[Note: To follow is an excerpt of a radio show interview conducted by Peter L. Mosca, host of Income Property Investment Talk dot com, with Dr. Sam Chandan, Global Chief Economist and Executive Vice President of Real Capital Analytics (RCA) and adjunct professor of real estate at the Wharton School of the University of Pennsylvania. To listen to the show archive or download an MP3, go to www.IncomePropertyInvestmentTalk.com/030310.]

Mosca: For me, California is a leader in a number of ways. Could take a minute or two and give us your thoughts about California as a potential market for investors in commercial real estate?

Chandan: California brings up a whole set of other issues that are going to be more significant in other markets over the course of the next year. Part of what has been very challenging in California, in Arizona, Nevada and some other states around the country is that over the course of the period between 2003 and 2006/2007 property taxes, income taxes, sales taxes were all increasing at a fairly brisk pace in part because of the housing booms and at the extent to where house prices were going up in those parts of the country and as we can reasonably expect local and state government expenditures were increasing in long step with revenue. As property, income and sale taxes have all declined in California, there has been a very difficult transition; the negative wealth effect on consumers and its further impact on businesses and retailers has really upset trends in that economy at the local level. Not only has that resulted in a deeper recession in California, it’s required that the state undertake a very difficult set of cuts to balance it’s budget.

The impact of those cuts spreads far beyond Sacramento and has impacted local economic activity in any city in California where there are teachers, where there are firemen, where there are policemen, where people depend on public transportation, all of those things that depend either directly or indirectly upon support from or transfers from the state or local government have suffered as a result of some very necessary but difficult cutbacks that have been undertaken in the state. What we do know is that for the upcoming fiscal year because budgets are planned in advance of the actual revenues that are realized, so we didn’t see the full effects of the cutbacks over the last year, as we look forward to the next fiscal year, there are other states where there are very difficult choices to be made as well. New York is one amongst them and we see that across the country some of the markets that did benefit fairly significantly from the housing boom are going to be cutting back in some areas over the course of the next year in spite of the fact that we see improvements in general economic activity. In California, it’s something we are going to have to watch very closely because they are in a potentially precarious public finance situation.

One other thing that Ryan mentioned that deserves elaboration for a very brief moment however is the GGP opportunity fund. I think what that really speaks to is again the bifurcation in the market between investors who are targeting and ready to pay for performing, good quality assets and investors who are a little bit more hesitant about assets that we may think of as being more opportunistic in nature. Part of what I think is the appeal of the Brookfield offer for GGP’s assets and the way in which they would support GGP is in as much as it provides for a separation of those two pools. Let us compartmentalize, let us separate out those assets that we perceive to be slightly riskier or more risky and separately target a pool of potential investors for those so that they don’t exert significant drag on the appeal from what is otherwise a very high quality, performing portfolio.

One of the challenges that the state government faces not necessarily the issue of whether cash flows and revenues from various taxes will stabilize over the course of the next couple of years is how do they raise cash now that will allow them to meet their current shortfalls and their current deficits in as much as they don’t have the flexibility to run deficits that we see at the federal level. I think what you will find is that assets will be coming to market in many cases at very attractive prices and there is the potential for an investor to enter into a relationship where they again acquire an asset at a discount but along with that get a very, very stable tenant as part of the deal. I think that is a situation that is potentially very attractive for investors in some of these markets.

One of the issues that it raises of course is that when investors are coming to market, the ones that are best positioned are the ones that do have access to well established, reliable sources of capital or credit and in part this is because the lending environment does remain significantly constrained both in terms of loan to value ratios and underwriting criteria having tightened up significantly but also in terms of the sources of credit at a very high level.

Mosca: Let’s talk a little bit about the recent report from the Congressional Oversight Panel headed by Elizabeth Warren. What types of policy interventions if any at all do you think Washington will attempt to support the commercial real estate sector, to support commercial real estate investors, to support real estate brokers and agents?

Chandan: When you look at that Congressional Oversight report and you can find it at COP.senate.gov, what you will find is that the committee is working to establish their research is designed to establish for the reader and the intended market for this is the legislator or policy maker, that this is not just a commercial real estate issue. I think that it’s not necessarily in the public interest to intervene to support commercial real estate markets per se. That’s a very difficult argument to make. So, I think in and of itself out comes in our market whether we have strong pricing, whether we have robust transaction activity, that’s not policy relevant.

What the panel I think is focused on establishing is that this isn’t just a real estate issue that if we continue to see increases in delinquency and default rates, particularly on the balance sheet of the smaller regional and community banks in the United States as a result of less than optimal outcomes in commercial real estate pricing and transaction activity but that has much broader implications. So, what we see in the report is a couple of things that they establish. One, they very clearly demonstrate that the concentration levels, the exposure of banks to commercial real estate is a more significant issue for regional and community banks. We have large exposures on the balance sheets of the large national banks.

We obviously have large exposures from CMBS for a broader pool of investors but when you think about where are those real concentrations? Who has a significant share of their overall exposure in commercial real estate that really is the smaller institutions? The critical issue for us is that those smaller regional and community banks are also the primary channels for making credit available to small businesses and to households in the United States. When we think about the kind of recovery that we might have over the next couple of years, one of the things that I think people feel very strongly about is that we need to have credit available where it is due and where it is deserved to small businesses and to households. The risks justify it where you have a credit worthy borrower, credit should be available, but if banks are constrained in their ability to extend credit to small businesses because their commercial mortgage portfolios are impacting their viability and their stability, then there is a potential for a spillover from outcomes in the commercial real estate market to what we observe in the broader economy.

Unfortunately, where I think the report falls a little bit short is that it does not demonstrate conclusively that the magnitude of the losses we will observe in commercial real estate are such that we will have these spillovers into lending and credit availability for these other types of businesses. There is still a little bit of room that’s left for debate over there but what I think it does go a long way to do is communicating that particularly for these smaller institutions, there is a policy role. There is a potential need whether it’s the FDIC, the Treasury, and the Fed to support the capacity of these banks to lend.

The only I would say meaningful movement that we’ve seen on this front over the last couple of months has been suggested round the time of the State of the Union address that we might redirect some of the TARP funds that were repaid by the large banks, a redirection of some of those funds to pools of capital that could then be made available in the form of lending by smaller banks. It’s not as easy as just suggesting that. There is a congressional gauntlet that that proposal would have to go through and there are many people in Congress who I think are opposed to the idea because as it stands, those funds cannot simply be used for other purposes once they are repaid. When we think about some of the other things that might then happen, over the course of the first half of 2009 most of the support for commercial real estate I think was at the very large level. Things like the TOUTH program being extended and expanded to include new and legacy CMBS in the hopes of triggering new CMBS activity. That program was mixed in its effectiveness.

We haven’t had new CMBS in a significant way but what we do know is that in the last half of 2009 that there was a greater and very visible focus on commercial real estate that would support those smaller banks in particular and aside from the Congressional Oversight Panel’s report towards the end of October, the Federal Financial Institution Examination Council released new guidance for banks. The FFIEC, for folks who aren’t familiar with it is a convening body that brings together the FDIC, the Fed, the Office of the Controller of the Currency, the Office of Thrift Supervision, the National Credit Administration, and really coordinates amongst those bodies to bring new guidance and new standards.

Mosca: I think they were on C-span in fact doing those hearings with all those people.

Chandan: They had conducted a set of hearings in, I guess the Oversight Panel as well in Atlanta and they have been reaching out to the industry. What we do is that there was some guidance that they released for the banks towards the end of the year that described new measures of flexibility that the banks would have in modifying loans to keep them performing. On one hand I think if you are an investor, you may perceive that that would slow down the process of these loans coming to market at discounts in ways that would allow you to invest but I think if you are thinking about the stability of the banking system, there is some important flexibility there.

Mosca: Has that reached the marketplace yet?

Chandan: It has reached the marketplace and I think if again you turn to Google or Bing and type in something to the effect of FFIEC Loan Workout Guidance, you’ll be able to get that report. We’ve certainly written a summary that we can make available to the listeners but what you will find in that report is that it’s really focused on two things.

Mosca: Do you agree with Standard & Poor’s recent report that indicated that the CMBS market is going to really experience a slow recovery?

Chandan: When you think about the time frame over which we might observe robust CMBS issuance in the market, there’s very little doubt and from the conversations that I’ve had with potential issuers, rating agencies, conduit loan originators here in New York City, what is clearly evident is that we will see some new issuance in the market this year. I think projections at this point; there is a consensus that we might see 20 to 30 billion dollars in issuance. Now, that number can change very quickly either increasing or decreasing but what we do know is that while that is certainly a positive signal in terms of the capacity of the market, the willingness of investors to potentially take exposures in CMBS over the long run, in terms of impact of overall liquidity and credit, it is a diminuous contributor in 2010. The deals that we are likely to see, I expect will be much smaller than the deals that we saw in 2006 and 2007, both in terms of the dollar volume but also in terms of the number of loans. Do investors have sources of cheap capital that they can use to then invest in CMBS? There are significant structural issues that we have to address in the CMBS market. Who is compensating whom? What are the incentives of the different parties? How ready are investors to look at reports, analyses that are done by third parties versus doing their own due diligence and assessing the nature of the risks that they are taking on when they expose themselves to these new CMBS. These are all things that we have to consider that are limiting the extent to which we might see new activity. I haven’t seen that S&P report specifically but I would concur with the general suggestion that it will take some time for CMBS to really reestablish itself as a significant source of new credit in the market.

Mosca: What is your golden nugget?

Chandan: While there may be strong investment interest in four or five major markets around the country and then other markets that are not attracting a significant degree of interest right now, there is going to be something below the observable threshold of just the largest 4 or 5 markets where there are great opportunities to buy very stable assets at deep discounts.

Mosca: So, you do see some opportunity there for the entrepreneurial investor?

Chandan: Absolutely. It’s just one where I think the investor will have to make sure that he or she is very well prepared for what will inevitably be a couple of years during which management of those properties will present challenges and will require a lot of time and energy.

Mosca: I think that management and we’ve got about 30 seconds, that management word is key especially for our commercial brokers and agents listening to us right now. They can be a big help.

Chandan: Absolutely. I think when you look at the market a couple of years ago as we approached the peak of pricing, it wasn’t necessarily the long term operator that was buying in part because the prices were so high relative to the operational capacity. It may have been a more opportunistic investor. Right now the market I think is returning to a set of conditions that really favors the strong operator of the market who will acquire the asset because they understand the long term potential that that asset has to generate income.

Published: April 8, 2010

Use of this article without permission is a violation of federal copyright laws.

Peter L. Mosca is president and founder of BAK Communications, Inc. He has over 22 years of communications and media consulting experience, serving a variety of nonprofit organizations, including the CCIM Institute and the REALTOR Association on all three levels – national, state and local. He is the Spokesperson Trainer for the CCIM's Jay Levine Academy and trains hundreds of residential REALTORS nationwide to be effective industry spokespeople. He is consistently ranked as "excellent" by about 90% of those who attend his presentations. While his principal consulting focuses are public speaking and media relations development and content delivery and management, Peter is also the host of the Voice America Network's weekly radio program, "Income Property Investment Talk," a one-hour program that brings the powerhouses of commercial and residential real estate to property investors every Wednesday at 11 a.m. EST. Peter is married 17 years to his wife Barbara. They have two children: Ashley, 15 and Kelli, 12. Hence, the name BAK Communications, Inc.