s price” and sellers hold out for “yesterday’s price”. In other words, when a market is in a state of decline, buyers are only interested in bargains. On the other side of the table, sellers who have good property with no immediate financing or operating problems are under no pressure to sell and, accordingly, will not offer their properties for sale at bargain prices. Instead they will usually opt to wait until the market improves before selling. The same is not true of property owners facing financing or operating problems. The first strategy of property owners facing difficulties is to try to solve the problem through either a re-financing of debt or a quick sale to preserve their equity. Sales that take place under these conditions do not provide reliable guidance as to the worth of the asset. In cases where the property has substantial operating problems with a concurrent declines in value the problem is compounded when value falls below outstanding debt leading to either a deed in lieu of foreclosure or a foreclosure. If the lender wants to immediately recover some of its investment, the property may be sold at what is considered a “bargain” price. However, many lenders, not under pressure to liquidate assets, will try to manage the asset back to health before placing it on the market for sale. The net effect of all of this is that market activity slows and the transactions that do take place fail to provide reliable indications of value.

Appraisers and market makers also rely on the ability to forecast rents and operating expenses as a guide to estimating the worth of an asset. In stable markets these forecasts can be made with a relatively high degree of confidence in the outcome. But, in markets where vacancies are increasing and rents are concurrently declining (law of supply and demand), forecasting future performance produces results that are developed under conditions of great uncertainty rendering them potentially unreliable.

The lack of adequate sales volume and the lack of stability in market rents and occupancies make it very difficult to estimate value with any great degree of comfort in the results. Accordingly, the valuation process tends to become based more on judgmental conclusions than on conclusions supported by “hard” market evidence. Mortgage holders often obtain more than one appraisal, over a period of time, before reaching a disposition decision. The difficulty of accurately measuring value leads to a certain degree of procrastination by the holders of property (mortgages) particularly when the people responsible for the asset have no, personal vested interest in the outcome of a decision. These patterns existed in the 1990’s when the Resolution Trust Corporation was in control of the assets of failed Thrifts and there is no reason that the same patterns should not emerge now. This may partially explain why opportunistic investors today are finding it difficult to acquire properties at what they consider to be “bargain” prices.

Another contributing factor to a short supply of CRE available for sale is the realization by owners that their yield, even at today’s depressed prices, is significantly higher than could be realized by placing the sale proceeds in an alternative investment.

Many observers believe that there are substantially more troubled assets overhanging the market than are being sold or offered for sale. This should not be expected to change dramatically unless those holding the assets become convinced that a market turn-a-round can not be anticipated in the foreseeable future. If that happens, the volume of troubled assets offered for sale should increase dramatically. On the other hand, if there are sustained signs of improved occupancies and rising rents assets may begin to come to market but not at “bargain” prices. Instead, they will most probably be priced at levels anticipatory of the values that may result from a recovery.

As of the moment, the existing market forces make it difficult to predict the value of commercial real estate with any great degree of certainty or comfort. But, the bottom line is that property is only worth what a buyer is willing to pay at a given point in time. The fact that a seller is unwilling to accept what a buyer proposes is not evidence of value.

The following article appeared in the news on January 4, 2010.

“Property owners at four struggling and bankrupt resorts in Idaho, Montana, Nevada and the Bahamas have filed a $24 billion federal lawsuit against Credit Suisse, saying the bank gave predatory loans to the resorts’ investors as part of a scheme to take over the properties.
Property owners at Idaho’s Tamarack Resort, the Yellowstone Club in Montana, Nevada’s Lake Las Vegas resort and the Gin Sur Mer Resort in the Bahamas filed the lawsuit Sunday. They are seeking class-action status.
The property owners say Credit Suisse set up a branch in the Cayman Islands to skirt U.S. federal banking regulations and appraised the resorts at artificially inflated values as part of a plan to foreclose.”

$24 Billion – Now that is not your run of the mill, little homeowner who claims being duped into taking on a mortgage that he or she couldn’t possible service. If the borrowers hadn’t borrowed the money there would have been no foreclosure. Claims that the lender over-appraised the properties as part of a scheme to foreclose just fly in the face of reason. The last thing a lender wants is to take over a financially failing property and try to work it out to recover 100% of its investment. If the property value, at the time of foreclosure, will not support the servicing of the debt, then it is axiomatic that the lender will take a loss if it must sell the property or will suffer a financial drain if it must continue to fund operations until the value of the property is restored.
If the borrowers believed that the lender had over-appraised the properties at the time of granting the loan, then they participated in that over valuation by accepting the funding of a loan predicated on that value. If the borrowers had just applied or a loan based on an appraised value that they believed to be reasonable, then the amount they borrowed would have been substantially less.

In this case, the lender Credit Suisse would appear to be the victim and not the borrowers. Credit Suisse did not cause the real estate market to crash. In the current market all kinds of developers have found themselves with loans that they are unable to service. The lenders do not set out with a strategy to foreclose. That is the last thing they want and to claim otherwise is very disingenuous. If all commercial property borrowers could sue and prevail against their lenders when they became unable to service their debts, then the real estate financing market will never be the same. We will go back to the old days when borrowers were required to have a substantial cash investment of their own in the property and achieve pre-sales or pre-leasing targets as a condition of the loan. Maybe that wouldn’t be such a bad idea as it would certainly curtail the type of speculation that contributed to the present economic malaise.

Hopefully, our judicial system will see through this type of lawsuit and not cause lenders to waste incalculable sums of money on legal fees in an attempt to defend their position. This type of lawsuit is like going to the casino and losing a vast sum of money and then suing the casino for allowing you to play. Borrowers must take responsibility for their own actions.

January 6, 2010 –

More news stories have appeared relative to the $24 billion suit against Credit Suisse. Based on the stories it would appear that the plaintiffs in the suit are not the people who borrowed the money from Credit Suisse but rather were investors, through homeownership or otherwise, in the projects financed by Credit Suisse. This makes the suits all the more interesting and bizarre. If the news portrayal of the suit is correct, it is very difficult to see how Credit Suisse had any direct relationship to the plaintiffs. It does not appear that the actual borrowers are the plaintiffs in the suit but, for better or worse, it was the actual borrowers who applied for, negotiated the terms of and accepted the funding of the loans. The loans were made at a time when the real estate market was overly exuberant and the bankruptcy of the financed projects resulted from a very negative real estate market not because of any scheme by Credit Suisse to be able to foreclose and acquire the projects on the cheap. That is just a delusional notion. The news stories also indicate that Cushman & Wakefield were complicit because they provided the Credit Suisse real estate appraisals, which implies that Cushman & Wakefield knowingly over-valued the properties to facilitate the schemes of Credit Suisse. That too is a delusional conspiracy theory. Cushman & Wakefield are one of the most respected real estate companies in the world with a gigantic revenue stream. They would have absolutely no incentive to risk their reputation and net worth in return for an appraisal fee that is “the size of a flea on an elephants behind” in relation to the revenue of the enterprise.

The bottom line is that the borrowers knowingly applied for and took the funding of the loans and now are unable to repay according to the loan terms. The lenders recourse is to foreclose. There can be little doubt that those directly involved in the loan, namely borrower and lender, had extreme optimism that everything would work out profitably. Those who became investors must have shared that optimism at the time of making the investment. Yes, the adverse market destroyed the euphoria of the developers and investors alike but to seek recovery against Credit Suisse is an attempt to hold someone else responsible for a bad investment decision. Such suit are akin to an investor who bought a financial stock in 2007 and lost 50% of their investment in the crash of 2008 bringing suit against the investment banks whose involvement in the mortgage backed securities causes the collapse.

Hopefully, the judicial system will see through this charade and will look only to the documentation signed by borrower and lender for any decisions and not to the wishful thinking and twisted logic of litigators.

REAL ESTATE APPRAISAL ISSUES
**
THE SALES COMPARISON APPROACH
TO
VALUE
(c) 2009 by Lloyd D. Hanford, Jr., MAI

Since the collapse of the real estate markets following the financial failures of 2007-08, it has become increasingly difficult to develop any reliable insights via the sales comparison approach to value. Thus, at least as far as commercial properties are concerned, one of the pillars of valuation theory has crumbled. However, despite this, appraisers still search for sales data and spend time trying to analyze whatever may be available. A critical look at the sales comparison approach suggests that, even before the markets turned, the approach was poorly understood by both appraisers and users of appraisal. The purpose here is to examine the approach in an attempt to provide a better understanding as to what it can and can not provide in the way of reliable guides to value.

The sales comparison approach to value is a “significant and essential part of the valuation process.”(The Appraisal of Real Estate published by the Appraisal Institute) Substantial time is devoted to it in the education and the learning process as one gains appraisal experience. The profession has done such a good job of promulgating the approach that many users of appraisals (such as courts, lenders etc) have come to rely too heavily on the results of the approach. However, the approach is not adequately or universally understood by users and appraisers and has become both highly used and abused.

The textbook The Appraisal of Real Estate (published by the Appraisal Institute) states the following: “The sales comparison approach is applicable to all types of real property interests when there are sufficient, recent, reliable transactions to indicate value patterns or trends in the market. For property types that are bought and sold regularly, the sales comparison approach often provides a supportable indication of market value.”(Emphasis added) This primary qualification will be discussed in more detail further on in this paper. The textbook goes on to say: “Generally the sales comparison approach has broad applicability and is persuasive when sufficient data are available. It usually provides the primary indication of market value in appraisal of properties such as houses which are not purchased for their income-producing characteristics. (Emphasis added). More, later about this also.

In addition to the foregoing quotes the textbook has the following to say:

“When the market is weak and the number of market transactions is insufficient, the applicability of the sales comparison approach may be limited.”

“Buyers of income-producing properties usually concentrate on a property’s economic characteristics, most often focusing on the rate of return for an investment made in anticipation of future cash flows.”

Thoroughly analyzing comparable sales of large, complex income producing properties is difficult because information on the economic factors influencing buyers’ decisions is not readily available from public records or interviews with buyers and sellers…Without complete information it will be difficult to arrive at a reliable indication of value for the subject property.” (Emphasis added)

“Rapidly changing economic conditions and legislation can also limit the reliability of the sales comparison approach. Perhaps the single greatest criticism of sales comparison is that the approach lags behind the market, resulting in appraisals that are based on dated information.” (Emphasis added)

The foregoing caveats appear to be completely disregarded by a large number of appraisers, and users of appraisal services such as the courts and investors as well as lenders

An essential criterion of the sales comparison approach is that there are “sufficient, recent, reliable” transactions to indicate value patterns or trends in the market. What does the term “sufficient” mean? The answer to that question appears to be left to the judgment of the appraiser. The term “sufficient” was probably intended to mean an adequate number of sales to provide a reliable conclusion. Many form, single family appraisals “require” three sales. Are three an adequate number? In the context of an active market three sales are probably inadequate. This will be probed later in this paper. But, in the field of major properties, three sales may the most one can get. The question of “reliability” of the approach should be foremost in the mind of the appraiser and user of the appraisal. It would seem to be axiomatic that the greater the degree of homogeneity within the sales sample (for example single family tract homes) the fewer the number of transactions needed to provide a comfort level (reliability). Thus, three recent sales of similar sized tract homes within the same sub-division may provide very strong evidence of value although there is no persuasive reason to confine the study sample to three sales if more, truly comparable sales are available for study. However, it would seem equally axiomatic that the more complex the property, the greater the number of variables that would impact value (a lack of homogeneity). Hence, a larger sales sample would be necessary for analysis to provide reliability. But, in the case of the single family home there is most likely a far larger sample available for study, where there is adequate homogeneity, to provide a reliable result, which begs the question as to why some lenders require only three sales. Conversely, in the case of complex properties, where a larger sample of sales would be necessary to provide reliable results, there are most likely far fewer sales available for study. Accordingly, regardless of analysis of those sales, it is most probable that the sample is of insufficient size to provide a reliable result. Returning to residential sales, a major argument against limiting the sample size to a few sales when there are many available to study is the potential for abuse by using only those sales which, on their face, support the selling price of the property being appraised rather than providing a broader view of the market by an analysis of a greater number of sales.

Why are “recent’ sales important? First, the further back in time that one goes, the greater the risk that there have been significant changes in the market. The sales would require adjustment for market changes but, as will be discussed further on in this paper, it is not always possible to make objective adjustments that are supported by empirical evidence causing any support to be based on subjective judgments or anecdotal evidence. Such adjustments may render any result unreliable. Next, what is “recent”? Is “recent” one day, one week, one month, six months, one year, two years etc? Except where otherwise required, defining “recent” appears to be left to the appraiser’s judgment. In single family appraisals, sales more than three months old are usually too old to be useful, particularly when there is a high volume of sales activity within a three month period. However, sales of complex properties such as major office buildings, shopping centers, hotels and large multi-family projects do not usually reflect any significant transaction volume within a one or even two year period. This factor often redefines the term “recent” for appraisal purposes. However, here there is a very substantial risk that the economic conditions surrounding a sale in the past were so significantly different that there can be no logical, supportable explanation for any adjustments.

What is meant by the term “reliable” transaction? Most probably the term, as used in this context, means that the sale has been verified as to all of the significant details of the transaction through completely reliable sources. In the case of the single family home, verification is easier than in the case of the more complex properties. Typically, homes are marketed thorough a local multiple listing service that tracks the important details of the sale. The same is not the case with larger, more complex properties. Most often, sales data on these properties comes from third party sources and participants in the transaction, for whatever reason, are reticent to provide all of the important details and are often under a confidentiality agreement preventing disclosure. Partial verification is not adequate to produce reliability. But, most importantly, the appraiser should not completely rely on third party sources as independent verification has demonstrated, too often, that there are inaccuracies in the third party data despite the fact that the source has ostensibly verified the data.

The criticism that the sales comparison approach “lags behind” the market is a very real concern. The approach is a backwards looking approach and the results of a sales comparison study may not adequately portray the market as it is on the value date. Economic conditions do change over time and imperceptible changes like, for example, a relatively consistent, 3% rate of inflation, while potentially influencing values upwards would not invalidate the results of a sales analysis because that inflation assumption may be inherently built into the minds of buyers and sellers in the market. However, a major event or events causing a radical change in the economy or parts of the economy may eliminate any reliability of a sales comparison study because that event or those events result in a complete economic disconnect between the past and present. Possibly, the easiest example to envision is the change that must have occurred on Sunday, December 7, 1941, the day that the Japanese bombed Pearl Harbor and signaled the entrance into World War II. Obviously, the United States was so completely different on Monday December 8th than it was on Friday December 5th that any indicators from December 5th and before would become “false indicators” because everything was different on December 8th. Similar, less obvious events were the date in 1979 when, at mid-night on a Saturday night, the Federal Reserve initiated a significant raise in the discount rate as a means of slowing run-away inflation. The timing was chosen because at mid-night on Saturday all financial markets in the world were closed, thus all participants received the news at the same time as far as doing business was concerned. That step changed all of the rules as to how real estate was financed and rendered all prior value indicators useless. In Northern California, in 2000, the high tech and dot.com sectors of the local economy began to implode. The implosion, over a few months, induced major changes in office real estate occupancy rates and rents with a ripple effect into other sectors. This event, coupled with the September 11, 2001 attack on the World Trade Center caused an economic disconnect between the period pre 9/11 and post 9/11 making it difficult to rely on sales or rental data prior to 9/11. Finally, the collapse, in 2008 of the sub-prime mortgage market with its spill over impact on the financial institutions and changing mortgage conditions caused an economic disconnect between the market pre collapse and post collapse. This impact especially affected the single family market at the outset but spilled over in to other sectors like retail and office. Even though sales of residential properties appeared to continue to close, the sales data became unreliable because prices continued to drop as foreclosures rose and demand faltered.

The next problem with the sales comparison approach arises because of the adjustments that are made to sales. A distinction must be made here between single family sales and the sales of more complex properties. Very often there is adequate single family sales evidence to permit somewhat objective adjustments but, in the more complex properties, the number of sales is usually insufficient to permit any objectivity in the adjustment process. This leads to a substantial risk that the appraiser will end up “manipulating” the adjustments to make the results appear reasonable. In the absence of empirical evidence supporting any adjustment, the adjustment factors become completely subjective and prone to manipulation. Observation of cross examination in litigated matters would lead a trained observer to conclude that the appraiser on the witness stand is most often unable to provide any factual data or persuasive support for adjustment factors used.

With the exception of rare circumstances the sales comparison approach will not prove to be reliable in the case of complex properties. First and foremost, the number of truly comparable, contemporary sales available for study is usually quite limited. In other words, the sample is too small to provide a reliable result. Secondly, the more complex the property, the greater the number of value variables. A value variable is an element that would have an influence on value such as location, leasing structure (length of leases, rents at, above or below market, specific lease terms), condition, amount of deferred maintenance, services, expense pass through items, tenant improvements, tenant improvement allowances, occupancy and other factors that may be observed. From a statistical standpoint, as the number of variables increase the requisite sample size for reliability also increases. This problem does not arise if there is substantial homogeneity in the sales sample (as in the case of single family tract homes where the majority of product is the same). In the more complex income properties, as stated, the available sample is most often too small or limited to produce reliable results but, in the final analysis, the net income from the property is usually the culmination of the interaction of all of the value variables. Thus, the income approach narrows the variables down to net income and capitalization rate and should provide a more reliable result than an analysis and subjective adjustment of limited sales data. .

Regardless of sample size, the sales comparison approach measures certain “units of value” such as value per square foot, value per rentable square foot, value per square foot of GLA, value per realizable square foot or number of units of improvements (new construction) value per unit, value per room or a gross rent (income) multiplier. Each one of these “units” has some limitations. In operating properties, the square foot values reflect the impact of income, which may not be uniform from comparable to comparable. In apartments, the value per unit may not properly adjust for the unit mix (number of 1 bedroom units in relationship to 2 bedroom units etc). And, the gross rent (income) multiplier is limited by the fact that the income characteristics (rents at market, below market, above market & occupancy) are not uniform and, accordingly, the result only provides a range rather than a free standing, self supporting multiplier.

In the appraisal world there is always a question of “form over substance”. Many things find themselves in an appraisal because they have “traditionally” been there. So it is with sales data. This is not intended to imply that sales be omitted from the complex appraisal altogether or that the residential appraiser must reflect all sales, whether needed or not. Instead, what is intended it to create a mind set that starts with the question of relevance. If there are twelve residential sales of which five are very relevant and seven are just of interest, it would be important to detail the five relevant sales and analyze them. In the complex income properties, it is suggested that the available sales data be provided with focus on extracting the capitalization rate. A detailed analysis of an insufficient sample is, by definition, a wasted exercise since any result is, at best, unreliable. ”

A sales search, in an of itself, is valuable to the appraiser as it should result in an understanding of the condition of the market even if the identified sales do not lead to a reliable, stand alone, conclusion of value. The search should indicate whether the market is active or inactive, whether there is current demand or whether the number of properties on the market exceeds the number of buyers active in the market. The search should indicate the length of time listings are on the market before selling as another indicator of activity. The appraiser must always be aware of the fact that when the market is weak the number of transactions is reduced and when the market is strong the number of transactions is increased. In periods of fierce activity prices appear to move upwards very rapidly with the probable result that price moves out ahead of value. Similarly, in a declining market, the probable result is that price drops below value. In each case this phenomena should be expected to last until the market stabilizes – that is prices stop rising or falling as the case may be. This awareness should assist the appraiser in rendering credible appraisals to the client and should help the client assess the reliability of the appraisal and risks inherent in the property.

In order to render credible appraisals, appraisers must process a substantial amount of information and data that, in the end, should provide a firm basis for judging the characteristics of the market including the behavior patterns of buyers and sellers. Whether sales data is useful in leading to a stand alone conclusion of value or not is not the most important question to be answered. The most important question is one of what the sales indicate about the market. All kinds of good information can be obtained from a study of sales even if the sales comparison approach does not provide a value answer in and of itself. Useful information from sales may include buyer identification (what is the profile of the typical buyer?), length of time on the market, number of similar, competing properties being offered at the same time, market participants perception of the market at that time, and financing environment, to name some information types. Even though the sales comparison approach may not yield a stand alone value conclusion, the approach is very important in understanding the market.

By now, if someone doesn’t know that real estate has declined in value, by a substantial amount, from its highs in 2007, they have just awoken from a three year sleep. There is no doubt that there was a real estate “bubble” and that the “bubble” has burst. That is not the question. Rather, the question is one of why did the “bubble” occur in the first place and why did it burst when there are so many supposedly brilliant, highly paid, bankers and investment advisors out there who should have seen it coming?

There is a vast difference between single family residential property and commercial or investment real estate yet, the root of the collapse would appear to emanate from a single cause. The market was being driven by “other people’s money”.

In the case of single family housing, the home buyer was chasing the illusion that values would continue to increase forever. This illusion was fed by irrational competition between lenders eager to push money (mortgage investor’s money and not their own) out the door and earn a fee for doing it. The mortgage brokers, eager to earn a fee, helped the lenders by supplying new and re-financings at a rapid clip. In some cases they helped unqualified borrowers to “qualify” through providing false financial information. But, none of their own money was at risk. The lenders relaxed their “due diligence” processes because they were going to package the loans and sell them to investors through investment banks as mortgage backed securities. Thus, in theory, they would have none of their own money invested in the mortgage. The investment banks, also eager to earn fees, sold mortgage backed securities to their investors and, theoretically, would have passed the risk on to those investors. To facilitate the sale of mortgage backed securities, the investment banks hired rating agencies to rate the securities. The rating agencies, eager to earn fees for this service, overlooked the risky practices taking place but, then, they had none of their own money invested in the product. The home borrower, in many instances, had very little of their own money invested in the home either by virtue of very low down payment requirements or by virtue of successive re-financings, as prices increased, to a point that more than 100% of what they initially invested had been taken back out. Thus, the foreclosed homeowner had no material investment in the property and it was the owner of the mortgage who suffered the financial hit. The market also evidenced a substantial amount of speculative activity from people who purchased many properties with the goal of a quick, profitable re-sale. Had it not been for the easy availability of credit, minimal financial qualifications and the lack of any real risk assumed by the home buyer/owner, would there have been a wild escalation in prices (bubble) leading to a collapse?

Supposedly experienced financial people should have seen the handwriting on the wall at least two years before the collapse occurred, as all of the signs were there. Low or no down payments, abundant availability of funds to loan, very relaxed borrower qualifications, ease of selling mortgage backed securities and a surge of speculative home buying taken in the aggregate were a prescription for disaster. But the fact that the bankers didn’t see the handwriting on the wall shows that, possibly, they were blinded by the substantial fees they were earning and that they succumbed to the competitive pressure of not wanting to “miss out” on a very profitable business opportunity. The fact that investment banks (led by people earning multi-million dollar bonuses) ended up with mortgage backed securities in their own portfolios only shows how they began to believe their own propaganda. Firms like Bear Stearns and Lehman are no longer with us because of the collapse of the mortgage backed securities market. Goldman, a brilliant survivor obviously saw it all coming and made billions shorting the mortgage market (while at the same time continuing to sell mortgage backed securities to investors).

The bottom line seems to be that the pressure of “other peoples money” drove the residential real estate market since the investors who purchased mortgage backed securities, theoretically at least, ended up with all of the risk while all others in the process earned fees but were left with no risk (unless they retained the mortgage securities in their portfolios). There was a time, earlier in the market history, where home buyers needed a relatively substantial down payment and were subjected to very demanding financial standards to assure that the buyer had the ability to service the loan. It is doubtful that the collapse would have occurred if more rigorous standards had been applied but, more importantly, things might have been different if the institution that originated the loan had been required to “age” the loan before selling it in a package of mortgage backed securities.

In the commercial/investment market easy financing was also available with the ability to highly leverage properties through the sale of commercial mortgage backed securities. However, that was only a fraction of the cause of problems in the commercial markets. Major players in the commercial markets are institutions (pension funds), investment funds marketed by investment banks and real estate investment trusts. In each of these vehicles the investment decisions appear to be made by people who are not the end investor.

Pension funds hire investment advisors who are paid substantial fees for vetting investments and guiding their clients into “suitable” investments. The advisor has only one risk – loss of the confidence of their client with a loss of the client. But, the advisors work under an unseen pressure, one that is not anticipated or factored in by the client. If the advisor does not produce “suitable” investments or turns down investments that are ultimately announced by a peer pension fund, the advisor may find that the client moves to another advisor. So, there is a pressure to produce results. And that pressure can, and most probably does color recommendations. This is especially true when there is fierce competition for real estate investments with little or few qualified offerings. The risks to the pension funds are great as seen by the Calpers (California Public Employees) purchase of two major apartment complexes in New York with an estimated loss of $500 million and CALSTERS (California State Teachers) estimated loss of $970 Million in a land development investment in California. Probably, no problems would have occurred if the properties had been acquired at the beginning of the real estate cycle but they were bought at the height of the cycle. Investment advisors should be able to recognize when cycles are nearing their highs but, competitive pressures may serve a blinders.

Investment funds put together by investment banks have the same root problem. They put together a large fund based on the investors’ expectation that they will be able to successfully invest and leverage those funds. Failure to put the money to work creates investor unrest leading to an unseen pressure to show some progress. That pressure often leads to “stretching” the analysis to make the numbers work. A major investor once remarked “even when I lie to myself with the numbers, the deal doesn’t work”. The difference there was the investor was investing his own money where in the case of funds, the purchaser is investing “other people’s money” and that decision does not seem to carry the same risk pressure. Once in a while an investment bank will acquire a property using a high degree of leverage anticipating the easy ability to easily raise the money later. Again, the decision is not made with the expectation that the investment bank will hold the property in its own portfolio other than very temporarily. When it works out as planned, no problem. However a major investment bank lost a substantial cash investment when investors did not buy the fund and ultimately lost the projects to the lender.

Again, it appears here that “other people’s money” drove the investment decisions. Institutions fall prey to the same competitive pressures as lenders. The pressure is the fear that someone else will end up with the deal to their embarrassment.

Real Estate Investment Trusts (REITs) are public corporations investing in real estate and are most often traded on a major stock exchange. Growth in the value of REIT shares comes about by any one of several routes or a combination thereof. Increasing cash available for distribution through increasing rents or decreasing expenses is the most obvious. This route is management driven. Expanding the portfolio by use of leverage and acquisition of properties where the acquisition would be accretive to earnings is another means of share value growth. Finally, a competitive reduction in the rate of return on properties (the capitalization rate) raises portfolio value. The latter is something over which REIT management has no control since it is completely market dominated.

The first avenue to value growth is strictly in the province of property management or operating management skills, but, comes into play by financial managers and the REIT board when making a purchase decision as part of a forward looking financial analysis. However, the ability to raise rents is strictly a function of the market. It is interesting that almost no analysts provide any commentary on the quality of property operations yet that is a very important aspect of growth.

Growth by acquisition comes about through the raising of new capital or leveraging the existing portfolio. Many of the current REIT problems are the result of over-leveraged portfolios in the face of declining rents. Here, again, the acquisition decisions are too often competitively driven with the decision made easy by the fact that it is the investors’ money being put at risk. The decision makers usually do not invest their own money in the acquisition. Competition between REITs places the same unseen pressures on the decision makers as in other vehicles using other people’s money.

There seems to be an inescapable conclusion that the decision makers risking other people’s money do not tend to view risks in the same light as an investor risking their own money. The investor investing his or her own money faces no competitive pressure or embarrassment for failing to make an offered investment and is only concerned with the probability of success of that single investment.

There is also another seemingly inescapable conclusion that the investment models utilized by investment managers (REIT, Investment Banks and Pension Fund Advisors) were most probably flawed by a failure to build in a sufficient downside risk factor. Many analysts utilize discounted cash flow models (DCFs) to determine investment suitability. The models usually forecast only future increases in rents and an increase in value at the time of sale. The models usually did not capture the potential competitive impact of new projects coming on stream and did not consider the possibility of negative economic factors causing vacancies and reducing rents over time. The models made it possible to easily manipulate the results to justify a favorable recommendation.

With all of this one might conclude that over optimism and naive beliefs, by money managers that things go up forever became “blinders” to risk. That attitude seemed to be fueled by continued rising prices and rents and an easy supply of money.

What happened in the recent past relative to commercial properties is reminiscent of the syndication explosion of several years ago. In that era, before public securitization of real estate via REITs, syndicators purchased a property and then sold it in the form of limited partnership shares at an aggregate price substantially above the acquisition cost. This type of market activity gave rise to a theory that the value of real estate was not its value to a single purchaser but rather was its value after being sold off in limited partnership interests. There is no question that tax benefits were a strong inducement to limited partnership investors. However, the pace of syndication activity and the ease of attracting limited partnership investors gave a strong push to the activity in the market and the market fed on itself. If it had not been for the ease of bringing in limited partners, the activity in the market would have been substantially less and prices would not have climbed so quickly.

One thing is certain; whatever has happened in the past will be repeated in the future, although probably in a different form. Those who earn their livings “creating” investment opportunities are very resilient and can be counted on to be able to “invent” a new theory demonstrating that a new type of investment vehicle or investment is bound to be successful even where reason and logic might dictate otherwise. Caveat Emptor!

December 16, 2009 – Recent discussions by some analysts regarding the pending financial regulation legislation have attempted to deflect blame from the banks and Wall Street by focusing on the role of Freddie and Fanny. While it is true that these quasi governmental corporations helped create the problem, the fact remains that without the ability to securitize the mortgage the problem would not have occured. They may have been facilitators but the greed of m mortgage brokers, loan originators, Wall Street, the rating agencies and, last but not least, the homeowners, the problems would not have taken on the magnitude they did.

Much has been said about the “poor homeowner” being forclosed out of their homes. What remains unsaid is that many home buyers knew they were providing false financial information to lenders in an attempt to get their loans because they were anxious to participate in the never ending real estate boom. In many cases they had little or no equity in their homes long before the collapse of the market. So, they are really not all big losers in a forclosure action. Little is said about the homeowners who had built up substantial equity in their homes over the years and then began to use that equity, thorugh succssive re-financings, to spend themselves into prosperity. By the time the forclosure notice arrived many of these people had little or no cash investment remaining in their homes. Finally, what remains unsaid is the part speculation played in the collapse. People caught up in the boom psychology began buying homes on speculation intending to sell them quickly at a profit. That worked for a while but it too came to an end. The only peoplefor whom tears should be shed are the hard working, “straight arrow” people who had built up a good equity in their homes, carrying a manageable mortgage, and then found themselves unemployed and unable to service their loans. These are the people who deserve a “bail out”.

January 26, 2010

The “bubble” mentality and force of “other peoples money” is very well demonstrated by the news that Tishman Speyer are giving Stuyversant Town to the lenders. Tishman, with other investors, acquired the property in 2006, at a market high, of $5.48 Billion. According to news releases Tishman invested $112 million of its own money in the deal. CalPers, through investment advisors reportedly invested $500 million and the Government of Singapore was reportedly in there too. The news release estimated the current value of the project at $1.8 Billion. In addition to the cash investors, the big losers are the primary and mezzanine debt holders. Reportedly, a cornerstone of the deal was the belief that the applicable rent controls could be modified.

One must assume that some pretty smart real estate, investment and finance people did a substantial amount of due diligence before entering into the transaction. So – what went wrong? Reading between the lines, the price of $5.48 Billion was probably not supported by the rents in place at the time of acquisition and to make the numbers work required relief from the rent control laws. One would also assume that the rent control issue was well vetted by a team of lawyers. It obviously was not a “slam dunk”. Those kinds of things never are. This leads to the conclusion that the euphoria of the day blinded all participants to the risks inherent in the deal and most of all, since the bulk of money was coming from investors and lenders, Tishman had a very high reward-risk potential if it all worked out. In 2006 who would have believed that the dynamic commercial real estate market would ever cease increasing rents and values. But, when it is “other peoples money” being risked the people behind the transaction rarely build the proper element of risk into the investment model and the lenders willingly buy into the story line. CalPers were put into the deal by an investment advisor but the investment advisor did not take the risk. Enough said.

On November 24, 2009 the New York Court of Appeals ruled 6-1 that it is lawful for the State to seize private property for use by private developers. This case involves taking, though eminent domain, private property to turn over to a private developer for the development of a sports arena complex including office buildings and rental apartment blocks. Apparently, a cornerstone of the use of eminent domain was the designation of the area in Brooklyn, known as Atlantic Yards as “blighted”. Yet, some of the property to be condemned includes condominium residential units valued at over $500,000. The claims of blight reportedly refer to the appearance of graffiti and the growth of weeds. It is possible that the definition of “blight” used for these purposes is much too broad. However, that is not something the Court can address. The Court, in its ruling, probably depended on the decision of the U. S. Supreme Court in the case of Kelo v. City of New London where private property was taken and turned over to the private development of a campus for Pfizer. In that case it would seem that the “public benefit” was an economic benefit to the community where, in the Atlantic case the “public benefit” appears to be removal of blight and the development of s sports arena.

Both the Atlantic and Kelo cases should create fear in the minds of all property owning citizens of the U. S. If private developers, through the use of lawyers capable of performing gold medal winning legal gymnastics can get the right to use eminent domain to take property for the benefit of those developers, then no one is safe anymore. Logic dictates that when the concept of permitting the State to take private property for a public benefit, no one involved in creating that legal right ever contemplated that eminent domain would be used for other than public projects such as governmental buildings, fire houses, police stations, public transit projects, hospitals, military installations and the like. It is understandable that Cities needed the right to re-develop areas that had become truly blighted. But, blight in this instance usually meant a substantial amount of dilapidated and/or vacant property where social as well as physical blight was present. However – an area with $500,000 condominiums – give me a break!

In the wake of the Kelo decision, many States enacted laws to make it much more difficult to use eminent domain to take private property. However, it was by no means universal. What is needed now is for the U S Congress to revisit the law and write a new law, covering Federal as well as State property takings so that eminent domain is confined to a true public purpose and not a trumped up one as in the case of Atlantic Yards and Kelo, which in the mind of this writer was one of the most poorly reasoned decisions of the Court, where the minority opinion should have been the law..

NET LEASED PROPERTIES
©2009 Lloyd D. Hanford, Jr., MAI

Long term, net leased properties have long been the darlings of the real estate investment world, particularly among the smaller investors. However, years of observing that market suggests that these investments are not well understood by the investors particularly with regard to the risks involved.

For years, the primary focus of investors has been on the capitalization rate or yield with “credit tenants” commanding the lowest capitalization rates. Emphasis on credit has been misplaced as clearly demonstrated by virtue of different factors. First, a high credit company may be “bought out” via a leveraged buy out that encumbers the company with a mountain of debt that may ultimately eliminate any creditworthiness and may lead to bankruptcy. Secondly, adverse economic times can quickly erode both the capital of a company and lead to a substantial decline in revenues that further jeopardize credit standing. As has been clearly shown in the recent months, many businesses have failed and rejected some or all leases in bankruptcy proceedings. Financial institutions, once believed to be substantial tenants, have failed and closed their doors. Retailers have gone out of business. Businesses in bankruptcy have been able to re-negotiate leases at a substantially lower rent under the implied threat of lease rejection if unable to do so. The bottom line here is that the credit of the tenant may not be as important in the investment decision process as once believed and may not warrant significantly lower capitalization rates than those available from lesser credits.

Fast food outlets like KFC, drug chains like Walgreens, Rite-Aid and CVS, as well as bank branches have been very popular with investors with historic capitalization rates being among the lowest in the market. The market activity in the past suggested that all were treated somewhat alike in that the investment focus was on the income. However, each property type has its own unique characteristics that should be analyzed by investors to a greater degree than has been exhibited to date.

A characteristic of many fast food outlets is a relatively special purpose building that frequently represents an under-improvement of the land because of the necessary parking. Thus, any analysis of these properties, in addition to location, should focus on land value and its potential growth over time as well as potential alternative uses of the improvements. If the improvements have limited alternative uses, then investors should focus on land value as the justification for making the investment. If the improvements have alternative uses then focus should be on the market rent for the property and the value that may be implied by that rent. In many cases, where the improvements are small in relation to land size, the contract rent, on a square foot basis, may well exceed any measure of market rent for alternative purposes. This result should place more attention on the value of the underlying land.

Single tenant retail properties are usually just “boxes” with no limited specialized interior improvements. In addition to location, the relationship of contract rent to market rent is an essential analysis. Often, rental being paid exceeds the indicated market rent. As in the fast food properties, it is important to identify the demand that would exist for the property if it were to be vacated and the rent that would be probable from an alternative user.

A common element of most single tenant commercial properties is an initial long term lease at a fixed rent. The fixed rent acts as an inhibitor to value growth as value growth is dependent on income growth. Also, many long term commercial leases contain renewal options at either the same rent or a very slightly increased rent. This type of provision also limits value growth and, historically, has resulted in rent, over the long term, falling far behind market rent. When this occurs, the tenant builds a substantial leasehold interest which does not revert to the benefit of the property owner until the lease ends.

Single tenant office properties present different problems. There are basically three types of single tenant office properties: general office, high tech office and medical office (includes doctors offices, surgical centers and specialized medical centers like radiology ets). In general offices, tenant improvements are usually fairly standard and, in many instances, can be re-used by a successor tenant with minor modifications. However, in the other types of office, highly specialized tenant improvements and configurations of space are the norm. The tenant improvements are often priced into the rent being paid and are usually far more costly than standard office improvements. Thus, when a tenant vacates these specialized facilities, it is probable that the interior improvements will either be outmoded or will not meet the needs of alternative tenants. In either case extensive new tenant improvements would be needed. More importantly, the market rental value of the space without the specialized improvements is at risk of being substantially reduced. This caveat applies to most special use, single tenant properties but usually not to the same extent as in high-tech,scientific or medical facilities.

Larger net leased properties, such as major office buildings, “big box” retailers or super-markets like Costco and Safeway are not discussed because they are more commonly purchased by very high net worth investors and/or institutions. However, these larger properties, in addition to location, require analysis of the relationship of contract rent to market rent as well as an analysis of alternative uses and demand if the single tenant vacates.

Regardless of the type of property, before committing a purchase, investors should have a firm understanding of the market rent for the property and the alternative use possibilities as well as having an exit strategy firmly in mind. The exit strategy should consider when the property might be sold, the type of purchaser that would buy it and the price it might fetch (a measure of profit) with comfort that this exit would meet investment objectives.

Real Estate Investment Trusts (REIT’s) appear to have come to life and some shares are again selling at prices at or above net asset value. Are the current valuations reasonable on a risk-reward basis? It is suggested that the answer is most probably NO.

Historically, REIT shares have been priced based on anticpated “total returns” which are composed of both dividends and share appreciation. This raises the question as to whether either dividends or share values will grow in the forseeable future?

There should be little question that the investment real estate market is in a down cycle. Vacancies in all property classes appear to be increasing and rents appear to be declining. Neither of these results bode well for dividend increases or future appreciation in the values of the underlying properties. If one accepts this thesis, then investments in REIT’s should be viewed as having a relatively high exposure to a risk of declining share values.

When vacancies rise and rent levels fall, there is a very real risk that cash flow will be insufficient to sustain the level of dividends reflected and the dividends become subject to reduction. Thie reduction of income, in and of itself, can cause a decline in asset value. When these kinds of things happen, total returns will decline

There are other problems for REIT investors. First, in the present market environment it is very difficult, if not impossible, for an investor to calculate the net asset value of a REIT portfolio because there are too many unknowns. Analysts do not focus on the operational management of the properties and, accordingly probably don’t know about vacancy exposure unless specific anticipated vacancies have been publically disclosed.

A second problem is that when cash flow declines the priority is to service the debt first which may force postponment of necessary maintenance or capital improvements and may limit cash availability to make necessary tenant improvements. When this happens, the maintenance problems are pushed off into the future and may negatively impact values.

A third problem arises when individual properties in the portfolio are not producing enough net revenue to support the historic values and, if major vacancies occur individual property values can fall below their outstanding debt.

Boards of Directors of REIT’s should be expected to have all of the information necessary to evaluate whether or not these kinds of problems exist but, the way things often work results in the information not being timely enough to direct defensive actions. For example, when a major tenant goes bankrupt and rejects its lease, that information usually comes too late to be useful. Some, but not all REIT’s have a “lead director” who is independent from management and that “lead director”, at least, should personally inspect each of the owned properties in order to verify the type of management job being performed as well as to view the condition of the properties. Many Annual Reports do not disclose the degree to which any director or directors have personally inspected the properties.

Unquestionably, Annual Reports (10 K’s) provide all required financial disclosures but they do not ordinarily discuss specific concerns such as increases in deferred maintenance, value declines that may be leading to debt being in excess of value. Nor do these Repors generally discuss declining rental markets and their anticipated impact on the particular portfolio.

These concerns suggest that REIT shares could come under downward pressure in those instances where share prices are at a premium to real net asset values. The near term does not look favorable for investment real estate and, as values decline, investors may be incentivized to dispose of assets with the result that the market will become an even stronger “buyers market” There is nothing in the current market to give rise to optimism that the real estate market will grow strong in the immediately forseeable future and ownership of property assets may have a much higher degree of risk attached to them than the market may reflect.

This is just the opiniion of one observer but does suggest caution, if nothing else.