Thursday, 15 April 2010 15:44

Wall Street Real Estate Funds Lose Between 61% to 98% for Their Investors as They Rake in Fees!

To all of your pension funds, UHNW, foundations, and family offices, you have been fleeced. I am about to walk you through (for the second time) the deci-billion dollar donation to the Wall Street Bonus Pool!

The second line of my very first post on BoomBustBlog in September of 2007 warned of an impending commercial real estate crash. I then went on to warn of this crash in specific detail:

More GGP Research

I shorted GGP in November of 2007 at about $57. It was a volatile, bumpy ride but I was confident CRE was sure to crash and GGP was the CRE leveraged poster boy. The rest was history. Why am I recounting history? Well, it appears as if this blogger was on to something that the number one and number two investment banks in the world somehow missed. No, it wasn't knowing that the CRE market would crash. I knew it, and I believed that at least some of the bankers and analysts at Goldman and Morgan Stanley knew it too. The big secret was how to go through the crash without FLEECING your clients.

In the post, "Doesn't Morgan Stanley Read My Blog?”, Iamented on the fact that I made very clear in 2007 that anyone who bought the Sam Zell/Blackstone flips were guaranteed to lose money. It was literally etched in stone. It was a miracle that Blackstone didn't lose their shirt. Well, guess who bought those buildings on behalf of their clients as they raked in the fees. You guessed it. None other than Morgan Stanley. This purchase was a 100% equity loss. The entire fund apparently lost about 61% of the shareholder's money. See this WSJ article: Morgan Stanley Property Fund Faces $5.4 Billion Loss.

Not to be outdone. Goldman lost nearly 100% of thier clients money in a similar CRE fund. Reference this FT article: Goldman real estate fund down to $30m (they lost $1.76 billion, yes, that's a very big percentage loss).

These funds did very well during the boom, but when the obvious bust came (and I blogged about it in full detail, so no one could say they didn't see it coming), these funds crashed. Professional asset managers should know better. They are simply delivering market beta, not alpha. Investors are paying a fortune in fees to ride the ups and downs of the market.

Oh, yeah! About them Fees!

Last year I felt compelled to comment on Wall Street private fund fees after getting into a debate with a Morgan Stanley employee about the performance of the CRE funds. He had the nerve to brag about the fact that MS made money despite the fact they lost abuot 2/3rds of thier clients money. I though to myself, "Damn, now that's some bold, hubristic s@$t". So, I decided to attempt to lay it out for everybody in the blog, see "Wall Street is Back to Paying Big Bonuses. Are You Sharing in this New Found Prosperity?". I excerpted a large portion below. Remember, the model used for this article was designed directly from the MSREF V fund. That means the numbers are probably very accurate. Let's look at what you Morgan Stanely investors lost, and how you lost it:

Operational Underperformance versus the Implicit Call Option: Does the Funds' "House" Always Win Scenario Cause GPs to Pursue Deals Regardless of Profitability?

While the aggressive acquisitions made during the bubble phase can be taken as a flawed investment strategy, the fact that fund managers intentionally structured their products as a win-win situation for themselves should not be ignored. The fact becomes even more significant since the signs of a bubble were so obvious to objective parties. I clearly outlined the risks of the CRE bubble in 2006 and 2007, the years in which CRE funds were making their largest investments ever! In "Doesn't Morgan Stanley Read My Blog?" I recapped the risks of the Blackstone portfolio in 2007, the very same portfolio whose portions Morgan Stanley, through their MSREF V fund, was forced to disgorge at a near 100% equity loss to LP investors who did not have the benefit of an implicit "call option" on the CRE market (see sidebar on the left). Needless to say, Morgan Stanley, the GP and effective holder of the "Call Option", actually saw significant cash flow from carried interest, management and acquisition fees despite its investor's losses.

Upon a close examination of the structure of funds such as the Morgan Stanley's MSREF, it has been observed that fund sponsors, acting as the GP (general partner) collect sufficient cash flows through fees to insulate themselves from negative returns on their equity contribution in the case of a severe price correction (Please refer to the hypothetical example below, constructed as an illustration of a typical real estate fund). The annual management fees (usually 1.5% of the committed funds) along with acquisition fees provide the cash flow cushion to absorb any likely erosion in the capital contribution (usually 10% of the total equity). Further, the provision of "GP promote" (the GP's right to a disproportionate share in profits in excess of an agreed upon hurdle rate of return) rewards the fund sponsor in case of gain, but does not penalize in case of a loss. Herein lies the "Call Option"! With cash flows increases that are contingent upon assets under management and the volume of deals done combined with this implicit "Call Option" on real estate, the incentive to push forward at full speed at the top of an obvious market bubble is not only present, but is perversely strong - and in direct conflict with the interests of the Limited Partners, the majority investors of the fund!

A hypothetical example easily illustrates how the financial structure of a typical real estate fund is so tilted to the advantage of the fund sponsor as to be analogous to a cost-free "Call Option" on the real estate market.

The example below illustrates the impact of change in the value of real estate investments on the returns of the various stakeholders - lenders, investors (LPs) and fund sponsor (GP), for a real estate fund with an initial investment of $9 billion, 60% leverage and a life of 6 years. The model used to generate this example is freely available for download to prospective Reggie Middleton, LLC clients and BoomBustBlog subscribers by clicking here: Real estate fund illustration. All are invited to run your own scenario analysis using your individual circumstances and metrics.


To depict a varying impact on the potential returns via a change in value of property and operating cash flows in each year, we have constructed three different scenarios. Under our base case assumptions, to emulate the performance of real estate fund floated during the real estate bubble phase,  the purchased property records moderate appreciation in the early years, while the middle years witness steep declines (similar to the current CRE price corrections) with little recovery seen in the later years.  The following table summarizes the assumptions under the base case.


Under the base case assumptions, the steep price declines not only wipes out the positive returns from the operating cash flows but also shaves off a portion of invested capital resulting in negative cumulated total returns earned for the real estate fund over the life of six years. However, owing to 60% leverage, the capital losses are magnified for the equity investors leading to massive erosion of equity capital. However, it is noteworthy that the returns vary substantially for LPs (contributing 90% of equity) and GP (contributing 10% of equity). It can be observed that the money collected in the form of management fees and acquisition fees more than compensates for the lost capital of the GP, eventually emerging with a net positive cash flow. On the other hand, steep declines in the value of real estate investments strip the LPs (investors) of their capital. The huge difference between the returns of GP and LPs and the factors behind this disconnect reinforces the conflict of interest between the fund managers and the investors in the fund.



Under the base case assumptions, the cumulated return of the fund and LPs is -6.75% and -55.86, respectively while the GP manages a positive return of 17.64%. Under a relatively optimistic case where some mild recovery is assumed in the later years (3% annual increase in year 5 and year 6), LP still loses a over a quarter of its capital invested while GP earns a phenomenal return. Under a relatively adverse case with 10% annual decline in year 5 and year 6, the LP loses most of its capital while GP still manages to breakeven by recovering most of the capital losses from the management and acquisition fees..


Anybody who is wondering who these investors are who are getting shafted should look no further than grandma and her pension fund or your local endowment funds...

Sourced from Zerohedge

Believe it or not, very few institutional investors are interested in seeing the mechanics of how they have been bilked to fund Wall Street bonuses. I have been very generous with the CRE analysis here. For those institutional investors who actually care about making money, or at least not losin 91% of it, I suggest you go through the public version of the model designed to create the analysis above. You can download it here: Real estate fund illustration & Interactive model Real estate fund illustration & Interactive model 2009-12-23 12:54:21 174.50 Kb. For those with even more interest, you should download our 2010 CRE outlook: CRE 2010 Overview CRE 2010 Overview 2009-12-16 07:52:36 2.85 Mb and our CRE consulting capabilitie statement: CRE Consulting Capabilities CRE Consulting Capabilities 2009-12-17 14:17:01 655.48 Kb. I must say, any client of mine would have been hard pressed to lose 91% of their money in a Goldman or Morgan Stanley fund.

It is my opinion that the CRE equities are back into bubble mode. Despite the fact that CRE is still in the crapper, with rising defaults, rising cap rates and falling rents and values; the equities of those companies (even the troubled ones) that invest in that very same troubled CRE are skyrocketing. Yes, even in the face of awful macro conditions. Why? Because many of them were able to (in cohoots with the very same banks that lost you all of that money) slough off their bad and underwater debts to unsuspecting equity investors. As a result, the bank issued buy ratings across the board. Of course, as soon as the analysts that issued those ratings left the banks, they nasty truth comes out.

This is an excerpt from

Well, the Wall Street Marketing Machine AKA "sell side research" is at it again.  Just as I turn bearish on CRE for the second time (see Re: Commerical Real Estate and REITs - It's About That Time, again...), check out the "pump and dump job" from Merrill: Here's a Big Company Bailout by the Taxpayer That Even the Taxpayer's Missed!.

The need to conserve cash, as explained above, stems directly and primarily from imprudently participating in bubble binging, and from a tertiary perspective, the dwindling refinancing market - of which would not be such a big deal if companies didn't overpay for, and overleverage properties in the first place. The solution? Team up with the Wall Street banks that gave you the imprudent loans that most should have known couldn't be paid back in an effort to shift the losses to the retail investor. This is a win -win situation for the banks that made the loans as well as for the REITs that took the loans. Here is the playbook (for illustrative purposes only, of course):

Step #1: Pump the stock - Reference the upgrades, and notice they happen to occur right before a secondary offering - From ZeroHedge: Merrill Lynch In Full REIT Upgrade Mode - The Sequel. Notice that the upgrades are made despite the fact that the CRE market is in total shambles with no near to medium term improvement in sight.

Step #2: Dump the stock: Again from ZeroHedge: Bank Of America Merrill Lynch Gets Paid To Pay Itself Back In Developers Diversified.

Today, Developers Diversified Realty announced it was issuing $300 million in senior notes, with lead underwriter "BofA Merrill Lynch"...

... The final deal terms were $300 million of 9.625% notes due March 2016, priced at 99.42% to yield 9.75%. The syndicate, primarily BofA ML will pocket $5 million in underwriting fees (oddly, less than the customary 3% for a HY offering - are companies starting to demand more bang for their buck?).

And the ever crucial Use of Proceeds? Why paying back Bank of America's 2010 maturing credit facility, as if there was ever any surprise. More specifically:

We intend to use the net proceeds of this offering to repay debt, including, without limitation, one or more of:

•· Borrowings under our $1.25 billion unsecured revolving credit facility maturing June 29, 2010 (with a one-year extension at our option subject to the satisfaction or waiver of customary closing conditions); as of June 30, 2009, total borrowings under our $1.25 billion unsecured revolving credit facility aggregated $1,169.5 million with a weighted average interest rate of 1.5%;

•· Borrowings under our $75 million unsecured revolving credit facility maturing June 29, 2010 (with a one-year extension at our option subject to the satisfaction or waiver of customary closing conditions); as of June 30, 2009, there were no amounts outstanding under our $75 million unsecured revolving credit facility;

•· A portion of our 4.625% Senior Notes due August 1, 2010; as of June 30, 2009, there was approximately $260.8 million aggregate principal amount of our 4.625% Senior Notes due August 1, 2010 outstanding; and

•· A portion of our 5.000% Senior Notes due May 3, 2010; as of June 30, 2009, there was approximately $193.6 million aggregate principal amount of our 5.000% Senior Notes due May 3, 2010 outstanding.

Not a bad deal: the company refinances BofA's 2010 bank facility, which has a 1.5% interest rate with a 2016 term piece of paper, paying 9.625%. Any way you look at it, it goes to show the "solid fundamentals" behind the sector, where the cost of extending a maturity is 6 times the current interest rate!

This excerpt was taken from the ZeroHedge posted linked above. What I think they missed was that the yield on the secondary was much less relevant than it appeared, since DDR was probably going to pay it in stock (that's right, that funny stock split cum dividend thing).

Step #3: Shift the tax liabilities upon those who you dumped the stock on... The last step in this new REIT game, after dumping the unpayable debt converted into follow-on offering stock is to push the fake dividends and shift the tax liabilities of said fake dividends from the entity that generated the liability on to the investor. Normally, if the cash is not paid out, the REIT would have to pay the taxes on it. Now the REIT can keep the cash, dilute the stock by offering the pump and dump secondary,  then pass the tax liability off to the guys that were suckered into buying the stuff, most likely by sell side brokers and analysts - as was exemplified by the BofA Merrill Lynch excerpts above. If you feel as if I (actually, Zerohedge since they broke the story) am being a little hard on the Merrill guys, check out what their ex-REIT analyst head had to say as soon as he left the company - More from Zerohedge: Some Totally Unexpected REIT Lack Of Love From Merrill Lynch -

"From a financing standpoint things are far worse; from a fundamental standpoint things are certainly getting worse.".

As a matter of fact, this alleged "bait and switch" behavior was called out by ZeroHedge in an open letter to the SEC: Open Letter To The SEC Regarding Wall Street's REIT Bait-And-Switch:

Zero Hedge is well aware that our regulatory friends at the SEC and FINRA enjoy going through our articles in search of the "next big scam." We are always happy to make their lives a little easier and not only connect the dots but give them everything they need on a silver platter so that even a green securities lawyer, 4 hours fresh out of law school, would be able to comprehend and litigate.

A few weeks ago I caught on a troubling trend whereby Merrill Lynch/Bank of America embarked on an epic quest to underwrite equity follow on offerings for a vast majority of the lowest quality REITs including Kimco, ProLogis, Duke Realty and others. I say lowest quality, because Merrill's own analysts had a Sell rating on these names as recently as March 31 (for Kimco) and January 6 (for ProLogis). How the global economy has really changed for the better of REITs since then is still a mystery to me. But I digress.

I received emails about DDR's predicament (Diversified Development Realty Email of Interest), which makes sense, because Goldman Sachs is pushing CMBS secured by this company's malls (Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off), which of course had a AAA tranche (see more on this Goldman phenomena below). What a coincidence! If you think that is a coincidence, just as pressure starts to turn up on in the CRE space with a bad macro outlook and an even worse fundamental outlook, Goldman upgrades the entire sector and issues a buy on Taubman (see my take. The Taubman Properties Research is Now Available). Anyone want to bet that Goldman won't help these REITs trade bad debt for more bad debt or bad equities??? The following table summarizes the valuation of each property through NOI-based and CFAT-based approaches. Individual property valuations will be discussed in detail separately, and released to professional subscribers. Click to enlarge...

The two deep underwater properties - The Piers Shops at Caesars and Regency Square were written down to the fair value by recording impairment charge in 3Q09. While the former is being handed over to the lenders for auction proceedings, the latter still remains with the Company and the Company continues to service its debt obligations.  Additionally, there are 5 more properties with LTV of more than 80%, making them highly susceptible to reach the negative equity territory in case of further declines in rentals or increase in cap rates.

Do you think they will have the gall, nerve, ability to push AAA financing for Macerich (A Granular Look Into a $6 Billion REIT: Is This the Next GGP?)?

Below is an excerpt of the full analysis that I am including in the updated Macerich forensic analysis. This sampling illustrates the damage done to equity upon the bursting of an credit binging bubble. Click any chart to enlarge (you may need to click the graphic again with your mouse to enlarge further).


Notice the loan to value ratios of the properties acquired between 2002 and 2007. What you see is the result of the CMBS bubble, with LTVs as high as 158%. At least 17 of the properties listed above with LTV's above 100% should (and probably will, in due time) be totally written off, for they have significant negative equity. We are talking about wiping out properties with an acquisition cost of nearly $3 BILLION, and we are just getting started for this ia very small sampling of the property analysis. There are dozens of additional properties with LTVs considerably above the high watermark for feasible refinancing, thus implying significant equity infusions needed to rollover debt and/or highly punitive refinancing rates. Now, if you recall my congratulatory post on Goldman Sachs (please see Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off), the WSJ reported that the market will now willingingly refinance mall portfolio properties 50% LTV, considerably down from the 70% LTV level that was seen in the heyday of this Asset Securitization Crisis. Even if we were to assume that we are still in the midst of the credit bubble and REITs can still refi at 70LTV (both assumptions patently wrong), rents, net operating income and cap rates have moved so far to the adverse direction that MAC STILL would not be able to rollover the debt in roughly 37 properties (31% of the portfolio) whose LTVs are above the 70% mark - and that's assuming the credit bubble returns and banks go all out on risk and CMBS trading. Rather wishful thinking, I believe we can all agree.

... As stated above, Goldman is now underwriting CMBS under a broad fund our $19 billion bonus pool "buy" recommendation in the CRE REIT space. Let's take a look at another big bonus development exercise, marketing push they made into MBS a few years ago...

Anyone wishing to discuss my CRE outlook further can easily reach me via this link.

Last modified on Wednesday, 30 June 2010 10:09