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Seeing the forest and the trees.

Asset managers focus their skills on spotting the weaknesses that depress the value of a real estate portfolio. Armed with broad market knowledge and property-specific details, they suggest ways to preserve a portfolio's value.

The current decade promises to be one in which the real estate industry will pause, re-evaluate, strategize and position itself for what lies ahead. Already, the industry has turned its attention to the task of evaluating the current inventory of real estate and individual portfolios, in an attempt to identify and isolate the weaker stock that may be slowing the return to health of the overall market.

This separation of the weak from the strong represents an effort to maximize the health of the remaining stock and is somewhat akin to the way that a skilled lumberjack approaches the management of resources in a forest. Before any cutting begins, the lumberjack examines each tree, assessing its strength, maturity and value. And then, only after evaluating the forest as a whole, and the trees within that forest, can the cutting process begin with any confidence that the most will be earned for the efforts made, and there will be something left to harvest another day.

In the lending community, the problems of examining and evaluating a portfolio in a regional context is made all the more difficult by the inherent "hush-hush" nature of the business. Most lenders are unwilling to disclose to other real estate professionals, as well as to the larger community of residents, businesses and policymakers, the exact condition of their real estate portfolios and share specific information about it. The basic lack of communication between lenders and the real estate community can foster several problems, such as the perception that regulators are treating lending institutions differently in terms of the valuation of their real estate assets and overall portfolios. And a resulting unrest and distrust can arise in such an information vacuum.

In some cases, there really may be valid claims of unequal treatment, whereas in other cases, the differences may be in perception only. For example, the New England banking community is presently undergoing regulatory scrutiny akin to that which occurred in Texas in the mid-1980s. It has been said that the regulators have been treating local bank portfolios, such as Fleet's, differently than say, Citibank's holdings in the New England region. While there is probably some truth to this concern, it is also likely that real estate deals of comparable size are being treated comparably, even if overall portfolios essentially are not. Furthermore, differing treatment occurs depending on the regulatory agency and the individual examiner looking at the books.

Problems created by a lack of communication and information regarding overall portfolio health include the inability to accurately assess the severity of a region's problems and a resulting inability to develop strategies for resolving them. In Boston, the Real Estate Finance Association's Policy and Research Subcommittee has attempted to grapple with the issue of how large the area's real estate problems really are, with the ultimate goal of developing a strategy for improving the liquidity of these assets.

One of the first tasks tackled by the subcommittee was to try to take an inventory of the region's real estate and categorize it by property type and performance level. It came as no surprise that it was nearly impossible to establish exactly what the overall real estate market picture was and to assess the size and extent of any potential or existing problems. The association found there was no one place to go for a list of real estate holdings, let alone a list dividing those holdings into subcategories of types of real estate or performance level. As a result, there was no efficient way to determine what the workout load might be, or make any other determination that was contingent on knowledge of the extent of the problem.

The absence of real estate inventory and performance statistics in the greater Boston market was further highlighted by looking at an employment graph for that market that spans the period from 1983 to the present. The graph shows that employment levels today are almost exactly where they were 10 years ago. The bubble which exists between 1983 and 1992 conceivably represents construction and real estate that was put into service in order to support the business boom in the area.

Due, in part, to the overall push in American business to become more efficient and boost productivity, the advance of high technology and computers, and other related trends, it is quite possible that employment in the greater Boston market will never climb as high again as it was in the mid-to-late 1980s. As result, many of the buildings that were constructed or rehabilitated to accommodate anticipated employment growth may simply stand empty and neglected, eventually becoming functionally obsolete.

This brings up the question of balancing land uses. Is open space more valuable than an existing building? In much the same way that communities have to make difficult decisions regarding the assets in their backyards, so to, the real estate industry - individually, and as a whole - needs to assess its inventory, manage its assets and plan for the future.

There is an additional problem that arises from the general lack of industry communication and an absence of thorough regional information about real estate. That problem is the inability of local communities to accurately assess what their real estate development needs are and to formulate policies to enhance community development accordingly. An example of this inability to accurately gauge local development needs and make policy to accommodate those needs is evident from a recent speech delivered to the local Chamber of Commerce by the mayor of Bellevue Washington. In that speech, the mayor announced that the community had done too good a job of limiting growth by tightening the construction permit process. The mayor indicated that they would be loosening some of the requirements in order to get things moving again.

A few years ago, downtown Bellevue was the choice development spot for office product and after several major office buildings were built and the space began to be absorbed, it became evident that the infrastructure was not capable of handling the increase in traffic and parking needs. In an effort to solve this problem, developers of new projects were required to pay a surcharge to fund improvements to the infrastructure to accommodate the increased traffic and also to complete impact studies prior to receiving their construction permits.

While at the time of the mayor's speech it wasn't clear yet how local policymakers would go about relaxing the permit process, the recognition was there that these measures that were intended to control rapid growth, instead had brought it to a nearly complete halt. The city's normal growth needs were not being met and the permit process needed to be changed to accommodate and encourage controlled growth.

The need for asset managers

While lenders and the real estate community may not communicate because of competitive and confidentiality reasons, some of this lack of communication stems from a dearth of actual in-depth knowledge about the portfolios they hold. The increasing awareness of the importance of obtaining, analyzing and maintaining accurate, up-to-date information regarding real estate portfolios, has crystalized the need for a distinct well organized and professionally staffed asset management department within most real estate organizations.

Asset management has traditionally been regarded as the management and disposition of real estate owned (REO). More recently, the definition of asset management has been broadened to include the analysis and care of performing loans, with the primary goal of maintaining value and enhancing liquidity looking towards maturity. We have gone from the assumption that values will always rise, to a mindset of expecting a decline in values. Or in other words, we are now to the point where we expect that underwriting criteria will continue to tighten to the degree that loans that were made yesterday would not be possible tomorrow.

Whether a lender, syndicator, pension fund, life company or private investor, the function of the asset manager is essentially the same. One of the most important aspects of the asset manager's job, then, is to maintain and improve whenever possible, the value of the overall portfolio. The asset management team can work with each individual property within the portfolio and make specific recommendations to improve the performance of the individual assets, but keeping an eye always focused on taking the steps that will improve the performance of the overall portfolio.

The asset manager is responsible for looking for value, both in terms of market and investment. Short of hiring an MAI-designated appraiser to re-appraise each property within the portfolio, the asset manager goes through a complicated series of steps to determine what each of the portfolio's properties are worth, one by one. There are many traditionally used valuation methods available to the industry today. They include the cost approach, rating systems and discounted cash flow models. Variations on these methods have been cropping up in response to the economic downturn experienced in most real estate markets across the country in recent years.

The method most commonly used is the income approach, largely because of the availability of operating statements on a regular basis and because of the investment nature of the value of the properties. In a perfect world, the actual performance of the property can be tracked, a market capitalization rate applied to the net operating income, and, there you have it - a value for the property.

Unfortunately, we don't live in a perfect world. This point-in-time valuation, or "snapshot" can be somewhat deceptive or completely inaccurate due, in part to the cyclical nature of the industry and its vulnerability to fluctuations in the market. Operating information utilized to establish net operating income (NOIs) upon which cap-rate-driven valuations are based may represent a peak or valley of the cycle and thus distort the picture. No one really objects as long as the snapshot is taken at the high end of the cycle or during good economic times. But, as recent experience shows, the downside can be very significant and cannot be ignored. Only by tracking the long-term, continuing performance of the property can the picture take on clarity and meaning.

In an effort to arrive at a value that takes into account the swings of the business cycle, operating statistics are obtained and projected out over a period of years to establish what is considered to be the "stabilized" performance level for the project. The present value of the resulting cash flow is then determined and discounted at the investor's threshold investment rate. This is the very familiar discounted cash flow analysis, which has been very popular as an investment comparison model. But this method fell out of favor because frequent users realized that the results were only as good as the assumptions on which the projections were based. It has regained some popularity in recent times in valuing properties in existing portfolios due to the improvement in data base information.

In much the same way, better data base information should provide the industry with a good indicator of how income trends will play out. Will income really increase at a consistent percentage per year, or will it more likely follow trends up and down? Will rent concessions remain, phase out or increase over time? Will rent always increase or will reductions need to be made in the future? The best cash flow projections will not try to paint with too broad a brush, but will instead, make an effort to assign realistic changes to each item on the list.

Realistic changes are determined from property history and investigating the market conditions for the project. Market data can be obtained through a variety of sources and methods including subscription publications, phone surveys, visits to local municipal offices, appraisal and real estate offices and by "shopping" the market physically. Whoever is asking for a value on this property, whether the request comes from an investor or an internal request, that party is depending on your expertise concerning that particular market to make a good judgment.

Market data comparisons are also important to identify any property management philosophies that may be causing unusual operating results. Take, for example, the borrower who owns and manages a multifamily project personally. He sets the rent structure at the high end of the market and does not start out by offering rent concessions. Essentially, the owner/operator begins operating by seeing what the market will bear. In this example, concessions in the market are high and the borrower has double the vacancy of his competitors. His resulting operating statements show operations at less than breakeven. This raises the question of whether it is appropriate to use his NOI for determining the value of the property, when it is most likely that he is mismanaging the property for its market.

More appropriately, the value should be heavily influenced by the market, due to the concept that with another owner/manager, the property could be generating a positive cash stream. However, the question that comes into play is what to do when values in the market become depressed overall, due to wholesale dumping of real estate, such as the auctions conducted by the Resolution Trust Corporation (RTC) and the Federal Deposit Insurance Corporation (FDIC).

Let's assume that the borrower in this example will remain as the operator of the property for the next seven years and will have to cover the negative cash flow out-of-pocket, refinance or go into bankruptcy and possible foreclosure. What effect will this have on the market perception over time? Any value assigned to the project has to reflect the effect of current management.

On the other hand, the pendulum can swing to the other extreme. A different borrower who also owns and manages the project receives rent well above the norm for similar projects and the expenses are well below the norm. Simply applying a market cap rate to the NOI will reflect a value much higher than the property may truly be worth, due to the skill of the current management in maximizing cash flow. Conventional wisdom tells us to discount the value of the project to bring it into line with its neighbors. This can be achieved by using expenses that are more typical for the market. The rents can be shown to be accepted, even if they are on the high end of the market.

From this we can clearly see that the management of a project is just as great a concern as the operating results in determining a property's value. If the portfolio is being valued from the perspective of possibly owning the projects, which is the lender's view after all, then consideration has to be given to how the property would run without the influence of the current owner.

Leo T. Spang, president of New England Real Estate Advisors, Andover, Massachusetts, supports the view that the value of commercial real estate fluctuates over time as we go through business cycles. He believes strongly that lenders need to determine if the real estate securing their loans is temporarily or permanently impaired. Permanently impaired real estate should be accounted for based on its current value. If, however, the real estate's value is only temporarily impaired and its value can be expected to increase over the next 7-10 years, then it should be accounted for based on its future stabilized value. Since future value is less certain than current value, Spang suggests that lenders set up appropriate reserves to cover the gap between current and future value and review these reserves annually. Spang says that our financial system would not be able to withstand the shock of marking all commercial real estate to market on the assumption that it will never increase in value.

A potential tool for dealing with today's real estate valuation problems might be to use what has become known as "bifurcation," or the breaking down of a loan into two parts, performing and nonperforming and dealing with each separately. All real estate carries with it an element of "good will." Bifurcation suggests that a building may have a range of values, rather than just one.

The only way to determine if impairment to the value of a piece of real estate is temporary or permanent is to understand the local economy and what's going on in the market.

All of this points continually back to the importance of thorough due-diligence in the origination and underwriting of real estate investments and a return to basics. Until there is a study of a market area, the concept of future value means nothing. Furthermore, market information must be constantly updated. If all that value is based on is one income stream, such as the previous year's operations projected forward, you place yourself in a dangerous position. All you have are your assumptions and what if they are wrong?

A changed outlook on value

When obtaining recent appraisals for foreclosure purposes, Continental Bank in Seattle asked appraisers to include an "as-is" value as well as a stabilized value. The bank recognized that the current condition of a distressed property is often less than if it were operating at market or stabilized conditions.

This represents a change in the outlook on the part of lenders regarding value. In 1988, Continental made a loan for an office/industrial development in the middle of one of the best markets for that particular property type. The loan was made to a borrower who had little experience in development, but who had retained competent contractors and consultants. Not far into the construction process, the general contractor was fired and the borrower took over completion of the construction. The borrower ran into cost overruns, the loan was completely drawn, and the project was not completed. The loan went into default, foreclosure was initiated, and a Chapter 11 bankruptcy was filed.

Through the course of the proceedings, the appraiser was instructed to provide the bank with an "as-is" value because the project was not complete, and the borrower's influence on the property was negatively impacting the lease-up. The stabilized value conclusion of the appraiser was $13 million, whereas the "as-is" valuation was $10 million. One year later, through the process of bankruptcy, a sale offer was made at $9 million, and a recent offer was made at $8 million, with the property now considered a "re-hab." Those who made the offers were convinced that they could easily achieve the $13 million value, but the extent of deferred maintenance, lease-up considerations and completion items accounted for the difference in offer price.

The point here is that value is subjective and not truly a market-driven creature. Methods of valuing a portfolio may be inaccurate if they don't take into consideration future value, personal and community interests and temporary impairment. Essentially, value derives from the purpose for which it is being established. Market value is just one point in a range of values.

In much the same that the value of each tree in a forest is established in the mind of a lumberjack, the question that must be answered next is: "What quality are the trees and what will their future value be if left standing?" Managing the commercial loan portfolio requires turning attention to the future quality of the assets. While it is important that lenders be fully aware of current values, they should not be required to write their loans down to those values, particularly when this may undermine the financial viability of the lending institution. It is crucial that both regulators and lenders recognize the concept of temporary impairment and allow loans to be accounted for accordingly.

Dick Bonz, president of Bonz and Company, Boston, and a seasoned real estate player in the New England market, believes that market distortion is getting worse and that valuation in today's real estate market is "as bad as theology... all speculation."

The issue is how to get back to the basics of the performance of the property. The mark-to-market approach is an attempt to convert a real estate market, where at present the assets are not highly saleable, to a stock market-type of valuation, which is inappropriate due to the basically illiquid nature of real estate where capital is formed on a property-specific basis. Bonz expressed concern over the possibility that the mark-to-market approach would severely impact the market in general. "If every insurance company had to write every existing mortgage to market," he says, "the loss would be incalculable. Real estate would, in effect, be treated like a commodity exchanged, like the stock exchange, which would result in the wiping out of major financial institutions and it would depress the market even further."

Instead, Bonz says that we shouldn't be so concerned about the underlying value of every mortgage. He adds that in today's economic environment, debt service coverage and loan-to-value methods present no better option. Instead, we should look to the overall portfolio, not the individual assets in relation to valuations of the portfolio's strength. In the case of life insurance companies, where a portion of all assets are real estate, and money is needed to pay claims and various expenses, other sources of income should be looked to first. Thus, Bonz says, insurance companies should look first to other fees generated through their operations in a broader context to cover claims payments and then should look at cash flow from investments as one small piece of the picture in meeting claims obligations.

According to Bonz, "We are in a national real estate workout." The key question for financial institutions should be whether interest and then principal payments will be forthcoming, rather than having an appraiser saying the property is worth some percentage on the dollar. The lender should be focused on the likelihood that the debt will be covered, from any or all sources, and if the real estate is eventually taken back, what exactly does the lender have that is worth anything. The supposition is that there is little equity in real estate any more, rather we are faced with the realism of cash flow. Unless we are saying that there will be no economic recovery, then the issue isn't the value of the building but rather, the value of the income stream.

The asset manager's role

The role of the asset manager, says Bonz, is to concentrate on cash flow and developing strategies for covering debt service. In order to accomplish that, it is necessary to pay close attention to the fundamental economics of a region. In addition, asset managers and real estate professionals need to further their education and expand their vision. Up until now the industry has been somewhat myopic. Bonz says there needs to be more uniformity in the industry in terms of valuation methodology and real estate performance perspectives and that getting back to the fundamentals of real estate on a regional basis is key.

Jenny Netzer, vice president and head of the asset management division of the Boston Financial Group, Boston, agrees with Bonz that we need to return to basics. She adds that investors are concerned about the back-end, or the time of refinancing or sale of the property, which once again raises the issue of how to value the portfolio. The first priority, says Netzer, is to establish the investing objectives. If we earmark properties for specific investment objectives, different valuation approaches can become more useful. Categorizing the portfolio is the first step in doing this. Assets are categorized many ways, but essentially are grouped as follows:

* Cash producers, loved by all, found by few;

* Marginal producers that have limited upside potential;

* Under-performing properties, which with management and work can be turned around to become at least properties whose value holds in a steady state or perhaps may even become cash producers;

* Workouts, (both pre- and post-default);

* Foreclosures;

* Those in position for sale or refinance (a much ignored category in the asset management portfolio);

"The primary role of the asset manager,' says Netzer, "is to add value to the investment for the investor, wherever possible, and to maintain value through: monitoring the property to ensure that the physical asset is maintained; developing a long-term disposition strategy; anticipating and working out problems before they get out of control, whether market, property or management-specific; and lastly assisting in improving the positioning of the property in the market, even those that are stabilized or performing well." Ideally, workouts and shouldn't be necessary, but the asset manager's job extends into these realms due to the intimate knowledge of the property gained through oversight. According to Netzer, the asset manager should be focused on protecting against downside risk, as well as on enhancing the property. The key is to manage each asset with the portfolio objectives clearly in mind.

Valuation issues aggravate the


In summary, valuation issues exaggerate the liquidation problem in real estate. There is a tremendous spread between buyers and sellers; and auctions and fire sale prices have created a paralysis in the market. Only a few, well-capitalized investors exist who wait for the fire sales and buy up the "good" properties. There are little or no funding sources to solve the problem and to assist the average buyer.

One of the contributing factors is our basic inability to assess the amount of real estate on the market or coming onto the market, including trouble loans, bullet loans and so forth. (A situation which, to date, life companies have not addressed. Life companies, as yet, have not done a complete inventory of the performance of their portfolios, so there might be far more performing or nonperforming deals than the market anticipates. Quantifying the performance of the underlying loans would help the overall real estate industry position itself for the future.)

Impediments on the liquidity side include major pricing differentials between buyers and sellers. Borrowers and lenders alike are "shell-shocked" due to the lack of definition of where the bottom of the recession will be, and the difficulty in predicting market recovery. Lack of communication between lenders and real estate professionals regarding inventory and performance of real estate assets creates inequity in valuation.

The resulting emphasis on internal management of real estate portfolios and their underlying assets can help produce a long-term solution by: defining the extent of the problems in the portfolios and creating a data base of information; returning the industry to the basics that were abandoned during the real estate race of the 1980s; and formulating a proactive approach to the future. As the positive results of proactive asset management become apparent, internal and industry communication will improve and the quality of real estate deals will rise.

As the lumberjack stands before the forest assessing the trees, he sees the ones that suffer from incurable blight, others that have been overshadowed and stunted by their larger neighbors and also the weed-like scrub. Then, he lays a plan to clear out these impediments to the health of the greater forest. He looks with pleasure at the inventory that has grown strong and that provides his current livelihood, and he proceeds with care, leaving the still growing young stands to be nurtured for a future harvest.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:ways to preserve the value of a real estate portfolio
Author:Litter, Mary Ellen; Tribble, Tom
Publication:Mortgage Banking
Date:Jul 1, 1992
Previous Article:Doing business with the RTC.
Next Article:Building new boundaries for life companies.

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