We are approaching the three year mark since the start of the Great Recession. The Feds have stimulated the economy and worked their best monetary policy but it feels like we are having our own Lost Decade a la Japan of the ‘90s.
ü Employment growth has been tepid at best. With the Census jobs ending and state and municipal government’s cutting upwards of 500,000 jobs and private companies in no hurry to add payroll, the recovery in jobs – the leading demand driver for real estate – is going to take a long time (Economists forecast that it will be 2014 or later before American payrolls recover to their pre-recession levels).
ü Vacancies are climbing and rental rates are declining as absorption in most commercial markets continues to be negative with reversal of these trends tied to real employment growth and proven economic recovery.
ü Financial reform and other external forces are making the process of refinancing commercial mortgage loans a long and arduous task with only the highest quality properties getting financed – a situation which will not be alleviated any time soon.
For owners of income-producing properties which have suffered, or anticipate suffering, the loss of tenants and/or the realities of lease rate reductions covering regular debt service has become a challenge with many having to fund payments from other sources.
Further, as tenants’ leases roll, financially-strapped owners do not have the funds to pay for tenant improvements or leasing commissions – thereby taking the property out of the market and putting a cap on occupancy. The volume of these buildings has grown to where they have a name – Zombie Buildings – since they are the living dead.
As an owner, if you find yourself feeding a property one way or another, you are buying time until the market recovers. The question becomes: Is it worth the investment?
Recently, I had a client approach me for advice on an 80,000 sq. ft. building which went from 100% occupancy to zero as a result of one tenant not renewing its lease at expiration and another going bankrupt. Facing an uphill battle to lease the property, my client asked the right question: Does it make economic sense to carry the building and lease it up?
The Background: My client had a $12.5 million first mortgage secured by the building which had annual debt service approximating $850,000. Real Estate taxes are $236,000 annually while insurance, utilities and maintenance ran $6.00 per square foot. As a result, holding costs are running around $130,000 per month.
To answer my client’s question I obtained the facts on the property including operating expense estimates, primary loan terms, recent leasing proposals and current marketing materials. I also gathered published third-party market information from several brokerage firms.
From the materials gathered, I gained an understanding of market rents, occupancies, absorption, lease terms, tenant improvement allowances and the contractual lease commission rates.
Using this information, I prepared two financial analyses: a Break-even Rent Analysis and a Solvency Test.
1. In the Break Even Rent Analysis, I calculated the gross rent per square foot which the building would need to achieve in order to cover operating expenses and debt service and to recover the leasing costs over an average lease term under two scenarios: One at market occupancy and one at full occupancy.
2. In the Solvency Test, I calculated a pro forma net operating income at the Property’s asking rents, budgeted operating expenses and estimated the value upon lease-up utilizing “normalized” cap rates and deducted an estimate for selling and closing costs, the mortgage balance as well as the leasing costs to determine net residual value to equity – or the Project’s Solvency.
Accordingly, in my Breakeven Rent Analysis, I determined that the break even rent would be 30% above the Property’s current asking rents at market occupancy and 6% above average asking rents at full occupancy – and both were above current sub-market asking rents. My conclusion was that the property could not achieve break-even rent in the market – currently or in the foreseeable future. In my Solvency Test, I determined that if the property only leased up to market occupancy, it was insolvent (the owner’s would lose money from the sale of the property) and that it would recover a net of $800,000 if the property were leased to full occupancy which, at the $130,000 per month burn rate, would cover roughly six months of holding costs – clearly not a feasible timeframe during which the building could be leased and occupied.
Given the current market conditions, I determined that the best option for our client was to negotiate a deed in lieu or short sale with the lender.
Real estate investors believe in their properties – that is a significant factor in buying one property over another. That belief, when combined with an optimistic perspective, can lead an owner to continue feeding a property with the hope of recovering their capital and making a return. Many times, like in the example presented above, buying time is a bad investment.
Starting with these quick analyses, owners can start making some decisions which will lead to either the development of a business plan which is used to renegotiate certain of the mortgage terms or make arrangements to give the lender the keys. Of course, extraneous facts and circumstances, like loan guarantees, additional collateral and leasing reserves, can make the decision and the action plan more difficult to effect.
As a CPA, a CRE and a FRICS with over 30 years of experience in underwriting, analyzing and valuing real properties to help clients buy, sell, finance or workout their debt, I can help you to see the risk within the numbers and to effect the most appropriate strategy. For a free one-hour consultation, phone me at 305-665-2450.
Friday, July 30, 2010
Tuesday, April 27, 2010
Failed Banks Had $566.9Bln of Assets, FDIC Has $33Bln Left
Based on the following article in today's CRE Direct, the FDIC is succeeding in a battle against time to dispose of the assets of failed institutions it is taking over. It is still a program of the large investors buying assets in structured transactions which leaves out the everyday investor but it is working for the Feds....As expected, the market for non-performing commercial mortgages has not grown into the same feeding frenzy that occurred in the RTC days...but it is still early in the game....we will have to watch how the special servicers who are expected to have double-digit default rates by the end of the year choose to dispose of their bad loans....It may be time to re-sharpen that saw and be prepared - but then again, it may just be more of the same of what we have experienced over the past two years....May G-d be with us all.
Failed Banks Had $566.9Bln of Assets, FDIC Has $33Bln Left
Monday, 26 April 2010
Commercial Real Estate Direct Staff Report
The FDIC, which since the beginning of 2008 has taken over 205 failed banks with $566.9 billion of total assets, has only about $37 billion of those assets left to sell.
And roughly $4.2 billion of those assets are in the process of being brought to market through the agency's structured sales, where it partners with investors on large acquisitions and provides them with financing. Factor those out and the FDIC is left with about $33 billion of assets left to sell.
Interestingly, that's roughly the same volume of assets the agency had left to sell six months ago, after it had taken over 118 failed banks with $476.4 billion of assets. That indicates that its sales efforts are accelerating. And the expectation is that they'll continue to accelerate, especially because so many other institutions have issues. Indeed, 702 banks with $402.8 billion of assets were formally tagged as "problem" institutions by the FDIC at the end of last year. Those are the highest levels since 1993 and are up from 552 banks with $345.9 billion at the end of the third quarter.
And, according to Trepp, a common thread among problem banks is their relative exposure to commercial real estate.
The agency is expected to continue relying on its structured offerings to dispose of the lion's share of assets it takes over because of their relative efficiency. It's able to sell $1 billion or more of assets in one fell swoop, while retaining a stake, which could allow it to benefit if asset values climb. It has also offered financing and has been able to sell that into the market.
In addition, the agency will continue to sell assets individually through its whole-loan, or cash sales, which are handled by five advisers. It had until early this year sold commercial real estate assets on a whole-loan basis, but has since then shifted its focus to sell such assets solely through its structured packages.
And while the agency has yet to securitize assets taken from failed banks, that's expected to change. Sheila Bair, FDIC chairman, said earlier this year that "securitization will play an increasing role" in the agency's efforts to rid itself of assets from failed banks.
The reason the agency has relatively little left to sell is that buyers of deposits of failed banks have generally acquired most of their assets, largely because of the backstop against losses that the agency provides.
Until recently, the FDIC would insure up to 80 percent of any losses from failed-bank assets subject to the loss-sharing agreements. In some cases, its insurance would climb to 95 percent. But lately, it has sought to reduce the scope of its backstop. And because market conditions have improved, evidently it's been able to do just that.
When TD Bank agreed to acquire three failed banks, American First Bank of Clermont, Fla., First Federal Bank of North Florida, Palatka, Fla., and Riverside National Bank of Florida of Fort Pierce, Fla., it agreed to assume $2.2 billion of the institutions' assets. And the FDIC agreed to cover only 50 percent of the possible losses from those assets.
The $566.9 billion of assets held by banks that failed since the beginning of 2008 compares with $519 billion of assets held by the 1,043 savings and loans that failed during the S&L crisis of the early 1990s. While that volume is not adjusted for inflation, it puts the current banking issue in context. It also shows just how large some failed banks have been.
Indeed, this time around, a $307 billion-asset institution - Washington Mutual Bank - failed. No similar-sized institution failed during the last crisis. Another seven institutions had more than $10 billion of assets each.
If you exclude WaMu, the 205 banks that have failed had an average of $1.3 billion of assets. But the top 25, exclusive of WaMu, had an average of $7.5 billion of assets.
Comments? E-mail Orest Mandzy or call him at (215) 504-2860, Ext. 211.
Copyright ©2010 Commercial Real Estate Direct, a service of FM Financial Publishing LLC. All rights reserved.
Failed Banks Had $566.9Bln of Assets, FDIC Has $33Bln Left
Monday, 26 April 2010
Commercial Real Estate Direct Staff Report
The FDIC, which since the beginning of 2008 has taken over 205 failed banks with $566.9 billion of total assets, has only about $37 billion of those assets left to sell.
And roughly $4.2 billion of those assets are in the process of being brought to market through the agency's structured sales, where it partners with investors on large acquisitions and provides them with financing. Factor those out and the FDIC is left with about $33 billion of assets left to sell.
Interestingly, that's roughly the same volume of assets the agency had left to sell six months ago, after it had taken over 118 failed banks with $476.4 billion of assets. That indicates that its sales efforts are accelerating. And the expectation is that they'll continue to accelerate, especially because so many other institutions have issues. Indeed, 702 banks with $402.8 billion of assets were formally tagged as "problem" institutions by the FDIC at the end of last year. Those are the highest levels since 1993 and are up from 552 banks with $345.9 billion at the end of the third quarter.
And, according to Trepp, a common thread among problem banks is their relative exposure to commercial real estate.
The agency is expected to continue relying on its structured offerings to dispose of the lion's share of assets it takes over because of their relative efficiency. It's able to sell $1 billion or more of assets in one fell swoop, while retaining a stake, which could allow it to benefit if asset values climb. It has also offered financing and has been able to sell that into the market.
In addition, the agency will continue to sell assets individually through its whole-loan, or cash sales, which are handled by five advisers. It had until early this year sold commercial real estate assets on a whole-loan basis, but has since then shifted its focus to sell such assets solely through its structured packages.
And while the agency has yet to securitize assets taken from failed banks, that's expected to change. Sheila Bair, FDIC chairman, said earlier this year that "securitization will play an increasing role" in the agency's efforts to rid itself of assets from failed banks.
The reason the agency has relatively little left to sell is that buyers of deposits of failed banks have generally acquired most of their assets, largely because of the backstop against losses that the agency provides.
Until recently, the FDIC would insure up to 80 percent of any losses from failed-bank assets subject to the loss-sharing agreements. In some cases, its insurance would climb to 95 percent. But lately, it has sought to reduce the scope of its backstop. And because market conditions have improved, evidently it's been able to do just that.
When TD Bank agreed to acquire three failed banks, American First Bank of Clermont, Fla., First Federal Bank of North Florida, Palatka, Fla., and Riverside National Bank of Florida of Fort Pierce, Fla., it agreed to assume $2.2 billion of the institutions' assets. And the FDIC agreed to cover only 50 percent of the possible losses from those assets.
The $566.9 billion of assets held by banks that failed since the beginning of 2008 compares with $519 billion of assets held by the 1,043 savings and loans that failed during the S&L crisis of the early 1990s. While that volume is not adjusted for inflation, it puts the current banking issue in context. It also shows just how large some failed banks have been.
Indeed, this time around, a $307 billion-asset institution - Washington Mutual Bank - failed. No similar-sized institution failed during the last crisis. Another seven institutions had more than $10 billion of assets each.
If you exclude WaMu, the 205 banks that have failed had an average of $1.3 billion of assets. But the top 25, exclusive of WaMu, had an average of $7.5 billion of assets.
Comments? E-mail Orest Mandzy or call him at (215) 504-2860, Ext. 211.
Copyright ©2010 Commercial Real Estate Direct, a service of FM Financial Publishing LLC. All rights reserved.
Thursday, April 8, 2010
Demand still outstripping supply in US nonperforming loan market
Telling us what we already knew, my friends at Ernst & Young have published the results of a new survey which sheds addtiional light on an otherwise dark tunnel. This is not being handled like the RTC days or any other prior times. The nursing of toxic assets rather than quick liquidation has prevented the market from establishing a floor. Meanwhile, institutions have depositor capital tied up in bad or underperforming loans rather than in making new loans to fund acquistiions, leasing and redevelopment activities - and slowing the recovery in commercial real estate. Sooner or later Washington will find out it is a Phyrric Victory and we will have all paid a dear price for it. Check out the report - perhaps there is a pearl you can use to create something bankable. May G-d bless you!
Demand still outstripping supply in US nonperforming loan market, according to new survey by Ernst & Young
New York, 1 April 2010 – More than sixty percent of respondents to a new survey of the distressed debt market bid on or priced US nonperforming loan (NPL) portfolios in the last year, but fewer than 17.5 percent were successful in completing a transaction. This is one of the key findings in a report published today by Ernst & Young’s Real Estate Distress Services Group based on a survey of real estate investment and opportunity funds, private equity funds, institutional investors and real estate developers conducted in late December 2009.
The Ernst & Young survey portrays a US nonperforming loan market in which investors last year were eager to buy, but in which sellers were unwilling or unable to sell. Consequently, the few deals that came to market attracted multiple bids, leaving more investors foiled than fulfilled.
“The question on everyone’s mind today is whether the US distressed loan market in 2010 and 2011 will be the same as 2009; characterized chiefly by buyers waiting for sellers to turn up and transact,” said Mark Grinis, leader of Ernst & Young’s Real Estate Distress Services Group. Added Chris Seyfarth, a partner in the Real Estate Distress Services Group of Ernst & Young LLP, “The continued development of an efficient market for nonperforming loans here in the US will depend on sellers being prepared to enter the process over the next six months.”
Nevertheless, investors remain bullish about the opportunity to put out significant sums into NPL purchases in 2010 and 2011. More than half of the investors surveyed believe that conditions in the NPL market will be favorable enough for them to enter this year with almost 40%expecting to enter the market sometime after June 1. Behind this projection may be a feeling that by the second half of the year, the country’s economic recovery will be well underway and a bottoming of commercial real estate values may be within sight.
What are these investors most interested in buying? In terms of loan type, nearly three quarters of investors surveyed preferred distressed whole loans backed by office, industrial and multifamily properties. About a third of investors favor distressed residential loans such as single family and condo loans as well as Acquisition and Development (A&D) and construction loans. Some investors also want hotel, CMBS, and land loans, but none favored residential MBS loans.
The capital is clearly there for a market to develop quickly. When asked how much they had allocated to invest in NPL portfolios, two thirds of respondents indicated they would have up to US$500 million each available for purchases. Almost 5%of respondents have made US$500 million or more available for such purchases.
However, the critical piece of the puzzle for a robust market in distressed loans in 2010 is still absent, says the Ernst & Young report. Despite an increase in troubled loans and growing Congressional scrutiny of financial institutions’ loan exposure, banks generally have been slow to deal with their problem loan portfolios, most likely due to a fear of incurring losses from loan write-offs, reductions in earnings or erosion of capital. According to recent FDIC data, US banks’ provisions for loan loss reserves totaled US$61.1 billion in the fourth quarter 2009. The Ernst & Young survey suggests that respondents believe regional banks and thrifts are the most likely active sellers of commercial real estate loans in 2010.
For a comprehensive summary of the entire survey and to download a copy of the published report, “Is history repeating itself? Distressed real estate loans investor survey,” go to www.ey.com/realestate.
About Ernst & Young’s Global Real Estate CenterToday’s real estate industry must adopt new approaches to address regulatory requirements and financial risks – while meeting the challenges of expanding globally and achieving sustainable growth. The Ernst & Young Global Real Estate Center brings together a worldwide team of professionals to help you achieve your potential – a team with deep technical experience in providing assurance, tax, transaction and advisory services. The Center works to anticipate market trends, identify the implications and develop points of view on relevant industry issues. Ultimately it enables us to help you meet your goals and compete more effectively. It’s how Ernst & Young makes a difference.
About Ernst & YoungErnst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 144,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential.
For more information, please visit http://www.ey.com/.
Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.
This news release has been issued by Ernst & Young LLP, a member firm of Ernst & Young Global Limited.
Demand still outstripping supply in US nonperforming loan market, according to new survey by Ernst & Young
New York, 1 April 2010 – More than sixty percent of respondents to a new survey of the distressed debt market bid on or priced US nonperforming loan (NPL) portfolios in the last year, but fewer than 17.5 percent were successful in completing a transaction. This is one of the key findings in a report published today by Ernst & Young’s Real Estate Distress Services Group based on a survey of real estate investment and opportunity funds, private equity funds, institutional investors and real estate developers conducted in late December 2009.
The Ernst & Young survey portrays a US nonperforming loan market in which investors last year were eager to buy, but in which sellers were unwilling or unable to sell. Consequently, the few deals that came to market attracted multiple bids, leaving more investors foiled than fulfilled.
“The question on everyone’s mind today is whether the US distressed loan market in 2010 and 2011 will be the same as 2009; characterized chiefly by buyers waiting for sellers to turn up and transact,” said Mark Grinis, leader of Ernst & Young’s Real Estate Distress Services Group. Added Chris Seyfarth, a partner in the Real Estate Distress Services Group of Ernst & Young LLP, “The continued development of an efficient market for nonperforming loans here in the US will depend on sellers being prepared to enter the process over the next six months.”
Nevertheless, investors remain bullish about the opportunity to put out significant sums into NPL purchases in 2010 and 2011. More than half of the investors surveyed believe that conditions in the NPL market will be favorable enough for them to enter this year with almost 40%expecting to enter the market sometime after June 1. Behind this projection may be a feeling that by the second half of the year, the country’s economic recovery will be well underway and a bottoming of commercial real estate values may be within sight.
What are these investors most interested in buying? In terms of loan type, nearly three quarters of investors surveyed preferred distressed whole loans backed by office, industrial and multifamily properties. About a third of investors favor distressed residential loans such as single family and condo loans as well as Acquisition and Development (A&D) and construction loans. Some investors also want hotel, CMBS, and land loans, but none favored residential MBS loans.
The capital is clearly there for a market to develop quickly. When asked how much they had allocated to invest in NPL portfolios, two thirds of respondents indicated they would have up to US$500 million each available for purchases. Almost 5%of respondents have made US$500 million or more available for such purchases.
However, the critical piece of the puzzle for a robust market in distressed loans in 2010 is still absent, says the Ernst & Young report. Despite an increase in troubled loans and growing Congressional scrutiny of financial institutions’ loan exposure, banks generally have been slow to deal with their problem loan portfolios, most likely due to a fear of incurring losses from loan write-offs, reductions in earnings or erosion of capital. According to recent FDIC data, US banks’ provisions for loan loss reserves totaled US$61.1 billion in the fourth quarter 2009. The Ernst & Young survey suggests that respondents believe regional banks and thrifts are the most likely active sellers of commercial real estate loans in 2010.
For a comprehensive summary of the entire survey and to download a copy of the published report, “Is history repeating itself? Distressed real estate loans investor survey,” go to www.ey.com/realestate.
About Ernst & Young’s Global Real Estate CenterToday’s real estate industry must adopt new approaches to address regulatory requirements and financial risks – while meeting the challenges of expanding globally and achieving sustainable growth. The Ernst & Young Global Real Estate Center brings together a worldwide team of professionals to help you achieve your potential – a team with deep technical experience in providing assurance, tax, transaction and advisory services. The Center works to anticipate market trends, identify the implications and develop points of view on relevant industry issues. Ultimately it enables us to help you meet your goals and compete more effectively. It’s how Ernst & Young makes a difference.
About Ernst & YoungErnst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 144,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential.
For more information, please visit http://www.ey.com/.
Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.
This news release has been issued by Ernst & Young LLP, a member firm of Ernst & Young Global Limited.
Thursday, March 11, 2010
No Uptick Anytime Soon - Too Many Toxic Assets on the Books
As noted in CoStar's Watch List article, banks are becoming cash strapped to cover loan losses - especially from Commercial Real Estate which means that any liquidity banks were expected to lend to the real estate investment market will not materialize and will choke any new lending and, therefore, any recovery. As I noted last summer, the extend and pretend program will be a Phyrric Victory - and will cause the pain and devastation currently being felt on Main Street to also be extended into the future. I still believe that banks will not shed toxic assets faster than their capital account and loan loss reserve will allow them....which will restrict their ability to loan new money for good new deals...did anyone say Catch 22? With more than 10% of all CMBS loans in special servicing - and growing monthly, the commercial real estate liquidity crisis is the next shoe to fall - and it has the potential of throwing the whole economy down with it - WE NEED TO ACT NOW to provide liquidity to the marketplace with a new CMBS market.....
Thinning Loan Loss Coffers May Restrict CRE Lending
Efforts To Squirrel Away More Cash Keeping the Lid on Commercial Real Estate Lending
By Mark Heschmeyer
March 10, 2010
In addition to keeping an eye on declining property values, falling rents and rising vacancy rate numbers, the commercial real estate community is also concerned over ominous signs in banking industry numbers.
One big area of concern is the fact that banks are stowing away more money to cover problem loans. The amount being set aside is rising rapidly and is now higher than it has been for a quarter of century. Meanwhile, the amount of problem loans is rising at even more than twice that rate.
The implications of the increased loan loss coverage for the commercial real estate industry is that it will likely further limit the amount of money available for borrowings. Those numbers also signify that this will continue to encourage "extend and pretend" policy that some lenders have pursued, and it may further encourage lenders to be optimistic about their recovery rates to avoid taking further losses/writedowns. And at the same time, lenders won't hesitate in demanding more money out of borrowers' pockets.
Mark Fitzgerald, senior debt analyst at Property and Portfolio Research (PPR), a CoStar Group subsidiary, keeps track of the rising levels of loan loss reserves and problem assets and the ratio between the two. Similar to what happened in the early 1990s, bad loans are piling up so fast, banks can't increase reserves fast enough without showing huge negative earnings, he said.
"It looks like the loan loss allowance to noncurrent loan ratio began declining in second half of 2006," Fitzgerald noted. "Noncurrent loans and leases began increasing in second half of 2006, whereas loan loss allowances began increasing in second half of 2007. The average from 1992-2009 is 1.33, compared to 0.58 today."
Put in dollars, that means that for the past 15 years or more, banks kept aside an average $1.33 for every dollar in bad debt they were carrying on their books. Today, banks have only 58 cents set aside.
"The biggest takeaway from those numbers is that banks will continue to need to carefully manage their way out of this --- timing of earnings, reserves, and write-offs are all critical to keeping capital ratios intact," Fitzgerald said. "As delinquencies continue to rise, reserves will need to be kept at high levels, and new lending could be restricted for some time." (See related CoStar Group coverage of recent analysts' takes on CRE mortgages and other capital markets trends.)
Patrick Fitzgerald (no relation to Mark), CCIM, vice president, REO Property at KeyBank Asset Recovery Group, has been on one of the major front-lines fighting the effects of the recession: Florida.
"There is pro-cyclicality in the reserves such that in good economic times the reserves get built up a bit as they are sparsely used and in bad they are tapped to cover losses. It's not surprising to see the coverage ratio decline," Patrick Fitzgerald said.
"During 2009, most line employees in banks spent the majority of time going through loan portfolios and figuring out exactly what they had, how much underlying collateral values had changed, and aggressively marking-down distressed and non-performing loans to reflect new recovery assumptions," Patrick Fitzgerald said. "Thus, a lot of reserves were used in 2009 as loans were charged-off (partially or in full) to essentially mark-to-market the loan book.
" In addition, KeyBank's Fitzgerald noted that federal banking regulators -- in Washington, at least - have shown banks a willingness to allocate less reserves as a percentage of non-performing loans.
This should be a bullish signal to the market, Patrick Fitzgerald said. "At a minimum it says that the belief is that things are getting less bad. We've gotten our arms around our loan book and although non-performing loans may still grow a bit, we believe the biggest write-downs are in the rearview mirror. And if this isn't the case, God help us all."
Indeed, year-end balance sheet numbers for banks do show some hope. The amount of some noncurrent loans decreased in the past quarter for the first time in years. For example, the total amount of noncurrent construction and development loans fell for the first time in four years. In addition, the average net charge-off ratio also improved after peaking in third quarter, and early stage delinquency trends showed promise.
Despite these signs of stability, the bad news is that the increase in overall noncurrent loans last quarter was driven largely by real estate. The amount of real estate loans secured by nonfarm nonresidential real estate properties that were noncurrent rose by $4.5 billion (12.2%). And such exposure will likely necessitate considerable more reserves this year. So while some forms of lending seem to be coming out of the woods, banks will still be trying to clear a path through the commercial real estate thicket.
"Loan delinquencies and defaults continue to rise as expected, but they still fail to capture the enormity of distress in the commercial real estate market, as most properties are still producing enough cash flow to adequately meet debt payments," writes Josh Scoville, Director, US Equity Research at PPR in PPR's Daily Update for March 10. "However, given the massive correction in property values, it is increasingly likely that assets with debt are upside down - i.e., the property value has fallen below the principal left on the loan. This may be all fine and dandy in our extend-and-pretend world as long as two things occur: 1) the cash flow remains high enough to continue to meet debt service, and 2) there are no major capital events required to maintain the asset. With market cash flows falling, the first requirement is under growing pressure, and this distress is directly reflected in the rising delinquency and default rates. However, the latter requirement may be an even bigger issue, as debt maturities continue to force capital events."
"The banks are trying desperately to survive the current crises without facing up to massive losses," said Robert D. Domini, MBA, MAI, president of Continental Valuations Inc. Perrysburg, OH. "With delinquencies mounting, loan loss reserves are definitely falling behind. How long [banks] can hold off will depend on how bad the commercial real estate crisis gets. Vacant, deteriorating buildings in default can't be papered over for long."
Cash Is King
Jeffrey Rogers, president and COO of Integra Realty Resources, the largest independent commercial real estate valuation and consulting firm in North America, said the banking numbers show that they may be out of the "crisis phase" but still have a lot of clearing out to do.
"We still have a long way to go before we have a normal banking system again," Rogers said. "We are still in a period of deteriorating assets and loan losses to work through. This will take some time. 140 banks were shut down by the FDIC last year. This year, we will have more than twice that. The weak banks must be cleared out of the system and it is a process. Notwithstanding, we are through the crisis phase of the cycle and the top thirty banks are healthier than they were a year ago today."
"No institution wants to sell an asset at the bottom of the market unless it has to. As long as the asset does not deteriorate significantly during the hold period and the asset will likely increase in value in a normal market, there is a bias to hold," Rogers said. "Moreover, when banks were at their weakest point, taking big losses on assets would have been even more perilous. Banks need time to earn their way out of this recession. They will be able to absorb losses better after recapitalization and positive operating metrics."
"In a recession and in the midst of a banking crisis, lending standards tighten significantly," Rogers said. "Nothing becomes more important than cash. There is still a lot of uncertainty in the capital markets and no one has the appetite for risk. Those with the cash will come out on top." And when it comes to getting cash, there still remains a great deal of uncertainty, Rogers said. The following are additional comments from industry observers on the state of the banking credit markets.
Stymied
Banks are willing to take a wait and see attitude, forbearance has come into play as well as blend and extend. There is an unreal expectation that values of these non or spotty performing assets is higher than what the market would pay. It is a Catch 21, wanting the assets off the books but expecting pricing to be at unusual levels. This leaves the banks with assets that require more coverage dollars than may be necessary. Taking the loss, on the heels of previous loss write downs keeps the holes from being further dug, or filled in. I think there is a stymie right now and more and greater losses on the horizon. Trish Walden, Broker-Associate, Advisor, Sperry Van Ness Florida Commercial Real Estate Advisors, Lake Mary, FL
Trying To Cope
Everybody is trying to spread the manure out, hoping that there isn't so much it just burns the plants. Folks knew in their heart of hearts that the music would stop. The party would be over, but now that it is, they're just trying to cope day by day. Charles B. Warren, MRICS ASA-Urban Real Property, Pleasant Hill, CA
Trying to Dollar Cost Down
Waiting for a real estate and economic rebound to take place before shedding "non-performing loans and assets" in an economy that is de-leveraging itself is a mistake. These large financial institutions should start taking the "hits" on these loans and troubled real estate assets now in order to raise "cash" and preserve their liquidity. There is plenty of private equity money around that would surely jump at the idea of buying loans and assets at a "discount." The amount of refinancing that will need to take place especially in 2012 with rollover of 2002 (10-year) and 2007 (5-year) money will be rather significant. Keeping borrowers on extended "life-support" with short term "workouts" is like trying to "dollar cost down" rather than "cutting your loss" and get out from a bad situation that may worsen further (i.e. The value of the asset versus the loan balance continues to shrink). Howard Applebaum, President, Corporate America Realty & Advisors, Rutherford, NJ
Hoping Time Will Heal All Wounds
I specifically know of a certain case with a local community bank (I'm assuming this is pretty "normal") where they are pushing appraisers for high values so they can minimize reserve requirements, avoid having to re-classify or foreclose the property and will just continue to extend and pretend instead of taking the adequate reserve or taking the 30% loss that they would have to take if they foreclosed and re-sold the property. They are obviously hoping that time will heal and/or that they can spread out their reserves over time. I believe that the regulators are basically OK with this because they don't have the manpower to take over the number of banks who would need to be closed if true values were recognized today. David Blain, Principal, Pacific Southwest Realty Services, Irvine, CA
Wild West
Clearly the banks are not prepared to take on any more REO property. The way they have handled the residential problem is deplorable. They clearly saw what was coming and did nothing I can see to be ready for the take backs. The short sale process is like the Wild West and we are now getting ready to try it in commercial. The only difference is that there will be fewer deals (in number) and banks and borrowers are used to creative deal structuring with commercial deals. My concern is the bank mentality and the bank bureaucracy will make the process more painful than necessary. We may have casualties we don't need to have. Let the loan originators (the production folks) who have the flair to do creative deal structuring do the workouts, not the underwriters. Set up parameters but give folks who "get it" the authority to get it done. Cindy S. Chandler, Principal, The Chandler Group, Charlotte, NC
Whamo!
After living through the many bank missteps of at least six major recessions in my 55 years of real estate experience in dealing with troubled bank assets, the Feds have neither the dough or the staff or the will to shut down the many, many troubled banks; some say at least 1,000 or more are on the watch list. This time around, banks are holding, with Fed approval, assets at appraised value or loan amount, whichever is the higher number, unlike, for example, the '80s when while doing work outs at Senior George H. Bush's son's bank, Silverado in Denver, the minute a loan was 60 days overdue, Whamo, the Feds were at my door forcing a write down to a new appraised value which discounted a projected holding period for the asset, etc., etc. Does history repeat itself, you betcha, only this time around the Feds are in deeper trouble than ever given the reluctance of Washington to admit defeat on this issue, i.e., the banking system is in a world of hurt. David C. Nilges, President, Managing Broker, Nilges Commercial*Realtors Inc., Centennial, CO
Thinning Loan Loss Coffers May Restrict CRE Lending
Efforts To Squirrel Away More Cash Keeping the Lid on Commercial Real Estate Lending
By Mark Heschmeyer
March 10, 2010
In addition to keeping an eye on declining property values, falling rents and rising vacancy rate numbers, the commercial real estate community is also concerned over ominous signs in banking industry numbers.
One big area of concern is the fact that banks are stowing away more money to cover problem loans. The amount being set aside is rising rapidly and is now higher than it has been for a quarter of century. Meanwhile, the amount of problem loans is rising at even more than twice that rate.
The implications of the increased loan loss coverage for the commercial real estate industry is that it will likely further limit the amount of money available for borrowings. Those numbers also signify that this will continue to encourage "extend and pretend" policy that some lenders have pursued, and it may further encourage lenders to be optimistic about their recovery rates to avoid taking further losses/writedowns. And at the same time, lenders won't hesitate in demanding more money out of borrowers' pockets.
Mark Fitzgerald, senior debt analyst at Property and Portfolio Research (PPR), a CoStar Group subsidiary, keeps track of the rising levels of loan loss reserves and problem assets and the ratio between the two. Similar to what happened in the early 1990s, bad loans are piling up so fast, banks can't increase reserves fast enough without showing huge negative earnings, he said.
"It looks like the loan loss allowance to noncurrent loan ratio began declining in second half of 2006," Fitzgerald noted. "Noncurrent loans and leases began increasing in second half of 2006, whereas loan loss allowances began increasing in second half of 2007. The average from 1992-2009 is 1.33, compared to 0.58 today."
Put in dollars, that means that for the past 15 years or more, banks kept aside an average $1.33 for every dollar in bad debt they were carrying on their books. Today, banks have only 58 cents set aside.
"The biggest takeaway from those numbers is that banks will continue to need to carefully manage their way out of this --- timing of earnings, reserves, and write-offs are all critical to keeping capital ratios intact," Fitzgerald said. "As delinquencies continue to rise, reserves will need to be kept at high levels, and new lending could be restricted for some time." (See related CoStar Group coverage of recent analysts' takes on CRE mortgages and other capital markets trends.)
Patrick Fitzgerald (no relation to Mark), CCIM, vice president, REO Property at KeyBank Asset Recovery Group, has been on one of the major front-lines fighting the effects of the recession: Florida.
"There is pro-cyclicality in the reserves such that in good economic times the reserves get built up a bit as they are sparsely used and in bad they are tapped to cover losses. It's not surprising to see the coverage ratio decline," Patrick Fitzgerald said.
"During 2009, most line employees in banks spent the majority of time going through loan portfolios and figuring out exactly what they had, how much underlying collateral values had changed, and aggressively marking-down distressed and non-performing loans to reflect new recovery assumptions," Patrick Fitzgerald said. "Thus, a lot of reserves were used in 2009 as loans were charged-off (partially or in full) to essentially mark-to-market the loan book.
" In addition, KeyBank's Fitzgerald noted that federal banking regulators -- in Washington, at least - have shown banks a willingness to allocate less reserves as a percentage of non-performing loans.
This should be a bullish signal to the market, Patrick Fitzgerald said. "At a minimum it says that the belief is that things are getting less bad. We've gotten our arms around our loan book and although non-performing loans may still grow a bit, we believe the biggest write-downs are in the rearview mirror. And if this isn't the case, God help us all."
Indeed, year-end balance sheet numbers for banks do show some hope. The amount of some noncurrent loans decreased in the past quarter for the first time in years. For example, the total amount of noncurrent construction and development loans fell for the first time in four years. In addition, the average net charge-off ratio also improved after peaking in third quarter, and early stage delinquency trends showed promise.
Despite these signs of stability, the bad news is that the increase in overall noncurrent loans last quarter was driven largely by real estate. The amount of real estate loans secured by nonfarm nonresidential real estate properties that were noncurrent rose by $4.5 billion (12.2%). And such exposure will likely necessitate considerable more reserves this year. So while some forms of lending seem to be coming out of the woods, banks will still be trying to clear a path through the commercial real estate thicket.
"Loan delinquencies and defaults continue to rise as expected, but they still fail to capture the enormity of distress in the commercial real estate market, as most properties are still producing enough cash flow to adequately meet debt payments," writes Josh Scoville, Director, US Equity Research at PPR in PPR's Daily Update for March 10. "However, given the massive correction in property values, it is increasingly likely that assets with debt are upside down - i.e., the property value has fallen below the principal left on the loan. This may be all fine and dandy in our extend-and-pretend world as long as two things occur: 1) the cash flow remains high enough to continue to meet debt service, and 2) there are no major capital events required to maintain the asset. With market cash flows falling, the first requirement is under growing pressure, and this distress is directly reflected in the rising delinquency and default rates. However, the latter requirement may be an even bigger issue, as debt maturities continue to force capital events."
"The banks are trying desperately to survive the current crises without facing up to massive losses," said Robert D. Domini, MBA, MAI, president of Continental Valuations Inc. Perrysburg, OH. "With delinquencies mounting, loan loss reserves are definitely falling behind. How long [banks] can hold off will depend on how bad the commercial real estate crisis gets. Vacant, deteriorating buildings in default can't be papered over for long."
Cash Is King
Jeffrey Rogers, president and COO of Integra Realty Resources, the largest independent commercial real estate valuation and consulting firm in North America, said the banking numbers show that they may be out of the "crisis phase" but still have a lot of clearing out to do.
"We still have a long way to go before we have a normal banking system again," Rogers said. "We are still in a period of deteriorating assets and loan losses to work through. This will take some time. 140 banks were shut down by the FDIC last year. This year, we will have more than twice that. The weak banks must be cleared out of the system and it is a process. Notwithstanding, we are through the crisis phase of the cycle and the top thirty banks are healthier than they were a year ago today."
"No institution wants to sell an asset at the bottom of the market unless it has to. As long as the asset does not deteriorate significantly during the hold period and the asset will likely increase in value in a normal market, there is a bias to hold," Rogers said. "Moreover, when banks were at their weakest point, taking big losses on assets would have been even more perilous. Banks need time to earn their way out of this recession. They will be able to absorb losses better after recapitalization and positive operating metrics."
"In a recession and in the midst of a banking crisis, lending standards tighten significantly," Rogers said. "Nothing becomes more important than cash. There is still a lot of uncertainty in the capital markets and no one has the appetite for risk. Those with the cash will come out on top." And when it comes to getting cash, there still remains a great deal of uncertainty, Rogers said. The following are additional comments from industry observers on the state of the banking credit markets.
Stymied
Banks are willing to take a wait and see attitude, forbearance has come into play as well as blend and extend. There is an unreal expectation that values of these non or spotty performing assets is higher than what the market would pay. It is a Catch 21, wanting the assets off the books but expecting pricing to be at unusual levels. This leaves the banks with assets that require more coverage dollars than may be necessary. Taking the loss, on the heels of previous loss write downs keeps the holes from being further dug, or filled in. I think there is a stymie right now and more and greater losses on the horizon. Trish Walden, Broker-Associate, Advisor, Sperry Van Ness Florida Commercial Real Estate Advisors, Lake Mary, FL
Trying To Cope
Everybody is trying to spread the manure out, hoping that there isn't so much it just burns the plants. Folks knew in their heart of hearts that the music would stop. The party would be over, but now that it is, they're just trying to cope day by day. Charles B. Warren, MRICS ASA-Urban Real Property, Pleasant Hill, CA
Trying to Dollar Cost Down
Waiting for a real estate and economic rebound to take place before shedding "non-performing loans and assets" in an economy that is de-leveraging itself is a mistake. These large financial institutions should start taking the "hits" on these loans and troubled real estate assets now in order to raise "cash" and preserve their liquidity. There is plenty of private equity money around that would surely jump at the idea of buying loans and assets at a "discount." The amount of refinancing that will need to take place especially in 2012 with rollover of 2002 (10-year) and 2007 (5-year) money will be rather significant. Keeping borrowers on extended "life-support" with short term "workouts" is like trying to "dollar cost down" rather than "cutting your loss" and get out from a bad situation that may worsen further (i.e. The value of the asset versus the loan balance continues to shrink). Howard Applebaum, President, Corporate America Realty & Advisors, Rutherford, NJ
Hoping Time Will Heal All Wounds
I specifically know of a certain case with a local community bank (I'm assuming this is pretty "normal") where they are pushing appraisers for high values so they can minimize reserve requirements, avoid having to re-classify or foreclose the property and will just continue to extend and pretend instead of taking the adequate reserve or taking the 30% loss that they would have to take if they foreclosed and re-sold the property. They are obviously hoping that time will heal and/or that they can spread out their reserves over time. I believe that the regulators are basically OK with this because they don't have the manpower to take over the number of banks who would need to be closed if true values were recognized today. David Blain, Principal, Pacific Southwest Realty Services, Irvine, CA
Wild West
Clearly the banks are not prepared to take on any more REO property. The way they have handled the residential problem is deplorable. They clearly saw what was coming and did nothing I can see to be ready for the take backs. The short sale process is like the Wild West and we are now getting ready to try it in commercial. The only difference is that there will be fewer deals (in number) and banks and borrowers are used to creative deal structuring with commercial deals. My concern is the bank mentality and the bank bureaucracy will make the process more painful than necessary. We may have casualties we don't need to have. Let the loan originators (the production folks) who have the flair to do creative deal structuring do the workouts, not the underwriters. Set up parameters but give folks who "get it" the authority to get it done. Cindy S. Chandler, Principal, The Chandler Group, Charlotte, NC
Whamo!
After living through the many bank missteps of at least six major recessions in my 55 years of real estate experience in dealing with troubled bank assets, the Feds have neither the dough or the staff or the will to shut down the many, many troubled banks; some say at least 1,000 or more are on the watch list. This time around, banks are holding, with Fed approval, assets at appraised value or loan amount, whichever is the higher number, unlike, for example, the '80s when while doing work outs at Senior George H. Bush's son's bank, Silverado in Denver, the minute a loan was 60 days overdue, Whamo, the Feds were at my door forcing a write down to a new appraised value which discounted a projected holding period for the asset, etc., etc. Does history repeat itself, you betcha, only this time around the Feds are in deeper trouble than ever given the reluctance of Washington to admit defeat on this issue, i.e., the banking system is in a world of hurt. David C. Nilges, President, Managing Broker, Nilges Commercial*Realtors Inc., Centennial, CO
Friday, February 12, 2010
Betting on Bad Debt Becoming a Growing Investment Play
With the Great Recession in mid-stream and commercial real estate being a lagging component of the economy as demand for CRE space is a derived demand once potential tenants outgrow their current space needs and feel confident in the future, the declining property fundamentals, lack of liquidity in the market and rising investor yield requirements as reflected in cap rates, a large percentage of commmercial properties are not worth the face amount of the debt.
In this week's CoStar Watch List, A weekly column focusing on distressed market conditions, commercial real estate properties, mortgages and Corporations Published by CoStar News, the opportunity to buy distressed debt is highlighted. The article is below. You can sign up for the eblast from CoStar through their website www.costar.com.
The key is to recognize that buying a loan, while based on a thorough underwriting of the collateral (the foundation is always the real estate), is not buying a property and has a different cash flow characteristics and risks. I will be addressing issues in the loan valuation/pricing process in future blogs but awareness of the opportunity is the first step for many investors.
For many this is back to the future going back to the RTC days, but for others, this is the first time to pursue the acquisition of commercial mortgage debt on the secondary market. I have significant experience in this arena - from both the buy and sale side as well as a loan sale advisor and due diligence provider. Please let me know if I can be of service.
Betting on Bad Debt Becoming a Growing Investment Play
With Distressed CRE Debt Mounting, Investors Are Scouring Loan Books for Good Property Deals
By Mark Heschmeyer
With most if not all facets of commercial real estate investment mired in the dumps, one area is burgeoning -- the market for distressed debt. Indeed, investors say the distressed debt market is more active now than it has ever been, and still nowhere near where players see it going over the next couple of years. Spurring the action is new paradigm in property acquisition. Debt buyers are keen on the notion that properties can be acquired at significant discounts to their loan values - offering even bigger savings than the cost of purchasing a property outright.
Examples of this new arrangement are abundant, with AION Partners, a real estate private equity company in New York, being just one. AION is utilizing this loan-to-own strategy as a starting point for increasing its ownership portfolio. It recently purchased a portfolio of eight loan-to-own assets in opportunistic markets throughout the Sunbelt with a value in excess of $110 million. Since acquiring the loans, AION Partners has already foreclosed, or taken a deed in lieu on five of these non-performing first mortgage loans and plans to take control of the remaining properties in 2010.
The eight loans purchased in 2009 include: a 234-unit multifamily complex in North Miami, FL; a 192-unit multifamily property in West Palm Beach, FL; a 178-unit assisted living facility in Arlington, TX; a 287,000-square-foot distribution warehouse in Chester, NY; a 150-unit multifamily complex in Phoenix, AZ; a 196-unit multifamily property in Tucson, AZ; a 480-unit multifamily community in Atlanta, GA; and a 220-unit multifamily building in Charlotte, NC.
"We are committed to building a large, national portfolio of multifamily assets and are executing this strategy through the acquisition of distressed loans and properties and then employing our experience as investors, developers and managers to stabilize and build value," said Michael Betancourt, principal of AION Partners, which also owns office, retail and condominium properties in major cities including New York, Washington, DC, and Los Angeles. "If our success during 2009 is any indication of things to come, we anticipate activity in 2010 both on the investment and asset management fronts to surpass our initial projections for our partners and ourselves."
The bulk of the distressed debt sales in 2009 were in the CMBS arena and from the Federal Deposit Insurance Corp. and industry participants expect those numbers to continue growing this year.
The FDIC alone sold about 3,500 commercial real estate loans with a book value of more than $6.1 billion last year; that compares to commercial real estate loans sales in 2008 of just $153 million. Nonperforming loans went for 37 cents on the dollar last year but November and December 2009 sales prices coming in closer to 30 cents. Performing loans sold for about 57 cents on the dollar, but with the most recent sales coming in at 44 cents.
Also, the FDIC has a growing portfolio of bad loans to deal with as regulators are closing banks in record numbers.
According to analysis by Property and Portfolio Research (PPR), a CoStar Group subsidiary, as commercial real estate fundamentals continue to deteriorate through 2010, banks with large exposure to the commercial real estate sector will face increased pressure on their balance sheets. FDIC guidelines suggest that a bank whose commercial real estate holdings exceed 300% of capital is "overexposed" to the sector. Based on that metric, PPR says there is no shortage of candidates that the FDIC could seize in 2010. As of the end of the third quarter 2009, more 1,200 banks had commercial real estate exposure of greater than 300% of capital, and 500 of these banks had exposure greater than 400% of capital. The assets of those banks total approximately $650 billion.
So as far as the growth in the amount of debt the FDIC can dispose of, Steve Miller, director of debt research and risk management at PPR, says it is limited only by the FDIC's ability to deal with the growing volume of distressed financial institutions.
CMBS loan liquidations were averaging about $108 million a month in 2008 and last year the average jumped $182 million with November's totaling hitting $255 million and December's ballooning to $585 million, according to CMBS bond rating agency Realpoint. Loans were being liquidated at losses near 66%.
In addition, the rate at which liquidated or resolved CMBS credits are replenished by newly delinquent loans is growing and remains a high concern, especially regarding further growth in the foreclosure and REO categories (evidence of additional loan workouts and liquidations on the horizon for 2010).
To the selling side of the equation, industry participants also expect to see heretofore reluctant community and regional banks begin to dispose of more of their distressed commercial real estate assets.
"The secondary market for buying loans is a crowded space right now," said Barry C. Smith, president of LoanSaleCorp.com in Scottsdale, AZ. "There are many groups seeking deals, but transactions (other than the FDIC sales) actually taking place are not as great as one might think. Bid / ask spreads are still wide, but we do see things narrowing somewhat."
"January was interesting; it is apparent that both buyers and sellers are ready to get things going after a dismal 2009," Smith said. "We see good momentum in the market currently and we are happy to report that the community and regional banks we deal with seem to be more interested in actually doing something proactive. This contrasts with what we saw in 2009. Some banks are starting to come out of their Zombie like state and explore the disposition of identified problems. This is an encouraging sign for the market."
Bill Looney, president of loan sales at DebtX in San Francisco, said the market for commercial real estate debt is as active as he has seen it in 10 years.
"That's a function of weakening conditions in the commercial real estate market and a recognition among financial institutions that they need to actively manage their portfolio to reduce risk and protect the bottom line," Looney said. "Many institutions realize that a loan sale can expeditiously dispose of a loan at fair market value. By selling, rather than holding onto the loan in workout, institutions can remove the headwind from their balance sheet and get back to the business of making profitable loans again."
In addition to selling a significant volume of non-performing loans, Looney said he also expects to sell a fair amount of performing debt start coming to market.
New York-based Mission Capital Advisors conducted $9.2 billion in loan sales last year including $571 million of CMBS loan sales, a 77% increase year over year versus 2008. "We see the market as extremely active, with the most active sellers being the healthier community and regional banks who have successfully raised capital and nearly all special servicers (regardless of financial condition)," said William David Tobin, principal of Mission Capital Advisors. "Mission's commercial loan sale business was up 57% in 2009 versus 2008 in terms of balance offered. We expect a similar increase in 2010."
"The most active buyers are localized operators teamed with high net worth individuals or groups of individuals, with a strategic use for the property (and accordingly, a price advantage over strictly financial buyers)," Tobin said. "The second most active buyer profile is $50 million to $500 million private equity / high net worth investment funds."
In terms of buyers, Bill Looney said DebtX is seeing a lot of bidding and purchasing by opportunity funds, private equity funds and hedge funds.
"In addition, we're seeing a number of equity buyers who previously owned property, but have been in cash looking to get back in," Looney said. "Because many distressed properties are mired in default or are unable to service their debt, some equity players are seeking to re-enter the property market by purchasing the loans. Finally, we're seeing local players, such as community banks, selectively buying loans. Community banks often have a local market advantage because they are tied so closely to their communities."
Barry Smith at LoanSaleCorp.com said the major buying activity presently is in the sub- and nonperforming loan space. Buyers are not showing a clear preference for property types but that clearly loans in the major metropolitan markets are of the most interest.
Ken Cohen, chairman and CEO of The Mortgage Acquisition Co. in San Francisco, which has been active buyer in the capital markets since 1990, said the current market is tremendously active and is going to stay active.
"As a buyer we look at performing and nonperforming loans, although right now we're seeing many more nonperforming situations as borrowers are starting to miss payments," Cohen said. "We look at a lot of property types, but we stay away from land loans and major lease up issues - empty retail, big box office, big box anything."
In terms of pricing, Cohen said he is looks at the underlying cash flow of the property and strength of the sponsor backing the loan.
In this week's CoStar Watch List, A weekly column focusing on distressed market conditions, commercial real estate properties, mortgages and Corporations Published by CoStar News, the opportunity to buy distressed debt is highlighted. The article is below. You can sign up for the eblast from CoStar through their website www.costar.com.
The key is to recognize that buying a loan, while based on a thorough underwriting of the collateral (the foundation is always the real estate), is not buying a property and has a different cash flow characteristics and risks. I will be addressing issues in the loan valuation/pricing process in future blogs but awareness of the opportunity is the first step for many investors.
For many this is back to the future going back to the RTC days, but for others, this is the first time to pursue the acquisition of commercial mortgage debt on the secondary market. I have significant experience in this arena - from both the buy and sale side as well as a loan sale advisor and due diligence provider. Please let me know if I can be of service.
Betting on Bad Debt Becoming a Growing Investment Play
With Distressed CRE Debt Mounting, Investors Are Scouring Loan Books for Good Property Deals
By Mark Heschmeyer
With most if not all facets of commercial real estate investment mired in the dumps, one area is burgeoning -- the market for distressed debt. Indeed, investors say the distressed debt market is more active now than it has ever been, and still nowhere near where players see it going over the next couple of years. Spurring the action is new paradigm in property acquisition. Debt buyers are keen on the notion that properties can be acquired at significant discounts to their loan values - offering even bigger savings than the cost of purchasing a property outright.
Examples of this new arrangement are abundant, with AION Partners, a real estate private equity company in New York, being just one. AION is utilizing this loan-to-own strategy as a starting point for increasing its ownership portfolio. It recently purchased a portfolio of eight loan-to-own assets in opportunistic markets throughout the Sunbelt with a value in excess of $110 million. Since acquiring the loans, AION Partners has already foreclosed, or taken a deed in lieu on five of these non-performing first mortgage loans and plans to take control of the remaining properties in 2010.
The eight loans purchased in 2009 include: a 234-unit multifamily complex in North Miami, FL; a 192-unit multifamily property in West Palm Beach, FL; a 178-unit assisted living facility in Arlington, TX; a 287,000-square-foot distribution warehouse in Chester, NY; a 150-unit multifamily complex in Phoenix, AZ; a 196-unit multifamily property in Tucson, AZ; a 480-unit multifamily community in Atlanta, GA; and a 220-unit multifamily building in Charlotte, NC.
"We are committed to building a large, national portfolio of multifamily assets and are executing this strategy through the acquisition of distressed loans and properties and then employing our experience as investors, developers and managers to stabilize and build value," said Michael Betancourt, principal of AION Partners, which also owns office, retail and condominium properties in major cities including New York, Washington, DC, and Los Angeles. "If our success during 2009 is any indication of things to come, we anticipate activity in 2010 both on the investment and asset management fronts to surpass our initial projections for our partners and ourselves."
The bulk of the distressed debt sales in 2009 were in the CMBS arena and from the Federal Deposit Insurance Corp. and industry participants expect those numbers to continue growing this year.
The FDIC alone sold about 3,500 commercial real estate loans with a book value of more than $6.1 billion last year; that compares to commercial real estate loans sales in 2008 of just $153 million. Nonperforming loans went for 37 cents on the dollar last year but November and December 2009 sales prices coming in closer to 30 cents. Performing loans sold for about 57 cents on the dollar, but with the most recent sales coming in at 44 cents.
Also, the FDIC has a growing portfolio of bad loans to deal with as regulators are closing banks in record numbers.
According to analysis by Property and Portfolio Research (PPR), a CoStar Group subsidiary, as commercial real estate fundamentals continue to deteriorate through 2010, banks with large exposure to the commercial real estate sector will face increased pressure on their balance sheets. FDIC guidelines suggest that a bank whose commercial real estate holdings exceed 300% of capital is "overexposed" to the sector. Based on that metric, PPR says there is no shortage of candidates that the FDIC could seize in 2010. As of the end of the third quarter 2009, more 1,200 banks had commercial real estate exposure of greater than 300% of capital, and 500 of these banks had exposure greater than 400% of capital. The assets of those banks total approximately $650 billion.
So as far as the growth in the amount of debt the FDIC can dispose of, Steve Miller, director of debt research and risk management at PPR, says it is limited only by the FDIC's ability to deal with the growing volume of distressed financial institutions.
CMBS loan liquidations were averaging about $108 million a month in 2008 and last year the average jumped $182 million with November's totaling hitting $255 million and December's ballooning to $585 million, according to CMBS bond rating agency Realpoint. Loans were being liquidated at losses near 66%.
In addition, the rate at which liquidated or resolved CMBS credits are replenished by newly delinquent loans is growing and remains a high concern, especially regarding further growth in the foreclosure and REO categories (evidence of additional loan workouts and liquidations on the horizon for 2010).
To the selling side of the equation, industry participants also expect to see heretofore reluctant community and regional banks begin to dispose of more of their distressed commercial real estate assets.
"The secondary market for buying loans is a crowded space right now," said Barry C. Smith, president of LoanSaleCorp.com in Scottsdale, AZ. "There are many groups seeking deals, but transactions (other than the FDIC sales) actually taking place are not as great as one might think. Bid / ask spreads are still wide, but we do see things narrowing somewhat."
"January was interesting; it is apparent that both buyers and sellers are ready to get things going after a dismal 2009," Smith said. "We see good momentum in the market currently and we are happy to report that the community and regional banks we deal with seem to be more interested in actually doing something proactive. This contrasts with what we saw in 2009. Some banks are starting to come out of their Zombie like state and explore the disposition of identified problems. This is an encouraging sign for the market."
Bill Looney, president of loan sales at DebtX in San Francisco, said the market for commercial real estate debt is as active as he has seen it in 10 years.
"That's a function of weakening conditions in the commercial real estate market and a recognition among financial institutions that they need to actively manage their portfolio to reduce risk and protect the bottom line," Looney said. "Many institutions realize that a loan sale can expeditiously dispose of a loan at fair market value. By selling, rather than holding onto the loan in workout, institutions can remove the headwind from their balance sheet and get back to the business of making profitable loans again."
In addition to selling a significant volume of non-performing loans, Looney said he also expects to sell a fair amount of performing debt start coming to market.
New York-based Mission Capital Advisors conducted $9.2 billion in loan sales last year including $571 million of CMBS loan sales, a 77% increase year over year versus 2008. "We see the market as extremely active, with the most active sellers being the healthier community and regional banks who have successfully raised capital and nearly all special servicers (regardless of financial condition)," said William David Tobin, principal of Mission Capital Advisors. "Mission's commercial loan sale business was up 57% in 2009 versus 2008 in terms of balance offered. We expect a similar increase in 2010."
"The most active buyers are localized operators teamed with high net worth individuals or groups of individuals, with a strategic use for the property (and accordingly, a price advantage over strictly financial buyers)," Tobin said. "The second most active buyer profile is $50 million to $500 million private equity / high net worth investment funds."
In terms of buyers, Bill Looney said DebtX is seeing a lot of bidding and purchasing by opportunity funds, private equity funds and hedge funds.
"In addition, we're seeing a number of equity buyers who previously owned property, but have been in cash looking to get back in," Looney said. "Because many distressed properties are mired in default or are unable to service their debt, some equity players are seeking to re-enter the property market by purchasing the loans. Finally, we're seeing local players, such as community banks, selectively buying loans. Community banks often have a local market advantage because they are tied so closely to their communities."
Barry Smith at LoanSaleCorp.com said the major buying activity presently is in the sub- and nonperforming loan space. Buyers are not showing a clear preference for property types but that clearly loans in the major metropolitan markets are of the most interest.
Ken Cohen, chairman and CEO of The Mortgage Acquisition Co. in San Francisco, which has been active buyer in the capital markets since 1990, said the current market is tremendously active and is going to stay active.
"As a buyer we look at performing and nonperforming loans, although right now we're seeing many more nonperforming situations as borrowers are starting to miss payments," Cohen said. "We look at a lot of property types, but we stay away from land loans and major lease up issues - empty retail, big box office, big box anything."
In terms of pricing, Cohen said he is looks at the underlying cash flow of the property and strength of the sponsor backing the loan.
Friday, February 5, 2010
An open letter to the Appraisal Insitute: 20th Century Valuation Techniques are not appropriate for 21st Century Finance and Investment
When an economic calamity is so great it compels economists to reach for a new paradigm incorporating the value of collateral and the amount of leverage used to finance its ownership. When the understanding of commercial real estate operations and cash flow characteristics – and the ability to use computer programs to model it makes the three approaches to value – cost, sales comparison and capitalization of income – simplistic and, with one exception, anachronistic….
Δ First, the cost approach in which estimated value “is derived…by estimating the current cost to construct a reproduction of existing structure, including entrepreneurial incentive, deducting depreciation from the total cost and adding the estimated land value”* (which fluctuates based on market conditions) only works for special purpose properties as a reflection of value in use – as a factory which is designed and built to house production of a unique production process.
- Having been in a position to sell a Class B building in downtown St. Petersburg for under $15 per square foot in 1992 at the bottom of the last cycle which was empty in a time of oversupply I know that an empty building is not necessarily worth the cost of bricks and mortar and a developer adds value above replacement cost by developing and leasing the property which provides incentivized investment returns to both capital and management.
Δ Second, the sales comparison approach derives value “by comparing the property being appraised to similar properties that have been sold recently, then applying appropriate units of comparison making adjustments to the sale prices of the comparables based on the elements of comparison.”* This approach may be appropriate for owner-occupied housing where the principal of substitution is the primary basis for determining what a buyer would pay for a home; however, differences between commercial properties; including location, functionality and operational efficiency, lease structures and terms, and the capital structure, cost of capital and yield expectations of the buyer who pays “investment value” for a property; are too significant and extensive for an appraiser to be able to adequately address them in order to estimate the value of a comparable property.
- Being on the opposite side of a street or having more points of ingress can change the marketability of a property and reduce or increase market risk which should be reflected in the buyer’s yield expectation as reflected in the Internal Rate of Return and the resultant capitalization rate.
- Even if an appraiser used sales data on sales that closed as of the date of the appraisal, the information is dated since a normal commercial real estate deal takes between two and three months to negotiate and close with the purchase price generally agreed upon at the outset of the process – not the conclusion.
Δ Finally, the income capitalization approach which can be applied using two methodologies: (1) the capitalization of “one year’s income expectancy” at a “market-derived capitalization rate,” which happens to be the most commonly used method due to its simplicity; or (2) the discounting of “the annual cash flows for the holding period and reversion….at a specified yield rate.”*
- The capitalization of a one-year pro forma has the fatal flaw in that it implicitly assumes the net operating income from a property will be the same in perpetuity – and commercial real estate professionals including appraisers know that a property’s cash flow is not the same from one month to the next, much less does it remain the same for years on end. With the sole exception of a long-term absolute net leased single-tenant property, commercial real estate does not generate bond-type income streams. It has a mix quality of tenants with varying lease rollover times, vacancies and releasing costs.
- In addition, the traditional application of the income capitalization approach is to capitalize net operating income, which may be a proxy for net cash flow when there are no tenant improvements or leasing commissions to pay as is the case with apartment complexes, self-storage facilities and hotels but not with office buildings, shopping centers or industrial facilities. For commercial properties, the NOI should be reduced by an estimate of the annual expenditure for leasing costs and rollover vacancy to approximate the estimated net cash flow to be generated from the property operations. Problem is, appraisers cannot get the same information on competing properties in order to develop an appropriate cap rate.
Accordingly, the only reasonable method to establish what the accountants call “fair value” of commercial real estate is to forecast future cash flow from the operation and re-sale of the property and discount the resulting cash flows reflecting a prudent investor’s yield requirements given the cost of debt financing and the perceived market, operating and financial risk assumed through ownership in relation to other investment opportunities.
It is the 21st Century - we know better and we have the capability to estimate market value by employing the same tools investors use to establish investment value.
For the record, the generally accepted definition of market value (“The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite for a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress.”) is not at issue – the issue is that the aforementioned approaches to value are still accepted as a basis for estimating market value.
Accordingly, in my humble opinion, market value can only be based on the income characteristics of the subject property. Minimum standards would be established for the research and support used for developing the forecast assumptions used in preparing the cash flow forecast. Appraisals would be evaluated based on the assumptions used in estimating market rent, stabilized occupancy, downtime between leases, leasing costs, operating expenses, growth rates, capital improvement and replacement costs, reversionary capitalization rate and selling costs, and the yield, or discount rate, used to present value the future cash flows.
Δ The traditional cost, sales comparison and capitalization of income approaches would be used to test the reasonableness of the resulting range of values developed pursuant to the discounted cash flow approach within which “market value” is most likely to occur.
The Appraisal and Mortgage Financing Considerations
From a prudent lending perspective, the information contained in an appraisal provides many underwriting benchmarks – in addition to the traditional loan to value ratio - which provide establish loan sizing and structuring. For instance, prudent lending practice dictates that a construction loan should be capped at the cost of construction excluding land; however, in the last cycle, many non-recourse permanent loans were made based on appraised values far exceeded replacement cost which has increased the exposure to risk above which is prudent for commercial lenders: Permanent financing sizing should also be capped at replacement cost.
The objectively-created cash flow forecast used in an appraisal provides lenders with a timeline for potential default events like tenant rollover or major capital improvements or replacements enabling the loan officer to structure the loan with appropriate rollover and capital reserves. Further, the lender can determine a property’s ability to cover debt over the anticipated loan term and size the loan using a debt coverage ratio-based mortgage payment reflecting the minimum cash flow generated after unreserved leasing and capital costs including lost rent during rollover.
If an appraisal is being conducted for purposes of a loan application, the cash flow forecast should be for a minimum term of the loan plus at least two years. This timeframe allows a lender to fully evaluate the risk of default at maturity that may result from a major tenant rolling over immediately subsequent to the proposed loan maturity. Further, the lender can structure the loan with appropriate reserves and shorter amortization term to reduce the balance to reduce the default risk to an acceptable level.
It is clear from the impact escalating market value of commercial real estate based on unrestrained market liquidity and investor demand that the 20th Century valuation methods embraced by the Appraisal Institute and the financial community leads to ever escalating values in boom periods and draconian values in recessionary periods does not provide a prudent basis for loan sizing and structuring.
New loans, and loans to be restructured, need to reflect the property-specific risks of the collateral as reflected in an appraisal that appropriately reflects the cash flow characteristics of the property and the risks and returns of ownership.
- For instance, the interest rate and loan sizing parameter, loan to value ratio, would be influenced by the credit risk in the property’s tenancy and lease tenure, or rollover risk in the rent roll.
- The physical reserves would be structured to provide fro un-depreciated replacement cost in the year the expenditure is expected to occur as, ideally, the reserve and capital expenditure forecast would be obtained from a current property condition report.
The considerations in establishing the size and terms of a commercial mortgage loan extend far beyond loan to value and debt service coverage ratios – and it is time for mortgage lenders to fully utilize the information in the appraisal to minimize default risk.
Conclusion
The objective of policy-makers, regulators and bankers in the wake of the Great Recession is to provide prudently underwritten loans to qualified borrowers which will serve to eliminate, or at least moderate, market bubbles. Updating the appraisal methodology to reflect anticipated property performance is one of the first places to start. It is clear that the traditional approaches to estimate market value do not result in a value estimate appropriate for prudent loan underwriting and sizing.
My prediction is that issues involving collateral and collateral value will be at the forefront of financial and real estate industry concerns as we reach for the new economic paradigm. While traditional appraisals and broker’s price opinions will provide financial institutions a value benchmark, they will not provide the basis for the new economy.
It is time for the Appraisal Institute to effect a paradigm shift in the appraisal process of a commercial property – it is time for valuation methodology and loan underwriting to enter the 21st Century!
This is my first eblast this year but it is not my first post to my blog. I welcome your comments and opinions and look forward to continuing the dialogue.
We know real estate and we understand commercial mortgages - let me know if we can be of service.
Best regards,
Paul Jones, CPA, CRE, FRICS
* NOTE: All definitions are from The Dictionary of Real Estate Appraisal, Fourth Edition, Appraisal Institute, 2002.
Friday, January 15, 2010
Rule Makers Remove CMBS Market's Accounting Linchpin
Until now, issuers of CMBS bonds would assemble a pool of mortgages and then create a Qualified Special Purpose Entity (QSPE), usually a trust, which would then issue bonds and sell them to investors in order to "buy" the loans from the issuer. The sub-institutional rated bonds and the first-loss position, or non-rated bonds, were sold to a "B-piece" buyer who typically acts as special servicer and has ultimate control of the disposition of the mortgages.
Qualifying special-purpose entities (QSPEs) generally are off-balance-sheet entities that are exempt from consolidation. The new standard eliminates that exemption from consolidation. Many qualifying special-purpose entities that currently are off balance sheet will become subject to the revised consolidation guidance in the proposal on consolidations of variable interest entities.
The new standard requires a company to provide additional disclosures about all of its continuing involvements with transferred financial assets. Continuing involvement can take many forms—for example, recourse or guarantee arrangements, servicing arrangements, and providing certain derivative instruments. The new standard also requires a company to provide expanded disclosures about its continuing involvement until it has no continuing involvement in the transferred financial assets. A company will also need to provide additional information about transaction gains and losses resulting from transfers of financial assets during a reporting period.
It is the B-piece buyer who is severaly impacted by this new accounting rule as they will now have to record the full face value of the mortgages and related bonds as assets and liabilities on their balance sheets which will make B-piece investing unattractive.
So, in the event of a CMBS issuance, who will now buy the B-piece? The bottom line: If there are no buyers, there can be no CMBS!
And because this affects all legacy deals, what happens to the existing pool of B-piece buyers?
Following is an artcle that appeared in this morning's CREDirect.com.....for your edification.
Rule Makers Remove CMBS Market's Accounting Linchpin
Thursday, 14 January 2010
By John Covaleski, Commercial Real Estate Direct Staff Writer
A new accounting rule that requires B-piece buyers of CMBS loans to record on their balance sheets the entire value of the bonds they handle has taken effect.
The Financial Accounting Standards Board, or FASB, has formally codified its FAS 167 standard, which eliminates qualifying special-purpose entities, or QSPEs, an accounting concept that's been the linchpin for CMBS.
The QSPEs allowed controlling-class investors to buy bonds from transactions without having to book the entire deals on their balance sheets. That in turn has enabled bond issuers to sell, for accounting purposes, the loans that they packaged into CMBS. They otherwise would have to carry the bonds' entire value on their books.
FAS 167, which also sets new reporting rules for the securitization of other types of assets, applies to existing CMBS as well as new issues. An overview of the rule is available on FASB's Web site.
It foists the responsibility to record CMBS bonds' total values on their controlling class investors or other entities that receive significant fees for managing the bonds' performance.
Both those definitions apply to B-piece buyers.
The codified version of FAS 167 is virtually identical to what FASB proposed last summer, stoking widespread fear that CMBS issuance and management would be severely crippled.
The new rule means that a B-piece buyer of a bond consisting of hundreds of millions or billions of dollars worth of loans would have to record the bond's entire value on its balance sheet, even though it may only own a stake worth say 2-3 percent of that value.
"This issue has not changed since last summer. QSPEs are gone," said Tom Barbieri, a partner in the assurance services practice of accounting firm PricewaterhouseCoopers.
FASB, the accounting rule maker for the United States, had been considering reining in CMBS issuers' user of QSPEs ever since the Enron accounting scandal. The credit crisis that began in 2007 heated regulatory interest in the issue this go-round.
The rule technically took effect Jan. 1 for companies that report by calendar years, and the first fiscal year beginning after Nov. 15, 2009, for all other companies.
"For the most part, issuers are in a discovery process to see what's going to have to go on their balance sheets. We have yet to see a lot of discussion of how they will deal with the rule," Barbieri said.
Loopholes could emerge from the rule's later interpretations. Barbieri said there could theoretically be cases in which a servicer's stake in a bond is too small and the performance-based component of its fees too small to consider it a controlling investor.
To be sure, he said those cases would be rare and that the SEC will closely monitor the management of CMBS deals for changes made to sidestep FAS 167.
The rule may also be modified somewhat in negotiations that FASB is having with the International Accounting Standards Board regarding converging their respective rules. FASB has deferred money market funds from having to meet the FAS 167 rules until after the convergence project is completed later this year.
Meanwhile, the rule is expected to be a major and costly accounting headache for CMBS B-piece buyers. Rick Jones, chairman of the Commercial Mortgage Securities Association's political action committee, last summer noted, "It will be extremely expensive to meet these reporting standards and it will not make financial statements more understandable."
The FDIC last month issued its own rule that gives banks a year to phase in their implementation of FAS 167 so they can meet the agency's risk-based capital standards.
Qualifying special-purpose entities (QSPEs) generally are off-balance-sheet entities that are exempt from consolidation. The new standard eliminates that exemption from consolidation. Many qualifying special-purpose entities that currently are off balance sheet will become subject to the revised consolidation guidance in the proposal on consolidations of variable interest entities.
The new standard requires a company to provide additional disclosures about all of its continuing involvements with transferred financial assets. Continuing involvement can take many forms—for example, recourse or guarantee arrangements, servicing arrangements, and providing certain derivative instruments. The new standard also requires a company to provide expanded disclosures about its continuing involvement until it has no continuing involvement in the transferred financial assets. A company will also need to provide additional information about transaction gains and losses resulting from transfers of financial assets during a reporting period.
It is the B-piece buyer who is severaly impacted by this new accounting rule as they will now have to record the full face value of the mortgages and related bonds as assets and liabilities on their balance sheets which will make B-piece investing unattractive.
So, in the event of a CMBS issuance, who will now buy the B-piece? The bottom line: If there are no buyers, there can be no CMBS!
And because this affects all legacy deals, what happens to the existing pool of B-piece buyers?
Following is an artcle that appeared in this morning's CREDirect.com.....for your edification.
Rule Makers Remove CMBS Market's Accounting Linchpin
Thursday, 14 January 2010
By John Covaleski, Commercial Real Estate Direct Staff Writer
A new accounting rule that requires B-piece buyers of CMBS loans to record on their balance sheets the entire value of the bonds they handle has taken effect.
The Financial Accounting Standards Board, or FASB, has formally codified its FAS 167 standard, which eliminates qualifying special-purpose entities, or QSPEs, an accounting concept that's been the linchpin for CMBS.
The QSPEs allowed controlling-class investors to buy bonds from transactions without having to book the entire deals on their balance sheets. That in turn has enabled bond issuers to sell, for accounting purposes, the loans that they packaged into CMBS. They otherwise would have to carry the bonds' entire value on their books.
FAS 167, which also sets new reporting rules for the securitization of other types of assets, applies to existing CMBS as well as new issues. An overview of the rule is available on FASB's Web site.
It foists the responsibility to record CMBS bonds' total values on their controlling class investors or other entities that receive significant fees for managing the bonds' performance.
Both those definitions apply to B-piece buyers.
The codified version of FAS 167 is virtually identical to what FASB proposed last summer, stoking widespread fear that CMBS issuance and management would be severely crippled.
The new rule means that a B-piece buyer of a bond consisting of hundreds of millions or billions of dollars worth of loans would have to record the bond's entire value on its balance sheet, even though it may only own a stake worth say 2-3 percent of that value.
"This issue has not changed since last summer. QSPEs are gone," said Tom Barbieri, a partner in the assurance services practice of accounting firm PricewaterhouseCoopers.
FASB, the accounting rule maker for the United States, had been considering reining in CMBS issuers' user of QSPEs ever since the Enron accounting scandal. The credit crisis that began in 2007 heated regulatory interest in the issue this go-round.
The rule technically took effect Jan. 1 for companies that report by calendar years, and the first fiscal year beginning after Nov. 15, 2009, for all other companies.
"For the most part, issuers are in a discovery process to see what's going to have to go on their balance sheets. We have yet to see a lot of discussion of how they will deal with the rule," Barbieri said.
Loopholes could emerge from the rule's later interpretations. Barbieri said there could theoretically be cases in which a servicer's stake in a bond is too small and the performance-based component of its fees too small to consider it a controlling investor.
To be sure, he said those cases would be rare and that the SEC will closely monitor the management of CMBS deals for changes made to sidestep FAS 167.
The rule may also be modified somewhat in negotiations that FASB is having with the International Accounting Standards Board regarding converging their respective rules. FASB has deferred money market funds from having to meet the FAS 167 rules until after the convergence project is completed later this year.
Meanwhile, the rule is expected to be a major and costly accounting headache for CMBS B-piece buyers. Rick Jones, chairman of the Commercial Mortgage Securities Association's political action committee, last summer noted, "It will be extremely expensive to meet these reporting standards and it will not make financial statements more understandable."
The FDIC last month issued its own rule that gives banks a year to phase in their implementation of FAS 167 so they can meet the agency's risk-based capital standards.
Thursday, January 14, 2010
Fed issues Beige Book Survey Finds Continued Weakness in Commercial Real Estate
Reviewing the Beige Book gives an indication of the economy and, especially, the Fed's viewpoint on it....It should be good reading for all....
Fed Survey Finds Continued Weakness in Commercial Real Estate
Wednesday, 13 January 2010
Commercial Real Estate Direct Staff Report
Commercial real estate remains weak throughout the country, according to the Federal Reserve's beige book survey of its 12 districts.
The Fed, which surveys its district offices eight times a year and reports its findings in what is commonly referred to as its Beige Book, said conditions in non-residential markets in each of its districts "remained soft," with some district offices, namely New York, Philadelphia, Kansas City and San Francisco, reporting declines in demand for commercial and industrial space. The bank's Richmond, Va., district office reported that leasing of office and retail space appeared to have "picked up."
But as data from various providers has shown, vacancy rates have continued to climb, while rents have fallen across the board. The Fed noted that some of its district offices had reported that tenants were now able to extend existing leases at low rents and with allowances as property owners strived to retain their tenants.
The Fed said that economic conditions overall had "improved modestly," but remained at low levels.
For a copy of the full report, go to: http://www.federalreserve.gov/FOMC/BeigeBook/2010/20100113/fullreport20100113.pdf
Fed Survey Finds Continued Weakness in Commercial Real Estate
Wednesday, 13 January 2010
Commercial Real Estate Direct Staff Report
Commercial real estate remains weak throughout the country, according to the Federal Reserve's beige book survey of its 12 districts.
The Fed, which surveys its district offices eight times a year and reports its findings in what is commonly referred to as its Beige Book, said conditions in non-residential markets in each of its districts "remained soft," with some district offices, namely New York, Philadelphia, Kansas City and San Francisco, reporting declines in demand for commercial and industrial space. The bank's Richmond, Va., district office reported that leasing of office and retail space appeared to have "picked up."
But as data from various providers has shown, vacancy rates have continued to climb, while rents have fallen across the board. The Fed noted that some of its district offices had reported that tenants were now able to extend existing leases at low rents and with allowances as property owners strived to retain their tenants.
The Fed said that economic conditions overall had "improved modestly," but remained at low levels.
For a copy of the full report, go to: http://www.federalreserve.gov/FOMC/BeigeBook/2010/20100113/fullreport20100113.pdf
Monday, January 11, 2010
Fed: It's Time the Market Stands on its Own
It seems the fixed income securities arena as it relates to real estate needs to be through rehab by the end of the first quarter as the Fed is no longer going to be a crutch......I do not see how we will be ready but understand that it cannot last forever....The true test of the CMBS and RBS markets - especially the secondary market will occur once the Fed pulls out....Now is the time to adopt the Boy Scout credo and "Be prepared "
Fed: It's Time the Market Stands on its Own
April 1 will be the first day that the Federal Reserve will end its debt purchase program and allow the struggling U.S. mortgage market to operate unassisted. As a result, the Fed believes mortgage rates will rise about three-quarters of a percent to about 6 percent, Boston Fed President Eric Rosengren said Saturday.Fear of a worldwide perception that the U.S. government is simply printing money to use to purchase mortgage-related securities is a big reason the Fed has pulled back, analysts say. If that fear caused a sell-off of U.S. government bonds, it would push borrowing costs substantially higher and derail the economic recovery."We are still in uncharted waters," Fed Vice Chairman Donald Kohn said in an unrelated speech Saturday. "We will need to be flexible and adjust as we gain experience."Source: Reuters News, Pedro Nicolaci da Costa (01/08/2010)
Fed: It's Time the Market Stands on its Own
April 1 will be the first day that the Federal Reserve will end its debt purchase program and allow the struggling U.S. mortgage market to operate unassisted. As a result, the Fed believes mortgage rates will rise about three-quarters of a percent to about 6 percent, Boston Fed President Eric Rosengren said Saturday.Fear of a worldwide perception that the U.S. government is simply printing money to use to purchase mortgage-related securities is a big reason the Fed has pulled back, analysts say. If that fear caused a sell-off of U.S. government bonds, it would push borrowing costs substantially higher and derail the economic recovery."We are still in uncharted waters," Fed Vice Chairman Donald Kohn said in an unrelated speech Saturday. "We will need to be flexible and adjust as we gain experience."Source: Reuters News, Pedro Nicolaci da Costa (01/08/2010)
Tuesday, December 29, 2009
America's Route to Recovery
Continuing to look for solutions to the Great Recession, the report on America's Road to Recovery was released by Reuters today and it provides great insight into the way out of this economic morass as well as the life of the future which all of us, even us gray-beards, need to recognize for our own survival. The Reuters report is fairly long but worth reading.
On this occasion, may the new decade be good to you and your family!
SPECIAL REPORT-America's route to recovery
Tue 29 Dec, 2009
Reuters
(For the Reuters multimedia project Route to Recovery, a team of journalists toured America to examine the impact of the recession and posted their reports online. The following story is the last installment in the series that can be found at www.reuters.com/routetorecovery)
(To hear Nick Carey discuss the project on Reuters Insider TV please click on http://link.reuters.com/nec88g)
Successive bubbles masked underlying economic woes
Chasing smokestacks no longer the key to prosperity
Renewed focus on small business and education
By Nick Carey
YOUNGSTOWN, Ohio (Reuters) – When Bob Hagan was a boy people hereabouts equated the coke dust they swept off their doorsteps each day with opportunity, for it came from the steel mills that built this city.
After graduating from high school more than 40 years ago, Hagan worked briefly at one of the local steel mills that dominated the local economy. In 1971, he became a locomotive engineer at railroad company CSX Corp, switching rail cars in every mill and yard in the area over the years.
The job afforded him a ground-level view of the slow-moving disaster that would tear out Youngstown’s heart over the next decade and a half — as it did many other towns in America’s Rust Belt.
“In my rides through this valley on the train, I used to watch the fires of prosperity burn,” said Hagan, 60, an Ohio state representative since 1986 who still works for the railroad when not in session. “And then, years later, I watched the lights go out.”
On September 19, 1977 — remembered locally as Black Monday — Sheet & Tube Company laid off more than 4,000 workers in a single day. In the following years, the steel industry all but died here.
In hindsight, the big mistake was trying to save it.
“We have spent the past 20 to 25 years looking in the rearview mirror,” said Jay Williams, the city’s 38-year-old, independent mayor. “Letting go of the past has been difficult for many people because the past was so good.”
Today, the city immortalized by Bruce Springsteen’s 1995 Rust-Belt anthem “Youngstown” is moving on. Among other things, it has created an incubator to attract the types of small businesses that are expected to drive future growth. Despite the thousands of vacant homes that serve as reminders of a traumatic past and turbulent present, some business and civic leaders think this heartland city has a chance to lead the U.S. into its next era of prosperity.
Getting to there from here, however, won’t be easy — for Youngstown, for Ohio, for the nation.
BURST BUBBLES
Youngstown is an extreme but by no means unique case in America. On a basic level, it represents some of the challenges facing the country today in the wake of the longest and deepest downturn since the 1930s.
After two economic expansions based not on sustainable growth but on asset bubbles — the dotcom boom of the 1990s then the far more damaging housing mania this decade — longstanding problems have been brought into sharper focus.
Even during the recent good times, the U.S. manufacturing sector, the muscle behind U.S. post-war economic might, was buffeted as corporations shipped low-cost production overseas.
“The easy, blue-collar shot to the middle class is gone,” said Mike Rollins, president of the Austin Chamber of Commerce. “It’s going to take a lot more work to get there now.”
In short, the world’s largest economy is at a crossroads.
With a smaller manufacturing sector and a consumer base less able to keep leveraging future earnings, where will sustainable, long-term prosperity come from? And more immediately, where will jobs come from?
This is a debate that is taking place at the local level around the country, from Youngstown to El Centro, California, and many places in between. But it is also a discussion that few see taking place at the national political level.
“Washington just doesn’t get it,” said Shane Savage, a real estate agent in Pensacola, Florida, smoking a cigarette outside the home of a client who needs to sell fast in a down market. “It’s going to take a long time to fix the mess that we’re in and our politicians don’t have a clue how bad it really is out here.”
REINVENTING A NATION
Local politicians and businesses acknowledge that the answers to America’s primary problems have been long known.
The country has to get smarter and send more people to college, making it more able to compete in the global high-tech “knowledge economy” of the future. And America needs to keep attracting the world’s best and brightest to help it prosper.
Manufacturers must also continue moving up the value chain, switching to niche production that cannot be easily transferred to China or Mexico. In the future, the sector will involve fewer but more-educated workers.
Now civic and business leaders are looking closely at another part of the economic equation. After seeing the impact that the departure of large corporations can have, there is a renewed focus on fostering small businesses instead.
The reasons are simple: They create more jobs and can be more easily replaced if they leave.
According to the U.S. Small Business Administration, companies with fewer than 500 employees accounted for 64 percent of new jobs from 1993 to the third quarter of 2008.
Small firms also tend to be more involved in their local communities than major corporations.
“We have forgotten in this country that there is so much more to capitalism than just the exchange of goods and services,” said Amy Kedron, who runs Buffalo First, which sells books of coupons promoting businesses in this city at the far northern end of New York State. “It’s also about community.”
“And local businesses are the best at building communities,” she added, “because their owners are in it to make a living, not a killing.”
The other, not unrelated new focus is the “green” economy. Wind farms, solar panels and geothermal power plants will require someone to manufacture them, plus a trained workforce to run and maintain them. And if the private sector and government agree on anything, it’s that this industry must and will become increasingly relevant.
So at a time when critics have been quick to dismiss the U.S. economy as a has-been, some see the makings of an eventual if not immediate resurgence.
“America’s greatest ability has always been its capacity to reinvent itself,” said Diane Swonk, chief economist at Chicago-based financial services firm Mesirow Financial. “We may be able to emerge stronger and better, to the possible anger and envy of some parts of the world.”
But getting there will take a lot of time, effort and money in a nation not renowned for patience and long-term planning.
“Neither our political system nor our capital markets are used to anything but a short-term view, and fixing K through 12 is a long-term proposition,” Swonk said. “Not addressing the issue is an option we don’t have. There is a difficult decade ahead of us.”
The first step toward inventing the future, as Youngstown has found, is acknowledging that the past is gone.
“The thing we’re starting to understand is that the prosperity of the steel mills was the past,” Hagan said. “So let’s accept it and let’s move on into something that makes it even better.”
CASTLES BUILT ON SAND
What sets America’s current downturn apart from most past recessions is that the Great Recession has been national in scope. “Other recent recessions have been regional in nature,” says Swonk. “But this time, there is nowhere to hide.”
Data from the U.S. National Association of Realtors shows the median home price rose every year from 1989 to 2006 before the slide began in 2007. According to real estate website Zillow.com, as of the third quarter of this year 21 percent of all American homeowners owed more than their homes are worth. That equates to 12.4 million single-family homes with mortgages in negative equity, Zillow.com said.
Real estate gains have been a major source of wealth creation and class mobility, so the hangover from the recent binge is likely to prove more painful than usual.
“I keep telling people this is not a housing downturn,” said Al Muller, a partner at Pensacola, Florida-based Metro Market Trends Inc, which tracks real estate markets in Florida and Alabama. “We are in the middle of the bursting of the biggest real estate bubble in the history of this country.”
The wealth destruction in Florida, which along with California has been among the hardest hit by the property tailspin, has been staggering.
“In the years of easy credit we all thought that we had more money,” Muller said after flicking through a wad of papers that included the names and addresses of the 3,018 foreclosures for the first 10 months of 2009 in Escambia and Santa Rosa counties where Pensacola is located.
“The people in foreclosure could be your neighbors, your friends or you could go to church with them or work with them,” Muller said pointing to the papers with evident sadness.
“We all thought (in the boom) that we could live in a bigger house. But we never realized that we were not getting any wealthier… Now there’s simply less money everywhere.”
From its peak in 2005 to the second quarter of 2009, U.S. home equity fell 37 percent, or $4.7 trillion, according to the Federal Reserve. To put that into context, China’s economic output in 2008 totaled around $4.3 trillion.
By the second quarter of 2009, Americans’ total net worth had shrunk 17 percent or $10.7 trillion from its peak in 2007.
FEWER JOBS EVERYWHERE
As well as their money, many have lost jobs. Unemployment stood at 10 percent in November after hitting a recession high of 10.2 percent in October. More than 7 million Americans have become unemployed since the recession began in December 2007.
For areas like Wilmington, Ohio, the job losses involved a single major employer.
This town of 14,000 was home for two decades to express delivery company Airborne Express. In 2003, Airborne was bought by DHL, a unit of German post office operator Deutsche Post, which was looking to take on America’s homegrown package giants FedEx (FDX.N: Quote, Profile, Research) and UPS (UPS.N: Quote, Profile, Research) on their home turf.
After spending billions of dollars, DHL gave up and shut down its U.S. domestic operations in January of this year, with a cost of 9,500 jobs.
DHL was the biggest employer not just in Wilmington, but in the five surrounding counties. The shock waves are being felt in communities filled with people who were able to make a good living with relatively little education.
“I hate to say it, but you have to wonder whether in the long run it was a good thing having DHL and Airborne Express here,” said Katy Farber, president of the Chamber of Commerce in nearby Highland County.
Some 2,800 people out of a population of 42,000 in Highland County lost their jobs when DHL left. The county had Ohio’s highest unemployment rate in October — 15.9 percent. Unemployment in the area before DHL began ratcheting down operations in May 2008 had long been around 3 percent.
“For decades our children were able to make $50,000 to $60,000 a year throwing boxes without even a high school diploma,” Farber said. “We have to retrain our workforce because those jobs are gone.”
It’s a challenge to which Michigan, home of the automobile, has become accustomed.
“The hardest thing for many auto workers who’ve been doing the same job for 25 years or so to accept is that instantly, permanently, their standard of living has been ratcheted down 80 percent,” said Douglas Stites, chief executive of Capital Area Michigan Works, a career center in Lansing, Michigan. “You may have been making $25 an hour making widgets for years, but now your skill set means you’re worth $8 an hour.”
The center is a hive of activity, with people filing in to make job applications and sign up for retraining courses.
Stites recalls a group of Hmong men who turned up after being laid off at an auto supplier. Although they moved from Southeast Asia to America decades ago, their low-skilled jobs meant they never had to bother learning English.
“What do you tell people like that?” he said. “There is no way they’re ever going to be able to sustain the lifestyle they’ve become accustomed to.”
Accepting that many of the easy, high-paid jobs of the past are gone is the first step in a process that some communities have taken toward reinvention. Youngstown, for instance, spent many years looking for a way to revive the steel industry.
“We have had to embrace the fact that we are going to be different and there is no going back to where we were,” said Mayor Williams. “But being smaller can also be better.”
Part of Youngstown’s Plan 2010 strategy involves trying to revitalize neighborhoods that can be saved and — in a city with 4,500 vacant homes — letting go those that cannot.
“We are aiming to focus on the neighborhoods that can be saved,” said Phil Kidd, a community organizer at the nonprofit group Mahoning Valley Organizing Collaborative. “But we have to accept the fact that we are going to have to wind down some neighborhoods gracefully.”
From a peak of 28.3 percent in 1953, manufacturing’s share of U.S. Gross Domestic Product fell to 11.5 percent in 2008.
Much of that decline in the recent past has been due to production moving overseas to developing nations like China or across the U.S. southern border into Mexico.
This is a source of frustration and anger for workers like the 1,100 former employees at the Whirlpool (WHR.N: Quote, Profile, Research) refrigerator plant in Evansville, Indiana, which has said it will shut in 2010 as the company shifts production to Mexico.
“It was like a punch in the gut,” said Natalie Ford, 42, of the announcement in August. Ford worked at the plant for nearly 19 years, while her husband Jim, 47, counts 18 years there.
“After all we have done for Whirlpool, I feel like we’ve been betrayed,” she added, her eyes misting over.
A NEW REVOLUTION
Leslie Taito is executive director of Rhode Island Manufacturing Extension Services (RIMES), a nonprofit that provides consultation for small and medium-sized manufacturers in Rhode Island, a state of 1 million people.
Rhode Island was the home of America’s first mechanized cotton mill, but since Taito arrived 16 years ago, the number of manufacturers here has fallen to 1,945 from 2,800. Still, she believes that all of those that are left can be helped to survive and thrive — and the best way is to get smart and not try to compete with low-cost Chinese producers.
“Manufacturers have to specialize and find a niche where they develop high-end goods that are not sold just based on cost,” Taito said. “Sure, China can make it cheaper than we can,” she said, while weaving in and out of traffic en route through the heart of Providence. “But what they don’t have is the design or engineering capabilities that we do.”
One of the companies that RIMES has worked with in the past is Pawtucket-based Blow Molded Specialties, which makes products from hot plastic that is blown into molds where it sets. Its clients are predominantly in the healthcare sector.
President and majority owner Tom Boyd describes how the company’s largest customer switched production of a basic product to Mexico because it could be made there for 2 cents apiece instead of 8 cents in the United States.
That company had accounted for some 35 percent of business. “That was nearly the end of us,” Boyd said with a wry smile.
So instead of trying to compete on low-cost products, Boyd’s company specializes in high-end, complicated and intricate products, and even develops products for customers.
In the company’s meeting room, he shows off some of the firm’s products including one which looks almost like a plastic accordion and is about the same size, with evident pride.
This, he explains is a plastic bellows his firm developed for a healthcare company, whose name he says he cannot divulge. It has a special function. Conventional practice in organ transplants has been to ship organs on ice. But Boyd says it has been found that a better way to ship organs is to keep them functioning, and the bellows he holds in his hands is part of a device to keep a set of lungs pumping while in transit.
Asked how much Blow Molded charges for a pump like this, Boyd shrugs his slight shoulders. “Maybe a few dollars each. And we only sold a few of them.”
But then he leans forward with right eyebrow and right forefinger raised. “Ah, but you see, the money’s not in the product,” he said, his grin widening. “The money’s in the engineering. We bill our customers for the development work we do.”
Communities around the country say they want to attract small firms like Blow Molded rather than focus on major corporations, for the simple reason that when a giant plant shuts down, it is almost impossible to replace the jobs lost.
The classic example is Wilmington, Ohio, where empty store fronts on Main Street are grim testimony to what happened when DHL axed nearly 10,000 jobs.
“When a big company like that goes, it leaves a very large hole to fill,” said Mayor David Raizk (pronounced “risk.”)
“I’d rather see 200 small companies with 50 employees each than one big one,” he said. “You can lose one, two or even 10 of those and find a way to replace them. Big companies are great when they’re in town, but when they leave they devastate communities.”
One such small firm is Computer Technology Solutions Inc, the largest privately-held software firm in Alabama, which has added some 40 jobs this year and now employs 150 people. “If that’s what we can do in a recession, imagine how we can do when the economy improves,” said president Sanjay Singh.
CTS got its start in a business incubator run by the University of Alabama in Birmingham. Singh said that unlike big corporations — which tend to be bureaucratic, slow-moving and inclined to withhold responsibility from young employees — CTS gives its 20-something employees multimillion-dollar projects to run on their own.
“If you give young people responsibility, they deliver,” he said. “We don’t hang over our employees’ shoulders waiting for them to get things done, we just let them do it.”
GREEN ECONOMY A LONG HAUL
There are great expectations that alternative energy or the “green economy” will help move America forward.
According to Lisa Frantzis, managing director for energy at Navigant Consulting Inc, in 2009, 7,000 megawatts of wind power was installed in America with the creation of 70,000 jobs — 50,000 direct and indirect jobs, plus 20,000 service-related jobs. Solar power saw 300 megawatts installed with the creation of 60,000 jobs.
Jay Paidipati, a Navigant managing consultant who works with Frantzis, said because of the industry’s breadth and relative youth, it is hard to make forecasts. “I would feel comfortable saying that the number of green jobs will be in the millions,” he said. “Just how many millions, I don’t know.”
It will be years, however, before that potential is realized. One of the main problems is the mass of rules and regulations that make building plants a lengthy process.
Imperial County in southern California has hit on a novel way to get around red tape, using a provision of state law that allows local authorities to streamline the approval process for building a plant, as long as it is under 50 megawatts.
This loophole enables officials to handle the approval process in as little as a year, compared to several years at the state level.
“Getting anything done in California is hard,” said Imperial Valley Economic Development Corporation CEO Tim Kelley, at his office in El Centro some 100 miles (160 km) east of San Diego. “But it is less hard to get it done here.”
This area has 360 days of sun a year and has suitable geological conditions for geothermal power — there are 10 such plants already. Thirty others for solar, geothermal and wind facilities, are in the process of acquiring permits.
Red tape is not the only challenge.
Paul Rich is Chief Development Officer at Deepwater Wind LLC, which aims to develop America’s first offshore wind farm, in Rhode Island. The farm, which would eventually provide 15 percent of Rhode Island’s electricity, should come in two phases. The first test phase with six to eight turbines could be installed off the coast by 2012. By around 2015 the wind farm would contain around 100 wind turbines.
Rich described the coast between Maine and Maryland as the “Saudi Arabia of wind,” predicting an “enormous, exponential leap in jobs, manufacturing and infrastructure.”
Part of the reason for the long lead time is the need for extensive tests of local wind conditions, he said.
“It won’t happen overnight,” Rich said. “We are trying to create a truly new industry here and it has to be done right.”
“A far bigger concern for us is finding a qualified workforce to run and maintain the wind farm when it becomes operational.”
In blighted states like Michigan, many former manufacturing workers are already training for green jobs, even though relatively few have been created.
Matthew Derra, 41, lost his job at struggling auto supplier American Axle & Manufacturing Holdings Inc (AXL.N: Quote, Profile, Research) in July 2008. Now he is taking an associate degree in renewable energy and wants to find a job maintaining wind turbines.
“There’s nothing out there in my old field of work,” he said. “And there will be thousands of people out there chasing every green job, but I have to try.”
“I can’t just sit home and watch television.”
Even in California, which has America’s most aggressive climate change regulations, just 159,000 of the state’s 18 million jobs are considered “green” as of the start of 2008, according to public policy group Next 10.
Still, there are encouraging signs that money is flowing into renewable energy even in a sluggish economy.
Bill Gibson, is a business broker and principal of Gibson & Associates Inc in Pensacola, Florida. Gibson finds buyers for companies that want to sell.
He noted that companies selling luxury items are having trouble finding buyers because gun-shy banks won’t lend for that kind of investment, but he has noticed a lot more interest in renewable or alternative energy firms.
“There are definitely going to be haves and have-nots,” Gibson said. “Green energy is part of the future.”
The green energy industry is also seen as an opportunity for manufacturing firms to retool.
“What concerns me is when I hear people talking about manufacturing in the past tense,” said Virg Bernero, mayor of Lansing. “If we want wind turbines, someone here should manufacture them.”
GEEKS AT THE TABLE
Laurie White, president of the Greater Providence Chamber of Commerce, keeps a board covered in bad news — headlines from The New York Times, The Washington Post, The Boston Globe and The Economist about how badly the economy of the state has been faring. Rhode Island’s unemployment rate was 12.7 percent in November, the second highest in the country after Michigan.
“Our problems have made not just national but international headlines,” White said. “That motivates me to find a new way forward.”
Rhode Island is pinning its hopes on a strategy dubbed “Strengthening Providence’s Knowledge Economy.” It has involved bringing together local and state government, the Chamber of Commerce, the Rhode Island Economic Development Corporation (RIEDC) and hundreds of small hi-tech software companies.
“The geeks have finally been offered a seat at the table,” said business consultant Jack Templin.
White said there was an easy explanation: “The geeks are just about the only ones creating jobs right now.”
Companies like Working Planet, which handles algorithmic online market research for its clients, are now at the table.
“Up until a few years ago the chamber was focused on major companies and its existing membership base,” said Working Planet Marketing Group Inc president and co-founder Soren Ryherd. “Over the past three years the chamber has done an about face and is now also about the smaller companies that are creating jobs.”
“We have also become more organized because we need to reach the local universities so we can find and retain top talent,” he added.
Mike Saul is the interim executive director of the RIEDC and has spent much of his career as a “turnaround guy” taking poorly performing companies and making them thrive. He wants to do the same here, in part because three of his four children, like many of the state’s offspring, live outside Rhode Island because there was no work here for them.
“In any turnaround that is going to work you have to ask where is the enterprise value that I can push forward,” he said. According to Saul, the state’s education system and its wind potential create much of its enterprise value.
“Rhode Island’s attempts at economic development have been episodic in the past, but this time everyone is on the same page,” Saul said. “A crisis makes things happen. It helps individuals reinvent themselves and will help this country reinvent itself.”
‘CHASING SMOKESTACKS’
The idea of the “knowledge economy” is a common thread in different parts of America.
Commercializing research and leveraging highly-qualified university students, plus helping create small businesses via incubators has become a major focus in many communities.
The University of Alabama at Birmingham, for instance, has an incubator called the Innovation Depot, which provides low-cost space and resources for small startup firms. The incubator is currently home to around 70 small companies.
UAB’s annual research budget of around $400 million is 80 percent focused on biomedical research, followed by engineering and the physical sciences.
Birmingham, like Youngstown, was once a steel town. The city’s population has dropped more than 30 percent to 230,000 from 340,000 in 1960 and it has focused too frequently on trying to lure back big industry, according to Richard Marchese, vice president of research at UAB.
“The city has done its fair share of chasing smokestacks,” he said. “Birmingham has undergone an important adjustment by realizing that it needs to transform itself from an industrial based economy into an economy driven by innovation.”
Youngstown, like Birmingham, is betting part of its future on an incubator, the Youngstown Business Incubator, which has 28 business-to-business software firms in its portfolio with some 300 employees. The incubator occupies three renovated buildings in downtown Youngstown — which was mostly dead a few years ago — and will move into a fourth in 2010.
“We didn’t want to have a broad range of industries that we couldn’t serve properly,” said James Cossler, the incubator’s CEO. “We wanted to pick one sector and be a world class incubator… We picked software because it is in almost everything we use.”
One condition for startups to receive benefits and resources, including deferred and reduced rent and paid utilities for furnished offices, is they must share their expertise and resources with other member companies, even after they “graduate” and move out.
Craig Zamary owns Green Energy TV, which he describes as the “YouTube of the green movement.” It takes videos from around the world on innovations in alternative energy.
Zamary said that not long after Green Energy TV moved into the incubator in early 2008 he told a fellow business owner he was having trouble with code for his website. The next day the fellow business owner turned up with the code he needed.
“I was wondering what he was going to bill me for it, but he said ’That’s not how we do things around here,’” Zamary recounted. “Some day if he needs something from me I’ll be able to repay the favor.”
Cossler said office space in Youngstown’s incubator costs $8 per square foot compared to $200 in Silicon Valley, while “programming talent” costs about 60 percent more in California. There are also several universities within an hour’s drive, including Youngstown State University a few blocks away.
Cossler said criticism of the incubator — that it will not return Youngstown to its former size — has been misguided.
“We’re not going back to where we were,” he said. “Nothing can take us back and we have had to embrace the fact that we are going to be a smaller city.”
“But it’s absolutely realistic to expect that within a few years we could have 2,000 to 3,000 people employed here,” at the incubator or around it, he added. “This could be very powerful and very transformational for Youngstown.”
Youngstown’s Plan 2010 was developed by Youngstown State University in conjunction with the city and reflects a common thread between this city and other parts of the country like Rhode Island, Birmingham, or Austin, Texas, in that all of them have developed a strategy requiring cooperation between the authorities, local businesses and a local university.
MIND FACTORY
Unlike Youngstown, Birmingham or Rhode Island, Austin has had a business development strategy in place since the 1980s.
“We made a very clear and conscious decision that above all we were going to kowtow to the creative classes,” said Lee Cooke, a former mayor.
From food to music and entrepreneurial opportunities, Austin has focused on attracting creative people.
“It’s very simple. Creativity begets creativity,” said local state senator Kirk Watson.
Austin’s strategy has paid off. The city’s population has tripled to around 750,000 in 2009 from 250,000 in 1970. According to the U.S Bureau of Labor Statistics, the city of Austin had the highest level of job creation in America from 2003 to 2008. Private sector jobs overtook public sector ones — it is the Texas state capital — in the mid-1990s.
Austin has become known as a city of entrepreneurs — Michael Dell founded computer maker Dell Inc (DELL.O: Quote, Profile, Research) while studying at the University of Texas in 1984 — and has grown as people have flocked here looking for jobs.
While the inflow has slowed during the recession, the city is still a magnet for people like Norbert Wangnick. An entrepreneur who sold his niche recruitment firm in Germany at the peak of the market in 2007, Wangnick, 45, moved to Austin late in 2008. After a year off, he is looking to either invest in a company or start a new one.
“Austin has so much energy,” he said. “It’s a great place to be if you want to start a business.”
The city, which hosts the annual SXSW live music festival and considers itself a cultural oasis in Texas, is a strongly Democratic city in a Republican state. Former mayor Cooke, a Republican, said Austin’s political leanings are not in line with his own or the more conservative business establishment. But he added that this fact is irrelevant.
“The choices we have made concerning the economic future of this city transcend politics,” he said. “This is about everyone pulling together.”
Cooperating for the good of the community is something Cooke said is lacking at the national level in America.
“I’d like to get rid of all 535 politicians in Washington and get rid of all the politics of the last 75 years,” he said. “Washington is all about the politics of self-perpetuation, not doing what is right for the country.”
The cornerstone of Austin’s strategy is coordination among the city, businesses and its biggest asset — the University of Texas at Austin. With 50,000 students, it is one of the country’s largest universities and a research powerhouse — biomedical science, engineering, math, physical sciences. UT vice president for research Juan Sanchez estimates some 10 companies graduate from the university’s incubator every year.
Senator Watson said Austin’s fortunes have been a mixture of luck and the sense to capitalize on its “enterprise value.”
“We were lucky in that we weren’t like Detroit, we didn’t have an old industrial factory to protect,” he said. “In places like Detroit it’s understandable spending a lot of energy trying to save the old factory because it means jobs for local people. What we have here is UT.”
“UT is our mind factory.”
Watson describes that “mind factory” in largely industrial terms, even referring to students as “natural resources.”
Watson and Gary Farmer, chairman of Opportunity Austin — a regional economic development strategy — recall visiting Samsung Electronics Co Ltd <005930.ks> in South Korea in 2005 with UT’s Sanchez to persuade the world’s top maker of memory chips to choose Austin for a new semiconductor plant.
Watson and Farmer say a critical moment came when Sanchez informed Samsung executives that there were hundreds of Korean students at UT. In April 2006 Samsung said it would invest $3.5 billion in a plant here creating nearly 1,000 jobs.
“The authorities in Austin, the business community and the university have marched in step for a long time,” Sanchez said. “Much of this has been based on the recognition of UT’s potential.”
Sanchez said such recognition is growing in America.
“There is a growing understanding that intellectual capital is going to be at least as important as manufacturing and natural resources,” he said.
FIXING ‘K THROUGH 12’
Conversations with civic and business leaders around the country support that statement.
In Evansville, Indiana, while Mayor Jonathan Weinzapfel laments Whirlpool’s decision to move production abroad, the company’s decision to keep its research and development facility here is something he says the city can build on.
In cooperation with colleges like the University of Southern Indiana, Weinzapfel argues Evansville may be able to attract other R&D operations. “You have to find what your strengths are,” he said. “And you have play to those strengths.”
Locals around Bentonville, Arkansas — home to America’s biggest private employer Wal-Mart Stores Inc (WMT.N: Quote, Profile, Research) — say it is no coincidence that while Arkansas has one of America’s worst education systems, this local area’s school system is among the better performers.
“Walmart has provided a lot of support for the local school system,” said Jonathan Watson, pastor at the Bella Vista Assembly of God in nearby Bella Vista. “This is no accident, as Walmart uses the schools as a feeder system for providing well-educated future employees for its headquarters.”
According to Andreas Schleicher, the Paris-based head of the indicators and analysis division of the Organization for Economic Cooperation and Development (OECD) — a group of 30 mostly high-income, democratic nations — the problem with primary and secondary education in the United States, known as K through 12, is that it has been in suspended animation.
“For decades America has mostly been treading water while the rest of the world has been working hard to get ahead,” he said.
In 2007, some 78 percent of U.S. high school students graduated, slightly below the OECD average of 82 percent.
OECD data from the 1960s shows that 80 percent of American children graduated from high school then, compared to just 37 percent in South Korea. Now some 97 percent of South Korean children complete high school.
“America has been falling behind,” Schleicher said. “By the age of 15 a quarter of American students have problems with math and science, which foreshadows the problem many have completing high school.”
He added that although America spends more on education than many countries, its school systems are far more uneven in quality, particularly in inner cities. The graduation rate in some inner cities in America in 2008 was 50 percent or below.
“We’ve known about problems with America’s education system for the past four decades, but we haven’t had to deal with them,” said Mesirow Financial’s Swonk. “We were able to just stick under-educated people in factories and not worry about dealing with the problem. That is no longer an option.”
Sheldon Steinbach, a senior counsel in the postsecondary education practice at Washington-based law firm Dow Lohnes, said the United States has plenty of top-quality colleges and universities, but the problem does not lie there.
“As the old saying goes, if you put garbage in you get garbage out,” he said. “America’s K through 12 system has been broken for a long time and I am not sure if can be fixed because there are too many different authorities, federal, state and above all local, involved.”
UT’s Sanchez said if more young people make it to higher education, the pieces are in place for long-term growth.
As he notes, according to the OECD America still leads the way in research and development (R&D) spending. In 2007, the latest year for which data are available, America accounted for around 41 percent of R&D spending in the OECD. Japan was next with 26 percent. China’s R&D spending was equivalent to around 11 percent of the OECD total.
“It was not so long ago that China spent nothing on R&D,” Sanchez said. “Now they are a major power.”
“America is still clearly the global leader by a long way,” he added. “But we can’t afford to rest on our laurels.”
Two of the problems with the U.S. college system, however, are that it is expensive and too little is done to prepare school children to apply. State colleges and universities charge on average close to $20,000 a year, while some private institutions charge $30,000 to $50,000, Steinbach said.
David Kyvig, a distinguished research professor in the history department at Northern Illinois University, whose specialties include the Great Depression, notes that President Franklin D. Roosevelt’s New Deal in the 1930s helped but did not solve the country’s economic ills. World War Two lifted the economy thanks to massive government spending, funded by higher taxes. The U.S. government deficit stood at $10 billion in 1939 but hit $100 billion in 1944.
“The myth today is that Americans will never accept higher taxes,” Kyvig said. “But the deficit during the war was funded by higher taxes and Americans were willing to pay more because they knew it had to be done.”
He said that a large chunk of government spending went on the GI Bill — passed in 1944, it provided returning World War Two veterans with a college or vocational education.
“The GI Bill was the backbone of a quarter of a century of American prosperity and helped create America’s middle class,” Kyvig said. “It was not cheap, it cost an awful lot of money. But it paid off.”
Former Austin mayor Cooke, a Republican, agrees something like the GI Bill could help now.
“Americans will pay more in taxes if they know what they’re paying for,” he said.
In 2002 some 52 percent of high school graduates went on to tertiary education. That figure reached 62 percent in 2009 and is expected to hit 64 percent in 2010.
“We still have a long way to go,” said Opportunity Austin chairman Farmer, echoing state senator Watson’s analogy: “We need to develop a better pipeline for our mind factory.”
ATTRACTING THE BEST AND BRIGHTEST
The six-minute plus video that Mary Tribble prepared for the annual meeting of the Charlotte Chamber of Commerce is aimed at encouraging business to embrace another changing dynamic in the U.S. economy — immigration.
As technicians bustle about preparing for the meeting, Tribble plays the film, making a slightly nervous gesture that says “humor me, please.” A music video appears entitled ‘I see,’ featuring ordinary residents of Charlotte, many of them Asian, Hispanic or black.
“This is a major departure for the chamber,” said Tribble, owner of Tribble Creative Group, an event organizing firm. “The cast of this film does not reflect the composition of the audience that will see it.”
What she means is while those in the video are ethnically diverse, the audience will be almost entirely white.
“Charlotte has changed a lot over the past few decades and the people here need not just to be aware of that fact, they should embrace it,” she said. “If we embrace diversity, more people will come and keep our local economy growing.”
Charlotte saw its white, non-Hispanic population decline to 55.3 in 2008 percent from 70 percent in 1990. Its black population edged up to 28.7 percent from 26.3 percent during that period but its Asian population more than doubled to 3.9 percent and Hispanics soared to 10.2 percent from 1.3 percent.
It’s a similar story nationwide. In 1900 one in eight Americans was not white, by 2000 that number was one in four. Census Bureau projections put whites in the minority by 2050.
Immigration has become a hot button issue, especially when it comes to low-skilled Hispanic workers from south of the border. Critics complain these immigrants steal American jobs.
But many people warn against shutting the doors to newcomers, noting that a big part of America’s success has been its ability to attract the highly educated people who can contribute to future U.S. prosperity.
“The last generation of immigrants in has a tendency to want to close the door behind them,” said Swonk. “But if we descend further into populism we risk losing that ability.”
Since the al Qaeda attacks of Sept. 11, 2001, the visa process for foreign students has become tougher, and the system also makes it hard for many to stay after they graduate.
CTS’ Singh in Alabama describes himself as the “poster child” for what America has represented to the world.
Revealing a history he says he has preferred not to divulge over the years, Singh said he came to America in the mid-1980s as a college dropout from India. While flipping burgers for a living, a chance meeting with an academic who interrogated him about the courses he had taken in India led to an invitation to enroll in an MBA course at Georgia College & State University in Milledgeville, Georgia. After his MBA , he did consulting work for some large southern corporations.
“Here I was advising the CEOs of big companies two years after flipping burgers,” Singh said.
“The point being that with an education anything is possible in America.”
He said on recent visits to India he has talked to young, well-educated Indians who feel less inclined to come to America because of visa difficulties, plus growing employment opportunities closer to home as the Indian economy grows.
“America’s two biggest strengths have been its ability to reinvent itself and its ability to attract the best and brightest from around the world,” Singh said. “The moment that stops being the case, it’s over.”
DETERMINATION
There is no doubt the world’s largest economy faces a multitude of challenges. But many are convinced they can be overcome. The feeling among many Americans is that the United States must embrace what needs to be done and move forward.
In Youngstown, U.S. Congressman Tim Ryan believes that thanks to its software incubator and other local businesses, “this area could lead the recovery.”
State representative Bob Hagan — who watched this city stagger and fade as the steel mills left — is also convinced that Youngstown, and America, will emerge stronger.
“We can make a better future for our children,” he said. “But it won’t be quick, it won’t be easy and at times it will be painful.”
“We will get there. But we’re not there yet.”(Editing by Jim Impoco and Claudia Parsons)
On this occasion, may the new decade be good to you and your family!
SPECIAL REPORT-America's route to recovery
Tue 29 Dec, 2009
Reuters
(For the Reuters multimedia project Route to Recovery, a team of journalists toured America to examine the impact of the recession and posted their reports online. The following story is the last installment in the series that can be found at www.reuters.com/routetorecovery)
(To hear Nick Carey discuss the project on Reuters Insider TV please click on http://link.reuters.com/nec88g)
Successive bubbles masked underlying economic woes
Chasing smokestacks no longer the key to prosperity
Renewed focus on small business and education
By Nick Carey
YOUNGSTOWN, Ohio (Reuters) – When Bob Hagan was a boy people hereabouts equated the coke dust they swept off their doorsteps each day with opportunity, for it came from the steel mills that built this city.
After graduating from high school more than 40 years ago, Hagan worked briefly at one of the local steel mills that dominated the local economy. In 1971, he became a locomotive engineer at railroad company CSX Corp, switching rail cars in every mill and yard in the area over the years.
The job afforded him a ground-level view of the slow-moving disaster that would tear out Youngstown’s heart over the next decade and a half — as it did many other towns in America’s Rust Belt.
“In my rides through this valley on the train, I used to watch the fires of prosperity burn,” said Hagan, 60, an Ohio state representative since 1986 who still works for the railroad when not in session. “And then, years later, I watched the lights go out.”
On September 19, 1977 — remembered locally as Black Monday — Sheet & Tube Company laid off more than 4,000 workers in a single day. In the following years, the steel industry all but died here.
In hindsight, the big mistake was trying to save it.
“We have spent the past 20 to 25 years looking in the rearview mirror,” said Jay Williams, the city’s 38-year-old, independent mayor. “Letting go of the past has been difficult for many people because the past was so good.”
Today, the city immortalized by Bruce Springsteen’s 1995 Rust-Belt anthem “Youngstown” is moving on. Among other things, it has created an incubator to attract the types of small businesses that are expected to drive future growth. Despite the thousands of vacant homes that serve as reminders of a traumatic past and turbulent present, some business and civic leaders think this heartland city has a chance to lead the U.S. into its next era of prosperity.
Getting to there from here, however, won’t be easy — for Youngstown, for Ohio, for the nation.
BURST BUBBLES
Youngstown is an extreme but by no means unique case in America. On a basic level, it represents some of the challenges facing the country today in the wake of the longest and deepest downturn since the 1930s.
After two economic expansions based not on sustainable growth but on asset bubbles — the dotcom boom of the 1990s then the far more damaging housing mania this decade — longstanding problems have been brought into sharper focus.
Even during the recent good times, the U.S. manufacturing sector, the muscle behind U.S. post-war economic might, was buffeted as corporations shipped low-cost production overseas.
“The easy, blue-collar shot to the middle class is gone,” said Mike Rollins, president of the Austin Chamber of Commerce. “It’s going to take a lot more work to get there now.”
In short, the world’s largest economy is at a crossroads.
With a smaller manufacturing sector and a consumer base less able to keep leveraging future earnings, where will sustainable, long-term prosperity come from? And more immediately, where will jobs come from?
This is a debate that is taking place at the local level around the country, from Youngstown to El Centro, California, and many places in between. But it is also a discussion that few see taking place at the national political level.
“Washington just doesn’t get it,” said Shane Savage, a real estate agent in Pensacola, Florida, smoking a cigarette outside the home of a client who needs to sell fast in a down market. “It’s going to take a long time to fix the mess that we’re in and our politicians don’t have a clue how bad it really is out here.”
REINVENTING A NATION
Local politicians and businesses acknowledge that the answers to America’s primary problems have been long known.
The country has to get smarter and send more people to college, making it more able to compete in the global high-tech “knowledge economy” of the future. And America needs to keep attracting the world’s best and brightest to help it prosper.
Manufacturers must also continue moving up the value chain, switching to niche production that cannot be easily transferred to China or Mexico. In the future, the sector will involve fewer but more-educated workers.
Now civic and business leaders are looking closely at another part of the economic equation. After seeing the impact that the departure of large corporations can have, there is a renewed focus on fostering small businesses instead.
The reasons are simple: They create more jobs and can be more easily replaced if they leave.
According to the U.S. Small Business Administration, companies with fewer than 500 employees accounted for 64 percent of new jobs from 1993 to the third quarter of 2008.
Small firms also tend to be more involved in their local communities than major corporations.
“We have forgotten in this country that there is so much more to capitalism than just the exchange of goods and services,” said Amy Kedron, who runs Buffalo First, which sells books of coupons promoting businesses in this city at the far northern end of New York State. “It’s also about community.”
“And local businesses are the best at building communities,” she added, “because their owners are in it to make a living, not a killing.”
The other, not unrelated new focus is the “green” economy. Wind farms, solar panels and geothermal power plants will require someone to manufacture them, plus a trained workforce to run and maintain them. And if the private sector and government agree on anything, it’s that this industry must and will become increasingly relevant.
So at a time when critics have been quick to dismiss the U.S. economy as a has-been, some see the makings of an eventual if not immediate resurgence.
“America’s greatest ability has always been its capacity to reinvent itself,” said Diane Swonk, chief economist at Chicago-based financial services firm Mesirow Financial. “We may be able to emerge stronger and better, to the possible anger and envy of some parts of the world.”
But getting there will take a lot of time, effort and money in a nation not renowned for patience and long-term planning.
“Neither our political system nor our capital markets are used to anything but a short-term view, and fixing K through 12 is a long-term proposition,” Swonk said. “Not addressing the issue is an option we don’t have. There is a difficult decade ahead of us.”
The first step toward inventing the future, as Youngstown has found, is acknowledging that the past is gone.
“The thing we’re starting to understand is that the prosperity of the steel mills was the past,” Hagan said. “So let’s accept it and let’s move on into something that makes it even better.”
CASTLES BUILT ON SAND
What sets America’s current downturn apart from most past recessions is that the Great Recession has been national in scope. “Other recent recessions have been regional in nature,” says Swonk. “But this time, there is nowhere to hide.”
Data from the U.S. National Association of Realtors shows the median home price rose every year from 1989 to 2006 before the slide began in 2007. According to real estate website Zillow.com, as of the third quarter of this year 21 percent of all American homeowners owed more than their homes are worth. That equates to 12.4 million single-family homes with mortgages in negative equity, Zillow.com said.
Real estate gains have been a major source of wealth creation and class mobility, so the hangover from the recent binge is likely to prove more painful than usual.
“I keep telling people this is not a housing downturn,” said Al Muller, a partner at Pensacola, Florida-based Metro Market Trends Inc, which tracks real estate markets in Florida and Alabama. “We are in the middle of the bursting of the biggest real estate bubble in the history of this country.”
The wealth destruction in Florida, which along with California has been among the hardest hit by the property tailspin, has been staggering.
“In the years of easy credit we all thought that we had more money,” Muller said after flicking through a wad of papers that included the names and addresses of the 3,018 foreclosures for the first 10 months of 2009 in Escambia and Santa Rosa counties where Pensacola is located.
“The people in foreclosure could be your neighbors, your friends or you could go to church with them or work with them,” Muller said pointing to the papers with evident sadness.
“We all thought (in the boom) that we could live in a bigger house. But we never realized that we were not getting any wealthier… Now there’s simply less money everywhere.”
From its peak in 2005 to the second quarter of 2009, U.S. home equity fell 37 percent, or $4.7 trillion, according to the Federal Reserve. To put that into context, China’s economic output in 2008 totaled around $4.3 trillion.
By the second quarter of 2009, Americans’ total net worth had shrunk 17 percent or $10.7 trillion from its peak in 2007.
FEWER JOBS EVERYWHERE
As well as their money, many have lost jobs. Unemployment stood at 10 percent in November after hitting a recession high of 10.2 percent in October. More than 7 million Americans have become unemployed since the recession began in December 2007.
For areas like Wilmington, Ohio, the job losses involved a single major employer.
This town of 14,000 was home for two decades to express delivery company Airborne Express. In 2003, Airborne was bought by DHL, a unit of German post office operator Deutsche Post, which was looking to take on America’s homegrown package giants FedEx (FDX.N: Quote, Profile, Research) and UPS (UPS.N: Quote, Profile, Research) on their home turf.
After spending billions of dollars, DHL gave up and shut down its U.S. domestic operations in January of this year, with a cost of 9,500 jobs.
DHL was the biggest employer not just in Wilmington, but in the five surrounding counties. The shock waves are being felt in communities filled with people who were able to make a good living with relatively little education.
“I hate to say it, but you have to wonder whether in the long run it was a good thing having DHL and Airborne Express here,” said Katy Farber, president of the Chamber of Commerce in nearby Highland County.
Some 2,800 people out of a population of 42,000 in Highland County lost their jobs when DHL left. The county had Ohio’s highest unemployment rate in October — 15.9 percent. Unemployment in the area before DHL began ratcheting down operations in May 2008 had long been around 3 percent.
“For decades our children were able to make $50,000 to $60,000 a year throwing boxes without even a high school diploma,” Farber said. “We have to retrain our workforce because those jobs are gone.”
It’s a challenge to which Michigan, home of the automobile, has become accustomed.
“The hardest thing for many auto workers who’ve been doing the same job for 25 years or so to accept is that instantly, permanently, their standard of living has been ratcheted down 80 percent,” said Douglas Stites, chief executive of Capital Area Michigan Works, a career center in Lansing, Michigan. “You may have been making $25 an hour making widgets for years, but now your skill set means you’re worth $8 an hour.”
The center is a hive of activity, with people filing in to make job applications and sign up for retraining courses.
Stites recalls a group of Hmong men who turned up after being laid off at an auto supplier. Although they moved from Southeast Asia to America decades ago, their low-skilled jobs meant they never had to bother learning English.
“What do you tell people like that?” he said. “There is no way they’re ever going to be able to sustain the lifestyle they’ve become accustomed to.”
Accepting that many of the easy, high-paid jobs of the past are gone is the first step in a process that some communities have taken toward reinvention. Youngstown, for instance, spent many years looking for a way to revive the steel industry.
“We have had to embrace the fact that we are going to be different and there is no going back to where we were,” said Mayor Williams. “But being smaller can also be better.”
Part of Youngstown’s Plan 2010 strategy involves trying to revitalize neighborhoods that can be saved and — in a city with 4,500 vacant homes — letting go those that cannot.
“We are aiming to focus on the neighborhoods that can be saved,” said Phil Kidd, a community organizer at the nonprofit group Mahoning Valley Organizing Collaborative. “But we have to accept the fact that we are going to have to wind down some neighborhoods gracefully.”
From a peak of 28.3 percent in 1953, manufacturing’s share of U.S. Gross Domestic Product fell to 11.5 percent in 2008.
Much of that decline in the recent past has been due to production moving overseas to developing nations like China or across the U.S. southern border into Mexico.
This is a source of frustration and anger for workers like the 1,100 former employees at the Whirlpool (WHR.N: Quote, Profile, Research) refrigerator plant in Evansville, Indiana, which has said it will shut in 2010 as the company shifts production to Mexico.
“It was like a punch in the gut,” said Natalie Ford, 42, of the announcement in August. Ford worked at the plant for nearly 19 years, while her husband Jim, 47, counts 18 years there.
“After all we have done for Whirlpool, I feel like we’ve been betrayed,” she added, her eyes misting over.
A NEW REVOLUTION
Leslie Taito is executive director of Rhode Island Manufacturing Extension Services (RIMES), a nonprofit that provides consultation for small and medium-sized manufacturers in Rhode Island, a state of 1 million people.
Rhode Island was the home of America’s first mechanized cotton mill, but since Taito arrived 16 years ago, the number of manufacturers here has fallen to 1,945 from 2,800. Still, she believes that all of those that are left can be helped to survive and thrive — and the best way is to get smart and not try to compete with low-cost Chinese producers.
“Manufacturers have to specialize and find a niche where they develop high-end goods that are not sold just based on cost,” Taito said. “Sure, China can make it cheaper than we can,” she said, while weaving in and out of traffic en route through the heart of Providence. “But what they don’t have is the design or engineering capabilities that we do.”
One of the companies that RIMES has worked with in the past is Pawtucket-based Blow Molded Specialties, which makes products from hot plastic that is blown into molds where it sets. Its clients are predominantly in the healthcare sector.
President and majority owner Tom Boyd describes how the company’s largest customer switched production of a basic product to Mexico because it could be made there for 2 cents apiece instead of 8 cents in the United States.
That company had accounted for some 35 percent of business. “That was nearly the end of us,” Boyd said with a wry smile.
So instead of trying to compete on low-cost products, Boyd’s company specializes in high-end, complicated and intricate products, and even develops products for customers.
In the company’s meeting room, he shows off some of the firm’s products including one which looks almost like a plastic accordion and is about the same size, with evident pride.
This, he explains is a plastic bellows his firm developed for a healthcare company, whose name he says he cannot divulge. It has a special function. Conventional practice in organ transplants has been to ship organs on ice. But Boyd says it has been found that a better way to ship organs is to keep them functioning, and the bellows he holds in his hands is part of a device to keep a set of lungs pumping while in transit.
Asked how much Blow Molded charges for a pump like this, Boyd shrugs his slight shoulders. “Maybe a few dollars each. And we only sold a few of them.”
But then he leans forward with right eyebrow and right forefinger raised. “Ah, but you see, the money’s not in the product,” he said, his grin widening. “The money’s in the engineering. We bill our customers for the development work we do.”
Communities around the country say they want to attract small firms like Blow Molded rather than focus on major corporations, for the simple reason that when a giant plant shuts down, it is almost impossible to replace the jobs lost.
The classic example is Wilmington, Ohio, where empty store fronts on Main Street are grim testimony to what happened when DHL axed nearly 10,000 jobs.
“When a big company like that goes, it leaves a very large hole to fill,” said Mayor David Raizk (pronounced “risk.”)
“I’d rather see 200 small companies with 50 employees each than one big one,” he said. “You can lose one, two or even 10 of those and find a way to replace them. Big companies are great when they’re in town, but when they leave they devastate communities.”
One such small firm is Computer Technology Solutions Inc, the largest privately-held software firm in Alabama, which has added some 40 jobs this year and now employs 150 people. “If that’s what we can do in a recession, imagine how we can do when the economy improves,” said president Sanjay Singh.
CTS got its start in a business incubator run by the University of Alabama in Birmingham. Singh said that unlike big corporations — which tend to be bureaucratic, slow-moving and inclined to withhold responsibility from young employees — CTS gives its 20-something employees multimillion-dollar projects to run on their own.
“If you give young people responsibility, they deliver,” he said. “We don’t hang over our employees’ shoulders waiting for them to get things done, we just let them do it.”
GREEN ECONOMY A LONG HAUL
There are great expectations that alternative energy or the “green economy” will help move America forward.
According to Lisa Frantzis, managing director for energy at Navigant Consulting Inc, in 2009, 7,000 megawatts of wind power was installed in America with the creation of 70,000 jobs — 50,000 direct and indirect jobs, plus 20,000 service-related jobs. Solar power saw 300 megawatts installed with the creation of 60,000 jobs.
Jay Paidipati, a Navigant managing consultant who works with Frantzis, said because of the industry’s breadth and relative youth, it is hard to make forecasts. “I would feel comfortable saying that the number of green jobs will be in the millions,” he said. “Just how many millions, I don’t know.”
It will be years, however, before that potential is realized. One of the main problems is the mass of rules and regulations that make building plants a lengthy process.
Imperial County in southern California has hit on a novel way to get around red tape, using a provision of state law that allows local authorities to streamline the approval process for building a plant, as long as it is under 50 megawatts.
This loophole enables officials to handle the approval process in as little as a year, compared to several years at the state level.
“Getting anything done in California is hard,” said Imperial Valley Economic Development Corporation CEO Tim Kelley, at his office in El Centro some 100 miles (160 km) east of San Diego. “But it is less hard to get it done here.”
This area has 360 days of sun a year and has suitable geological conditions for geothermal power — there are 10 such plants already. Thirty others for solar, geothermal and wind facilities, are in the process of acquiring permits.
Red tape is not the only challenge.
Paul Rich is Chief Development Officer at Deepwater Wind LLC, which aims to develop America’s first offshore wind farm, in Rhode Island. The farm, which would eventually provide 15 percent of Rhode Island’s electricity, should come in two phases. The first test phase with six to eight turbines could be installed off the coast by 2012. By around 2015 the wind farm would contain around 100 wind turbines.
Rich described the coast between Maine and Maryland as the “Saudi Arabia of wind,” predicting an “enormous, exponential leap in jobs, manufacturing and infrastructure.”
Part of the reason for the long lead time is the need for extensive tests of local wind conditions, he said.
“It won’t happen overnight,” Rich said. “We are trying to create a truly new industry here and it has to be done right.”
“A far bigger concern for us is finding a qualified workforce to run and maintain the wind farm when it becomes operational.”
In blighted states like Michigan, many former manufacturing workers are already training for green jobs, even though relatively few have been created.
Matthew Derra, 41, lost his job at struggling auto supplier American Axle & Manufacturing Holdings Inc (AXL.N: Quote, Profile, Research) in July 2008. Now he is taking an associate degree in renewable energy and wants to find a job maintaining wind turbines.
“There’s nothing out there in my old field of work,” he said. “And there will be thousands of people out there chasing every green job, but I have to try.”
“I can’t just sit home and watch television.”
Even in California, which has America’s most aggressive climate change regulations, just 159,000 of the state’s 18 million jobs are considered “green” as of the start of 2008, according to public policy group Next 10.
Still, there are encouraging signs that money is flowing into renewable energy even in a sluggish economy.
Bill Gibson, is a business broker and principal of Gibson & Associates Inc in Pensacola, Florida. Gibson finds buyers for companies that want to sell.
He noted that companies selling luxury items are having trouble finding buyers because gun-shy banks won’t lend for that kind of investment, but he has noticed a lot more interest in renewable or alternative energy firms.
“There are definitely going to be haves and have-nots,” Gibson said. “Green energy is part of the future.”
The green energy industry is also seen as an opportunity for manufacturing firms to retool.
“What concerns me is when I hear people talking about manufacturing in the past tense,” said Virg Bernero, mayor of Lansing. “If we want wind turbines, someone here should manufacture them.”
GEEKS AT THE TABLE
Laurie White, president of the Greater Providence Chamber of Commerce, keeps a board covered in bad news — headlines from The New York Times, The Washington Post, The Boston Globe and The Economist about how badly the economy of the state has been faring. Rhode Island’s unemployment rate was 12.7 percent in November, the second highest in the country after Michigan.
“Our problems have made not just national but international headlines,” White said. “That motivates me to find a new way forward.”
Rhode Island is pinning its hopes on a strategy dubbed “Strengthening Providence’s Knowledge Economy.” It has involved bringing together local and state government, the Chamber of Commerce, the Rhode Island Economic Development Corporation (RIEDC) and hundreds of small hi-tech software companies.
“The geeks have finally been offered a seat at the table,” said business consultant Jack Templin.
White said there was an easy explanation: “The geeks are just about the only ones creating jobs right now.”
Companies like Working Planet, which handles algorithmic online market research for its clients, are now at the table.
“Up until a few years ago the chamber was focused on major companies and its existing membership base,” said Working Planet Marketing Group Inc president and co-founder Soren Ryherd. “Over the past three years the chamber has done an about face and is now also about the smaller companies that are creating jobs.”
“We have also become more organized because we need to reach the local universities so we can find and retain top talent,” he added.
Mike Saul is the interim executive director of the RIEDC and has spent much of his career as a “turnaround guy” taking poorly performing companies and making them thrive. He wants to do the same here, in part because three of his four children, like many of the state’s offspring, live outside Rhode Island because there was no work here for them.
“In any turnaround that is going to work you have to ask where is the enterprise value that I can push forward,” he said. According to Saul, the state’s education system and its wind potential create much of its enterprise value.
“Rhode Island’s attempts at economic development have been episodic in the past, but this time everyone is on the same page,” Saul said. “A crisis makes things happen. It helps individuals reinvent themselves and will help this country reinvent itself.”
‘CHASING SMOKESTACKS’
The idea of the “knowledge economy” is a common thread in different parts of America.
Commercializing research and leveraging highly-qualified university students, plus helping create small businesses via incubators has become a major focus in many communities.
The University of Alabama at Birmingham, for instance, has an incubator called the Innovation Depot, which provides low-cost space and resources for small startup firms. The incubator is currently home to around 70 small companies.
UAB’s annual research budget of around $400 million is 80 percent focused on biomedical research, followed by engineering and the physical sciences.
Birmingham, like Youngstown, was once a steel town. The city’s population has dropped more than 30 percent to 230,000 from 340,000 in 1960 and it has focused too frequently on trying to lure back big industry, according to Richard Marchese, vice president of research at UAB.
“The city has done its fair share of chasing smokestacks,” he said. “Birmingham has undergone an important adjustment by realizing that it needs to transform itself from an industrial based economy into an economy driven by innovation.”
Youngstown, like Birmingham, is betting part of its future on an incubator, the Youngstown Business Incubator, which has 28 business-to-business software firms in its portfolio with some 300 employees. The incubator occupies three renovated buildings in downtown Youngstown — which was mostly dead a few years ago — and will move into a fourth in 2010.
“We didn’t want to have a broad range of industries that we couldn’t serve properly,” said James Cossler, the incubator’s CEO. “We wanted to pick one sector and be a world class incubator… We picked software because it is in almost everything we use.”
One condition for startups to receive benefits and resources, including deferred and reduced rent and paid utilities for furnished offices, is they must share their expertise and resources with other member companies, even after they “graduate” and move out.
Craig Zamary owns Green Energy TV, which he describes as the “YouTube of the green movement.” It takes videos from around the world on innovations in alternative energy.
Zamary said that not long after Green Energy TV moved into the incubator in early 2008 he told a fellow business owner he was having trouble with code for his website. The next day the fellow business owner turned up with the code he needed.
“I was wondering what he was going to bill me for it, but he said ’That’s not how we do things around here,’” Zamary recounted. “Some day if he needs something from me I’ll be able to repay the favor.”
Cossler said office space in Youngstown’s incubator costs $8 per square foot compared to $200 in Silicon Valley, while “programming talent” costs about 60 percent more in California. There are also several universities within an hour’s drive, including Youngstown State University a few blocks away.
Cossler said criticism of the incubator — that it will not return Youngstown to its former size — has been misguided.
“We’re not going back to where we were,” he said. “Nothing can take us back and we have had to embrace the fact that we are going to be a smaller city.”
“But it’s absolutely realistic to expect that within a few years we could have 2,000 to 3,000 people employed here,” at the incubator or around it, he added. “This could be very powerful and very transformational for Youngstown.”
Youngstown’s Plan 2010 was developed by Youngstown State University in conjunction with the city and reflects a common thread between this city and other parts of the country like Rhode Island, Birmingham, or Austin, Texas, in that all of them have developed a strategy requiring cooperation between the authorities, local businesses and a local university.
MIND FACTORY
Unlike Youngstown, Birmingham or Rhode Island, Austin has had a business development strategy in place since the 1980s.
“We made a very clear and conscious decision that above all we were going to kowtow to the creative classes,” said Lee Cooke, a former mayor.
From food to music and entrepreneurial opportunities, Austin has focused on attracting creative people.
“It’s very simple. Creativity begets creativity,” said local state senator Kirk Watson.
Austin’s strategy has paid off. The city’s population has tripled to around 750,000 in 2009 from 250,000 in 1970. According to the U.S Bureau of Labor Statistics, the city of Austin had the highest level of job creation in America from 2003 to 2008. Private sector jobs overtook public sector ones — it is the Texas state capital — in the mid-1990s.
Austin has become known as a city of entrepreneurs — Michael Dell founded computer maker Dell Inc (DELL.O: Quote, Profile, Research) while studying at the University of Texas in 1984 — and has grown as people have flocked here looking for jobs.
While the inflow has slowed during the recession, the city is still a magnet for people like Norbert Wangnick. An entrepreneur who sold his niche recruitment firm in Germany at the peak of the market in 2007, Wangnick, 45, moved to Austin late in 2008. After a year off, he is looking to either invest in a company or start a new one.
“Austin has so much energy,” he said. “It’s a great place to be if you want to start a business.”
The city, which hosts the annual SXSW live music festival and considers itself a cultural oasis in Texas, is a strongly Democratic city in a Republican state. Former mayor Cooke, a Republican, said Austin’s political leanings are not in line with his own or the more conservative business establishment. But he added that this fact is irrelevant.
“The choices we have made concerning the economic future of this city transcend politics,” he said. “This is about everyone pulling together.”
Cooperating for the good of the community is something Cooke said is lacking at the national level in America.
“I’d like to get rid of all 535 politicians in Washington and get rid of all the politics of the last 75 years,” he said. “Washington is all about the politics of self-perpetuation, not doing what is right for the country.”
The cornerstone of Austin’s strategy is coordination among the city, businesses and its biggest asset — the University of Texas at Austin. With 50,000 students, it is one of the country’s largest universities and a research powerhouse — biomedical science, engineering, math, physical sciences. UT vice president for research Juan Sanchez estimates some 10 companies graduate from the university’s incubator every year.
Senator Watson said Austin’s fortunes have been a mixture of luck and the sense to capitalize on its “enterprise value.”
“We were lucky in that we weren’t like Detroit, we didn’t have an old industrial factory to protect,” he said. “In places like Detroit it’s understandable spending a lot of energy trying to save the old factory because it means jobs for local people. What we have here is UT.”
“UT is our mind factory.”
Watson describes that “mind factory” in largely industrial terms, even referring to students as “natural resources.”
Watson and Gary Farmer, chairman of Opportunity Austin — a regional economic development strategy — recall visiting Samsung Electronics Co Ltd <005930.ks> in South Korea in 2005 with UT’s Sanchez to persuade the world’s top maker of memory chips to choose Austin for a new semiconductor plant.
Watson and Farmer say a critical moment came when Sanchez informed Samsung executives that there were hundreds of Korean students at UT. In April 2006 Samsung said it would invest $3.5 billion in a plant here creating nearly 1,000 jobs.
“The authorities in Austin, the business community and the university have marched in step for a long time,” Sanchez said. “Much of this has been based on the recognition of UT’s potential.”
Sanchez said such recognition is growing in America.
“There is a growing understanding that intellectual capital is going to be at least as important as manufacturing and natural resources,” he said.
FIXING ‘K THROUGH 12’
Conversations with civic and business leaders around the country support that statement.
In Evansville, Indiana, while Mayor Jonathan Weinzapfel laments Whirlpool’s decision to move production abroad, the company’s decision to keep its research and development facility here is something he says the city can build on.
In cooperation with colleges like the University of Southern Indiana, Weinzapfel argues Evansville may be able to attract other R&D operations. “You have to find what your strengths are,” he said. “And you have play to those strengths.”
Locals around Bentonville, Arkansas — home to America’s biggest private employer Wal-Mart Stores Inc (WMT.N: Quote, Profile, Research) — say it is no coincidence that while Arkansas has one of America’s worst education systems, this local area’s school system is among the better performers.
“Walmart has provided a lot of support for the local school system,” said Jonathan Watson, pastor at the Bella Vista Assembly of God in nearby Bella Vista. “This is no accident, as Walmart uses the schools as a feeder system for providing well-educated future employees for its headquarters.”
According to Andreas Schleicher, the Paris-based head of the indicators and analysis division of the Organization for Economic Cooperation and Development (OECD) — a group of 30 mostly high-income, democratic nations — the problem with primary and secondary education in the United States, known as K through 12, is that it has been in suspended animation.
“For decades America has mostly been treading water while the rest of the world has been working hard to get ahead,” he said.
In 2007, some 78 percent of U.S. high school students graduated, slightly below the OECD average of 82 percent.
OECD data from the 1960s shows that 80 percent of American children graduated from high school then, compared to just 37 percent in South Korea. Now some 97 percent of South Korean children complete high school.
“America has been falling behind,” Schleicher said. “By the age of 15 a quarter of American students have problems with math and science, which foreshadows the problem many have completing high school.”
He added that although America spends more on education than many countries, its school systems are far more uneven in quality, particularly in inner cities. The graduation rate in some inner cities in America in 2008 was 50 percent or below.
“We’ve known about problems with America’s education system for the past four decades, but we haven’t had to deal with them,” said Mesirow Financial’s Swonk. “We were able to just stick under-educated people in factories and not worry about dealing with the problem. That is no longer an option.”
Sheldon Steinbach, a senior counsel in the postsecondary education practice at Washington-based law firm Dow Lohnes, said the United States has plenty of top-quality colleges and universities, but the problem does not lie there.
“As the old saying goes, if you put garbage in you get garbage out,” he said. “America’s K through 12 system has been broken for a long time and I am not sure if can be fixed because there are too many different authorities, federal, state and above all local, involved.”
UT’s Sanchez said if more young people make it to higher education, the pieces are in place for long-term growth.
As he notes, according to the OECD America still leads the way in research and development (R&D) spending. In 2007, the latest year for which data are available, America accounted for around 41 percent of R&D spending in the OECD. Japan was next with 26 percent. China’s R&D spending was equivalent to around 11 percent of the OECD total.
“It was not so long ago that China spent nothing on R&D,” Sanchez said. “Now they are a major power.”
“America is still clearly the global leader by a long way,” he added. “But we can’t afford to rest on our laurels.”
Two of the problems with the U.S. college system, however, are that it is expensive and too little is done to prepare school children to apply. State colleges and universities charge on average close to $20,000 a year, while some private institutions charge $30,000 to $50,000, Steinbach said.
David Kyvig, a distinguished research professor in the history department at Northern Illinois University, whose specialties include the Great Depression, notes that President Franklin D. Roosevelt’s New Deal in the 1930s helped but did not solve the country’s economic ills. World War Two lifted the economy thanks to massive government spending, funded by higher taxes. The U.S. government deficit stood at $10 billion in 1939 but hit $100 billion in 1944.
“The myth today is that Americans will never accept higher taxes,” Kyvig said. “But the deficit during the war was funded by higher taxes and Americans were willing to pay more because they knew it had to be done.”
He said that a large chunk of government spending went on the GI Bill — passed in 1944, it provided returning World War Two veterans with a college or vocational education.
“The GI Bill was the backbone of a quarter of a century of American prosperity and helped create America’s middle class,” Kyvig said. “It was not cheap, it cost an awful lot of money. But it paid off.”
Former Austin mayor Cooke, a Republican, agrees something like the GI Bill could help now.
“Americans will pay more in taxes if they know what they’re paying for,” he said.
In 2002 some 52 percent of high school graduates went on to tertiary education. That figure reached 62 percent in 2009 and is expected to hit 64 percent in 2010.
“We still have a long way to go,” said Opportunity Austin chairman Farmer, echoing state senator Watson’s analogy: “We need to develop a better pipeline for our mind factory.”
ATTRACTING THE BEST AND BRIGHTEST
The six-minute plus video that Mary Tribble prepared for the annual meeting of the Charlotte Chamber of Commerce is aimed at encouraging business to embrace another changing dynamic in the U.S. economy — immigration.
As technicians bustle about preparing for the meeting, Tribble plays the film, making a slightly nervous gesture that says “humor me, please.” A music video appears entitled ‘I see,’ featuring ordinary residents of Charlotte, many of them Asian, Hispanic or black.
“This is a major departure for the chamber,” said Tribble, owner of Tribble Creative Group, an event organizing firm. “The cast of this film does not reflect the composition of the audience that will see it.”
What she means is while those in the video are ethnically diverse, the audience will be almost entirely white.
“Charlotte has changed a lot over the past few decades and the people here need not just to be aware of that fact, they should embrace it,” she said. “If we embrace diversity, more people will come and keep our local economy growing.”
Charlotte saw its white, non-Hispanic population decline to 55.3 in 2008 percent from 70 percent in 1990. Its black population edged up to 28.7 percent from 26.3 percent during that period but its Asian population more than doubled to 3.9 percent and Hispanics soared to 10.2 percent from 1.3 percent.
It’s a similar story nationwide. In 1900 one in eight Americans was not white, by 2000 that number was one in four. Census Bureau projections put whites in the minority by 2050.
Immigration has become a hot button issue, especially when it comes to low-skilled Hispanic workers from south of the border. Critics complain these immigrants steal American jobs.
But many people warn against shutting the doors to newcomers, noting that a big part of America’s success has been its ability to attract the highly educated people who can contribute to future U.S. prosperity.
“The last generation of immigrants in has a tendency to want to close the door behind them,” said Swonk. “But if we descend further into populism we risk losing that ability.”
Since the al Qaeda attacks of Sept. 11, 2001, the visa process for foreign students has become tougher, and the system also makes it hard for many to stay after they graduate.
CTS’ Singh in Alabama describes himself as the “poster child” for what America has represented to the world.
Revealing a history he says he has preferred not to divulge over the years, Singh said he came to America in the mid-1980s as a college dropout from India. While flipping burgers for a living, a chance meeting with an academic who interrogated him about the courses he had taken in India led to an invitation to enroll in an MBA course at Georgia College & State University in Milledgeville, Georgia. After his MBA , he did consulting work for some large southern corporations.
“Here I was advising the CEOs of big companies two years after flipping burgers,” Singh said.
“The point being that with an education anything is possible in America.”
He said on recent visits to India he has talked to young, well-educated Indians who feel less inclined to come to America because of visa difficulties, plus growing employment opportunities closer to home as the Indian economy grows.
“America’s two biggest strengths have been its ability to reinvent itself and its ability to attract the best and brightest from around the world,” Singh said. “The moment that stops being the case, it’s over.”
DETERMINATION
There is no doubt the world’s largest economy faces a multitude of challenges. But many are convinced they can be overcome. The feeling among many Americans is that the United States must embrace what needs to be done and move forward.
In Youngstown, U.S. Congressman Tim Ryan believes that thanks to its software incubator and other local businesses, “this area could lead the recovery.”
State representative Bob Hagan — who watched this city stagger and fade as the steel mills left — is also convinced that Youngstown, and America, will emerge stronger.
“We can make a better future for our children,” he said. “But it won’t be quick, it won’t be easy and at times it will be painful.”
“We will get there. But we’re not there yet.”(Editing by Jim Impoco and Claudia Parsons)
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