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In Straight Talk From the Homebuilder CFO: The tricks builders use to disguise the true losses on their, the impairment game was discussed as a method of hiding losses on builders' balance sheets by taking impairments on what could be considered exaggerated book values. The exaggeration may not be that hard considering how far, how fast, and potentially how long property and land values can continue to fall.

Again, I refer to the comparative chart that shows the appreciation rate of Japan's major city real property values as their GDP started to ramp up and out of a major recession:

japanese_land_vs_gdp.jpg

This brings me to mind of what is actually going on in the CRE space now. As my regular readers know, I tend to actually analyze the portfolio of REITs by hand, which acts as a check and balance against overzealous reporting of book values that may or may not run in line with realistic market values. Upon performing this exercise with General Growth Properties, solvency issues became quite obvious during a time when most of the street still had a buy on this company ( see my work with GGP).

Well, I'm back to taking the forensic microscope to various companies' portfolios and it is interesting what can be found. Here, an institutional real estate owner describes a voluntary impairment of its asset in a recent 8K filing:

The Board’s decision considered that The Pier’s current cash flows, as well as estimates of future cash flows, are insufficient to cover debt service and operating costs due to economic conditions, tenant sales performance, high capital requirements to complete the property’s lease-up, high operating costs, and the anticipated refinancing shortfall at the loan’s maturity in May 2017. After recognizing the noncash impairment charge, representing the excess of book value of the investment over its estimated fair value, the consolidated joint venture’s remaining book value of the investment will be approximately $52 million. A default on this loan will not trigger any cross defaults on the Company’s lines of credit or any other indebtedness. The Company’s cash investment in The Pier is approximately $35 million.

The Company has concluded that the investment in Regency Square is also impaired based on current estimates of future cash flows and the expected holding period. After recognizing a non-cash charge in the range of approximately $55 million to $58 million, representing the excess of book value of the investment over its estimated fair value, the remaining book value of this investment is expected to be approximately $30 million. At the current level of cash flow, Regency Square intends to continue to service its non-recourse mortgage loan. This loan has a current principal balance of $74.5 million, with
$71.6 million due on this amortizing loan at its maturity in November 2011. On September 22, 2009, the Company issued a press release announcing the write down of the book value of The Pier and Regency Square to fair value.

This company has seen its share price rise despite these negative evens, and further analysis reveals that this is probably going to be necessary another 3 to 6 times over the coming quarters (or potentially 25% or so of their portfolio) - all on top of a rising share prices and what I see as a further deteriorating macro environment. The big question is, "Who is there to call this, or any other REIT, out on valuation issues?" The sell side has strong buys on the company and not one that I know of has bothered to seriously address the valuation of the portfolio. This is/was the case with GGP, and all of the other REITs that I have covered or are anticipating covering.

The underlined phrases above are instrumental in determining true value in the REIT portfolio. 100 LTV+ loans (in reality, any loan over 85 LTV in the CRE space), negative cash flows and excessive vacancies are the banes of this industry of the next 12 or so quarters. Many loans that are underwater from a valuation perspective will be able to continue debt service, with the blessing of many (or most) banks making the ability to truly identify distress in these situations a bit more befuddled due to the government endorsed "extend and pretend" rules now in place. We have government complicity in the purposeful opacity of the values of mortgage assets (see the FDIC "Prudent Commercial Real Estate Loan Workouts" guidance issued Oct 30th, as reported by the WSJ: Banks Hasten to Adopt New Loan Rules and the new FDIC guidance that states performing loans "made to creditworthy borrowers" will not require write downs "solely because the value of the underlying collateral declined").

Now, keep in mind that although banks may not be calling these under water loans in, they are essentially under collateralized, or in some cases literally uncollateralized loans (any mezzanine level loans should be considered worthless in many of these deals). This changes the risk profile immensely, and if the graph above depicting the Japanese land values bears any semblence to what is to come in the US,  the pretending stance of the banks will simply lead to defaults with minimal or zero, if not negative recovery values. This may increasingly be the case in non-recourse situations when the borrower has tough decisions to make. Very much like the residential home owner and jingle mail, certain REITs may simply throw in the towel, which will leave the banks in a lurch, particularly since  they decided to ignore prudent lending practices by pretending the loan that shouldn't have been written now doesn't need to be called in when there is some value left in the term recovery value.