August 11, 2009

Garbage-In-Garbage-Out

Maguire Properties, a Real Estate Invesment Trust (REIT), recently notified the holders of $1.06 billion of its debt that it may not exactly be able to pay the next note payment.

The following analysis from Seeking Alpha brings to light the idea of GARBAGE-IN-GARBAGE OUT. This is also why investors like Warren Buffett constantly talk about having a margin of safety when you invest.

"Obviously, those REIT's whose assumptions were most favorable going into these deals are the ones getting burned right now. Maguire and many others examine a property from the front-end using a pro forma that includes future assumptions about market rents. Usually these assumptions end up as a linear, positive function; that is, rents are assumed to rise steadily and incrementally throughout the first 10 years of the building's life. The result is inevitably a model which indicates steadily higher levels of free cash flow, after paying for the building's management and dropping some maintenance dollars into the escrow of course. Obviously, the closer to the peak of the commercial real estate market a building was financed/modeled, the quicker it will approach the "danger zone". This is a term that I'm completely making up, but it refers to the point at which a commercial building's cash flow is insufficient to service its debt. This ends up being a function of the severity of declines in market rents, the viability/solvency of the individual lessee's, and the level of financing secured for the property relative to its value (LTV)."

This is probably the tenth time I have stated this on this blog, but this story is just begging me to once again quote Oatkree Capital's Howard Marks, who said:

Leverage + Volatility = Dynamite

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