Volume VII Issue 1 A Publication of Paramount Capital Corporation Jan 15, 2015 Strategy and Insight for the Commercial Real Estate Industry Inside This Issue: Real Estate Focus: Cracks are Beginning to Appear in the Fed’s ZIRP. CRE Financing Rates, Courtesy of Berkadia Commercial Mortgage, LLC. REIT Returns. Economic/Investment Focus: Financial Repression Redux. Alternative Investments. Are Stocks Massively Overvalued? REIT Focus: Avalon Bay Communities, Inc., an Apartment REIT. REAL ESTATE FOCUS Cracks are Beginning to Appear in the Fed’s ZIRP The great wall of the Federal Reserve’s ZIRP (zero interest rate policy) is beginning to crack, as a number of companies that used cheap Fed debt to grow by buying overvalued real estate assets at a rapid, dangerous and uncontrolled clip are in a death spiral. ZIRP has created distortions in the capital markets, by lowering the cost of capital to unrealistic levels, which inflates asset values to nose bleed levels and increases risk. Many investment, hedge and institutional funds have used this low cost of capital to acquire operating companies, real estate, common stocks, art, bonds, oil and other assets, further pushing up the price for these assets and lowering yields. The assets are also levered up to 60%-80% of cost at very low floating rates over LIBOR or treasuries. Two real estate companies that have leveraged their way to growth recently are American Realty Capital Properties, Inc., (ARCP) the largest net lease REIT and Ocwen Financial Corporation, (OCN) the largest
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Volume VII Issue 1 A Publication of Paramount Capital
Corporation Jan 15, 2015
Strategy and Insight for the Commercial Real Estate Industry
Inside This Issue:
Real Estate Focus:
Cracks are Beginning
to Appear in the Fed’s
ZIRP.
CRE Financing Rates,
Courtesy of Berkadia
Commercial
Mortgage, LLC.
REIT Returns.
Economic/Investment
Focus:
Financial Repression
Redux.
Alternative
Investments.
Are Stocks Massively
Overvalued?
REIT Focus:
Avalon Bay
Communities, Inc., an
Apartment REIT.
REAL ESTATE FOCUS
Cracks are Beginning to Appear in the Fed’s ZIRP
The great wall of the Federal Reserve’s ZIRP (zero interest rate policy) is beginning to
crack, as a number of companies that used cheap Fed debt to grow by buying overvalued
real estate assets at a rapid, dangerous and uncontrolled clip are in a death spiral. ZIRP has
created distortions in the capital markets, by lowering the cost of capital to unrealistic
levels, which inflates asset values to nose bleed levels and increases risk. Many investment,
hedge and institutional funds have used this low cost of capital to acquire operating
companies, real estate, common stocks, art, bonds, oil and other assets, further pushing up
the price for these assets and lowering yields. The assets are also levered up to 60%-80% of
cost at very low floating rates over LIBOR or treasuries. Two real estate companies that
have leveraged their way to growth recently are American Realty Capital Properties, Inc.,
(ARCP) the largest net lease REIT and Ocwen Financial Corporation, (OCN) the largest
mortgage servicer of single family loans.
ARCP is a high flying net lease REIT that was cobbled together into a $18 billion asset
behemoth by Mr. Nicholas Schorsch, a slippery New York based CRE promoter. In the
span of a few years, Mr. Schorsch grew ARCP into the largest net lease REIT, by using
cheap debt capital in a dizzying array of acquisitions. In 2013 and 2014, Mr. Schorsh
engineered the acquisition of at eight large net lease companies and portfolios totaling over
$16 billion at very inflated cap rates of between 5% and 6%. Net lease portfolios should
trade in the 7% to 8% cap rate area. The majority of the net lease deals that ARCP now
owns are net leased to retailers like Walgreens and Dollar General and restaurants like Red
Lobster. ARCP substantially overpaid for all these acquisitions and is saddled with more
than $8.8 billion in debt and $2.3 billion in goodwill. Any REIT that is required to book
$2.3 billion in goodwill on acquisitions has severely overpaid for those assets. This means
that ARCP’s auditing firm could not allocate the full inflated purchase price to the real
estate assets acquired and had to charge the excess to goodwill.
Things started deteriorating for ARCP in April 2014, when one of its largest institutional
investors, sent a letter to the board of directors asking for the company to stop making these
large acquisitions, so that the financial statements could be analyzed without the volatility
of all the deal making. Mr. Schorsch was subsequently forced to resign as CEO and a new
CEO was hired. During mid-2014, ARCP disclosed that there were intentional
misstatements in its financial statements of approximately $23 million, which resulted in
the entire executive suite resigning including Mr. Schorsch. This included the new CEO
(who had replaced Mr. Schorsch), CFO, COO and CAO. ARCP has also delayed filing its
3rd
quarter 10Q until late January 2015 and is in the process of hiring a new executive team.
Due to the overpayment of assets, accounting misstatements and management turmoil, the
stock of ARCP has dropped from $15/sh. to $9/sh. or -40% during the last year.
The other high flying real estate company that grew on a cheap debt fueled expansion and
crashed, is Ocwen Financial Corp. Ocwen was formed by Bill Erbey back in the early
nineties to buy and workout CRE assets from S&L’s and other lenders in the first secular
CRE downturn that lasted from 1987 to 1992. Ocwen grew tremendously and morphed into
the largest servicer of single family mortgages in the county with assets of $8.3 billion as of
9/30/14. During the last few years, Ocwen spun off four different public companies,
Alitsource Portfolio Solutions (ASPS), that provides foreclosure and other services to
Ocwen’s servicing portfolio, Home Loan Servicing Solutions (HLSS), a company that
acquires mortgage servicing rights, Altisource Residential Corporation (RESI), a REIT that
owns non-performing single family loans and homes and Altisource Asset Management
Corporation (AAMC), the asset manager for RESI. The organization chart of this
convoluted group of companies looks like the schematic diagram for the Space Shuttle.
The growth of Ocwen and these spin-offs took off during the last few years until the Fall of
2014. During that period, Ocwen was sued by the NY State Department of Financial
Services and the U.S. Consumer Financial Protection Bureau (CFPB) for shoddy loan
serving practices and had to pay a $2.1 billion settlement to the CFPB. Mr. Erbey was
forced to resign as CEO of Ocwen and his board positions on the four spin-offs. Early in
2015, the State of CA alerted Ocwen that it may suspend its mortgage servicing license for
various company violations. All these regulatory sanctions have frozen Ocwen’s
acquisitions of new mortgages to service and severely curtailed its business and that of the
spin-offs. The stock prices of Ocwen and its spin-offs have dropped like lead balloons.
During the last year, the price of Ocwen has declined from $52/sh. to $6/sh. or -88%, ASPS
from $162/sh. to $17/sh. or -89%, HLSS from $23/sh. to $13/sh. or -43%, RESI from
$35/sh. to $16/sh. or 54% and AAMC from $1,209/sh. to $161/sh. or -87%.
No doubt there are other real estate centric companies that are suffering from overpriced
acquisitions and high leverage and we suspect many of these will be exposed in 2015.
CRE Financing Rates
The beginning of 2015 is off to a running start as 10 Year T-Notes hit their lowest levels
since the first quarter of 2013. While many economists predicted rising interest rates for
this year, a weakened global economy keeps inflation fears in check. And even if the Fed
raises rates later this year, the impact should be minimal on long-term rates as international
investors flee to safety of U.S. treasuries.
Such news continues to benefit borrowers and sellers as CRE pricing levels stay at
extremely favorable levels. Pressure continues on investors to find reasonable debt and
equity yields as outlined below:
10-yr UST @ 2.08% + 120 to 210 bps = 3.28% to 4.18%
5-yr UST @ 1.6% + 140 to 250 bps = 3% to 4.1%
10-yr Swap @ 2.29% + 160 to 210 bps = 3.89% to 4.39% (Conduit)
FHA 223(f) refi program at 3.20% + 60 bps MIP and FHA 221(d) (4) new-
construction program at 3.65% + 65 bps MIP.
As has been the case for the past three years, mortgage spreads consistently
dropping lower (5-10 bps)
Yields across the CRE spectrum compressing, as in select instances for core
properties, capitalization rates fall within 100 basis points of longer term rates
Financing rates and data are courtesy of John Oharenko, Senior Vice President, Berkadia
Commercial Mortgage, LLC, [email protected], 312-845-8565 and feel free to
contact John for your real estate financing needs.
REIT Returns
The table below shows the total return including dividends for our REIT buy
recommendations since 9/13 and the FTSE NAREIT Equity Index for 2014.
REIT Date of Buy
Recommendation
Buy
Stock
Price
Current
Stock Price
Total
Return
(1)
Highwoods Properties, Inc. (HIW) 9/15/13 $35 $47 27%