Archive for December, 2008

The Bear - Tales from a Financial Panic

Friday, December 26th, 2008

The following is based upon unsubstantiated accounts.

EXT: SIDEWALK NEW YORK CITY

Ground floor view looking up at a skyscraper. 

The building is grey, gothic and mammoth.  An ornate sign over the entrance gives us the name of the owner of this building: JPMorgan Chase.

A date flashes at the bottom of the screen: March 13, 2008

INT: OFFICE LOBBY

Two men stand uncomfortably in front of a beautiful, red headed woman, BRONWYN HENDRICKS, who sits at a receptionist’s desk.  One man is bearded and bald.  The other is thin and boyish looking with floppy brown hair.  Each wears a cheap, ill fitting suit with shoes that don’t match.  These men are BEN BERNANKE and TIMOTHY GEITHNER.   

BRONWYN: Is Mr. Dimon expecting you?

TIMOTHY: Well, not exactly, you see…

BEN (cutting TIMOTHY off, somewhat franticly): We have to see him!

TIMOTHY: Just tell him it’s ol’ Timmy Geithner.

BEN (even wider-eyed and more frantic than before): We have to see him!

 BRONWYN (dubiously): Geetner and

BEN: Bernanke!

BRONWYN: OK, I’ll see.  Please sit over there while I check in with Mr. Dimon.

TIMOTHY: Remember to tell him it’s Timmy Geithner.

BEN: We have to see him!

TIMOTHY: Don’t worry, Ben. (Grabbing Ben by the shoulders and moving him to the waiting area.)  You see me and Jamie go way back.  Yes we do.  Jamie told me if I ever got into a fix I should call him up and he would take care of it.

BEN (Calming slightly):  He did? 

TIMOTHY: Now, you let me do all the talkin’, Ben.  I know these Wall St types.  They real tough.  Tough as nails, but I know how to speak their language.  

Out of the doorway of the office walks a tall, fit, good looking man.  He is impeccably dressed and groomed.  He stands straight, walks with confidence and oozes success.  He flashes a big, bright smile as he exits his office door and enters the reception area.  This is JAMIE DIMON.

JAMIE: Little Timmy Geithner.  What are you doing in these parts?  (looking at Bronwyn reproachfully) Bronwyn, how could you keep Timmy Geithner waiting?  Timmy’s an important man.

TIMOTHY: Ah gee, Jamie…

JAMIE: And what do we have here?  Is that Ben Bernanke?

BEN: We’re in a heck of a mess, Jamie!

TIMOTHY: Shush, Ben!  Yes, this is Ben.  Say hi, Ben.

BEN (embarrassed and downcast): Hi, Jamie.

JAMIE: A mess, huh?

TIMOTHY: No, no, Jamie.  Not a mess.  More like, um, we have a great opportunity for you.

 JAMIE: A great opportunity for me?  Come on in and tell me all about this great opportunity.  Bronwyn, get these boys a glass of Noah’s Mill.  Ice or neat, boys?

BEN: Is that alcohol?  I dunno if we should be drinking right now.

TIMOTHY (furiously to Ben): Ben!  Quiet! This is the way you do it on Wall St!  Yes, of course we would love some Noah’s Ark.  Neat is just fine.

JAMIE: Great.  Come right in.  Bronwyn, some Noah’s Mill for the boys and me.

BRONWYN: Yes, Mr. Dimon.

INT: JAMIE DIMON’S OFFICE.

Jamie walks in and sits behind a massive oak desk.  The office has expansive views of the New York skyline.   Ben walks in with mouth opened awe.

BEN: Wow.

Timothy and Ben sit in the guest chairs.

JAMIE: They say Mr. JP Morgan himself used this desk.  Really something, isn’t it?  Now, what is this about an (beat) opportunity?

BEN: It’s Bear, Jamie.  They can’t pay their bills…

TIMOTHY: Ben!

Bronwyn interrupts to drop off the drinks

TIMOTHY: Thanks.

Timothy takes a big sip of courage before restarting.

TIMOTHY:  It’s Bear, Jamie.  Jimmy Cayne, he’s got himself in a whole heap of trouble.

JAMIE: Jimmy? My mother was at a bridge tournament recently and saw him there.  She said he looked great.  Has something happened?

TIMOTHY: Oh, it’s this whole subprime mortgage thing, Jamie.  I guess, Jimmy, he got himself a little too deep in that stuff and now he needs some help gettin’ out.

JAMIE: Subprime?  I’m not sure I’m the right man for that.  I’m a simple commercial banker. 

BEN (animatedly): You have to help!

 TIMOTHY: Quiet, Ben.  Let me do the talking.  See the thing is Jamie, Bear is having some, um, short term cash flow needs and they need a little money, just for a little while mind you, or they may go (leans in and whispers) out of business. 

JAMIE: Short term cash flow needs?

TIMOTHY: Yes, exactly.  See, Ben and I here we was hopin’ that maybe you can help Bear out with a little loan. 

JAMIE: Golly, boys.  You know how much I would love to help, but I don’t think there is anything I can do.  I’m so busy right now.  (Gestures at the two files sitting on his desk) My wife is badgering me about re-doing the kitchen at our Hamptons place.  Bronwyn keeps pestering me to look at some plans for renovating the building lobby.  I’m burning the midnight oil around these parts.

BEN: Man, oh, man.  That is a lot of stuff.

TIMOTHY: (Losing his cool) Jamie, you have to… (Immediately calming himself down)   I mean, couldn’t you even check it out, Jamie?  It would mean the world to us.

JAMIE: I tell you what I’ll do.  Now, I’m going to get in trouble with Bronwyn over this, so you owe me big time, but maybe I can put that dang lobby renovation on hold and take Bear off your hands.

BEN: (Excitedly) You would do that for us?     

TIMOTHY: That’s great, Jamie.  And what are you thinking of paying for Bear?

JAMIE: Paying?

TIMOTHY: You know, what are you willing to pay for Bear to, uh, take them off our hands?

JAMIE: (Rubbing his chin) Well, I guess if you guys take, I don’t know, let’s say $30 billion of the worst assets off their books then it is one done deal.       

 BEN (Dumbfounded): $30 billion?

TIMOTHY: (Wiping sweat off his brow) $30 billion?  That’s a lot of money.   Well, I guess maybe we can do that.  Yeah, yeah, we can do that.  OK, how much will you pay then?

JD (Confused): Pay?

TG: For all the rest of the assets and liabilities?

JD: (Shaking his head) I’m sorry, guys.  I thought I had explained about the lobby renovation.  That is a big sacrifice.  Then there is also all the work of bringing the Bear guys over and teaching them the JPMorgan corporate song.  It takes a lot of work to get that song right.  I’m not sure you guys appreciate…

TG: Oh, no, Jamie.  It ain’t like that.  We totally understand.  Don’t we, Ben?

BEN (Nodding furiously):  We understand!

TIMOTHY: It’s just the taxpayer, Jamie.  Sometimes they don’t understand all this high finance and e-co-nomics talk.  Some reporter tells them that we gave Bear to JPMorgan while taking on $30 billion dollars in potential losses and they think we ain’t doin’ our jobs.  Ain’t that right, Ben.

BEN: The taxpayer, Jamie.  He just don’t understand all this finance and economics.

JAMIE: Hmm.  I guess that is a problem.  I know what a great job you all are doing and I would hate for some know nothing from the NY Times to get this all mixed up.  (beat)  I tell you what I will do boys. (Pounding his desk)  I will take on the first $1B in losses on that $30B portfolio.  How can anyone complain then?

TIMOTHY: Great.  OK, ok, and the shares?  How much will you pay for those?

JAMIE:  Man, you boys drive one hell of a hard bargain.  The board is going to crucify me for this one, but, for you little monkeys, I’ll do it.  I’ll give you 2 bucks a share.

TIMOTHY: Gee whiz, 2 dollars, Jamie.  You would do that just for us?  That’s mighty swell.  That’s mighty swell, ain’t it, Ben?

BEN: Oh, oh, great job, Tim.  Wait til we tell Paulson.  He’ll respect us then.  He’ll start letting us attend the big boy meetings after he hears about this.

 JAMIE: Ah, my reputation is going to be shot, but it’s a deal, boys. (Standing up and walking over to shake hands).  Bronwyn (calling out), pour a celebratory round for me and the boys.

Bronwyn enters and tops off everyone’s glass.

JAMIE: (holding up his glass) To Wall Street!

BEN and TIMOTHY together: To Wall Street!

The three men clink their glasses and take deep sips.

Fade to black.     

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BAILOUT - A Play in One Act

Friday, December 19th, 2008

 

HOSPITAL INTERIOR: Dr. H. Paulson sits at his desk, examining charts.  Vikram PANDIT, a Super Bowl-winning wide receiver, enters, hobbling, his hand clutched to his thigh.

 

PANDIT:                               Dr. Paulson! Just the man I wanted to see!

PAULSON:                           What seems to be the problem here? [Double take as he recognizes the famed WR] Oh my goodness! Are you Vikram Pandit?

PANDIT:                               Yeah, playa! You see this ring? [Flashes gleaming Super Bowl ring, denoting wealth and status]

PAULSON:                           [Startled] You’re bleeding!  How did this happen?

PANDIT:                               Well, I was at the club, and, well… some unprecedented market conditions went down, and, well… the result is I got shot.

PAULSON:                           Oh, well, clearly.

PANDIT:                               C’mon Paulson, get movin!  Where’s my bailout at?  Stitch me up, beeatch!

PAULSON:                           Well, the law requires me to go through certain constitutional procedures before I stitch you up…

PANDIT:                               “Bleep”  THAT! We need to keep this on the DL, so I maintain my competitive position against the Germans and Swiss.

PAULSON:                           [Getting agitated] Actually, I’m not sure that’s legal…

PANDIT:                               “Bleep” legal, I’m BLEEDING dammit.

PAULSON:                           [Alarmed] I guess you’re right.  [Bellows] NURSE!

Bearded male nurse enters, groveling, whimpering a bit

NURSE BERNANKE:         [Meekly] Yes, Dr. Paulson?

PAULSON:                           [Panicking]  Can’t you see this man is bleeding?!  Get some “bleepin”  gauze and stuff, stat!

NURSE BERNANKE:         [Calm, but uncertain]  But… but… how did this happen?

PAULSON:                           [Yelling at the poor nurse] Unprecedented market conditions, goddammit! Just “bleepin”   do your job!

NURSE BERNANKE:         Well, hold on.. . That doesn’t really make a lot of sense.  Most people don’t just get shot because of “unprecedented conditions” – don’t you think we should ask a few more questions?

PAULSON:                           [Really panicking now] NO! Dammit, this is critical!

NURSE BERNANKE:         OK, I’ll call the proper authorities, as we are required by law to do.

PAULSON and PANDIT [unison]:                               “BLEEP” THAT!

NURSE BERNANKE:         [Meekly]  Ummm, ok, ok.  I’ll do it.  [He shudders to himself, shaking his head, disgusted at what he has become.]

 

END

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Basic Real Estate Valuation

Thursday, December 18th, 2008

Given the current interest (dare I say hysteria) associated with investing in dirt and buildings, I thought it might be interesting for our readers to have a quick, dirty manual on real estate valuation.  My perspective comes from years in the industry as well as some time learning at the knee of some of the better real estate minds in academia.

 

I will separate (to some degree) investing in one’s residence, for consumption, from investing in real estate for fun and profit.   The reason for this separation is that much of the utility or value of one’s home is locked in the pleasure one gets from living in it, or consuming it.  Although there are certain ego strokes to owning large buildings, an edifice complex – if you will, the value associated with land, apartments, office buildings and warehouses is locked in the cash flow they provide or will provide.  [That edifice complex comes in to play with large, trophy assets – I wouldn’t expect any of our readers to be buying the TransAmerica Pyramid or the Sears Tower, but there is an interesting argument as to why those buildings deserve premiums over their nearby competitors – that discussion will have to take place at another time.]

 

The first basic principle to understand is that any asset is only valuable to the degree to which it will provide cash flow to its owner.  It is important to see office buildings, not as office buildings, but as rent creation machines.  One should see land, not as dirt, but as an option to build and rent out or sell – and thus, create cash flow. 

 

 

‘But, JS, how can I decide what to pay for those cash flows?’ And ‘JS, what if the cash flows are unpredictable or are hard to estimate?’ I hear your questions, and they are good ones.  And that is why there are different ways to assess the value of real assets.

 

There are four basic ways to approximate the value of a building or piece of land.  There is the Discounted Cash Flow method, or DCF, there is the Cap Rate method, there is the Replacement Cost method and there is the Comparable method.  Each one has its own advantages and disadvantages. 

 

DCF

Discounted Cash Flow analysis or DCF analysis is not unique to real estate; in fact, it works with most any capital asset.  DCF is the process of forecasting cash flows forward for some realistic period of time (any investment banking analyst will have done so many 10-year DCFs that he or she will be seeing them in their sleep) usually five or ten years and then discounting those cash flows back to the present to find the current value of the building.  I am not going to get in to the ins and outs of choosing the appropriate discount rate (but maybe one of my fellow columnists will) but suffice it to say that the appropriate discount rate should take in to account the relative surety of the future cash flows (or more precisely, the risk associated with the cash flows specific to this asset).  The cash flows include the rents or the cash that will be spit out as well as the terminal value (or the value that the building will fetch at a sale (less transaction costs) at the end of the analysis).   Below is an example of a DCF analysis.  Notice how one might value the building very differently depending on one’s discount rate.  Assume that the asking price for the building is $150 – perhaps this wouldn’t be such a great investment.  Building a simple model on excel and fiddling with rent flows and terminal values will show how sensitive these analyses are to even small changes.

 discounted-cash-flow-analysis1

 

 

The advantages to this type of valuation are that if you are relatively sure about the future cash flows and understand the true cost of your capital as well as the correct discount rate for this type of asset, then one can get a good idea of what to bid or what you’d be willing to pay for an asset.  Of course, the disadvantages are that if someone can accurately predict anything for the next ten years, I want to meet them and buy them anything they want – they are worth my weight in gold (no small number I assure you).  Also, choosing the right discount rate is an art and not a science, as such, it is not only difficult, but it is also prone to be tinkered with.  Or in other words, many of my colleagues (and JS is not to be held out as better than anyone else) as well as myself have worked backward to get to get to the asking price.  Or we have done the model and then chosen the discount rate in order to arrive at a value that will in fact make the building trade.

 

In general, I don’t favor this type of valuation.  It is too sensitive to judgment / errors and doesn’t take in to account the vagaries of the market.  Additionally, this method doesn’t work well with land, vacant buildings, redevelopment opportunities or any type of asset that has no cash flow or extremely difficult to predict cash flows.

 

Cap Rate

The Capitalization method or cap rate method is similar to the DCF method.  In fact, it is really just a shortcut for the DCF method.  The following equation explains what a cap rate is:

 

First Year NOI ÷ Building Purchase Price = Cap Rate

 

NOI is Net Operating Income.  NOI is basically cash flow from a building, excluding debt service and income taxes (not real estate taxes).  As an example, if we take the building from the above DCF Analysis and we assume a purchase price of $100 and an NOI of $10, the cap rate is 10%. [$10 / $100 = .10 or 10%].  In order to use the cap rate method to find out what to pay for a building, one only needs to understand two things, the expected NOI for the year after purchase and the cap rate for similar assets (and this usually means tenants) in the market.  If you deconstruct this method it begins to look like a DCF valuation – but those similarities and why they may or may not make sense is better saved for a later column.

 

In commercial real estate, this is the most common method of quoting property prices or talking about valuations.  Brokers will talk about buildings ‘trading at an 8 cap.’  That means that a building sold at 12.5x its first year NOI.  Be careful to delineate between ‘in-place NOI’ and ‘projected’ or ‘pro-forma NOI.’  Also be careful to accurately predict capital contributions needed to keep a building leased or lease-able.  Because cap rates only take in to account NOI, they often don’t differentiate between buildings that require massive amounts of capital and labor to keep up and ones that don’t.

 

In general, this is a great short-cut to decide if a building is worth doing more work on.   Cap rate analysis is just a starting point in deciding what to bid for a property.  But understanding market cap rates (or the average cap rate that assets have been trading for) is a very valuable metric.  I would place this as the second best method for valuing real estate.

 

Replacement Cost Analysis

The replacement cost analysis is exactly what it sounds like.  The replacement cost is the cost to recreate that exact asset in that exact location.  A good replacement cost analysis will not only take in to account land values and building costs but also developer profit and carrying cost for construction debt.

 

Although brokers often say ‘this is going to trade below replacement cost’ it is often not the case and also, that is usually not a relevant metric.  The replacement cost is a backward looking metric and one that doesn’t take in to account the most important thing, what the building will be able to earn right now.  Remember, cash is king. 

 

I will say that in general, this method is unhelpful.  The argument that if you buy something under replacement cost, ‘you can only get hurt if no one ever builds here again’ is a shabby one.  If you are buying in a vibrant market with high volatility, this argument could have some merit.  But unless you are getting an off-market deal or there is some reason to believe that other informed buyers haven’t been made aware of the deal you are exploring, you should ask yourself why you can buy something at below replacement cost. 

 

Comparable Analysis

This is the most important method for valuing any type of asset, but it is especially helpful in real estate.  The comparable method or comp method is simply looking for assets in the market that are similar to the one you are acquiring and looking at what they have traded for on a per square foot, per acre or per unit basis.   If you are paying more, then everyone else in the market, there had better be a good reason.  And if you are paying less, figure out why.

 

This method is best for ‘hard to value assets’ like vacant buildings, land and residential homes.  For those items, cash flows are non-existent or too difficult to estimate.  Embedded in this method of valuation is a central theme, that of the efficient market.  So long as there are ample bidders and relatively fair market disclosure the prices at which assets have been trading are probably the best indication of their value. 

 

 

If you have more specific questions about another method or about something in this article, please do not hesitate to write me or post it to whatbubble.com.

 

-js

 

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