It’s Tough Being a Vulture. Really.

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John Dizard gives a cautionary tale to the growing ranks of vulture wannabes, and in a clever two-for-one, also warns against bottom fishing in commercial mortgage backed securiites. Although the piece revolves around a single anecdote, it’s revealing.

Dizard’s story reminded me of this Oscar-winning song from 2005 (skip to the one minute mark):

From the Financial Times:

At about this stage of a US economic cycle – that is, past the beginning of a growth decline and just entering the first bear market rally – you see a large number of new recruits to the vulture business…. I see why this “industry” is more attractive to newbies than to veterans.

This is a depressing business. You spend a lot of time in conference rooms in Courtyard Marriotts (business hotels), mostly near regional airports, going over badly drawn legal documents looking for flaws. There are usually a lot of those. Invariably, people who are approaching insolvency have cut corners on their financial reporting, so a lot of those boxes in the warehouse that the accountants saw may be empty…..

Those entering the vulture business right now, inspired perhaps by business magazine covers, will need distractions… because they are not going to get rich quick. They may, indeed, get poor slowly, along with their limited partners.

I had an interesting conversation a week ago with a Palm Beach County real estate investor. He had moved there three years ago from suburban New York, having made some money over the years, principally in commercial properties. I was intrigued by what he and his partners were doing to take advantage of the values on offer down there on the Gold Coast.


He had the advantage of inside information, personal ties to locals and national operators, and decades of experience in the business. All of that is telling him to leave the restructuring opportunities in Florida residential and commercial real estate to people who don’t know what they’re doing, which means you and me.

In particular, he was dubious about the recovery possibilities for commercial mortgage-backed securities (CMBS) paper.

First, the clever vulture would try to pick the most advantageous level of seniority in the debt structure, which is the one that is just impaired enough to get control of all the equity (and that upside!), but not so impaired that it gets swept away by a restructuring.

But then, as our non-vulture says: “Here is what CMBS paper does not have that institutions such as the life companies have: it is not able to go and look at the assets. It is completely passive. It cannot turn the paper into property.

“That is up to the trustee or the servicing agent. You would have to buy the entire pool. Most of the people taking on these roles – they may be well-run companies, but they are not familiar with how to deal with the problems of managing properties.”

Then there are the fun little bits of new legal knowledge you can acquire in that hotel conference room. For example, if you buy just a handful of cheap, distress sale condos in Florida, you may find yourself designated a developer by the state.

And that is not necessarily a good thing. You may now be required to put up a warranty for the physical condition of the properties you sell, for a long period of time. And you will not necessarily have control over that condition. Did you install the water pipes? No? Doesn’t matter. You have to fix them anyway.

As our Florida investor, or, now, non-investor, says: “When Wall Street commoditised commercial real estate securities, it added a level of apparent liquidity that was not founded in the basic nature of the asset.”

One aspect of that basic nature is that buildings depreciate. If you don’t maintain, or effectively rebuild, a building it will deteriorate over time. You, Mr or Ms Vulture, will have to take off that Hugo Boss suit and put on a pair of overalls with a little name tag sewn on the right breast: “Herb”, or “Vulture” perhaps. Put down the LV briefcase. Pick up the toolbox.

The biggest issue is the one that vultures think about the most: price. The crucial variable in commercial real estate valuation is the cap rate. That is the net operating income divided by the sales price. Right now the cap rate for commercial property transactions in many markets is between 6 and 7. Except that there are not many transactions taking place.

As our Palm Beach investor says: “Long term, you should figure on a cap rate of 10. That would drop the average price of commercial real estate in this country by 40 per cent from the peak, rather than the 10 per cent decline registered so far in many places. Of course we could be bailed out by inflation . . . “

Don’t catch this falling piano, at least for another couple of years.

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  1. prostratedragon

    So, who’s really the vulture at last? Reminds me of an old British comedy routine that I’ve been unable to track down.

    As I recall, an auctioneer was intoning the goods in some estate lot: “…two volumes, How to Tame Vultures … four volumes, How to Leave Vultures Alone …”

  2. Anonymous

    Vultures remain in the air looking for fresh road kill:

    Asst Sec Ryan Remarks at SIFMA Wall Street to Washington Conference
    Thursday, May 01, 2008; Posted: 07:33 PM

    At the February 2008 Quarterly Refunding, we discussed settlement failures in the Treasury market with our Treasury Borrowing Advisory Committee (TBAC), a committee sponsored by SIFMA and comprised of some of the finest, most experienced professionals in the financial market place. As you know, settlement failures, or fails, occur when a party selling a security fails to deliver the security to the buyer on the agreed upon settlement date. Settlement failures, occur for a variety of reasons including errors in the back office and miscommunications, and are generally small and resolved quickly.

    Larger, more chronic fails can occur due to wide-scale operational disruptions or financial market conditions, such as when interest rates reach low levels.

    Treasury and the TBAC discussed the potential risk of chronic fails in a lower interest rate environment, a risk that we believe impairs liquidity and threatens to raise our cost of borrowing. In addition, we asked market participants to pursue market-oriented solutions, adapt and implement practices for such a situation, and report back to us regarding their progress.

    Over the past twelve weeks, we have seen rates drop quickly, the demand for Treasury securities skyrocket, and a rapid increase in fails to deliver in the Treasury market. In a short time period, we entered an interest rate regime in which the cost associated with fails declined significantly – and, perversely, weakened the financial incentive to rectify a fail. While the cost of failing to deliver may be low for a single market participant, the aggregate cost can be high when it potentially impairs the overall system, and such behavior is certainly not consistent with professional best practices.

    This week, at the May 2008 Quarterly Refunding, we asked the TBAC for their view on actions taken by market participants to date. Committee members were encouraged by the collaborative efforts undertaken by the private sector industry groups to formulate viable solutions to address chronic fails, and members broadly accepted that the initiatives outlined by SIFMA and TMPG would improve market practices for fails monitoring and remediation in the near-term.

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