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INTELLECTURAL PROPERTY: Cloud-cuckoo land

The use of unrealistic, aggressive assumptions in real estate acquisitions over the past few years is now posing a challenge for some GPs. PERE magazine February 2009 issue.

There are two basic rules when flipping a house: don't waste time, and don't be overly optimistic with your assumptions. It can almost be taken for granted that when you are converting, renovating or developing a house, something will go wrong and you should therefore have room (read, capital) to manoeuvre.

The plethora of television reality shows highlighting hapless house-flippers have given plenty of evidence that not everyone follows these rules.

So for example, when Freda from Florida or Christopher from California snap up an internet-auction single family home, recently repossessed by the bank, with plans to overhaul the entire building in four weeks, with a budget of $10,000 and with hopes of a 6x multiple on their equity, we suspect that their assumptions are slightly out of kilter with reality. Put another way, they are living in cloud-cuckoo land.

However, it isn't just amateurs that have been found to have been living in an unrealistic, idealistic state where everything is perfect. Even battle-scarred veterans of the RTC are realising that assumptions used during the real estate bull markets of 2005, 2006 and 2007 were a tad over-optimistic.

Take, for example, one of the largest residential deals seen in New York City in 2006, the $5.4 billion acquisition of Stuyvesant Town and Peter Cooper Village by Tishman Speyer Properties and BlackRock Realty Advisors. The firms' strategy hinged upon the success of converting much of the 56-building complex's rent-stabilised units into market-rent properties.

With its location on 80 acres of prime east Manhattan real estate and renowned as one of New York's most iconic and successful post-War private housing communities, Tishman assumed Stuyvesant Town and Peter Cooper Village would be able to increase its net operating income (NOI) from a reported $112 million in 2006 to $160 million in 2008. According to data from commercial mortgage research company Trepp in the nine months to the end of September 2008, NOI was $101 million. Market-rent properties for the same period comprised 37 percent of the 11,227-unit complex, compared to 28.4 percent at the time of the deal.

That rate of conversion hasn't proved fast enough. When Tishman announced the deal, it set aside interest reserves of $400 million. By the end of 2008 those reserves were down to just $140 million. “This was a tough strategy [even] in a great market. There wasn't a lot of room for error. In a declining market it's even harder to pull off,” one analyst told PERE.

And Tishman isn't the only private equity real estate player struggling with their assumptions for converting rent-stabilised properties in New York City. In 2006, Rockpoint Group bought the 1,230-unit Riverton rental apartment, in Harlem, New York, with Stellar Management for $130 million. Around 90 percent of the units in the multifamily complex were rentstabilised, with plans to convert around half to market rates.

By July 2008, just 10 percent, or 128 apartments, had been transferred to market rates. Reserves ran out in August last year, according to Trepp, and by the autumn, Rockpoint and Stellar (who had refinanced the deal and taken out a $225 million loan) had sent default letters to the borrower and mezzanine lender. Foreclosure proceedings, being driven by the mezzanine lender, are scheduled for 20 February. A spokesman for Tishman was unavailable for comment. Rockpoint declined to comment.

According to mortgage documents relating to the Tishman Speyer deal, Stuyvesant Town and Peter Cooper Village were expected to be worth $6.9 billion as of 1 January, 2011: a 28 percent rise in the appraised value of $5.4 billion at the time of the deal in 2006.

That figure will no doubt need some tweaking as Tishman surveys the wreckage of the bursting of the real estate bubble. Just like Freda and Christopher, Tishman won't have to look far beyond its underlying assumptions to find one of the causes of the problem.

While the real estate market, and debt, was hot these assumptions worked well and were backstopped by the knowledge that there was always someone else ready to buy at a higher price.

Today's market, though, is a reminder that because real estate valuations don't always rise, it is important to make the original assumptions realistic. And just like on reality TV, where viewers groan at the foibles of wannabe property millionaires, so too can the professionals sometimes be shown to suffer from irrational exuberance.