Saturday, June 4, 2016

What did that Broker Just Say?

I think it's safe to say that we're in a hot, perhaps bubbly commercial real estate market. Prices have increased rapidly, cap rates are at all time lows, lenders are getting increasingly aggressive, big portfolio deals have made a furious comeback, certain market segments are seeing large increases in supply, etc... I think a lot about where we are in the cycle and how much runway is left frequently and I'm always looking for signals / indicators.

Michael Burry, as made famous in The Big Short, had a great line where he claims one of the best indicators of a bubble is rampant fraud occurring in the marketplace. There's certainly a good amount of truth to that--just look at the dot com bubble where there were numerous scam "tech" companies selling stock to the public based on total fraud. In the housing bubble, mortgage origination was so fradulent and widespread that it was basically a well known joke that if you fogged a mirror you could get a million dollar loan--again, this was mainly based on fraud and lack of oversight on many levels.

I think identifying fraud can actually be pretty tricky. Thinking back on the housing bubble, again, everyone sort of knew that it was insanely easy to get a mortgage, perhaps too easy, but I get the sense that most people viewed that as a feature, not a bug. There was almost an attitude of, well, it's probably a little too easy to get a mortgage, but so what? What could go wrong? Plus, it's really nice to be able to get a high leverage mortgage without providing any documentation!

I can't say I see blatant rampant fraud in the commercial real estate industry at the moment, but I am seeing a lot of what I consider fraud-light, and that's brokers being extremely promotional / stretching the truth in order to get a deal done. Now, brokers are very well known for being shady and living on the edge of truth and proper ethics no matter what time period you're talking about, but over the last 6 months especially it seems like I've seen a massive up-tic in both the amount of broker lies and the magnitude of them.

For example, my company was recently looking at buying a building with a large tenant that occupied 25% of the building. Their lease was going to expire about 6 months after we were anticipating closing on the deal. Whether the tenant was planning on renewing their lease or vacating was going to have a huge impact on our returns and what price we would be willing to purchase it for. Well, we were working with a broker that brought the deal to us and he had a good relationship with the tenant. We asked the broker what the tenant was planning and, of course, the broker said they were in the process of renewing their lease and there was nothing to worry about. We subsequently submitted an offer and went into escrow at a purchase price that assumed the tenant was staying.

A week into our due diligence period, I'm talking with the property manager, and specifically ask about the large tenant. The property manager accidentally let slip the fact that they had no intention of renewing their lease and would be vacating after it expired. Apparently, the landlord had been made aware of this fact months ago.

Now, we were upset, but assumed the broker just misheard or was misled somehow. The only problem is, a week after the discussion with the property manager we found a marketing flyer for the large tenant's space produced by the broker that told us they are staying! This broker, upon learning we were interested in buying the building, purposefully took the marketing flyer off the internet and tried to hide the fact that he knew they were leaving.

It gets even better. After finding the flyer, we called the broker and called him out on his shenanigans. Instead of owning up to it, or acting even slightly sheepish, the guy goes on to push the deal on us even more, claiming that it's still a great deal even with the tenant gone because the in-place income would still be a 5% cap on the purchase price! He said, and I quote, "that's way better than the 1% you'll earn in a bank account!"

Obviously, we blew out of the deal and will no longer be working with that broker. That's only one instance, but I can recall several similar instances that have occurred just within the last 6 months. To me, this fraud-light just indicates a lack of long term vision, short term money grab type of attitude in the market right now. That attitude, I think, is largely driven by speculative / bubbly conditions. The broker in the above example is making so much money, is so busy, has so many clients, that he can lie, mistreat, risk a lawsuit, and alienate a major real estate company in his market. I just can't see that type of behavior occurring in anything but a bubble.

I think this up-tic in fraud-light is probably the best indicator I've come across yet that we're in the late innings of the cycle. Time will only tell and I'll probably be wrong, but we'll see...

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