2014 Review and 2015 Outlook

Our Outlook is being published this week. Please contact us at info@thecygnusgroup.com to get on the mailing list!

Annual Wrap-Up and 2014 Outlook Published Today

Please contact us at info@thecygnusgroup.com if you would like a copy.

Private Equity Real Estate Summit

Yesterday (May 23, 2013), Cygnus Group (Cygnus), Trinity Capital Advisors (TCA) and 25 Capital Partners (25 Capital) hosted an event for approximately fifty local real estate investors including family offices, institutional, and high net worth investors located in the Charlotte, NC area. The event was titled, "Private Equity Real Estate Summit, Investing in Today’s Real Estate: Residential to Commercial, Paper to Hard Assets." It included 30 minutes of introductory presentations by each firm (Justin Starnes of Cygnus, Shaun Ahmad of 25 Capital and Sean McKinley of TCA) and an hour long roundtable discussion around key real estate issues, opportunities and risks. The three participating panelists included Frank McCollum (Cygnus), Walker Collier (TCA), and Shaun Ahmad (25 Capital). The discussion was moderated by Dr. Cheryl Richards, CEO and Regional Dean of Northeastern University - Charlotte. The roundtable panelists discussed a variety of topics including:

1. What is your opinion on the trajectory of real estate fundamentals in your respective markets?
2. What do you see as your top one or two opportunities for investment in your respective markets?
3. As an asset manager, what key lesson have you learned from the last five years - bubble period leading up to 2007, followed by the credit crisis/recession?
4. As an investor, what do you see as the two most important risks to consider over the next 12 months?
5. What is your outlook on interest rate risk and inflation and how does that affect your market?
6. What's been most surprising to you in 2013 in your particular markets?
7. What keeps you up at night?
8. What are the key headwinds in commercial and residential real estate?

How does the current government regulatory environment affect your businesses?
Key themes included: Opportunities still exist, but require deep due diligence and a platform to execute from, risks are economic downturn, rates and regulatory/governmental uncertainty, opportunities in credit MBS, cash-like MBS, Residential Interest Only strips (IOs), hard assets such as suburban office, raw land for residential development and distressed single family residential mortgages sold by governmental agencies. One recurring point was that government intervention has created enormous opportunities, but has also created new risks.

Feedback from the event has been positive and we expect to host similar events in the future. If you would like to participate in future events or if you would like a copy of the presentations from each group, please email us at info@thecygnusgroup.com.

Bloomberg Reports: Stuyvesant Town Rewarding Patient Money

Bloomberg posted an article today regarding Peter Cooper Village/Stuyvesant Town, the 11,200 unit apartment complex on the East Side of Manhattan. The article speaks for itself, but as many of you know, this property has been the poster-child for bubble in commercial real estate.

The $5.4 billion transaction was initially leveraged with a $3billion senior mortgage, additional subordinated notes, and a plan to convert it from rent control units to units paying market rates. Unfortunately it transacted near the peak of the bubble, and then it immediately ran afoul of rent control regulations as it began evicting rent control tenants to replace with market-paying tenants. Not only were the owners benefiting from a tax break for remaining under rent control, a point which they later lost roughly a year's worth of revenues in litigation damages, but the ownership group was so aggressive in their eviction tactics that new laws were implemented in New York City to try to dampen the efforts. During this time period the ownership group threw the keys back to the special servicer, CW Capital, which has been representing bondholders for the last two years. Earlier this year, CW Capital came to a settlement agreement with all but 5 tenants, which has led stakeholders to believe that a sale of the property is becoming increasingly likely.

Just last week, ironically as we were performing a check up at the property, residents were literally protesting in the streets due to rent increase notices that had been placed under their doors the night before. Because the litigation was in progress for so long, most of the new leases signed allowed for rent increases before the end of the lease. The settlement agreement passed its last day for appeals on May 14th, and we witnessed the protests on May 15th, so CW Capital wasted no time in serving tenants notice of rent increases. While many tenants are obviously upset over the sudden rent increases, we view this as a positive for bondholders both because it will increase revenues at the property by bringing it closer to market-level rents, but also is another step in preparing the property for a sale. An important side note that we have mentioned in the past is that there remains a tenant group that continues to be willing to make an offer on the property in collaboration with Brookfield Asset Management.

CRE Fundamentals

Wells posted their CRE Chartbook a few weeks ago (you can request it, and other reports via wellsfargo.com/economics), which contains an amalgamation of a number of useful charts and data from various sources. They also have some summary commentary on each sector. I pulled out a few interesting charts below:

CMBS is a dwindling piece of the pie, losing 1.7% net issuance during the 3rd Quarter 2012, although GSE deals gained ground.

There are still some problems to get worked out... This chart shows the status of all CRE loans, not just CMBS.

Delinquencies have improved dramatically. (Also all CRE)

Retail prices seem lofty, perhaps JCP should re-evaluate a REIT conversion.

CMBS 2013 Outlook

The CMBS market has certainly enjoyed a revival during 2012 and there are a number of reasons to be optimistic about 2013 including the pick up in originations, continued low rate environment, and improved fundamentals within outstanding CMBS deals. Morningstar notes that the consensus is that "it's gotta be better than 2012". Some quotes from RBS and CS reports can be found here. The best write-up we've seen so far is Nomura's, and you can contact your sales coverage there for a copy of the 12/6/12 2013 Outlook: The Road to Recovery (If you don't have coverage there, and are a client of ours, send me an email and we'll get you a copy with their permission).

Some of the points others have highlighted as positive include:

1. The mix of maturing loans shifts from the heavy burden of 5 and 7 year loans originated between 2005 and 2007 to 10-year loans originated in 2003, which results in lower term and maturity risk. Maturity risk should remain muted the next 2 to 3 years, but ramp up in 2016 and 2017 when 10-year loans from 2006 start to mature. Further, as Nomura points out, prices are back to 2005 levels (still down 26% from the peak), so fewer 2005 loans are not "under-water".
2. Issuance could exceed $100 billion (Nomura >$100 b, Morningstar - $50-75b), although this is partly driven by the deterioration in underwriting we've witnessed in 2012. Nomura breaks it out by $41b in Conduit, $10b in Agency, and $53.2b in Agency.
3. Delinquencies have likely peaked - Nomura
4. Capital availability has led to increased transactions ($200b in 2012, up 8% - Nomura)
5. Fewer modifications expected as climate improves. This is due both to easier availability of credit to borrowers so they can lend their way out of problems, but more towards the ability of lenders to foreclose on properties and sell them.

Some negative counterpoints include:

1. $40+ billion in defaulted loans are still in the pipeline. We should see increased loan sales from this pool.
2. Deal losses will continue to grow as delinquent loans are resolved. Nomura is looking for an increase from 2.9% deal-level losses on 2005-2008 vintage loans to 5% by the end of 2013.
3. Dodd-Frank - pretty much everyone made a passing reference to legislative risks, but there was less focus than on other risks.
4. Prices are too high, and the easier credit is going to cause more bonds to pay off at par faster than premium buyers are expecting - RBS & CS. I certainly wouldn't be buying premium front or next pays right now either. RBS recommends buying further down the stack, and that is in line with what we did late in 2012 for some strategies.

New rules regarding treatment of MBS debt on bank balance sheets

A recent ruling by the Comptroller of the Currency, FDIC, and Federal Reserve adopted some new rules for the CRE world and are set to take effect next year. The two major implications of the rule are that more capital must be held in reserve for both banks taking positions in CMBS, and a formula has been enacted to calculate the risk level of a debt security, negating the former method which was based on the rating agencies. For now the formula is only in place for securitizations, corporate debt, and other debt on banks’ trading books but it may spread to include all bank holdings of these securities. 

This formula, which is called the “Simplified Supervisory Formula Approach,” was born because of terms in Dodd-Frank stating that ratings cannot be used to determine credit risk. Under the terms, any bank involved in debt securities must analyze and evaluate data on the underlying loans to determine the credit risk of the holding. One exception to the SSFA rule is the case where a bank already has an approved internal model and will be allowed to continue using that instead of the new formula. The majority of banks do not have this approval though, and will now have until January 1, 2013 to get set up. This could have an adverse effect on CMBS and RMBS pricing performance as well as liquidity in times of turmoil. The real problem is that regulations such as this do nothing to prevent the type of crises that we experienced in 2008 and 2009, while at the same time they vastly increase costs to the bank and at some level this will discourage banks from participating in the mortgage market. 

While it is logical to us as money managers that we want to scrutinize loan-level data when making investment decisions in MBS, regulating as much on a bank is at best unfair from the perspective that they do not have the same requirements in other securities. For instance, if the bank were to buy GE corporate debt (AA- rated), they are not regulated in a manner that forces them to analyze all of its subsidiaries or even GE’s top level financials. In fact, under the legislation there is an investment in the corporate debt of GE Capital (AA-) is treated no different from CIT Group (B+); despite vast differences in their credit quality they each receive a flat 8% “specific risk weighting”. An even better example would be ETFs – the bank could easily invest in a theoretical ETF, whose underlying holdings were solely subprime mortgages or corporate junk bonds, and never have to analyze the ETF’s holdings, whereas buying the bonds directly would require them to adhere to this needlessly onerous regulation.