Lessons from Losses in Commercial Real Estate
LESSONS FROM LOSSES IN
COMMERCIAL REAL ESTATE
Errors that Lead to Significant Financial Losses
In Commercial Real Estate Investing and Lending
VERNON MARTIN
Lessons from Losses In
Commercial Real Estate
Vernon Martin
American Property Research
Los Angeles, California
©2010 Vernon Martin
4.26.2010
TABLE OF CONTENTS
PREFACE 4
CHAPTER ONE RELYING ON WRONG INFORMATION 8
SECTION 1.1 SELLER AND BORROWER MISREPRESENTATIONS 10
SECTION 1.2 WRONG CHOICE OF DATA 30
SECTION 1.3 BAD ADVICE 33
CHAPTER TWO ERRONEOUS METHODS OF ANALYSIS 47
SECTION 2.1 SUPPLY AND DEMAND ANALYSIS 47
SECTION 2.2 DISCOUNTED CASH FLOW ANALYSIS 53
SECTION 2.3 DEMOGRAPHIC ANALYSIS 70
SECTION 2.4 UNREALISTIC EXPECTATIONS 73
SECTION 2.5 ASSIGNING VALUE TO NONTRANSFERABLE RIGHTS 75
SECTION 2.6 ASSIGNING REAL PROPERTY VALUE TO PERSONAL PROPERTY 78
SECTION 2.7 CONFUSING REIT PERFORMANCE WITH COMMERCIAL REAL ESTATE PERFORMANCE 79
CHAPTER THREE LACK OF KNOWLEDGE 81
SECTION 3.1 Lack of geographic knowledge 81
SECTION 3.2 Lack of property knowledge 87
CHAPTER FOUR CONFLICTS OF INTEREST 95
CHAPTER FIVE ORGANIZATIONAL FAILURES 104
CHAPTER SIX INVESTMENT MANAGEMENT ERRORS 117
CHAPTER SEVEN PROFILES IN SPECTACULAR LOSSES 127
CHAPTER EIGHT POOR ASSET RECOVERY EFFORTS 131
EPILOGUE 135
REAL ESTATE TRANSACTION FRAUD PREVENTION CHECKLIST 137
ABOUT THE AUTHOR 139
Cartoons Pages 5, 7, 28. 29, 33, 68, 71, 74, 82, 107 and 122
PREFACE
This book will not make money, nor will my photo sit beside Donald Trump’s photo in an Airport Hilton ballroom, but some things just need to be said. Rather than being a roadmap to real estate riches, this book will only serve as a map of the potholes and the roadside bombs. The road to riches has been explained well enough by many others.
The primary goal here is to describe what has seldom been described elsewhere: a detailed analysis of the many different circumstances in which commercial real estate investors and lenders experience financial losses. It is not meant to discourage real estate investing or real estate lending, but to guide it. The premise of this book is how to avoid losing money in commercial real estate, as I attempt to catalog or classify the failures witnessed over a 26-year career, most of it working for the lending industry. As I present these errors and their examples, some readers may ask, “How could anyone have been so foolish?” to which I respond that these are all errors that were made or almost made by investors or lenders who should have known better.
This book is not about cost-cutting trivialities, but about fundamental errors in research, analysis, due diligence, investment management and placement of trust in others that can jeopardize a real estate investment. My focus will be on investment grade commercial real estate, but there are lessons to be learned about smaller properties and residences, too.
This book is not quite meant to be an academic textbook, although I will be recycling lecture material I have written for my own university students or has found its way on to other business school reading lists, including Wharton. Chapter Two will include analytical methods, including mathematical proofs to dispel certain misconceptions common in our industry. To understand these concepts, though, the highest level of math skill you will need is high school Algebra. If this still intimidates you, be comforted to know that Algebra has not changed any in our lifetimes.
I have been in a unique position to watch investors and lenders lose money in real estate over the last 26 years. Beginning my career as an appraiser and analyst at Jones Lang Wootton in Texas in 1984, at a time and place in which a commercial real estate mania was about to hit a brick wall, I got to meet glib real estate developers, lazy “institutional advisors”, dishonest real estate syndicators, brain-dead bankers, clueless appraisers and also a few people who knew and explained what was going on (not that things have changed much since then).
During the 1990s I held several management positions at Home Savings of America, then America’s largest savings and loan institution, and got to observe the entire lives of many failed commercial and residential loans. I had the opportunity to travel the nation to visit many failed assets and do post-mortem analyses, always asking “How could things have gone so wrong?” I effectively became a real estate and loan autopsist. I call that episode of my career, “CSI: Home Savings.”
I had a brief, thrilling, but disastrous run as the chief commercial appraiser at IndyMac Bank, where all the rules of prudent lending were thrown out by design. There are many lessons to be learned in that bank’s failure, extending all the way up to Board-level policymaking decisions. My previous Internet blog on my experience at IndyMac has been the most popular piece I have written, and I will include it in this book for both instructional and amusement purposes.
Most recently, I have spent the last eight years in the seamy world of private and “hard money” lenders serving as lenders of last resort for desperate property owners with desperate agendas. During this time, I have been cataloguing every trick used to deceive lenders while studying the subject of fraud, earning my CFE (Certified Fraud Examiner) credential in 2004.
Desperate borrower
This book is meant for:
· Experienced investors in commercial real estate
· Mortgage lenders seeking to minimize loan losses
· Secondary market investors wishing loan buy-backs from originating lenders
· Senior management and corporate boards seeking to improve institutional real estate investment or lending policies
· Government regulatory agencies
· Real estate appraisers, advisors and consultants who wish to improve the quality of their advice to clients, and
· Attorneys searching for the “smoking gun” in cases of real estate fraud or negligence.
I have organized the book into general categories in which real estate losses occur, which are:
1. Relying on wrong information
2. Errors in analysis
3. Lack of knowledge
4. Conflicts of interest
5. Failures in policymaking within institutions
6. Investment management errors
7. Poor asset recovery efforts
I could add the category, “Failures in due diligence”, but examples of such failures will be found in most of the other chapters.
Because I have spent the bulk of my career in the lending industry, I will particularly focus on mistakes often made by lenders.
Unlike a textbook, the chapters do not necessarily need to be read in order, nor the book read in entirety. Many topics will be independent of each other. The section on real estate syndications, for instance, might not have relevance to a lender who specializes in small commercial mortgage loans.
This book, because it is self-published, is also a work in progress, and I will be editing or updating it every one to two weeks while it is on my web site. For that reason, if readers want to send a copy to their colleagues, it would be better to refer the link to my web site than to download the .pdf document for redistribution. For the record, this e-book can presently be accessed at:
www.americanpropertyresearch.com/TheMartinBook
Please understand, too, that this is copyrighted material, even if I may have provided you with a complimentary copy. You may share it (but not sell it) with others, but please remember to acknowledge the source, which is:
Vernon Martin
American Property Research
Los Angeles, California
As for the reason to make this alpha online edition of my book complimentary, there is no profit potential in writing a book on how to lose money in real estate. The sales from a print edition would probably be less than the fee from one international consulting assignment. I have also observed that many real estate investors do not consider the possibility of error by themselves or their advisors, and the very ones who need to read this book are the very ones who would not buy it.
By using this free Internet edition to maximize readership, I also hope to get sufficient feedback to improve the book and make it even more useful, perhaps eventually justifying a print edition.
“Martin! Mr. Trump says that you’re pooping on the party and
he’s come here to personally fire you.”
CHAPTER ONE RELYING ON WRONG INFORMATION
“Wherever possible there must be independent confirmation of the ‘facts’”
--Carl Sagan, “The Fine Art of Baloney Detection”,
The Demon-Haunted World
In order to begin right in real estate investing or lending, one must first get the facts right.
Let us start with one fundamental truth about human nature. People lie.
Why do people lie? People lie to get what they want. Some of them want your money, your client’s money, your employer’s money, or the government’s money.
As a part-time academic, I am still waiting to see a Finance textbook that sufficiently discusses this fundamental flaw in human nature. It seems almost as if business school students are programmed to believe what they are told.
Here is a second fundamental truth: The real estate industry does not attract saints. It may attract sincere people, but mostly people who just sincerely want to become rich.
Sometimes, when a convicted mortgage broker is led from court in handcuffs, he or she may say, “But I was making the dream of homeownership a reality for people who would have never had the chance to live in their own home!” in a tone of voice so sanctimonious as to make one wonder why Mother Theresa wasn’t a mortgage broker, too, until one considers that people with bad credit who lie about income and assets might not actually deserve homeownership.
How can a liar be detected?
Most of my work is in advising hard money lenders. Sometimes I am asked, “How did you know the owner was lying?” as if I had the powers portrayed by Tim Roth on the “Lie to Me” television series. Although I have taken courses as a fraud examiner on visually detecting clues of deception, the simple truth is that I usually detect lies by taking the time to verify the information that is given. Looking for facial twitches and “panic blinking” is a poor substitute for simply doing your homework.
Although one cannot ordinarily conduct a polygraph examination of sellers or borrowers, I try to informally replicate the polygraph examiner’s methods by asking “calibrating questions” which establish a base level of honesty. For instance, having just inspected a cinema for appraisal purposes, I asked the borrower about the area of the footprint of the building, which he emphatically stated as 8500 square feet. I already had the assessor’s plat map indicating only 8180 square feet of site area, including a setback on one side, and I had previously measured the exterior dimensions of the building as 60 x 127 feet, indicating a footprint of only 7620 square feet. Thus I knew that I had an exaggerator on my hands.
To be facetious, another way to tell if a property owner is lying is to watch to see if his lips are moving.
The neglected art of verification
We live in an extraordinary time that is sometimes called “The Information Age”. More than ever before, we can verify facts with a few minutes of Internet research.
For example, a real estate developer claimed to have purchased some remote California mountain land for $30 million, but the purchase price was unpublished. In California, Proposition 13 directs county assessors to assess at market value upon sale; in most cases the purchase price is considered the market value. The new assessed value is then increased by 2% each year. In this instance, a quick Internet trip to assessor’s web sites indicated a total assessed value of less than $14 million two years after this reported purchase, suggesting that the land had been purchased for closer to $13 million. This fact may seem insignificant until one considers that the phony purchase price tricked an appraiser into valuing the mountain for $100 million.
A generation ago, such research would have required a time-consuming visit to a government office. Now it can be done in a matter of minutes by anyone with an Internet connection. You can hire college students to do this.
SECTION 1.1 SELLER AND BORROWER MISREPRESENTATIONS
Sometimes a property owner has a problem on his hands, but he would rather sweep it under the rug and find a sucker to buy him out (or refinance him with cash out) than to spend extra resources to solve the problem. Let us catalog some of the ways that these problems are misrepresented:
1. Misrepresentation of occupancy and tenancy
Sometimes it is hard for a property owner to misrepresent occupancy. Retail centers, for instance, tend to have large glass windows and merchants open for business during business hours. With mobile home parks, the unit is either there or not there. On the opposite end of the spectrum are large apartment buildings and hotels. A buyer or lender inspection needs to be much more careful to protect against deception about occupancy when there are many units which are not freely accessible and visible from the outside.
Sometimes it is not practical to fully inspect an apartment complex of several hundred units. In these cases, it is important for the buyer or inspector to be in control of the sample selection of the units to be inspected, so as not to be “steered”, and to select units in different sections of the property. By “steering”, I mean the practice of preventing access to units that have been misrepresented as to size, occupancy, or condition. As you verify that each tenant is there who is supposed to be there you will come to a point where you can be confident in the rent roll’s representation of occupancy and tenancy. But wait! There’s more!
It’s the rent, Stupid!
It is important to remember, though, that occupancy per se is not going to fill your pockets. Rental income is what will fill your pockets. That is why a property inspection should include some elements of rent verification when possible and some study of past rent rolls to better understand tenant histories.
In the financial performance of an income-producing property, moreover, a non-paying tenant is a worse drag on profit than a vacancy. At least the vacancy can be promptly filled without having to hire a lawyer.
Talk to the tenants
When I am inspecting a unit and a tenant is present, I like to ask “May I ask how much you are paying in rent?” Earlier in my career I was afraid to ask such questions in the presence of the landlord or manager for fear of offending them. When I started asking such questions, though, protests were rare, and I was sometimes finding myself surprised by the tenants’ answers, causing me chagrin in not adopting this questioning policy sooner.