Much has been written recently about the decline in REIT share prices with most of the blame attributed to rising interest rates or the fear of rising interest rates. Some pundits see rising interest rates as a problem while some do not. Most of the analyses reviewed focus on whether or not rising interest rates are a problem for REITs but, that type of analysis may fall very short of identifying the real risks faced by REITs.

Most analysts would probably agree that the great advantage of REITs is liquidity followed by shelter from income taxation (the REIT pays no income tax if it distributes the statutory amount to shareholders). Neither of these advantages is impacted by interest rates and will survive regardless of whether rates are high or low. But, an analysis of the effect of rising interest rates must go further.

The very low interest rates in the last few years have caused capitalization rates to fall to a historically low level.  The capitalization rate (cap rate) is the rate of return that is used to convert net income into value by dividing that net income by the rate. Historically, as rates fall values rise and conversely as rates rise values rise.  Hence, rising interest rates can trigger a reduction of individual and portfolio property values. This, in turn can impact share prices. This effect can be immediate.

Rising interest rates will force debt service to increase at the time of re-finance which, in turn, may reduce the cash flow available for distribution? This is not an immediate problem and is often postponed until refinancing is necessary.

However, interest rates are not the only REIT problem and the lack of analytical research on other potential problems for REIT investors may result on causing the focus to be limited to a simple issue rather than seeing the range of potential issues.

Management:  One analyst observed the contribution of management as “acquisitions, dispositions and development” as well as “effective capital allocation”. There is no doubt of the importance of these skills.  However, much more important and rarely discussed is the “operating management” skill of the management team.  Properly managing the day to day operations of each individual property includes; effective tenant retention, effective leasing and rental programs, minimizing vacancy risk, strong preventive maintenance programs and rigid control over operating expenses to name a few. Most analysts fail to offer any analysis of these important functions as contributors to dividends and value. Unfortunately most REIT investors have no means for evaluating management and, thus face a risk that management shortcomings could negatively impact performance.

Portfolio Diversification: Many REITs are sector REITs (investing in one type of property like offices, apartments etc) rather than being diversified into different property types.  There are good arguments pro and con on this subject. However, the fact is that not all property types can be expected to perform in the same manner in all types of economic circumstances. For example, Power Centers (“big box” retailers) face consolidation problems like the merger of Office Max and Office Depot or failure. The preferred means of achieving diversification is to own REIT shares in the various sectors.

Local Nature: Individual real estate is locked into its location.  It can’t be moved to another part of town or to another city. Many REITs are geographically concentrated and not all geographic areas can be expected to perform in the same manner. REIT investors need to consider the potential positives or negatives of ny geographic concentration.

Vacancy Exposure: One of the greatest risks of real estate ownership is the constant exposure to vacancy by virtue of lease expiration, tenant bankruptcy or tenant failure. Many REIT report their lease expiration schedule but few, if any, disclose the renewal probabilities for specific large tenants until the tenant has made some form of public announcement.

All of the foregoing problems, in addition to the interest rate problem are things that should be of concern to REIT investors and the need for information may be an opportunity for some analysts to find an unfilled niche.

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In the last couple of weeks there were four different, yet related, public discussions (TV or print media), on the current real estate market that were very interesting. The first discussion covered the re-emergence of the “competitive buying” phenomena that was prevalent before the “bubble burst” in 2008 when brokers were getting multiple offers on their listings. The thesis of the discussion was that improvements in the residential real estate market, suggesting a recovery, were bringing buyers back into the market.  However, the discussion pointed out that the competitive nature of this market favored the “all cash” buyer (buyer’s not purchasing contingent on receiving a loan). The discussion also pointed out that the buyer’s were not, for the most part, “end users” (people buying the home to live in it). Rather, the buyers were “operators” purchasing multiple properties in the anticipation of continued market improvement and being able to re-position the homes in the market for a turnaround sale at a much higher price. This type of activity does not necessarily spell out the actuality of a long term improved market.  The ultimate test will come when the properties are placed back on the market and “end users” step up to buy them.  That may not be as easy as it seems.  The ultimate homeowner is most probably dependent on conventional mortgage financing, which itself requires a good credit score and an income level satisfactory to service debt. This also raises the question of whether or not the economy has improved sufficiently to restore confidence in the mind of the home consumer. That has yet to be proven.


For most homebuyers, becoming involved in a “competitive” buying situation should be avoided because it can only lead to paying more for a property than it is worth. To avoid unwittingly being drawn into a competitive situation buyers should consider retaining their own agent, under contract, to act as the buyer’s exclusive agent charging that agent with responsibility for preventing being drawn into a competition.  Offers to purchase should be very short term and should contain a provision that, if the offer is being submitted to the seller along with competing offers it is deemed immediately withdrawn. A buyer’s exclusive agent can help manage this process while dealing with only the seller’s agent offers little protection because the seller’s agent has a primary obligation to the seller and not the buyer. No potential buyer wants to have their offer become the “stalking horse for another offer from a competing buyer. Agents like long term exclusive buyer representations because they have an assurance that when the right situation is found the agent will get a pay day and, because of that the agent will work hard to find the right situation.


The next discussion reported a shortage of “mega mansions” (multi-million dollar homes) in many markets. This phenomena pops up in places like the San Francisco Bay Area where each new IPO involving a high tech company in Silicon Valley disgorges an army of new multi-millionaires into the market.  This is an example of too much money chasing too few properties. The newly minted millionaires would be well advised to read a history of the local real estate market to learn what may have happened during previous market melt-downs. At the time of the bust many mega mansions suffered a substantial price decline. This could happen again. The shortage of mega mansions obviously creates an environment for competitive buying. Owning a mega mansion also requires the ability to remain super-rich. Forgetting the cost of debt service, the owner of a mega mansion in California, with a price of $15,000,000 would pay an annual real estate tax of $150,000+ on top of which would be high costs of maintenance, insurance, utilities etc. A buyer would need to be very comfortable that a sufficient fortune was possessed that there was no dependence on a job and an ever inflating value to the corporate stock held.


The third interesting discussion involved a discussion that the U S governments give home buyers a subsidy.  That is a very interesting notion that completely overlooks the fact that there is already a substantial subsidy given in terms of very low mortgage interest (because of the monetary policy in place), coupled with a tax saving via the deductibility of mortgage interest and property taxes. Government policy that is designed to stimulate homeownership proved to be a total failure that, in part, brought about the 2008 meltdown. The development of new initiative to stimulate homeownership would, most likely, lead to another meltdown in the future. If government policies do anything, they should responsible ownership by precluding assuming more debt than can be serviced and encouraging higher equity so that a short term downturn in prices does not cause wholesale collapse.


Finally, this week REIT shares came under downward pressure because of concerns that interest rates would rise causing a potential future decline in income available for distribution. There is little question that the easy money policies of the government have subsidized growth in the REIT industry and it is natural to feel that a change in the interest rate environment will change things for the worst. There is every good reason for believing that interest rates will increase over time if the economy continues to improve.  In terms of commercial real estate, rising interest rates may not only decrease net cash flow but will also decrease value because of the impact of interest rates on capitalization rates (the rate used to measure value).


At the present, despite published optimism, there is no certainty that the apparent improvement in the real estate markets will prove sustainable or of long term benefit to all segment of the market.  The behavior of the stock market in the week of June 17, 2013 suggests that there is an overhang of uncertainty leading to increased volatility. While it is very easy to sell securities to quickly take profits or minimize loss, it is not so easy to sell real estate and that suggests avoiding aggressive acquisitions except under unusual circumstances.

Posted in Property Ownership, Real Estate Economy, Real Estate Investment, REITs | Leave a comment


The New York Times Business Section of October 13, 2012 contained an article by Shalia Dewan entitled “Which House is Worth More?” The article is timely and interesting in that it highlights perceived problems of home sales facing the real estate appraisal process. The general complaint is that failure of a home to appraise at or close to its sale price will “torpedo” the deal. The article suggests that the “problem is so widespread” that the National Association of Realtors blamed faulty appraisals for holding back the housing recovery.

An example cited was one of a seller receiving multiple offers against an asking price of $197,500 and accepting one at $210,000 only to be faced with an appraisal of $195,000 causing a compromise price of $205,000. The seller commented “The part that blew me away – the appraisal can be such an arbitrary personal decision and there is no appeal process”. Further, adding to his indignation, according to the article, was the fact that a similar home two doors away sold for $225,000.

An analysis of this example suggests that the complaints may arise out of a lack of understanding what the appraisal is and what it isn’t and how appraisers work. First and most importantly licensed appraisers (appraisers of residential property for loan purposes are required to be State licensed) are bound by the Uniform Standards of Professional Appraisal Practice (USPAP) and those standards prohibit basing value on “arbitrary personal decisions”. USPAP recognizes that the final value conclusion is an “opinion” but an “opinion” arbitrarily reached or one based on a personal decision unsupported by facts and data would fail to be within required USPAP compliance. This doesn’t mean that no appraiser has ever been arbitrary or lacked proper evidence before concluding value. It just means that such would be the exception and not the rule.  If an appraisal fails to comply with USPAP a complaint can be filed against the appraiser with the State licensing board, which if sustained could lead to a loss of license. It may not resurrect the transaction but would provide satisfaction. Also, if fault is found with an appraisal based on data or process errors, most lenders will take another look.  It is foolish to believe that the lender doesn’t want to make the loan and lenders may reopen a file if convinced that an error was made.

The complaint that a home two doors away from the subject sold for $225,000 (while the subject was appraised for only $195,000) may or may not b a valid complaint. It is indicated that the home two doors away had $30,000 worth of upgrades that were not present in the subject house.  Assuming that the appraiser included the $225,000 sale in the comparable sales used and adjusted the comparable price downward to $195,000 to reflect the value of the upgrades, any complaint would be unfounded. However, if the appraiser did not include a similar home sale two doors away in the list of comparables, such omission might justify a valid complaint.

The National Association of Realtors in blaming “faulty appraisals” for holding back the recovery of the housing market cited unidentified member reports that more than a third of all deals were cancelled, delayed or renegotiated at a lower price because of a “low appraisal”.  The National Association of Realtors (NAR) is a Trade Association with a primary interest in promoting the real estate brokerage business (the business of a majority of its members). Their comments and criticisms are for the most part biased rather than objective and should be treated with suspicion absent supporting empirical evidence. There comments need to be carefully examined:

What do the complaints of “low appraisals” really mean?  Are they appraisals that fall short of objective market value measures? Or, is a “low appraisal” just an appraisal that did not report a value equal to or greater than the sale price.  It is most probably the latter.

The NAR report (the report) indicates that appraisers use previous sales of comparable houses to “help” value a home and if prices are just starting to climb, with sales taking two to three months to close, there can be a lag before the change in prices can be observed.  This statement is partially correct.  Appraisers do use sales to “help” value a home and it can take two to three months before a sale closes.  But, that causes a lag in closed sales prices but not a lag in the observation of sales.  Part of the appraisal process includes studying the market and being aware of shifts in demand for homes vs. the supply of homes available for sale. Part of the process also includes maintaining relationships with brokers (market makers) from whom the appraiser can learn whether or not asking prices are rising, demand is increasing and the spread between ask price and selling price is diminishing.  The multiple listing services report sales under contract so even though a lag time to close can be protracted, the data is there to be used. Using these kinds of information the appraiser can and usually does adjust older sales for change in market conditions rather than depending on the old sales as the entire basis for the value conclusion.

The report suggests that appraisers were improperly using foreclosures and neglected properties as comparable homes as well as failing to account for market conditions like scarce inventory and bidding wars. Using foreclosures and neglected properties of similar homes as “comparable” properties is not, in and of itself, wrong.  What would be wrong would be the failure of the appraiser to make proper adjustments to those comparables to reflect, if such is the case, the superior condition of the home being appraised and/or the negative impact of a foreclosure on value.  In the case of “neglected properties” the appraiser should adjust for the cost of putting the property in equal condition to the home being appraised. And, if market conditions have improved and/or there are bidding wars, that kind of information would also call for an adjustment in the comparable property. Further, the report faulted banks for using “inexperienced appraisers” and for creating unrealistic requirements like “six comparable sales instead of three” as well as criticizing lenders for using appraisers lacking local expertise.

USPAP contains a competency requirement.  If an appraiser, knowingly lacks the experience necessary to appraise a property because of unfamiliarity with the city, neighborhood or specific subdivision, then the appraiser risks being charged with a USPAP violation that could cause a loss of license. What is not said is that lenders usually require competitive bids or use appraisal management firms to select the appraiser and this process risks failing to retain the best appraiser for a property in favor of the cheapest one.

It is foolish to complain about a lender requiring six sales versus three.  The residential form appraisals appear to “require” three comparables and that has caused furnishing only three to be the norm.  However, if there are six or eight truly comparable properties, there is no prohibition against analyzing all of them and reporting based on all rather than three. A competent appraiser would look at all of the data in estimating value. One of the problems is that supplying only three sales became the norm and it is easy visualize how an appraiser might “cherry pick” the sales to select the easiest ones for use rather than sales requiring substantial work to analyze.  Instead of lenders requiring three or six sales, they should require appraisers to report sales data in whatever depth is necessary to accurately portray the market.

The report quotes the NAR Director of Research as saying “It’s (the appraisers being hired) holding sellers off the marker” and “Sales volume could probably be an additional 10 to 15 percent higher if we had normal lending practices and if we had normal appraisal practices”. These comments are totally self serving as the goal of NAR is to create more business for the Realtors who are their members and making loans easier to get would certainly do that. But, otherwise, the comments do not make any sense when logically analyzed.  First, what does the word “normal” mean in the context used above? Does it mean a return to the pre 2008 financing market that caused the financial meltdown? One would certainly hope not but, there is no recollection of NAR sounding any warnings, pre 2008 that what was going on in the market might well lead to destabilization in the market. Many professionals recognized as early as 2006 that prevailing market practices (speculative purchasing and lending without standard documentation) would lead to problems.  They just didn’t know when the problems would surface.

The notions that appraisal practices would hold sellers off of the market or that a “normalized” market could increase sales volume by 10 to 15 percent are speculative at best and completely lacking any kind of empirical evidence or proof.  At worst, they are misleading and delusional notions perhaps designed to involve the political process in the perceived problems. It is more probable that sellers under no particular compulsion to sell would, in their own self-interest, hold their property off of the market if they truly believed that market conditions were improving leading to a potentially higher price in the immediately foreseeable future. On the other side of the coin, sales volume would increase dramatically if buyers became convinced that prices were beginning to rise and that, by waiting too long to buy an opportunity would be missed. Whatever appraisers may or may not do has absolutely no impact on the law of supply and demand.  If supply is shrinking and demand is increasing, prices will rise.  If the converse is true, prices will fall. If sales volume is not at the level needed to push prices up, it is because buyers are unconvinced that the market is rising and they prefer to wait.  That decision may be wrong but it is what moves the market.

Are lenders more cautious?  Certainly.  Any lender that survived 2008 wants to be satisfied that newly originated loans are sound and not at risk of failing. It should be realized that, back in the dark ages, when 25% down payments were required and lenders retained loans in their own investment portfolio, there were few appraisal problems. However, when loans of 90% to 95% of sales price are involved, over estimating value can result in a loan being “under water” the day the deal closes with particular risk to the lender because the borrower has a very small stake in the property.

To the degree that the lending problems cited by NAR might be realistic, good agents (not all agents/brokers are good) can take steps to avoid the problems. Once a transaction is agreed the agent can put together a detailed description of the house including all special and distinguishing features as well as detailed information on all sales of similar property that have sold recently.  In addition, the agent can provide a listing of similar homes that are currently on the market or under contract as well as an overview of the current market. This process removes guess work from the appraisal process as it makes sure that the appraiser has all of the relevant information necessary to analyze value. Agents belonging to a multiple listing service have easy access to all of this information while appraisers may not have that access. There is no prohibition against making the job of the appraiser easier by eliminating the expenditure of time searching for otherwise readily available data and information. Real estate sales commissions are very high in relation to the service provided and laziness by an agent should not be acceptable by a client.

Finally, in some instances an agent will represent both seller and buyer.  Under the laws of many states, in these instances the agent is obligated to represent the interests of the seller while the buyer signs off on this relationship. If the agent is a “dual agent” it is doubtful that they would advise a potential buyer that the asking price was too high and that value was probably around $X. For this reason, buyers should select an agent to represent them as buyers.  That agent would have the obligation of advising the buyer as to price and terms without worrying about the best interests of the seller which can be left to the sellers agent.

What is most interesting is that whenever there is market “dislocation” the appraiser is blamed for market problems. The Appraisal Journal (Published by the Appraisal Institute) published an article by me in October of 1991 entitled “Appraisers Under Fire – Again”. Re-reading it suggests that nothing ever changes. If any reader is interested in that article a copy can be requested via a comment to this article.

(c) 2012 by Lloyd D. Hanford, Jr., MAI

Posted in Real Estate Economy, Real Estate Appraisal, Real Estate Investment, Real Estate Lending | 2 Comments



Well, another seven years have passed and still there have been no comments, pro or con, instructive or destructive forwarded for consideration and response. The Sales Comparison Approach has been a cornerstone of  of valuation study since the profession began. Yet, out of the thousands who have read this no one has yet  raised any challenge to any of the notions or conclusions expressed. Since the original reason for writin the article in the first place was to begin a professional dialog with an eye to improving the analytical portions of an appraisal. To my chagrin and disappointment it appears that no appraiser anywhere has bothered to raise a question. Does that mean that everytnhing set forth in the article is so correct that there is no challenge? Well, that outcome is doubtful. Does it measn that no one agrees or disagrees with the analysis? That outcome too would be doubtful. Does it mean that the institutions having control over appraisal theory and practice are uninterested?  That notion would be a stretch. Does this lead to a conclusion that those in charge of appraisal education have too much invested in in the current methodology to think about change?  That is certainly very possible because “once the gemie is out of the bottle” putting it back in would be impossible and would unleash much time consuming and expensive study.

What should be very obvious to anyone in the valuation field is the fact that there has been absolutely no new valuation theory introduced to the profession in over 60 years. There have been many improvements in analytical  tools and in appraisal methodology but the profession is still adhering to the original three approaches to value (Cost, Sales and Income) even though each has some identifiable flaws which reduce the reliability of the approach.  If the profession hopes to remain relevant for the next 100 years it would seem that efforts to expand and improve the theory need to be undertaken. The last decades have seen giant strides in Uniform Standards and it is time for the same efforts to be aplied to valuation teory








(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 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.

Posted in Real Estate Appraisal, Real Estate Investment | Tagged | 6 Comments

Condominium Irrationality

A very interesting article, although probably obscured from most readers’ field of vision, appeared yesterday (October 3, 2012).  It was interesting not because the events were important or earthshaking but because it was an example of the kinds of horror stories experienced today by people living in condominium housing.

The story involved the court victory, of a couple living in a condo, after 11 years and legal fees of over $200,000.  It seems that 11 years ago the condo association sent them a bill for over $2,000 for mowing their lawn. They just didn’t think that was right and took on the legal fight.

Without knowing the facts it is hard to judge the merits of the case but the court decision in favor of the homeowner suggests that the association was in the wrong. The lesson here, for condo dwellers is that associations are governed by CC & R’s (Covenants, Conditions and Restrictions) as well as State laws in some instances. Often, overzealous HOA’s (Homeowners Associations) act before determining that their actions are permitted under law.

Homeowners who become embroiled in disputes with HOA’s should read the governing documents and law before initiating a legal fight.  Once that is done, if they conclude that the action of the HOA was not permitted under the prevailing governing documents, the first action should be to the HOA Board of Directors citing the reasons for opposing their action(s).  If that doesn’t bring about dialog and resolution then there are steps that should be taken before commencing any legal action.

First, demand, in writing, copies of the Board minutes, surrounding the incident(s) in question as well as minutes for at last two years preceding the incident. Many HOA’s, particularly the smaller ones without professional management, do not operate in compliance with the governing documents or applicable law.  Finding out that there have been deviations from the governing documents provides an almost infallible step to a quick solution. Many larger HOA’s, with professional management, have the management company take care of fiscal management only with all other aspects of management reserved for the Board. In these cases some deviation from governing documents is likely.

Condominium projects (sometimes called Common Interest Developments (CID’s) are, in some States, subject to a body of law specifically addressing requirements for condominiums that are designed to protect the homeowners. In California the governing law is known as the Davis-Sterling Act.  These laws are usually readily available on the internet and, before taking any legal action, should be reviewed to make certain that the action(s) questioned are not permissible under law or are not implemented in accordance with the law. If this is the case, present the information, in writing, to the Board of Directors and request that immediate action be taken to correct the situation.

If letters to the Board do not succeed in bring about any corrective action, before taking legal action, the Board should be notified, in writing, of an intent to take legal steps and suggest that, before doing such, an agreement to quickly mediate is a workable remedy. Some States may require mediation but even if not, litigation can be very expensive and mediation may resolve the problem at far less cost.

If these steps fail, retaining an attorney may be the next step.  But, before doing so, determine if other homeowners are in the same boat and might agree to participate in any legal steps.  The cost of litigation would be more manageable if shared by several people.

In the case described, if the homeowner spent $200,000 in legal fees it must be assumed that the HOA also incurred extensive legal fees in defense.  The expenditure, on both sides, was irrational considering the amount at stake.  In the case of the homeowner, it was their money and they are entitled to be irrational. However, the HOA Board of Directors is not entitled to be irrational since it is money belonging to the homeowners that is ultimately used to pay legal expenses.  Either they or their attorney should have realized the futility of spending money on a $2,000 + case and should have found a way of resolving the problem without litigation.

HOA Boards should make sure they are competently advised as to the requirement of the CC&R’s and governing law in order to avoid needles conflicts with homeowners.  HOA’s are mini-governments and elected officers and directors have all of the same failings as other elected officials in that they may begin to like the power with a risk that they might abuse that power. In the instance of the subject Board, their action in litigating might have exposed them, individually, to liability for a fiduciary breach by spending homeowners money fighting a $2,000+ lawsuit.

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There was an interesting article in the WSJ on August  first describing the actions of housing activists in East Palo Alto, CA. It seems that the activists are very annoyed at Equity Residential, the REIT owners of a major apartment complex because delinquent rent notices are being sent out too quickly.  The housing activists see this as an attempt to speed up evictions and take advantage of a rising rent market by obtaining higher rent from the next tenant than could be charges to the current tenant under the provisions of rent control regulations. They have turned their anger on the property owner and are painting the owners to be the “bad guys”. This is just another example of an entitlement mentality gone awry. The notion that property owners should not quickly enforce the collection of past due rent is bizarre and irrational. What the housing activists overlook is the simple fact that if a tenant pays the rent on time, when due, as agreed in the lease or rental agreement they signed, there would be no delinquent rent notice.


Most residential rental agreements or leases provide that rent is due on the first day of the month and becomes delinquent on the fifth (5th) day of the month (or 3rd day in some cases) referred to as the “grace period”. Under California law, a three day notice to pay or quit (vacate) must be served before eviction proceedings can commence but can’t be served legally until the expiration of the “grace period”.  The laws in California are among the toughest in the nation in terms of protecting the residential tenant and, superimposed on top of that are local rent control laws that provide even greater protections to the tenant. A tenant can’t be evicted for the sole reason that their rent payment was late.  Except in some very rare and special circumstance situations, if all past due rent has been paid before the eviction hearing in Court takes place, it is usual that the complaint is dismissed (the eviction does not go forward).


East Palo Alto, like some other Cities has a residential rent control law that “freezes” the rent for the current tenant with only statutory annual increases permitted. There is absolutely no argument that, in a rapidly rising residential rent market, it is advantageous for a landlord to have current rent controlled tenants vacate so new tenants can come in at a higher rent. But, that fact is irrelevant in relationship to the actions of housing activists.  The mere receipt of a three day notice to pay or quit does not, in and of itself, force a tenant to vacate.  The State of California, and not the landlord, is in control of the process after the expiration of the three day period. So, what is the “beef” of the housing activists?


The property owner stated that the “timely” sending of three day notices to pay or quit resulted from installing a computer program to track late payments and automatically send the notice at the termination of any “grace period”. There is absolutely nothing wrong with that method of implementing the collection of past due rents.  In fact, it is a standard business procedure among professional property managers. And, it shouldn’t be overlooked that the tenant agreed, at the time of renting the unit, to pay on the date specified. Moreover, most prudent professional property managers are painfully aware of the high cost and complexity of an eviction (unlawful detainer) action and will work with a delinquent tenant to resolve the delinquent payment before commencing eviction proceedings. The East Palo Alto housing activists are not complaining about any unlawful eviction activity and, again, the California laws are so protective of tenants that they really don’t need the help of housing activists.  So, what is the “beef” of the activists?


The housing activists probably have no other current “cause” to promote in order to justify their existence.  They might just as well complain that Safeway is wrong to insist on the payment for the bag of groceries before leaving the store. The demonstrations organized by the housing activists are childish and irrational and the people who take part (tenants or others) are equally childish.  What the property owner is doing is absolutely not wrong from any viewpoint.  There is no harm to anyone by demanding that rent be paid on time, as agreed, and that failing to do so will cause a notice to be served, which is no surprise based on most rental agreements or leases. What is disturbing is that the activists completely overlook the obvious.  If the rent is paid on time, no notice will be served.


The activities of the activists are reminiscent of a time in the past when tenants formed “unions” to lobby for “tenants rights”. In one “union” meeting one of the organizers said it is not about “rights” it is really about “control” over the housing supply. The landlord-tenant laws of today make “tenant unions” unnecessary and irrelevant. These housing activists should recognize that fact and find something useful to do instead of wasting everyone’s time on nonsensical issues.

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The letter below from Howard Schultz appeared in many newspapers and while it has little to do with real estate it has a lot to do with the health of this country and is most appropriate for a 4th of July post.


Mr. Schultz, a very responsible business leader, has absolutely identified what is wrong with America today. It is a glaring leadership deficit where the elected appear to be much more interested in re-election than they are in solving problem. The political partisanship, ideological bickering and brinksmanship should be an embarrassment to all of them but it isn’t.  Winning political points and playing “gotcha” appears more important than solving the nation’s problems by rolling up the sleeves and working together.


Every thinking American should join in this discussion whether today or later, and let our elected politicians knows that if they can’t get their acts together and act responsibly to solve America’s problems with civility and cooperation, the voters will find new people to represent them.

To spark the conversation in your neighborhood Starbucks, please join us this 4th of July for a free tall hot brewed coffee.

An Open Letter: How Can America Win This Election?

Friday, June 29, 2012

Posted by Howard S., Starbucks chairman, president and chief executive officer

On Independence Day, our country celebrates the promise of America.

It’s a day to remember that the principles that bind us together vastly outweigh what keeps us apart. The freedom to dream and the opportunity to create a better life – not just for ourselves, but for each other – has always defined our great nation.

I am a product of that American Dream. As a kid who grew up in public housing, went on to get an education at a state university and build a business, I am grateful for what this country has made possible for me. In turn, at Starbucks, we have always tried our best to honor our responsibility to the communities we serve.

And on this Fourth of July, our communities need all of us.

Across the country, millions of Americans are out of work. Many more are working tirelessly yet still unable to adequately care for their families. Our veterans are not being welcomed home with the level of support they deserve. Meanwhile, in our nation’s capital, our elected leaders are continuing to put ideology over real solutions. I love America, but we all know there is something wrong. The deficits this country must reconcile are much more than financial, and our inability to solve our own problems is sapping our national spirit. We are better than this. America’s history has showed that we have accomplished extraordinary things when we act collectively, with courage, creativity, and generosity of spirit—especially during trying times.

As we celebrate all that is great about our country, let’s come together and amplify our voices.

Let’s tell our government leaders to put partisanship aside and to speak truthfully about the challenges we face. Let’s ask our business leaders to create more job opportunities for the American economy. And as citizens, let’s all get more involved. Please, don’t be a bystander. Understand that we have a shared responsibility in solving our nation’s problems. We can’t wait for Washington.

At Starbucks, we are trying to live up to our responsibility by increasing our local community service and helping to finance small-business job creation with Create Jobs for USA. Our company is far from perfect, and we know we can do more for America. But we need your help. We need your voice.

Join the national conversation with #INDIVISIBLE. Starting today, I invite you to share your view of America, and how we can all put citizenship over partisanship. On Instagram, post a photo of the America we all need to see. On Twitter, provide a link to an innovative idea. Blog about who’s making a difference in your community; or on YouTube, share how you made your American Dream come true. No matter where you post, if you use the tag #indivisible, Starbucks will do its part to collect and amplify your voices.

To spark the conversation in our stores, your local Starbucks will proudly serve everyone a free tall hot brewed coffee on the Fourth of July.

Together, we can set a new tone in America. We hope you agree that doing so is a powerful way to celebrate our nation’s birthday.

In 2012, America needs to win the election more than either party does. It is time now to join together as Americans. It is time, whatever our differences, for us to strive and succeed as one nation – indivisible.


Posted in Condominiums, Eminent Domain, Property Developemnt, Property Ownership, Real Estate Economy, Real Estate Appraisal, Real Estate Investment, Real Estate Lending, REITs, The Real Estate Economy | Tagged | Leave a comment


The commercial real estate investment market has experienced substantial change over the years and it is questionable as to whether or not the change has been good for all participants including the developer/investor/owner, the tenant and the lender.

Before real estate became “big business” the decision makers consisted of individual investors purchasing and selling properties and mortgage lenders applying tried and true formulas to lending. These individual investors usually functioned on a formula of “one deal at a time” and may have included investor partners in the venture. Some highly successful developers were able to align themselves with major non-real estate companies as their prime investors. Corporations like insurance companies, contractors and manufacturing companies found it very profitable to be aligned with highly experienced and successful developers. Most often the developer in these ventures took on the same degree of financial risk as their money partners.

Tenants often had a direct contact and relationship with the property owner or dealt with a property manager retained by the project owner. The property manager most often was responsible for implementing policies that encouraged tenant retention. Thus responsiveness was very important.

The emergence of syndication began to change the real estate investing landscape but was focused mainly on existing projects with an emphasis on tax shelter. Tax shelter investing has some benefits for the high bracket investors but too often the only return received by the investor was the tax shelter. When projects failed down the road investors were often left with recapture provisions of the tax code that nullified the benefits of the shelter. The syndicator was more often than not taking fees (commissions + other fees) and a carried interest in the project rather than having a real cash investment at risk. Syndicated properties were frequently highly leveraged and the syndicator, not the ultimate investors, was the managing partner with all decision making power. Tenants in syndicated properties were usually dealing with someone that had little or no cash invested in the property and thus not as interested in tenant relationships as following policies that would make their “carried interest” more valuable. Also, syndicated properties were often short of additional operating cash needed to properly develop and maintain the asset since much of the emphasis was on the tax shelter aspects of the investment. Changes in the tax codes resulted in the end of tax shelter investing with a further result that projects acquired at inflated prices couldn’t be resold. This caused pain for many investors in syndicated real estate projects particularly those exposing investors to very significant recapture of tax sheltered dollars when the investment was disposed of.

Two other developments served to change the real estate investing landscape. These were the entry, on a large scale, by pension funds into real estate ownership and development and the emergence of publically traded Real Estate Investment Trusts (REITs). In both of these instances money managers earning salaries or fees made the investment and management decisions rather than the money investors who were totally removed from any buy/sell/management decisions. At the outset these institutional investors were not overly aggressive in either purchase decisions or the use of leverage. However, as time went on that changed. The changes were mainly induced by the competition for available properties as the demand for “investment grade” properties increased and the available supply decreased. The completion for property forced rates of return (capitalization rates) to decline substantially to a point where the returns did not reflect the investment risks.  There was a kind of “herd mentality” at work as each money manager feared that a failure to acquire would impact their future.

The growth of the institutional real estate owner was further expanded to include multi-million dollar (billion dollar) real estate investment funds on a worldwide basis. These funds were often promoted by investment banks where fee motivated management was operating in a highly competitive market for real estate investment.

The pension funds, REITs and investment funds were all seeking investment returns that exceeded the returns from other, more traditional investments like stocks and bonds. As the hunger for returns expanded so did the use of more exotic forms of leverage without adequate consideration of the fact that the higher the amount of leverage the greater the risk exposure. All of these investment vehicles appeared to move forward under the assumption that rents only went up. Pension fund investors went into more exotic and higher risk investments in order to boost returns like land development.

From the standpoint of tenants, the shift to money managers making investment decisions was not terrific. Many management decisions were focused on the impact on “this year’s net” rather than the long term needs of the property. Often leasing decisions were focused on the cash flow needs of the property rather than the question of market rent (the competitively attainable rent). Tenants were subject to impact from non-market forces rather than being only subject to market forces and accessibility to decision makers was more remote.

The entire class of intuitional real estate real estate investors used a discounted cash flow (DCF) model as one of the determinants of the price to pay for an asset. It is probably very safe to say that prior to 2008 no DCF model contained an assumption of declining rents in future years. It would really be interesting if all of the DCFs used in purchase decisions in 2005, 2006 and 2007 could be brought out into the open with their forecasted 2008, 2009, 2010 and 2011 shown and compared to actual performance for those years. It would probably be a very sobering experience.

Private pension funds do not generally release operating results to the public so there is no way to know for sure how much their real estate investment portfolios may have declined in value post 2008. But there is some information on “public” pension funds like those for state employees. Public employee pension funds in the State of California lost many millions of dollars invested in land as well as many millions as a participant in investment funds managed by investment banks. Large investment banks like Morgan Stanley and Goldman Sachs lost billions in failed investments and, most recently, Goldman basically walked away from its portfolio of office buildings in Seattle. These results demonstrate that for many reasons real estate is very tricky because if the really very “big boys” take really “big hits” in spite of their research and analytical abilities, what chance does the small individual investor have?

With the exception of housing and small investment properties bought by real live people, the commercial real estate market has become an institutional investment market driven by for fee managers with little or none of their own money invested in a deal. The ultimate investor is dependent on the ability of the fee manager to identify, analyze and manage acquired properties in a profitable manner. However, by its very nature, a market where competing managers are going after the same investment it is obvious that the manager has an incentive to convince himself or herself as to why they should pay whatever price is needed to “win” the property. It is suggested that this may not be the perfect model. What is needed is a model where the interests of the money investors and fund managers are aligned. Some REITs have accomplished this by requiring their top executives and directors to be substantial stockholders in the REIT. If pension fund managers and investment banks were similarly required to make substantial cash investments (say a minimum of 10%) in any property acquired such a rule might align the investor’s interests with the manager’s interests. Another change that might be considered would be the avoidance of deadlines by when the collected funds must be invested. Deadlines encourage investment mistakes as preferable to losing the funds by the operation of a deadline.

The recent implosion of the real estate market seems to have corrected the excesses that lenders became competitively involved in and there appears to be a return to more “defensive” lending with greater borrower scrutiny and higher underwriting standards. This will probably continue to be the case for the foreseeable future at least until the banks and institutions have more money available to lend than there are borrowers making demands for money.

Posted in Property Ownership, Real Estate Economy, Real Estate Appraisal, Real Estate Investment | 2 Comments


The December 14, 2011 issue of the Wall Street Journal contained an interesting article about the problems facing the Morgan Stanley global real estate fund. The article points out that Morgan Stanley (MS) was forced to return about $700 million to investors and to reduce fees in order to persuade investors to stick with them after a lack luster performance. This, in and of itself, is not newsworthy. Morgan Stanley did what it had to do to retain the management (and management fees) of its $4.7 billion fund. What is noteworthy is the fact that, as part of the deal, the investors gave the fund (Msref VII) an additional year (to June 2013) to invest instead of being required to return billions to investors. The fund, apparently has invested only $2.5 billion of the committed funds leaving $2.2 million un-invested with a deadline of June 2012. This leads one to question the sanity of the investors in imposing a deadline.

There is no indication as to who the investors are but it is possible that a large number, if not the vast majority, are institutional investors managing other people’s money OPM) such as pension fund managers, rather than being representative of individual investors investing their own money. In any event, the imposition of an investment deadline does not appear to be a decision, or strategy that a knowledgeable, sophisticated individual investor would make.

The reasons for failing to invest the money should be carefully examined. There is no question that conventional wisdom suggested that there would be unlimited buying opportunities to acquire high quality real estate arising out of the collapse of worldwide investment real estate values. However, conventional wisdom appears to have been wrong. Even though many superior properties went into default due to the inability to be able to refinance or because of a drop in value attributable to reductions of rent, these properties were not offered to the market at “bargain” prices because the institutions controlling them made a decision not to sell into a falling market and instead to hold and manage the assets through a turn-around. Real estate is not a highly liquid asset and the key to successful investing is one of timing. Real estate professionals know and understand that the profits are made on the “buy side” of the transaction and not the “sell side”. In other words, if the property is acquired at a “good” price the ability to profit is more certain. On the other hand, if a property is acquired at an over-market price, the investor is dependent on luck for a profit at the time of sale.

The investors in the MS fund seem to be punishing management for acting prudently by refraining from paying over-market prices for available offerings. Action might be justified if MS were not making all reasonable efforts to place the money. But, if a substantial effort was being made but was thwarted by unwilling sellers, then the question of time limits or punishment were probably not appropriate strategies for the investors. Instead, the investors, along with MS should have examined the market and determined when and under what conditions would buying opportunities begin to surface and whether or not it was worthwhile waiting for those opportunities. Imposing an investment deadline makes no rational sense.

Why is an investment deadline an erroneous strategy? To start with, a fund manager, operating under a deadline, will be highly incentivised to buy something – anything even if the long term outlooks for the acquisition(s) are questionable. The fund manager, by failing to invest will lose the contract and all that goes with it. Thus, the fund manager may feel forced to make questionable acquisitions and pray that, by the time sale is indicated the market will have improved enough to override any overly aggressive buying decisions. It is also probable that others like MS, who raised money for opportunistic investment, are having similar problems. If they too feel investor pressure, the result can be a “herd mentality” resulting in many making overly aggressive purchases for fear of being subject to investor criticism. When this happens, property acquisition becomes a very competitive sport where “getting the deal” becomes more important than the economics of the deal. This “herd mentality” was evident in the period leading up to 2008 when the frenzy of activity pushed real estate prices beyond the outer edges of the envelope.

There is substantial uncertainty in the investment markets today. Much of the uncertainty is attributable to global economic problems as well as domestic problems. The volatility of the stock market indexes underscores that uncertainty. Unlike stocks and bonds real estate cannot be traded on a daily basis. It takes a substantial amount of time to either buy or sell a large piece of real estate. Real estate investors can’t hedge against adversity by placing “stop loss” orders. Once a property is acquired it becomes subject to the vicissitudes of the market, whether good or bad.

The bottom line for investors should have been whether or not MS was best qualified to execute an opportunistic purchase strategy when market conditions were conducive to acquisition and then deciding whether the timing was going to be within their anticipated time horizon. If the answer to either of these questions had been NO then, a return of the uncommitted money in the fund might have been a good decision. But, putting intense pressure on MS to invest the money was probably not the best or wisest decision.

Posted in Real Estate Economy, Real Estate Investment, The Real Estate Economy | 1 Comment

Goldman Sachs Takes A Loss

Buried on Page B 16 of the WSJ on Saturday, June 10, 2011, there was an article noting that Goldman Sachs suffered a major loss on its investment in the office building at 230 Park Avenue in Manhattan. This investment was part of the Goldman Sachs Whitehall real estate funds. A venture of the fund and Monday Properties purchased the building in 2007 for $1.15 billion (about $821 per square foot). According to the article, the value of the building was “about $300 million less than what it invested. Monday Properties remained in the deal and was recapitalizing the property, bringing in a new partner. Goldman’s exit from the property was part of the deal. The article also pointed out that Goldman’s Whitehall Funds surrendered to lenders the office building at 301 Howard Street in San Francisco and the La Costa Resort-Spa in Carlsbad, CA (near San Diego).

This news story, taken by itself, is no “big deal” but taken in the context of the major financial losses suffered by other investment banks invested in real estate as well as losses suffered by some public real estate companies, the story raises some interesting questions.
General Growth Properties, one of the largest publically held REITs invested in shopping centers went through bankruptcy. Morgan Stanley walked away from its investment in Crescent Properties in 2009 and took over $5.5 billion in real estate losses in 2010. Lehman Brothers failure was attributable, at least in part, to failed bets on mortgages as well as commercial real estate projects. Bear Stearns collapsed under the strain of mortgage investments and major banks took billions of losses on toxic residential and commercial real estate debt.

While much of the heavy property losses impacted private equity funds, those funds used investments from pension funds and thus, the spillover to the man on the street is recognized when the pension fund losses destabilize the ability of the funds to meet their pay out commitments. But, it seems that, with the possible exception of REITs, where individual investors play a roll, the common denominators were “other people’s money(OPM)” and size. The pension funds were investing OPM with private equity firms who then invested OPM. The private equity firms were fee driven as they earned placement fees, management fees and advisory fees. The same was true of the residential mortgage market where all “players” in the chain, except the hapless investor in mortgage backed securities, were fee driven.

The recent track record of the “players” brings into question the wisdom of trusting the judgment of investment vehicles managed by fee driven people who will have no personal “skin in the game”. Part of the problem is size. As the amount of money available for investment grows, so does the pressure to place that money. And, pressure (or a herd mentality) induces managers to “compete” for the few offerings available. This leads to overpaying and/or undertaking more risk than the investment warrants.

The same problem impacts publically held REITs which feel pressured to demonstrate portfolio and value growth. This, in turn, leads to “competitive” investing and the undertaking of more risk than the investments warrant. The dividend yields on REITs have been driven down by investor’s desire for dividends and the REITs have enjoyed excellent appreciation over the last several months. There are a limited number of ways in which the value of REIT stock can appreciate. The first, is increasing rents/and or decreasing expenses leading to an increase in dividend payout (REITs must pay out 95% of their net income). Next is an increase in the value of the portfolio by virtue of improved operating fundamentals and/or a market acceptance of a lower capitalization rate. Finally, growth can be achieved by the acquisition of new properties, accretive to earnings through direct purchase or merger or both. This kind of information is not always transparent in REIT annual reports and it is questionable as to the depth of understanding possessed by analysts as to how real estate works. What is obvious is that executives in some REITs also feel pressured to “compete” for property offerings.
Moving to the size issue, the larger the funds become, the more difficult it is to manage individual property operations. Investment real estate has always been very management intensive and good management requires quick decisions when problems arise. However, with very large portfolios many major decisions require centralized authority and result in delays. There is a risk that decisions will be based on their impact on earnings rather than the needs of the property. The same risk impacts leasing decisions where the market may be ignored in favor of unsupported or unrealistic potential outcomes.

The bottom line in all of this is that the big investment banks, commercial banks and private equity funds may not have earned the credibility and respect that they are accorded. But, greed will continue to induce them to create investment vehicles to entice the big money players, whether the investments are viable or not. The next market collapse will be attributable to different causes but the same players will be involved.

Posted in Property Ownership, Real Estate Economy, Real Estate Investment | Leave a comment