Friday, January 9, 2009

Robbing Peter to Pay Paul?

The credit crunch has spread all around the world. Over in Finland, the State Pension Fund is getting ready to invest hundreds of millions directly into corporate bonds:
The State Pension Fund is seen as the best source of relief for financing problems being experienced by large Finnish companies.

Under a proposal by renowned economist Antti Tanskanen, who carries the honorary title of Minister, the pension fund should buy corporate bonds, or commercial papers of large companies.

In Tanskanen’s view, such a move would ease the plight of smaller companies, as more bank financing would become available to them.

Tanskanen was commissioned by the Ministry of Employment and the Economy to draw up recommendations to help the Finnish economy through the current difficulties. On Thursday he submitted his report to the Minister of Economic Affairs, Mauri Pekkarinen (Centre).

Both Tanskanen and Pekkarinen emphasised that the proposals would not necessarily impose massive expenditure on the state. However, the proposal that the state-owned financing company Finvera provide additional guarantees is expected to bring between EUR 40-45 million in credit and guarantee losses.

In Tanskanen’s view, the state could even make a profit, if things go very well.

Tanskanen sees the Sate Pension Fund as a kind of “fire brigade waiting for authorisation to go”. It has invested in corporate bonds before. There is no need for detailed studies of the companies involved, because the State Pension Fund is already familiar with the few dozen large Finnish companies in question.

In many countries, such as the United States, it is the central bank which buys corporate bonds. Tanskanen notes that this is not possible in Finland, because the Bank of Finland is part of the central bank system of the Euro zone.

“It is important now to act fast”, Tanskanen emphasised. The State Pension fund is ready to do this, says the fund’s managing director Timo Löyttyniemi. “We can invest hundreds of millions of euros very quickly”, Löyttyniemi says.

The proposal by Tanskanen, a former banker, is undoubtedly good news for banks. He says: “healthy Finnish banks should not be burdened by conditions of such guarantees, which are justifiable only with respect to banks that have fallen into trouble.”

Parliament has already approved guarantees of EUR 50 billion for banks’ capital acquisition, and the government is still considering the conditions that should be applied.

Tanskanen feels that the increase in banks’ capital, which is only now under preparation, should be based on capital loans. He feels that it should not involve an increase in state ownership in banks, which has been used in a number of European bank support decisions, “because the banks don’t want it”. The state has set aside EUR 4 billion for this.

Tanskanen also proposes that the percentage of state capital loans of the banks’s primary capital could be raised from the current 15 per cent to 35 per cent. The change would improve the banks’ capital adequacy, and boost their ability to grant credit.
The credit crunch is hitting the United States particularly hard. Another dismal jobs report brought the combined total of job losses in 2008 to a
staggering 2.6 million, the most since World War II, and the pain is only getting worse with 11 million Americans out of work and searching.

Unemployment hit a 16-year high of 7.2 percent in December and could be headed for 10 percent or even higher by year's end:
Friday's government figures were "a stark reminder," said President-elect Barack Obama, that bold and immediate government action is needed to revive a national economy that's deep in recession and still sinking.

More than a half million jobs melted away as winter took hold in December -- 524,000 in all, the government estimated -- and the true carnage will almost certainly turn out to be even worse when the figures are nailed down more clearly a month from now.

Mounting job losses are why commercial real estate is bracing for its toughest year:

If real estate has always been about “location, location, location,” 2009 may be the year that commercial real estate becomes about “frustration, frustration, frustration.”

Even a downtown D.C. location just three blocks from the Verizon Center wasn’t enough to push forward a promising development that had already dug deep into the ground to lay the foundation.

Back in 2006, the First Congregational Church partnered with PN Hoffman Inc. to build condos, a new church and space for homeless and social services on its site at 10th and G streets NW. When the market for condos dried up, the partners decided to instead build eight floors of office space, breaking ground last spring.

Then the equity partner, an ING entity, walked away from the project in October, leaving PN Hoffman to ponder the market reality for a speculative office building with no tenants: “With the market continuing to get more and more uncertain, we made the decision to table the project until we had preleasing. We didn’t want to take that risk,” said Steve Earle, president at Bethesda-based PN Hoffman.

Even the Mortgage Bankers Association is finally admitting that the U.S. economic slowdown and credit crunch are beginning to affect the commercial real estate market in the United States:

"Despite relatively modest new construction activity, the slowdown in job growth, retail sales and other aspects of the economy has led to lower demand for commercial space and to declines in net absorption of space," read the MBA's Commercial Real Estate/Multifamily Finance Quarterly Data Book. "As a result, supply is outpacing demand."

As a consequence, commercial/multifamily mortgage debt outstanding declined 0.1% compared to the previous quarter as government-sponsored enterprises and Ginnie Mae broadened their holdings of multifamily mortgages by $14 billion.

Mortgage debt outstanding declined 0.1% in Q3.

"For more than a year, we have been faced with the question of whether commercial real estate would be the next shoe to drop," said Jamie Woodwell, vice-president of Commercial Real Estate Research for MBA.

"The weakening economy, in concert with the ongoing credit crunch, is demonstrating that commercial/multifamily is not entirely immune to the impacts felt by the residential market."

The report comes just one day after U.S. mortgage rates moved higher, according a another report from the MBA, which said that the average interest rate for a 30-year fixed-rate mortgage moved up to 5.07% from 5.03%.

Nevertheless, 30-year mortgage rates are off highest level last year.

And this from Steve Felix's latest weekly comment, The End of the Holidays:

I’m going to be moderating a panel at the iGlobalForum 2nd annual real estate private equity summit in New York. My panel is titled: VALUATION AND PRICING STRATEGIES FOR DISTRESSED ASSETS: The RTC Redux?

I’m now seeking out a representative from each of the buy/sell/hold contingents to join me in a dialogue (or debate) on this very subject, which I expect will be supported by someone from the valuation community as well.

It should be a lively exchange of ideas. So now, to conclude with another quote from David Snow at PERE: “…as the years go by, expect to see the 2005, 2006 and 2007 vintage years put blemishes on the overall track record of private equity real estate.

As is the case with most long-term asset classes, vintage years directly before recessions tend to perform poorly, while vintage years during and directly after recessions tend to be great.

Given the depth of the current crisis, astute LPs are right to be eager about the 2009 and 2010 vintage years, even though the capital has yet to be deployed. (SF Note: Not only not yet deployed but in many cases not even raised yet…another challenge we are curious to see play out).

As far as real estate valuations are concerned, you should read a comment from RE Journals, the devaluation of commercial real estate in 2009:

So what do you do? I would start by analyzing your current situation closely. Get an estimate of today's market value for your properties. Be realistic and conservative! If you bought your property 2-3 years ago, in most cases, it is worth less today. Look at your rent roll and tenant receivables, tenant renewals will not be 100 percent, and some of your stores won't make it through this recession. Plan for it, as painful as it might be!

Manage your NOI, paying more attention to your expenses. Act as if you will be absorbing all common area maintenance expenses, because you may be paying more than you think in the future. Negotiate the price for every supply and service contract you have. You probably have tenants who are giving notice that they are having trouble paying the full rent and are looking for concessions. If you can compromise, do it. Give them time to get back on their feet. These are the tenants that can leave your center for the lower rent center in a couple of years. Today you have to manage your expenses because it will help your tenants survive, which in turn, keeps you in the game as well.

If you have equity, move slowly. Buying opportunities will increase. Private equity investment groups (and some public equity groups) are buying with cash. They know where the value should be, where they are buyers, and it isn't at 2007 prices, or 2005 or 2006 for that matter. Most believe, as we do, prices will fall further.

However, we have yet to see many properties change hands, from the borrower to the lender. When it begins to happen, it will take more than three years to recover to today's values. An analogy we like to make is comparing commercial real estate to the current stock market crash. We are suggesting you sell when the Dow Jones is at 10,000 (now), or risk it going to 7,600 (2009-2010). Selling now gives you cash at a more favorable capital gains rate than the future will hold, and better buying opportunities are coming soon.

What's Hot, What's Not: Buyers will continue to flock to quality properties, with quality tenancy, with those cap rates slowly increasing. Distressed centers are also in demand, when they are priced appropriately, i.e. higher cap on actual NOI (no more master leasing). Triple net properties below a 7 cap, with flat income are not selling because there are so few exchange buyers. Also, any triple net property with less than 7 years left on the lease will be a difficult sell. That is, unless it is priced accordingly.

Bottom Line: Sell today or prepare to hold through this cycle. If you think the scenario summarized above is accurate and you do not have an interest in waiting for the next cycle which may be 4 to 7 years from now, we should talk about the real current value of your properties today.

Keep in mind that global pension funds are heavily exposed to commercial real estate debt and equity. No wonder pension funds, like the Connecticut state pension fund, are still deep in the red:

At the start of the Chris Dodd Bear Market, the Connecticut Retirement Plans and Trust Funds managed by state Treasurer Denise L. Nappier were in awful shape, mostly because a succession of governors and legislatures failed to fully fund the state's pension obligations. In the realm of robbing Peter to pay Paul, few larcenies have been this grand.

In the fall of 2007, as the equity markets began their descent after the collapse of the housing bubble Sen. Dodd helped create, the plans had nearly $26 billion in assets, but their liabilities exceeded assets, current and projected, by almost $15 billion.

By last June, the funds had lost 4.7 percent of their value, not bad considering major market indexes over that period fell about 15 percent. But from July 1 to Oct. 30, their assets plummeted 19.5 percent to $20.7 billion, Ms. Nappier reports. That's still better than almost every market index as well as the industry return-on-investment average against which she competes.

But that's little consolation to taxpayers or the 160,000 teachers and state and municipal employees covered by the plans who are out another $5.2 billion while the state faces projected deficits of about $10 billion over the next three years.

The Standard and Poor's 500 Stock Index has tumbled a further 6 percent since Ms. Nappier's Oct. 30 report, and most analysts agree it will be many years before pension funds can expect to recoup all their losses from the Chris Dodd Bear Market. All the while, Connecticut's government work force and its pension obligations are projected to grow.

As it is, the legislature's Office of Fiscal Analysis says the retirement funds as of Nov. 14 were underfunded by more than $16 billion, even after a special infusion of $2 billion into the teachers' retirement fund last April.

In addition, the state has promised current and future retirees $21.7 billion worth of health benefits for which it has no money. And that's on top of the $16.7 billion in other debts amassed by governors and legislatures circumventing the state spending cap.

In all, the state now has a staggering $57.4 billion in unfunded liabilities, the OFA reports, which is equal to 38 months of budgeted expenditures.

By comparison, Waterbury, infamous for its crushing long-term debts that nearly drove the city to insolvency, has unfunded liabilities totaling only 15 months' worth of spending. Perhaps an oversight board for the state is in order

I am not going to get into politics and claim that Senator Dodd is to blame for the housing bubble. From my Canadian perspective, both Democrats and Republicans allowed markets to deregulate to an absurd level, which sowed the seeds of the U.S. housing bubble.

But the important point is that there is a pension crisis going on all around the world and U.S., Canadian, Australian, Irish and all other pension funds that were heavily exposed to equities and alternative investments will suffer huge losses - to the order of 30%, 40% or more.

By contrast, those pension funds that had the sense to invest a good percentage of assets into government bonds suffered significantly less losses. This was the case of U.K. pension funds which outperformed the market as they switched into bonds:

U.K. pension funds lost 10% of their money on average during 2008, suggesting they are benefiting from a general shift in their investments toward bonds and other fixed-income assets.

Still, preliminary data from State Street shows that British pension funds are facing average negative returns of 13 percent for 2008:

It expects almost every scheme to record a negative result after a year marked by sharp falls on equity markets and volatility across asset classes. Charity funds are expected to show average losses of 19 percent for the year, it said.

The figures highlight how even traditionally conservative investors saw returns suffer in the credit crisis -- particularly those who adopted riskier strategies to boost returns.

"Those funds that have an equity bias, such as local authority schemes and many charities, will be most adversely impacted, while many of the corporate schemes, which have a relatively high commitment to bonds, will fare relatively better," State Street said.

Jeanette Patrizio, vice president of State Street Investment Analytics, said the poor performance should be viewed in the context of strong results during the bull run.

"Over the last decade, a period which includes not only the latest year but the negative returns from the fallout of the dot-com bubble, the average fund is still up more than 4 percent per annum," she said.

State Street noted that the losses estimated for UK pension funds and charity funds had been offset by the sharp decline in sterling towards the end of the year.

Well, I am not a fortune teller, but I would be willing to bet anyone that the next ten years will be nothing like the last ten years. And I am not being hopelessly pessimistic as I see great opportunities in alternative energy, infrastructure and health care/biotech sectors.

But the reality is that those large public pension funds that lost 30% or more in 2008 and are still heavily exposed to equities and alternative investments are going to be in a much tougher position than those British funds that lost 10% because the latter had the common sense to allocate sufficient assets into government bonds, protecting their downside risk in case of a systemic crisis.

Governments around the world are going to have to take serious measures to improve the health of public pension funds.

Alternatively, they can just continue to rob Peter to pay Paul until the crisis reaches a breaking point. That's when taxpayers will be called upon to to cover the pension deficits.

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