Are we in a cycle or a reset?

Here's a thought provocative enough to get me to post on a Sunday. RevPAR and occupancy are down so much at hotels that at least one industry mogul says this isn't cyclical:

What the U.S. hotel industry is experiencing today isn’t simply the downside of a highly cyclical business, emphasizes Thomas Magnuson, but rather a massive fundamental shift. “It’s a reset,” declares the CEO and principal of Magnuson Hotels, ranked by Inc. Magazine as the world’s largest independent hotel group.

So combine occupancy drops with supply increases and you have a whole new paradigm. Now for consumers that may be a good thing, even for the long term from a pricing perspective. You also have the possibility of some shutdowns, a ton of foreclosures and an even larger expansion on mom and pop owners buying properties on the cheap and managing them close to the bone to eke out a profit.

But let's look at this from a more macro perspective: could this thesis be expanded to the sector as a whole? We did not think office buildings were generally overbuilt. But with a jobless recovery it could be a while before demand picks up, and you may indeed see a trend toward minimizing office expenses. Ditto the retail sector. Without jobs, people reduce shopping. And if I am any example, people are buying more and more online. I would argue the industrial sector is less of a potential reset candidate because of fundamentals and different expectations, the numbers of vacant buildings I see notwithstanding.

I'm not prepared to say that the entire real estate market is in a reset mode. I still think we are at the bottom of a cycle, But the hotel theory extrapolated to the entire market is, in my humble opinion, an interesting thought, especially as we see the market look for and hit bottom. Perhaps then we'll know -- with 20/20 hindsight -- whether it was.

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I guess it's not impossible - judge rules against earnest money refund

I've written here before about buyers and borrowers raising defenses of impossibility or impracticability of performance or even force majeure under contracts because of the global economic situation. One of those deals was at 180 North LaSalle, where Younan Properties put down $6 million in hard earnest money to buy the building from Prime Group Realty Trust. Younan could not close and sued to get back the deposit.

Judge Maki in the Cook County Circuit Court has told Younan that it loses.

“The purchase and sales agreement is a promise to purchase this property for a set price on a set date with no provision for any financing contingency,” Judge Maki said. “That cannot be overlooked or given less importance because of other circumstances that. . . .possibly developed here.”....“That was the deal,” says Robert Hermes, a partner at Chicago-based law firm Butler Rubin Saltarelli & Boyd LLP, which represented Prime Group. Mr. Younan “assumed the risk if he didn’t have the cash to close.”

Younan is appealing. Meanwhile, Donald Trump, who used the force majeure argument with Deutsche Bank, is in a holding mode with the lender, whose counsel says courts are generally not buying the force majeure defense.

I haven't read the actual ruling, but impossibility of performance is a pretty steep hurdle to clear, even with fouled up credit markets. The precedent of a impossibility defense in these circumstances might also not be all that great from a public policy standpoint. But a few years ago we were doing hard money deals with no free looks in order to get the deal landed; and this is what happens. Perhaps it comes down to this: you pay your money, you take your chances. Who knows -- maybe the appellate court will disagree, so we'll stay tuned.

Have a good weekend!

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Is the buy-sell disconnect connecting?

That's what this article claims is happening, at least in Orange County. On top of loan money often not being there, the disconnect between buyers wanting to buy low and sellers wanting to sell high might be narrowing. Until that happens in many more markets, and money is there to lend instead of being spent on raising banker salaries then you'll see slow activity. Oh, and it goes without saying that a soft leasing market does not help either, and that won't improve for so long as unemployment keeps rising. I am starting to sound like Chicken Little again and I don't like that, so I'd better stop writing.

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$100 a square foot in Manhattan? Is that true, and, if so, is that the new market?

A couple of years ago, while trying to explain that my little local market was cheap, I told a friend that a large office building, 100% leased to a single credit tenant, and on a very good corner if redevelopment was necessary, sold for $100 a square foot. By contrast, I was just involved in a deal with a local medical office building costing and worth twice that.

CPN is reporting:

With rumors circulating of a sale price around $100 per square foot, the sale of the 66-story American International Group headquarters in Lower Manhattan likely set the bar for the biggest sale in the area market thus far in 2009.

Youngwoo & Associates (YWA), a New York-based investment and development firm, together with Kumho Investment Bank (Kumho), entered into an agreement to acquire the AIG building, 70 Pine Street (pictured), and an adjacent office building, 72 Wall Street. The two buildings will total 1.4 million rentable square feet in the heart of Manhattan's Financial District.

Okay. Let's assume the rumors are true. Now, this asset will require significant, if not complete re-leasing, which depresses the value since your income is, well, zero. I do not know the lower Manhattan market well anymore. But $100/sf? That's fire sale pricing in my humble opinion. Does it make a market? Beats me.

Another claim in the story is actually more interesting to me; namely, that there is a little thawing in the credit markets, especially in deals involving less than $100 million of $50 million. (I have always called these deals my sweet spot. I never liked big portfolio transactions and avoided them like the plague back in the day.) You mortgage guys out there would have to tell me about that and whether it is true.

UPDATE: Let's go to the other coast, where the WSJ is reporting the sale of a new office building in Irvine, California owned by Maguire Properties at a 40% discount to construction costs.

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Is CRE okay, a ticking time bomb or a lifetime opportunity?

That is what some people seem to be saying to Congress, even as the major banks are repaying TARP money to get the Feds off their backs.

I am not making any predictions. But we know this: tons of loans are coming due. Special servicers are just trying to hold on, often by granting short-term extensions. Refi money isn't there for many deals, and when it is the LTVs aren't great, meaning capital calls or mezz debt. (Can you say Barry Sternlicht?)

The question is whether the bleeding will remain stanched until things turn around or whether the stiches will burst and we will have Banking Crisis #2 for the Obama administration. Optimists say we're good and that current measures will work; pessimists say the worst is yet to come, especially since printing more money is going to be a problem. Vultures are supposed to be waiting to pounce, but there's a disconnect on some asset pricing that still hasn't settled yet. (I think Mr. Sternlicht even talked about 20 caps in a worst case scenario...wow! Check out Deal Junkie to see the interview)

Sorry if you wanted a prediction. The crystal ball just isn't working. The only thing that is certain is that we're in for some very interesting times.

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TIFs -- call me skeptical, but...

Is this what TIF money is meant for? Moving Willis, a company that got a great deal at Sears Tower PLUS naming rights, from three downtown locations to one consolidated one? Does anyone seriously think they are moving to Oak Brook or Schaumburg? Or is this a condition to the lease? Are there better ways of spending money? Or is this proposed subsidy a good thing for Chicago and money well spent? I am a fan of good TIFs, but I'm not sure whether this is a good one. Perhaps others have opinions more informed than I.

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Such a Deal!

The Tribune reports that Sears Tower is being renamed Willis Tower. But the London-based insurance broker is only taking 140,000 sf of space at $14.50 per foot net. Note that the word "initially" was used, so there are surely expansion options and perhaps even so-called "must-take" options in the lease. We don't know the length of the term from this story or any extension options, how much the rent does or does not increase with time and what other concessions are in the lease.

So on the surface at least this looks like a tremendous deal for Willis. First, the rent is reasonable and the naming rights to an iconic building are priceless. Well, I guess they aren't priceless any more. Until I know the whole story, I just call it a heck of a good deal for the tenant. And hey, the landlord gets PR, cash flow and occupancy!

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Auction Action!

I think that is what the PBS station used to say here when they did fund raising auctions every year back in the day. And I think you will see more of that in real estate, too.

Deal Junkie reports that you may see a few prominent auctions in the next few weeks (including the John Hancock Tower in Boston that was the subject of this post recently). The post also cites a New York Times story stating that an auction trade association has reported a sharp increase in activity.

Auctions in Chicago are not infrequent, due in no small part to the activities of Sheldon Good & Co., a national real estate company headquartered here. I am sure Shelley is doing well, notwithstanding the sad loss of Steven Good early this year.

But remember one thing: not all auctions are public. Take the EOP deal. That was essentially a private auction for the whole portfolio, followed by additional private auctions for some of the pieces. This is a great opportunity to maximize value when the time is ripe. Could that happen again? Sure. I could even see it with GGP, bankruptcy or not.

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Impossibility of performance - thoughts?

You may have heard that Younan Properties did not close on the acquisition of 180 North LaSalle in Chicago. There had already been three months of extensions granted and apparently Prime Group Realty Trust had had enough.

In anticipation of being unable to meet the latest deadline Younan filed an action in the Chancery Division of the Cook County Circuit Court apparently seeking the return of its $6 million in earnest money. The case is 2009-CH-06451 if you want to see the docket.

According to Crain's,

Mr. Younan filed the lawsuit Feb. 13, claiming he was unable to close the $124-million deal after the global recession and frozen credit markets prompted a key lender to back out of talks to finance the purchase. Prime Group issued a statement Thursday saying the deal, due to close by Feb. 18, was terminated and that the Chicago-based REIT was entitled to keep the earnest money. Mr. Younan’s lawsuit says the credit freeze means the “doctrine of impossibility and the impracticability of performance” should void the purchase contract and therefore the $6 million should be returned.

Impossibility and impracticability are two of those contract defenses you read about in the first year of law school and while preparing for the bar exam. In short, there has to be no way for the contract to be completed for performance to be excused. As I recall the growing trend is to excuse performance if it is objectively impossible to perform and not just impossible for a given party to perform.

Presumably Younan's argument will be that no one can do this deal right now with the credit markets frozen. And with a lot of money on the line, I'm sure Neal Gerber (Younan's counsel, and where I have a few former colleagues) will fight hard to get that money back or work out a settlement and Prime's lawyers will fight equally hard to keep it. (No title company was listed as a defendant or real party in interest, so perhaps the money was at some point paid to Prime as a deposit. I have seen many deals where that happens.) This could be an interesting case, and I will try to monitor the developments.

Have a good weekend!

UPDATE: With thanks to Doug Cornelius, I should have pointed out the striking similarity between this case and the Donald Trump defense over at Trump Tower Chicago. Thanks again, Doug.

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Office buildings - is it really this bad?

The New York Times has a gloomy piece today on the cycle of layoffs to subleases to vacancies to building owners not being able to pay the mortgages, thus leading to a potential "ticking time bomb." According to the story,

Many commercial property owners will face a dilemma similar to that of today’s homeowners who cannot easily get mortgage relief because their loans were sliced and sold to many different parties. There often is not a single entity with whom to negotiate, because investors have different interests.

By many accounts, building owners have been caught off guard by how quickly the market has deteriorated in recent weeks.

Rising vacancy rates were expected in Orange County, Calif., a center of the subprime mortgage crisis, and New York, where the now shrinking financial industry dominates office space. But vacancies are also suddenly climbing in Houston and Dallas, which had been shielded from the economic downturn until recently by skyrocketing oil prices and expanding energy businesses. In Chicago, brokers say demand has dried up just as new office towers are nearing completion.

I would think a lot of it is lease dependent. Are there termination options? Are bankruptcies playing a role as tenants reject leases? I was always under the impression that, generally speaking, things were not overbuilt, although I was concerned about so much space in Chicago coming on line. Even some tenants are backing out of commitments at new buildings here. Frankly, I never thought I would see New York vacancies approach 10%.

And the fact that many buildings are in CMBS pools makes it all the harder to do workouts. It makes me want to look at one of my deal toys: a bottle of Pepto-Bismol with a plaque that says, "Remind Me Again Why We're Doing a Conduit Loan Elixir."

All in all, this is a great time to be a tenant, the best in a while. And some say this is the perfect time to buy, especially if there is any government help. The trick will be to wait and see whether any stimulus will create jobs and the need for offices. One interesting thing is the speculation that President-Elect Obama wants to create 600,000 new government jobs. If that is the case, there will be a lot of need for government leases and the guaranteed, AAA-rated cash that come with them. Smart landlords may want to start gearing up now. GSA leasing is very tricky.

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Thank goodness for dumb doctor deals

Actually, that's a misnomer here. "Dumb doctor deals" are real estate transactions that make no sense but for the fact that there are doctors with plenty of money backing them.

Reading this NREI story was a welcome relief from all the gloom and doom in the news lately. The sector, while perhaps not recession-proof, is still alive:

According to the latest data from Real Capital Analytics, sales of medical office properties totaled $3.3 billion in the first nine months of 2008, a 13% drop compared with the same period a year earlier. But that dip pales in comparison to the 62% dive in property sales for the entire office market in the third quarter.

Whew! Someone's doing something! And banks are dying to lend money to doctors right now, as they think that is a good exposure for their money. Let's face it -- we all get sick. We are, however, noticing anecdotally that the ER is in more use lately. Why? People are waiting until they are really sick to see a doctor because of a lack of money or health insurance.

And on the personal front, I should add that the newest medical office building in Bourbonnais, Illinois is opening soon, probably in early to mid-January. Yes, I was the lawyer on the deal; if I hadn't been, I probably would have been kicked out of the house. Wait until they get the final bill!

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Institutional investors - overinvested in CRE?

This is something I've read about before, but it bears repeating.

The "denominator effect" looms as the next force that could pressure the slumping real-estate market.

Falling stock prices are leaving institutional investors overexposed to real estate, which could trigger further declines in property values as some of the market's most-active players move to the sidelines to recalibrate their portfolios.

Big pension funds, college endowments and insurance companies typically allocate most of their investment dollars to stocks and bonds and sometimes a smaller amount -- about 6% to 10% for pension funds and as much as 30% for other institutions -- to real estate. In the past decade, as real-estate values rose rapidly, many institutional investors expanded their real-estate holdings and in many cases became fully invested in the sector or close to it, bumping up against their preferred allocations.

Now that stock values are beaten down, and because real estate is typically appraised only once a year and not daily like stocks, the relative size of the real-estate portfolio has grown and in many cases is now higher than the funds' guidelines. This is known as the denominator effect.

So, because your other assets have tanked, you have to dump dirt to retain the allocation ratios. Of course, doing so at crazy low prices...well, you get the picture. It'll be interesting to see how the big guys deal with this issue.

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And just to brighten your day a little more

We have another prediction in that the next tsunami in the market will be commercial real estate. This one comes from Thomas Barrack, the founder of Colony Capital via the WSJ's Deal Blog. (H/T Traffic Court.)

Believe it or not, if Mr. Barrack is right I think this would be as bad or worse than the residential crisis. Why? The blog post says most of it well. If the loans mature and there are no buyers and no viable refinancing options, what next: RTC II? The Obama administration better be ready for the second half of its term when this all starts hitting the fan if not sooner.

The best case I see against this is fundamentals. But, as we've seen lately, those can change on a dime. Lawyers, start dusting off some old books just in case he is right. The other savior I see is opportunistic investing. There's money out there that is waiting, patiently, for a bottom.

I'm posting way too much for my day off, and a beautiful day at that. Latersville.

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Random Tuesday thoughts - bailout, banks, capital gains and loans

I'll probably write about the news later. For you sky-fallers, I can't really jump out a window because (a) I don't want to and (b) I'm writing from a basement.

Why commentary instead of news? There's a few things on my mind and thoughts I want to share.

The first is about the bailout. Okay, it passed. Now what? As my friend and client Dan Lukas discussed yesterday, perhaps nothing. Of course, the Treasury's going to buy the toxic loans and get them off the books of the banks.

To which I say, so what? I don't know of anything in the legislation that requires the banks to start lending money again. Indeed, in these market conditions I would not be surprised at all if banks sat on the reserves, fearful of a run on the bank or because they are afraid of their own shadows.

Should there have been some kind of requirement to loan money again? That's tough for me to say yes to. The free-market guy in me says, "Well, lenders have to lend to make money, so this will have to open things up." But the worrier in me thinks the CRE lending market may stay really tough for a long while because banks are more worried about staying in business than making cash.

Does that mean you can't get a loan? No. Some deals are getting done. But you'd be surprised at what is happening these days. Example I heard of through the grapevine: everyone is at the closing table for a nine-figure deal on an office building. The two main lenders are banks, and one pulled out at the closing table, refusing to fund its portion of the deal.

I don't know what happened next -- for instance, whether the seller walked away from the closing with what could be presumably millions in earnest money or how the contract was structured -- but it did get some of us to think about some things. Lenders will often insist on being able to walk from a deal at any time for any reason (which always made me wonder why it is called a commitment). So, who is at risk in a deal where the buyer is not only "very pregnant," but about to give birth? Buyers are going to have to think hard about how to structure a contract with a seller in a buyer's market and the loan commitment itself, because there could be serious money at risk if a buyer is ready to go and the lender walks away.

Money is supposedly out there, but it may not be easy to get for a long time. And, right now at least, expect to pay a premium. One reason banks may get back into the market is because LIBOR (yes, the rates at which banks lend money to each other) is so crazy high these days. But that's bound to change, especially if credit does loosen.

And how about capital gains? I think I am going to start ramping up for a wave of 1031s in the next few years, because capital gains taxes might be about as low as we'll see them for a long, long time. This will, in my humble opinion, cause many people to try to find ways to defer gain. Joe Biden notwithstanding, I don't think many Americans consider paying higher taxes patriotic.

Enough ranting for one day.

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Speaking of opportunity

There's speculation that if priced right, the Lehman and Merrill distress could bring a surge in buying. But does that really open up the transaction and debt markets? Some say yes, others say, "Not so fast, my friend." They think paralysis is the watchword.

But if a fire sale of Lehman's real estate holdings is unlikely, then "right pricing is not as likely. Nonetheless, I agree with the premise that cash has to eventually be deployed. And it is, believe it or not, out there.

With the AIG situation changing literally by the minute, the market is focused on that and on the Fed meeting. But the dirt will still be there. The question is whether we see an orderly sale of assets over time, or a dirt deal to end all dirt deals that will involve more lawyers than I can count.

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One other Lehman thought is this

This will put a HUGE hole in the Manhattan real estate market. Some months ago I mentioned that the time might be ripe to lease in Manhattan, but that the one thing that could really make things bad would be if there was trouble with the investment banks. And apparently there's already a lot of sublease space available.

Well, those days have come. If Lehman shuts its doors, that could bring another 2.2 million sf of space into the open market, some of which is owned and some of which is leased. Its Midtown HQ could fetch a billion in the open market, and predictions are that space could be 20-30% cheaper as a result of all this turmoil. How much coin are we talking?

Landlords would also sorely miss Lehman. In addition to owning its 1 million-square-foot headquarters on Seventh Avenue, the firm rents 2.4 million square feet at pricey New York addresses, including 399 Park Ave. and 1271 Sixth Ave. Lehman paid $250 million dollars in rent worldwide last year—a good slug of that amount going to Manhattan building owners. And it has committed to another $1.4 billion in leases over the next four years.

In other words, a lot. Those of you in BigLaw who read me may be thinking about your jobs, as the cuts already abounded. But in a way that seems silly since there will be so much work to be done, as well.

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One last Inland Steel Building story

The owners of the Inland Steel Building, including Frank Gehry, are going to pump $40 million or so into their acquisition, which is almost as much as they paid for the building.

The upgrades, according to Alby Gallun, consist of restoration work, upgrading the mechanicals, redoing the bathrooms and adding an environmentally sustainable roof to help get a LEED certification. Yes, roughly 40% of the money is expected to come from government sources, such as a TIF and landmark tax credits. (These deals can be winners, obviously. And I find the landmark work fun on the legal side.)

Altruism aside, there's also a practical reason for these upgrades: over 60% of the building (for which they paid $246.50/sf and now will go out of pocket roughly another $100/sf or so) is vacant or will be coming up for lease in the next year. That could be good if there's one big big big tenant that wants that space, which is the owner's goal. And a landmark building with naming rights can be great for some tenant. Otherwise, brokers will have to scramble to find a bunch of smaller tenants. Without the upgrades -- HVAC comes especially to mind in a building like this -- the space is much harder to lease. I would not be surprised if some of the upgrades take place after an anchor is identified. I don't know whether the $40 MM includes ancillary retenanting costs, too.

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B of A sells LaSalle Bank -- the building, that is

The sale of the beautiful Art Deco landmark has closed, according to CoStar. I've heard a little of AmTrust Realty Corp., the buyer, but the lender, Windy City Funding Co., LLC, is an admittedly unknown commodity to me. If anyone has some dirt, so to speak, then let me know. I love learning new things!

With its great mid-Loop location, I'm sure tenants would like the place. We don't yet know how much space B of A intends to keep and what the terms of any such lease might be. Ear, meet ground.

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Downtown office vacancies are.....down???

You read that right, and by no small number either. Vacancies dropped by 0.6% in the last quarter and demand improved to boot.

Now, before you get too excited, let's remember that portions of two big buildings went off the market due to pending hotel conversions, and that more space is coming on line in 2009. So, while this is welcome news, it may be a bit artificial. But if it isn't....

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What if this working from home thing actually catches on?

If I were still working at a law firm, I would demand to be able to work at home whenever I could. Why? Energy prices and recaptured hours.

The main reason I created my own gig was because I needed that flexibility. A 120 mile commute was not working for me.

But what if, instead of 1-2% of people working from home, that number went up to 10-20%? What would happen to the commercial real estate market? That's one of the thought-provoking questions in this post by Lisa Michelle Galley.

I have two observations:

First, prices would take a dip for sure. Supply -- demand, blah, blah, blah. But then developers would stop building until demand caught up with supply. So there's an additional lag and no new construction for a bunch of years. People in Chicago know all about that -- how many years did we go without a new high rise?

Second, not everyone can do this. Certainly my wife as to go to the office and the hospital and people have to come to her (although when I was a kid both my pediatrician and my dentist worked out of their homes, come to think of it). And many retail and service based industries have to do the same. But phone-based customer service people? Consultants? Lawyers? Accountants? The demand for an office is not as compelling in 2008 as it was in 1988 in my opinion.

The big obstacle was always IT. But gee, these days you can almost always call in to a computer to fix a problem. I have that ability and I use it all the time. (Ironically, however, a friend of mine who works for Citrix told me the other day that he always seems to be in his office!)

I'd personally like to see this, maybe because I took the plunge myself. On the other hand it may not be as good for business as I'd like.

PS: imo employers should also encourage the policy as well as flex time and 4 day weeks when possible. I think anything to cut back on energy demand is good for the country and the economy right now.

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