Chairman's Communiqué: RocHenge Capital No. 2September 25, 2009 Dear Investor, Over the span of 30 years, our real estate ventures have been consistently profitable. Much of this success is attributable to prescient market timing, whereby we try to enter markets when they are relatively inexpensive, and try to exit markets as they become relatively expensive. Cash on cash returns vary among the projects, but total weighted average annualized returns on all real estate investments approximates 44%. The sizable tax benefits realized from real estate ownership drive returns higher, depending on each investor's individual tax circumstances. The Panic of 2008 has triggered a series of events that will lead to the best buying opportunities in the US commercial real estate markets in generations. Not since the real estate depression in oil patch states caused by the collapse of oil prices, overbuilding engendered by deregulation of the thrift industry, and tax reform in 1986, have market conditions coalesced to cause such value destruction as the recession and credit debacle that began in August of 2008. Between 2007 and 2010, commercial real estate will have declined in value by as much as 75%, offering great opportunities to acquire property at considerable discounts to replacement cost. Additionally, conditions already in place will cause asset price inflation in the following years, providing opportunities for extraordinary profits for canny investors. Inflating the Bubble
"Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." - Sir John Templeton. Between 2005 and 2007, a veritable rush of capital into the commercial real estate market propelled prices to all time highs. Capitalization rates dropped to record lows, with properties leased to credit tenants trading at cap rates of 5% or lower. Real estate, viewed as a low risk proposition where values only rose, attracted buyers with little ownership or operational experience. Underestimating the risks of ownership and the real costs of operations was common during the manic phase of the cycle. Combined with exceptionally low cap rates, these factors led to unrealistic valuations of income streams. Other dynamics helped drive demand to frenzied levels, including promoters of TICs (Tenant in Common ownership), REITs (Real Estate Investment Trusts) flush with cash, securitization of debt, and foreign investors looking to repatriate dollars gleaned from the enormous US trade deficit. Promoters advertised TIC's with the promise of "hassle-free property ownership," and a way for smaller property owners to "trade up" to an undivided interest in trophy properties. We advised investors to steer clear for two main reasons. First, legal prohibitions disallowed promoters from keeping a piece of the deal as compensation. Instead, their incentives came up front, by acquiring the property and selling it, often at inflated prices, to the TIC, as well as with fees generated by the transaction. Once the deal closed, the promoters generally remained as property managers with no interest in the property and the only incentive of generating additional fees. Changes to management or operating agreements required the unanimous consent of a disparate group of up to thirty-two owners, each with their own motivations. The mishmash of a manager/promoter with no ownership interest and the inability to make adjustments to accommodate unforeseen issues proved a recipe for failure. TIC owned properties are now appearing on the market as troubled assets, and we expect a steady supply for the next five years. REITs were popular vehicles for real estate investment and attracted a cascade of capital from hedge funds, investment bankers and other promoters. As with TICs, the promoter and the owners have divergent interests. With REITs, the promoters are motivated to place as much capital as possible to generate fees and enlarge the total size of the entity. Hundreds of REITs and TICs competed for the same properties, driving prices to levels not justified by income streams. With surging demand, motivated buyers with capital sought to justify elevated prices by altering purchase criteria. Initially, lower cap rates helped, but eventually it was necessary to manipulate income streams to rationalize transactions. Expenses were compressed or eliminated; some reclassified as capital to move them off the income and expense statement. Income projections were increased to the level needed to justify a specified purchase price. A steady stream of securitized debt from investment banks and cooperative appraisers helped provide the capital necessary to complete the transactions. As in the residential market, investment banks discovered the appeal of securitizing commercial real estate debt and began gorging at the trough of the Commercial Mortgage Backed Securities (CMBS) market. As with prospective purchasers, investment banks and their appraisers did what was necessary to qualify properties for their AAA rated securities. Analogous to the residential MBS market, junk paper was placed into a blender and magically turned into AAA paper. As a result, the commercial market is sharing the fate of the residential markets with soaring default rates. Servicers have virtually no ability to negotiate terms, nor do they have anyone to consult, with hundreds or thousands of disparate owners spread across the globe, each with a sliver of ownership. The resulting mass confusion will lead to unnecessarily high discounts of paper sold to distressed debt investors or mass foreclosures. Finally, foreign buyers with excess dollars generated by the US balance of trade deficits were looking for alternatives to repatriating cash via historically low-yielding T-Bills. Whether through direct or indirect investment via REITs, CMBS and other instruments, they infused additional froth into the market. The influx of investors unmotivated by conventional criteria such as cash flow, intrinsic value and realistic potential drove the market to unsustainable levels. By late 2007, some sophisticated investors began to exit the market on concerns that it was poised for a correction. The simultaneous rush of properties to the market and vanishing purchasers slowed activity markedly. When the economy cratered in August of 2008, an already wobbly commercial real estate market buckled. The Bubble Bursts
"You don't want a capital market that functions perfectly if you're in my business." - Warren Buffett, CEO Berkshire, Hathaway in April 2008. Economic bubbles burst when the causal factors reverse. By 2007, the residential side of the market was showing signs of stress, especially in markets that had enjoyed the greatest appreciation in preceding years. Delinquencies and foreclosures rose sharply, inventory spiked, sales declined and days on market rose. In typical fashion, distress in the residential market worked its way in to the commercial market within a year. Combined with the slowing economy and rising unemployment, the rout was on in 2008, with market activity dropping sharply, and delinquencies on the rise. In short order, cap rates rose 30 to 40%, causing commensurate declines in value, assuming unchanged net income. However, net income was often tumbling as the tenant base destabilized. Tenants realigned space requirements with economic realities, or in many cases simply failed, further depressing revenue. Concurrently, many owners were awakening to the realization that the actual expense load on their properties was higher than projected at the time of purchase. As a result, expected net revenues declined rapidly, further disheartening reeling markets. As values declined and delinquencies soared, lenders cut back on the loans, inhibiting refinances and sales. This adverse spiral intensified the downturn, as more foreclosures caused contraction of capital in the pipeline for new activity. Finally, the economic and financial collapse proved the proverbial final straw. Once 50% of mortgage funding, the secondary market virtually disappeared as investment banks teetered and pension funds and insurance companies counted their losses. Commercial banks cut back lending in response to overleveraging, regulator pressure, and fear. Delinquecies in commnercial mortgages increased rapidly and are likely to approach levels unseen since the 1930's. Banks switched from lending to workout mode, and underwriting standards have eliminated all but the most qualified borrowers. The CMBS and secondary markets are virtually closed and are unlikely to return to former levels. Finally, private debt ballooned from approximately 35% of GDP after WWII to 150% of GDP in 2007. While economists interpret these numbers differently, there is general agreement that a considerable amount of deleveraging is necessary. This will lead to abridged spending habits, an adjustment in standards of living, and retrenchment for the economy for the near future. The Opportunity
"The time to buy is when blood is running in the streets." - Baron Nathan Rothschild, 1815
Banks and other lenders will initially attempt to work with borrowers, but in many cases the properties are too far underwater and the next steps are workouts, sale of notes prior to foreclosure, deeds in lieu of foreclosure, short sales, and ultimately, foreclosures. Even owners with equity in their portfolios may be compelled to sell properties to raise cash. ProLogis, the world's largest industrial REIT, is selling 33 million square feet of industrial space, much at a loss, to raise cash for operations. With a large amount of product hitting the market in a recessionary environment in which many potential buyers are dealing with financial distress, prices will decline further, in many cases to a fraction of replacement value. RocHenge Capital is raising funds to take advantage of the distress in the commercial real estate market over the next few years. We have employed a buy low, sell high strategy successfully in the last three major cycles over 30 years. We began investing during the upturn after the 1975 recession followed by the inflationary period ending in 1983, and sold prior to the crash in 1986. We began buying again during the recovery period from the real estate depression in the oil patch states that lasted from 1983-1989, and rode the crest to 2000. Finally, we generally sold before the downturn that began with the dot.com bust and September 11, 2001, and began buying property in 2004, riding the crest to 2007. Outlook and Plan
The general strategy is contrarian logic. Buy property when market conditions cause deflation in prices, specifically relative to replacement value. Purchase in desirable markets with growing populations and vital economies that will recover as the national economy improves, and manage those properties cost effectively. Selective improvements are made that add to the bottom line, including energy efficiency/green building improvements with tax benefits/tax credits and utility company rebates such as LED's, CFL's, insulation and automation of HVAC systems. Additional cosmetic changes enhance appeal to prospective customers, and perform deferred maintenance to extend the useful life of the property. Most important, don't fight market direction, buy when demand is weak, sell while demand is strong. Despite present economic difficulties, the markets will eventually recover and property values will rise as supply tightens. In past economic and societal collapses, human ingenuity has ultimately discovered ways to mitigate the damage from prior periods of excess. Periods of record prosperity have followed every downturn in the U.S. Any number of drivers could change the course of the present downturn, such as biotechnology, green energy, nanotechnology, internet V3, 4G networks, wi-max and robotics and artificial intelligence. What factors power the next boom is speculative; something will undoubtedly propel employment, space utilization in buildings, and economic growth. In addition to economic growth, other factors will influence demand for hard assets and push prices higher over the next decade. To deal with huge levels of foreign debt and intractable negative trade balances, nations with current account surpluses with the U.S. will employ currency arbitrage to repatriate dollars. In the recent past, investors purchased U.S. Government debt and Subprime AAA mortgage backed securities (MBS), sometimes backed by credit default swaps issued by the likes of AIG. The story of the MBS market is well known, and Treasury bills have very low yields. Given the concern for inflation and currency devaluation from deficit spending, some investors will seek refuge in hard assets, principally real estate. Massive monetary and fiscal stimulus as well as the exponential growth of government debt will inevitably lead to inflation. The U.S. presently has nearly $100 trillion dollars in unfunded liabilities ($350,000 per person), or more than 7 times the present GDP. According to David Walker, former head of the U.S. Government Accountability Office (GAO) and now CEO of the Peter G. Peterson Foundation, "America now owes more than Americans are worth, and the gap is growing." Government debt is growing so rapidly that tacit acceptance of higher inflation as a way to pare down national debt (invisible taxation) is likely. This inflation will only partially show up in the CPI or PPI because globalization has led to vast excess and expandable productive capacity that will restrain rising prices in consumer goods. Instead, increasing prices will show up in asset valuations, especially limited or fixed supply hard assets, including real estate and gold, as well as fossil fuels. Moreover, unlike gold, improved property ownership can provide income and substantial tax advantages. Competition for capital from governments running colossal deficits will lead to a relative scarcity of capital for private enterprise. In the shadow of massive losses from 2008-10, lenders will be more conservative and this risk aversion in the depleted credit markets will constrain new construction for many years. As excess supply is absorbed, vacancy rates will likely drop below the levels that sparked new construction in prior cycles. Tighter supplies will drive up prices and values. Vacancy rates will approach 20% in overbuilt markets, with new buildings coming on-line adding more than 5% to existing supply. With contraction in business due to the recession, vacancy rates could reach 30%. It might take ten years to bring occupancy levels to the equilibrium point where new construction is economically justified. Second tier markets similar to Denver, where new construction is adding only 2% to the existing inventory, will see lesser increases in vacancy and thus shorter and shallower corrections. Existing vacancy rates of 14% may increase to 16% due to business contractions, and 18% with the new supply. It will be possible to employ a tiered approach to investing, timing movement to markets with the best potential returns. RocHenge Capital No. 2 is uniquely positioned to benefit from this rare buying opportunity in commercial real estate. Its principal and predecessor companies have consistently generated exceptional returns over the past 30 years and have demonstrated the ability to navigate a wide range of market conditions. Bill Thorvilson and I each have experience beginning in the late 1970's and spanning to 2009, including the late 80's bust in Colorado in which we dealt with the Resolution Trust Corporation (RTC) and banks for Real Estate Owned (REOs), as well as owners of distressed properties. We have succeeded in all economic environments, but have special skills in downturns, rare in similar companies. In addition, we have brought in the next generation of talented managers for RocHenge Capital, and are arming them with the skills they will need to achieve similar results in the future. Past results are not necessarily a predictor of future performance, but may be the best gauge available. We will endeavor to perform as in the past.
Bob Collawn and RocHenge Capital No 2.:
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