Rick Sharga is correct, the fed’s new short sale program won’t be the answer the government seeks, or is selling. Sharga, RealtyTrac’s chief economist, was commenting on the new Treasury Department rules going into effect on April 5th. (Short sales suggested as option to loan modification, The Seattle Times, Real Estate, Sunday, March 28, 2010) Under the new rules, a short sale must presented to a borrower as the logical next step if the homeowner fails to meet the criteria for a home modification under the Home Affordable Modification Program (HAMP). According to Sharga, “While we’ll likely see an increase in the number of short sales, I doubt the reality will live up to the hype.” Currently, homeowners with their backs to the wall are going to their lenders to either request a deed in lieu (i.e., handing back the keys with the deed) or asking for approval of a short sale as alternatives to foreclosure when a loan modification request fails. Yes, they are asking the same lender that wouldn’t work with them on modifying the terms of their loan to approve a sale and take less than what is owed at closing… So, now the Treasury Department is requiring the lender suggest that the borrower consider a short sale after they turn down the same borrower’s request for a loan modification. And this is somehow going to change things? While lenders “must” offer the short sale alternative, there is no law requiring lenders to work in good faith to approve or consummate short sale transactions.

There are a couple good things coming out of the new rules – the borrower may receive assistance with relocation expenses from the lender (up to One Thousand Five Hundred Dollars) and the lender will be offered One Thousand of your dollars for each short sale completed. However, there is nothing to suggest that lenders have to consider a short sale unless the borrower agrees to take back a note for the deficiency (i.e., the difference between the amount the lender would have otherwise realized at closing and the amount short). This is a huge stumbling block as most borrowers, if they could afford to pay the deficiency, wouldn’t be asking for a short sale in the first place. To re-frame the issue, the borrower loses his or her home, then rents an apartment and on top of rent, has a residual note payment due each month to their former lender. A bitter pill, no doubt. That’s of course assuming that the short sale goes through before the foreclosure. Not that all borrowers are innocent victims. But that’s not the issue. The issue is – when are the feds going to deal with the short sale process and create definitive, non–ambiguous guidelines? No time soon I fear.

The really good news in the new program is that lenders will no longer be able to reduce real estate agent commissions. Agents have to work their tails off on these deals; they take months and months to complete, and hours and hours on the telephone for the negotiator, usually a real estate agent or lawyer. Lenders’ are resistant throughout the entire process, and then they want to all but eliminate broker commissions prior to finally approving the sale, if the sale is actually approved. Protecting commissions will incentivize agents and should generate more interest in working these kinds of deals. That alone should be some good news for underwater borrowers.

Senate Bill 6749, mandating disclosures in commercial real estate transactions, was signed into law today by Governor Christine Gregoire. The bill passed the house and senate unopposed. The following analysis was prepared by non-partisan legislative staff for the use of legislative members in their deliberations. This analysis is not a part of the legislation nor does it constitute a statement of legislative intent:

A seller of commercial real estate must provide a buyer with a disclosure statement about the land unless the buyer waives the right to receive it. The disclosure for commercial real estate concerns title, water, sewer/on-site sewage, structure, systems and fixtures and environmental. The disclosure statement must be provided within five business days, or as otherwise agreed to, after mutual acceptance of a written purchase agreement between a buyer and a seller. Within three business days of receiving the disclosure statement, the buyer has the right to approve and accept the statement or rescind the agreement for purchase. If the seller fails to provide the statement, the buyer may rescind the transaction until the transfer has closed. If the disclosure statement is delivered late, the buyer’s right to rescind expires three days after receipt of the statement.

Generally, complete due diligence on a commercial property acquisition, be it a redevelopment opportunity, development land, improved shopping center, industrial, or office property, always includes comprehensive review of title, utilities, structure, fixtures and environmental. This cost is generally absorbed by the buyer, normally a professional experienced in commercial real estate transactions, with all reports certified to the buyer. However, on smaller deals undertaken with less seasoned, unsophisticated buyers, this law will bring the importance of due diligence to the forefront of the transaction. Often this class of buyer is schmoozed into overlooking proper due diligence during the sell the sizzle not the steak, hard sell process. As an aside, that very pitch, heard by this writer first hand, was advocated by a certain President and CEO of a regional real estate brokerage with international offices, to the commercial real estate investment brokers and sales agents. His name, and that of the firm, shall go unmentioned.

Naysayers may argue that this law will increase the burden on sellers and increase transaction costs. I think it will protect a vulnerable class of buyers who are sometimes encouraged to close quickly without conducing proper investigation. The opt out language in the law, allowing the parties to shift the burden and costs from seller to buyer, negates the increased transaction cost argument. Most buyers will continue to bear the burden of due diligence.

I believe this is a good law protecting a potentially vulnerable, if not financially secure, class of real estate investors. The question becomes what level of detail in the disclosures will be minimally acceptable in litigated cases.

The law goes into effect in 90 days.

As most Washington residents now know, our legislature is proposing a first ever personal income tax to meet budget deficits (Senate Bill 6250). The tax will be imposed on all income of resident individuals, estates and trusts deriving income from Washington State. The proposed new rates look like this:

Married, filing jointly:
Not over $49,900 – 2.2% of taxable income
Over $49,900 but not over $120,650 – $1,098 plus 3.5% of the excess over $49,900
Over $120,650 – $3,574 plus 6.0% of the excess over $120,650

Head of household:
Not over $37,425 – 2.2% of taxable income
Over $37,425 but not over $90,488 – $823 plus 3.5% of the excess over $37,425
Over $90,488 – $2,681 plus 6.0% of the excess over $90,488

Individual:
Not over $24,950 – 2.2% of taxable income
Over $24,950 but not over $60,325 – $549 plus 3.5% of the excess over $24,950
Over $60,325 – $1,787 plus 6.0% of the excess over $60,325

Rate increases begin in 2012 to adjust for inflation. (Too bad incomes and sales don’t automatically adjust for inflation as well.)

Despite the constant background buzz around the alleged economic “recovery,” there are a lot of duel income families, and individuals, living pay check to pay check, very close to the edge. Many small and mid-size businesses are just getting by trying to keep the doors open. Others are trying to launch. Even with the proposed B&O tax credit these rates are going to kill a lot of struggling small businesses and and families trying to cope. Admittedly, belt tightening will only get our state so far; there are a lot of programs that need funding. Nonetheless, I don’t accept that a personal income tax is good for our state. As other commentators have pointed out, one need look no further than California. No bragging rights in that.

I didn’t have much chance to blog the last couple months. My resolution is to post more frequently this year.

Where will the economy take us this year? That’s the million dollar question. The GNP grew to 5.5%. Manufactures are restocking shelves. Some sectors of the economy are showing signs of life. That’s the good news. Signs of a recovery, but does it have traction? The national debt is approaching $1.3 Trillion. Sales of existing homes are at a 40 year low. Less than 5% of the millions of loan modification requests are getting approved and completed. Banks are taking an equally hard line on short sales. The employment market, particularly where real jobs are needed, is looking as bleak as the housing market with six job seekers for every opening. Locally we have years of office and retail space inventory. Retail real estate rents are almost half of what they were in 2007. You can lease first class retail strip center space for $18.00 PSF; these are store rooms that were pro forma $30.00 PSF space a few short years ago. Secondary space is more dismal. There are some deals being made, but few are bankable leases. The books of developers with extensions on 2007 or earlier construction loans are not looking too good. And a lot of the lenders that put them into those loans are gone; and for good reason. Then there is the $800 Billion of Commercial Mortgage-Backed Securities that are scheduled into default over the next three to four years. If CMBS defaults start to spike at the same time that the next wave of Alt-A defaults are scheduled to renew their upward trajectory, which could be as early as spring, it could set our recovery back a bit. Clearly there will be a lot of opportunity for those who can carve out a niche in these trends. A lot of displaced professionals are starting new businesses and buying franchises. Many of them will prosper and add value to our economy.

Last night the Food Channel has a special show on potatoes. Apparently world-wide consumption of potatoes is at an all time high. At the same time, the Travel Channel had a special on super yachts. Same thing, orders for new super yachts is at an all time high. I don’t watch a lot of TV, but I did find that programming juxtaposition interesting.

It will be in interesting year to say the least.

The Seattle Times reports today defaulted commercial loans are hitting local lender P&Ls. The commercial loan default wave is barley news worthy at this point. A number of local banks have been hit with cease and desist letters from the Feds in recent weeks. What’s interesting is that Seattle-Bellevue-Everett metro had the nation’s highest delinquency rate for construction and land loans in the second quarter of this year. I don’t think you can blame the developers, at least not all of them. Clearly lenders have been reckless in their evaluation of project viability and employment of funds held in their trust. When a lender approves a deal based on pro forma development costs and income with no basis in reality, backed by other projects from the same developer that are also based on blue sky pro forma income, at some point someone needs ask hard questions or put on the breaks. But no one did. Why is that? It’s way more fun to just make deals and get paid. No one wants to be accused of being a deal breaker. Plus, if your favorite developer is in obvious trouble, or is clearly cooking the books, that next loan may be all it takes to pull out of the tail spin. Right? Well, it sure doesn’t look like now.

The Mastro “friends and family” investor debacle grinds on. Does anyone have a clue how many other friends and family of other developers are in line for the big burn on limited liability company investments here in Washington State, regionally or nationally? Between your mom and pop developers, syndicators, 1031 exchange partnership members, and REITs, all of whom have heavily leveraged the savings of their investors, there is still a lot of blood being spilt with no tourniquet in sight. Some investors were well disclosed; most not creating a real liability issue for the sponsors. As a side question, why isn’t security law compliance part of the due diligence on a commercial loan application when it should be obvious based on a surface examination of the entity closing the loan that investor funds are at risk? I think a close examination would show that security law violations have been flagrant and widespread in the past decade locally and nationally. Which gets us back to the problem of today’s defaulted commercial loans – as long as the rising tide is lifting boats, no need to ask hard questions or disclose uncomfortable realities. A couple years ago everyone’s financial statements in these deals looked like rock stars. Now you have projects and partnerships in default and foreclosure with no end in sight. Lost are deferred salaries, retirement plans, college education funds, and saving. Despite the continuing reports that the economy is recovering, I think we have a very long, long way to go before all the trouble commercial assets shake out of the system. And the analysis didn’t take an economics degree to figure out in the first place. Assigning unrealistic cap rates to nonexistent income on marginalized deals based on beating the next guy to market never made much sense to me. I guess no one wants to be accused of being a deal killer or having a bad attitude. So scratch that. That’s all for now.

September is almost over and I haven’t had the chance to post to the BLOG all month. There were several stories that I was working on this month that I didn’t get around to completing, including:

Newsweek issued a warning about the impact the commercial real estate bubble will have on the greater economy. (Not that it’s news at this point.) The nation’s offices, hotels, and malls now carry $3.5 trillion in debt. Falling rent and rising defaults could inflict more damage on the greater economy (and result in further cap rate creep) in the coming year. According to sources, Seattle-Bellevue has over eleven years of Class A office inventory based on historic absorption rates. The spread between bid and offer on commercial sales continues to stall activity. Those sales that are closing are for the most part at barn burner prices. There is activity in commercial leasing and sales with some deals closing, however, it’s a tough market with no immediate end in sight. It’s a great time to be a cash buyer.

Housing is showing some signs of life with prices stabilizing in parts of the Seattle market. The Obama first time buyer tax credit is helping. Demand for residential properties priced over $1.5MM, however, is all but dead. Influencers include a general lack of interest in McMansions and lack of creative financing for upper end buyers. The high end outlying market has been way overvalued for a long time now. Financing will loosen up eventually, but the days of no down and easy credit and terms for high end buyers won’t be back soon.

Home inspectors in Washington State must now be licensed. RCW 18.280.020 provides that a person shall not engage in or conduct, or advertise or hold himself or herself out as engaging in or conducting, the business of or acting in the capacity of a home inspector without first obtaining a license as provided in this chapter. Any person performing the duties of a home inspector on June 12, 2008, has until July 1, 2010, to meet the licensing requirements. However, if a person performing the duties of a home inspector on June 12, 2008, has proof that he or she has worked as a home inspector for at least two years and has conducted at least one hundred home inspections, he or she may apply to the board before September 1, 2009, for licensure without meeting the instruction and training requirements of RCW 18.280. In order to become licensed as a home inspector, an applicant must furnish proof of a minimum of one hundred twenty hours of classroom instruction and up to forty hours of field training supervised by a licensed home inspector and pass a written exam. The license must be renewed every two years. A good law and one that was long overdue. Even with licensing in place, however, buyers still need to check the fine print on the contract, particularly the waiver and limitation of warranties.

On August 1, 2009, the FTC began enforcing its so called “Red Flag Rules,” which requires certain businesses, including franchisors, to develop effective programs to identify the warning signs of identity thief.

Franchisors that regularly extend “credit” to their franchisees or arrange financing are subject to the rule. A franchisee may be regarded as a creditor if it defers payments from its franchisees or extents credit or if a franchisor bills a franchisee after providing goods or services. The other way a franchisor would fall under the rule is if it suspects that it may be subject to risk of identity thief. With such broad coverage, most national and regional franchise systems would appear to be subject to this new rule.

If a franchise system is subject to the rule, then it is responsible to develop and put an effective identity theft program into place. The program must be approved by the corporate board of directors or senior management. Failure to comply could result in a franchisor being fined civil penalties.

Although burdensome on franchisors, hopefully this new rule will help curb identity thief, a growing international concern. For more information about the Red Flag Rules, the FTC has published a free plain-language handbook, Fighting Fraud with the Red Flags Rule: A How-To Guide for Business. For a free copy of the guidebook, or for more information about compliance, visit the FTC’s website.

Postscript: With news today of Federal prosecutors charging a Miami man of trying to gain access to 130 million credit and debit card accounts, mostly though hacking into retail networks, it’s difficult to argue against the logic of the Red Flag Rule, despite the obvious burden it places on certain business and franchise enterprises.

Today’s Seattle Times’ Retail Report featured a story on dwindling occupancy in the downtown retail core. Vacancies are up 3.4% and so are rents – from $31.50 to $31.80. Who would increase rents – even thirty cents a square foot – when vacancies are increasing at the same time with no end in sight? Owners and managers who want to offset the negative impact of rising cap rates (a income multiplier used to value commercial real estate) on pro forma operating statements for valuing real estate investments for one. There are other reasons too. But that is an incentive. At $31.80 PSF, a independent retailer needs to generate sales of $636.00 PSF to “make it” according to conventional wisdom and published statistics (ICSC) as a 5% rent load factor is optimal for most retailers. I said most. Food operators – double that. So, a typical 1,000 square foot boutique needs to generate $636,000 annual sales. In this business environment, that’s a tall order. Get out to your suburban strip center and mini-strip center, the numbers are a little less harsh as rent is quite a bit lower, however, same math applies. And foot traffic is lower, or non-existent, with sales much lower as well. In my client mix, I represent small retailers, the “moms and pops.” I’ve put them in business, and helped them shut ‘em down. It’s painful to watch years of savings and hard work, go down the drain in an economy like this. I’ve also helped many save themselves from themselves, by pointing out the flaws in their business plans, and advising to hold off for another day. I only digress to save my reader from thought that I may have been dishing on small business last week. I wasn’t. As to the recession benefitting “big retailers,” from the onslaught of bankruptcies this past year, I think the jury is still out on that one. Please support your neighborhood mom and pop stores. They stepped out and took the risk. Independent retailers need and deserve our business. Have a great Memorial Day Weekend. Enjoy the sunny Seattle weather.

This morning NPR featured a piece on the National Association of Realtors’ annual convention in Washington DC. The upshot is that the ever-optimistic Realtor group sees a ray of sunshine in the otherwise gloomy real estate market. Thanks to government programs, first time home buyers may qualify for products that may help the battered market. Not so lucky are the commercial real estate brokers, or investors for that matter, as the lending market continues its deep freeze. That with today’s report of lower than expected retail sales, I thought I’d revisit commercial real estate investment grade cap rates and sales.

Ouch… Deals that were going out a few years ago at 5% cap rates are now in the mid-sevens. What does this mean? If you had purchased a commercial property, say a Walgreens Drug Store with $300,000 net operating income (“NOI”) at a 5% cap rate, back around 2004, 2005, you would have paid around $6MM. A conventional take out loan at 75% loan-to-value would require $1.2MM equity investment. That same credit tenant lease and NOI today at a 7.5% cap rate is worth a mere $4MM. In other words, that brilliant 2005 addition to the portfolio is now upside down to the tune of two million bucks, rounded. You’ve not only lost all your equity, but your loan is upside down too. Worse for the rest of us, your lender is south in security in the neighborhood of $1.5MM (the difference between the $4.5MM he or she could have underwritten then, versus the $3MM that could otherwise be underwritten today). If you bought a little strip center to go along with your mini-anchor, filled or partially filled with zero-credit tenants (mom and pop coffee shops, dry cleaners, hair, nail and tanning salons, struggling franchised five buck sandwich shops, etc.), then that part of the portfolio is in even worse shape, if that’s possible. It certainly is on paper if you’re being honest. There are tons of those deals out there too. And I don’t think their impact has really hit public consciousness or pocketbooks yet. No question, however, that cap rate increases have hit the valuation of REITS, and private retirement portfolios; and increased illiquidity in capital markets, hence the freeze.

There is a title wave of commercial real estate foreclosures ready to hit. It is being held off in some measure, but who knows for how much longer. There is anecdotal evidence in the market that many developers and investors, particularly local and regional mom and pops, are still living in dreamland, grossly overvaluing their portfolios. Lender complicity in these dreams only postpones the pain. Will it turn around some day? Maybe. It always seems to, eventually, but that sunny day is not on the horizon just yet.

Last month the Department of Financial Institutions released an Interpretative Statement related to the Mortgage Broker Practices Act (“MBPA”) and the Consumer Loan Act (“CLA”). The statement was in response to inquiries as to whether or not loan modification service providers must be licensed in Washington State to offer services to Washington residents involving their Washington real property. Anyone exploring Craigslist, the Pennysaver or other compilations of classified ads knows that the sharks run thick in those waters trolling for the unwary looking for shelter from bad loans. Interestingly enough, companies from California and Florida seem to lead the pack. Some are looking for lawyers and former real estate agents to partner in the loan modification business.

The short answer is yes. In order to offer loan modification services in Washington State requires licensing under the Mortgage Broker Practices Act RCW 19.146, or Consumer Loan Act RCW31.04, unless a specific exemption applies. Significant excerpts from discussion section of the Interpretative Statement follows and makes for good reading for anyone seeking services from a loan modification specialist:

The Division has received many inquiries regarding the regulation of loan modification services. According to callers, individuals are communicating directly with borrowers and brokers offering to provide loan modifications services. Many callers inquire about what restrictions are applicable to loan modification services.

In addition to any applicable licensing requirements under either the MBPA or CLA, all individuals who offer or negotiate loan terms for borrowers are prohibited from directly or indirectly employing any scheme, device, or artifice to defraud or mislead borrowers or lenders or to defraud any person; engaging in any unfair or deceptive practice toward any person; obtaining property by fraud or misrepresentation; soliciting or entering into a contract with a borrower that provides in substance that the mortgage broker or loan originator may earn a fee or commission through “best efforts” to obtain a loan modification even though no loan modification is actually obtained for the borrower.

There seem to be new companies coming into, or forming in Washington State, on a weekly basis, offering loan modification services. Many are legitimate; however, many are simply out for a quick buck. And that buck quickly heads south and out of state. We’ve seen too much carnage in this area already. This interpretative has been circulated by the NWMLS and the WSBA Real Property Listserv to advise brokers and lawyers practicing in this area as to what the guidelines are for compliance. Consumers need the same information to make informed choices. As always, it makes sense to shop around before committing. Before you shop, make sure you know the rules of the road.