Restructuring Real Estate When Assumptions Change

- Hello, everybody. My name is Richard Green. I'm director of the USC Lusk Center for Real Estate, and this is "Lusk Perspectives," a podcast series which discusses real estate markets and things ancillary to the real estate market with a series of expert guests. It is our pleasure to be joined today by Cynthia Nelson, senior managing director at FTI Consulting, a company based in Los Angeles. Cynthia has more than 30 years of experience in advising and consulting. She works with the real estate industry as well as other industries, including retail, hospitality, film exhibition, healthcare, the automotive industry, and the public sector. She especially is well known for her work on turnarounds and dealing with bankruptcies and difficult mortgages and so on. And so a conversation with her seems particularly relevant at this time. Cynthia, thank you for being with us today.

- Oh, my pleasure, Richard.

- So Cynthia, we always like to start out by learning a little bit about our guest journeys, how they got to be the people they came to be. And so if you could fill our audience in on that a little bit, I would be grateful.

- All right, now I know when we talked earlier, we're not starting with my prom date. So, but I will say when I graduated.

- But he was a lucky guy.

- Well, we'll have to ask him later. I wanted to be an architect. So that really intrigued me. I was actually accepted into the impacted undergraduate program at Cal Poly Pomona. Did that for a year, decided I wasn't going to necessarily be one of the best in the class. And then they had this thing called urban planning. That sounded very interesting to me because of its multidisciplinary nature. And then, you know, the fact that it took into account economics and finance, I switched to that. It was the early '80s when I graduated. Hard to get a job in planning in the aftermath of Proposition 13 really being felt in cities. And so I decided I needed to get my MBA because that was really what was important. And I coupled that with a master's in planning at USC. After that, I was actually working for a master plan community developer, Valencia Company, part of New Hall Land and Farming. Developers of the new town of Valencia which was a great perspective, you know, bringing the business and the real estate and planning all together. And then shifted towards consulting. I was with Laventhal and Horwath, then moved to what at the time was Jones Lang Wooten before going to Price Waterhouse. And it was at Price Waterhouse in the early '90s that I shifted towards restructuring. In the early '90s, we were going through major recession in Southern California. Actually, you know, all over really. It's when we, you know, our defense and aerospace industry really got decimated with the peace dividend. And I started doing restructurings and litigation and found it fascinating. And stuck with that. And we, I ultimately became a partner at what ultimately became Price Waterhouse Coopers in the business recovery services practice. We sold our practice to FTI Consulting, which is actually based in Washington. I'm just in the Los Angeles office. And have continued to focus on real estate restructurings. And currently I co-lead our real estate restructuring practice at FTI.

- You know, we hadn't planned on talking about this, but since you brought up the early '90s in California I remember being at a cocktail party back then. I was living in Wisconsin, but I was here in California.

- Oh, okay.

- And an aide to Senator Barbara Boxer was at the party. And she said, "This is the worst." She said, "No, this is worse than the Great Depression." I though, "You're crazy. Nothing is worse than the Great Depression." But I came to realize she was talking very specifically about California, which did quite well through the Great Depression relative to the rest of the country. There was a great migration from other parts of the country to California at the time. Whereas, as you know, that basically collapse in aerospace defense was just devastating to California in general and Southern California, especially. As you think about it, and I know I haven't given you a chance to think about it before, but I'm going to ask you now. I mean, was that a turning point for California as a state? Because if you look at California's growth from the turn of the last century to about 1990 was just unending, right? And since about the 1990s, California's growth has slowed and slowed and slowed to the point where it's not growing at all anymore, as we know. Do you think that was an inflection point in the history of the state's economy?

- Yeah, I know that's a, it's a really interesting thought, Richard. And, you know, I think there is something to that. My dad was an aerospace engineer. I grew up thinking everybody's dad was an aerospace engineer. That was just-

- What town was this in?

- This was in the South Bay area.

- Okay.

- Of Southern California. I mean, he worked for every aerospace company. And it was, we actually had, and people don't believe this now, real estate values, particularly home values, declined on an absolute basis. And nobody can believe they actually declined. It wasn't that they just weren't growing as fast. They actually, that the bottom fell out, so it was. And I don't recall, and I've lived here all my life, I don't recall another sort of economic episode, and I've lived through a lot of cycles where there was that kind of you know, disruption. And of course, that was a company, you know, sort of right in close, close proximity with our riots and our earthquake. I mean, there was a lot of disruption. And I think we've been kind of climbing our way back, but I think other things have taken hold since then. You know, international trade and the ports, you know, just thriving. And we have an amazing entertainment industry, but that also is changing as we know. So I think something and technology, we, you know, we had the development of Silicon Beach. I mean, other things have wrote, you know, risen to sort of fill that in and expand and diversify the economy, but it was very, very significant.

- So yeah, I think not enough people know about that history. Because when they think of California, they tend to think of Hollywood and Silicon Valley, they don't think of it as being a place where once upon a time we built a lot of airplanes.

- Yeah, yeah, yeah. I mean, that's, I mean, it really grew into prominence World War II in its, you know, in its aftermath. It really was the center for all that, all this activity.

- So let's talk about, a little bit about the entertainment industry since you mentioned it is, of course, Hollywood is still synonymous with the entertainment industry, but again, there's a lot of worry about California losing its mojo. And, you know, it was many years ago that motion pictures were largely filmed outside of Southern California. But now there are worries about other things like streaming services and so on being under pressure and that not being the source of economic prosperity that it used to be. Do you have, do you have thoughts about the entertainment industry in Southern California going forward?

- Yeah, it's actually, I don't know when this is going to be available, but next week at the USC Business Law Real Estate Forum, I'm producing a panel on what's going on with Hollywood real estate. Hollywood 2.0 resetting real estate in the entertainment capital and-

- That's why I'm asking you the question.

- Yes, yes, yes. It's quite extraordinary. And it's both on account you've got a couple things going on. You've got we went through a real, a huge explosion in production during COVID with all the streaming services. And you could see we hit our peak during that period, and it's since come down. And this is just not in Southern California. It's just production worldwide. And during that time, there was an explosion of third-party development of studio space. I mean, historically, the sound stages were, you know, at Disney, at 20th Century Fox, at Warner Brothers. And there weren't independent owners and landlords of those sound stages. And now there's been an explosion of that. So with the, there's been a contraction in production as well as a proliferation of supply. So we've got very significantly decreased occupancies in sound stages across the Southland. And at the same time, lots of competition from competing geographies who, like, never would've even been contenders. I mean, you know, here in the States, Georgia, we've got Canada, we've got, you know, very much so London and the UK as well as, you know, some other regions across, across the world. So there's more competition, there's less production. There are more alternatives in terms of technology, in terms of creating content. So it's really changing, but at the same time and my panelists are going to be talking about this, there's some really exciting things going on that make a lot of alternative types of production possible with much smaller budgets. But that very much changes what's required, the space required, the type of technology that's required, the type of equipment that's required, and the operators for that equipment. You don't need, you know, a 25,000 square foot sound stage necessarily or a 250,000 square foot sound stage when you can get something accomplished maybe in, I don't know, 2,500 square feet. I mean, it's just really using volume stages instead of actually other types of equipment and special effects. So it's the technology's changed, but it's back to your question about Southern California. I mean, we can't count on having that industry here as well and all the follow-on effects, economic events, because it employs a lot of people.

- Well, and I think it's more than economic effects. It's also social and by that, I mean, one of the things that makes Los Angeles a fun city to live in is when you get to know people who are in the business, particularly those who are behind the cameras, the writers, the musicians, et cetera. They're our friends. I have a friend who's a master carpenter who's one of the most fascinating people I know. In fact, I think maybe we could solve our housing problem if we would have Hollywood carpenters think about how to do housing faster and better than they-

- Oh my God. They have to do it fast and on a budget. Yes, yeah.

- They have to do it fast. They have to do it on a budget, right?

- Yeah, yeah, my husband actually sells lighting for a manufacturer of lighting for film and TV. So like, I have some adjacency to that world and some insights.

- But I want to, so I want both forward-looking and backward looking. How do you underwrite? When we were building these studios, how were they underwritten? What were the assumptions behind them? And what are, what do leases look like? What are, is it like a hotel? Is it, how does that even work?

- Yeah, and I'm not an expert on how these deals are underwritten, but a lot of times there might be rent being paid by a master lessor who then, but there's no productions going on. So somebody could be paying rent, but the studio space could be empty. There's also a huge component that's providing the production services. And the operators of, the owners of these studios tend to control both. And so, you know, they make money when they actually have productions going on because of the production services that they sell. So it's more like a hotel in that respect, but it, you know, it's its own idiosyncratic land use.

- So let's talk about, you said that there are, I mean, you talked a little bit about how the requirements of these exciting new things may be not as great as the old-fashioned, if you can call streaming old fashioned. I think of that as-

- Right.

- So what are these exciting new things that are coming around then?

- And again, I'm not, I wish I had my panelists here, but.

- Yeah, yeah.

- That'll be another, another podcast.

- No, I'm sorry. Once we got this conversation rolling.

- I know, I know, I know. It's always, it's a lot of fun. No, there's a lot of immersive technologies are a big deal. It's a big, I mean, and I think you're, the sphere is I think the immediate example that comes to mind, but probably, you know, a couple of iterations, you know, beyond that. So which would involve live performances and actual experiential opportunities. So I think that's, from what I understand, there's a lot of that going on. Just in terms of creating content though the ability to do projections, and I'm not going to have the technical terms of this correct, on the walls. So, you know, you can be-

- So, like holograms.

- Yes. It's like the holodex, you know? Nobody knows what that is anymore. A holodeck. Nobody gets that reference anymore. But being able to create these, you know, virtual reality and I'm not doing justice to what the technology really is creating. And then, you've probably heard about verticals, you know, where there's these episodes that are one to two minutes long that you watch in your iPhone. And those aren't filmed on sound stages for the most part.

- You know, I find it at least encouraging that these action movies go on for two and a half, three hours, which shows me that people can have some attention span for something, even if it involves lots of, you know, pyrotechnics going off. So when you talk about two-minute entertainment, I'm thinking, "Oh my God, have we been reduced to a world where people can only pay attention for two minutes to something?"

- Yeah, I don't think we're the target market for it, Richard.

- Yeah and I was also going to say about a holodeck is, no, I think nerds of all ages know what a holodeck is. I think there are teenage Trekkies.

- Yes. Well, I don't know. The folks in my office didn't seem to understand the reference point.

- Okay, maybe I'm wrong. Okay. That's a depressing thought too that-

- Yes, it is.

- Anyway, I want to go back to your bit. And we're going to take this information forward, but you know, you talked about what got you so interested in this business is you found like coming across trouble and figuring out how to get people out of trouble.

- Yeah.

- Was something that really captured your imagination. And I think a lot of people in our audience don't know exactly what that means or what the mechanism is. And you talked about going back to the '90s and, you know, the aftermath of the savings and loan crisis.

- Right.

- And sort of the opportunities that that created. So can you walk us through sort of generically what that's all about? And then we'll talk about some specifics that are happening right now.

- Sure, so I get involved in what I'll broadly call workouts and restructurings through an actual judicial process, an actual bankruptcy. But more often than not, it's something that precedes a bankruptcy and a bankruptcy is a potential threat to drive outcomes. I also do get involved in litigations and disputes involving real property. I'll be a consulting or an expert witness. Those are usually when there's some, you know, bilateral dispute. Not workouts and restructions per se. But what I learned when I got exposed to this area is there's kind of a playbook in terms of workouts and restructurings. And you can be very creative in terms of working with the constituents to figure out what's an outcome that actually provides a better alternative to the parties. You know, the BATNA, if you will. But with restructurings, you potentially have the threat of a bankruptcy filing, which is not a good thing for anybody. And for a creditor or a lender, it's really something that they want to avoid because it's very costly and there are enormous risks for what is typically involving real estate, a secured lender in those circumstances. So being able to be involved in bringing an understanding of real estate, real estate companies, real estate portfolios, particular assets to a discussion among financial and legal professionals was very satisfying in terms of being able to reach an outcome that, you know, parties could take forward and preserve some value for their portfolio.

- So can you think of, without using names or too many specifics, but what would be an example that you're especially proud of that you worked on?

- So actually a fantastic, and this is now really dating myself, but it was such a great outcome. In bankruptcies, there's something called the Unsecured Creditors Committee. And FTI, we do a lot of work in this area. And so I led, we were the financial advisor for the General Growth Properties bankruptcy back in 2009 which was, you know, right in.

- So you worked with Adam Metz?

- I did, I did. So he was actually at the company.

- Right, right.

- That was a situation where GGP had just made, you know, some bad bets in terms of this, the short end of the yield curve.

- Yeah.

- And got caught with a lot of cross-collateralized properties that just, you know, dominoed in terms of creating a bunch of defaults. And they had not just mortgage level property debt, they also had corporate level debt that was unsecured. And, you know, that's those unsecured note holders.

- And just for the folks who haven't, tell us a little bit about who GGP was.

- Oh, so General Growth Properties is one of the major, you know, regional mall owners. Now it's ultimately, as a result of this whole process, is now Brookfield. Brookfield has, there's more than just what the legacy GGP properties were, but these are regional malls. These are among the best, at the time, among the best regional malls and still are, you know, across the country. So it was extraordinary that and organized as a real estate investment trust. So there was that overlay. And it was really quite extraordinary to anybody at the time who'd grown up with regional malls. It was the darling of the investment community.

- Yeah, if I remember, they owned Water Tower Place in Chicago, which was one of the most successful retail centers in the world for many, many years.

- Yes, yes and the Las Vegas Fashion Show on The Strip and many others. And they had also purchased the assets of the Rouse Company.

- That's right.

- So, you know, very, very well known and well-regarded, you know.

- So that's why I was trying to set the stage about this, this was an amazing company we're talking about.

- Yes, yes and so it was really quite extraordinary that they found. When it looked like things were not going well, it was, I remember speaking with colleagues and actually some pension fund advisors and we were thinking, oh my gosh, could GGP actually file bankruptcy? It was just unthinkable. Ultimately, I think there was what happens when there's no liquidity, there was a liquidity issue that causes, you know, prices to fall. And ultimately there was enough interest by other parties in terms of making investments in GGP that the real collapse of the values was very much a temporary reaction. And the underlying value was still there, maybe not to the extent that had originally been thought, but investors believed in the actual value of the collateral. There were significant, Pershing Square came in. Bill Ackman made a huge play on the stock, made billions of dollars. And Brookfield came in and then I'm, there were other parties, I'm probably, I'm not remembering all of them, but brought in equity to the extent that everybody got paid in full, which is not the typical outcome for a bankruptcy. Usually unsecured creditors get, you know, pennies on the dollar. And here, unsecured creditors got 100 cents and even the unsecured lenders got default interest as well. So it was a very, very positive outcome. And you can see, you know, it survives today. Called something else, but it is still one of the, you know, the leading operators and owners of regional malls and obviously many other assets.

- There's a Cain's quote along the line of the ability of markets to stay irrational longer than you can stay liquid is, you know.

- Yeah, that's great.

- I'm not getting it exactly right.

- Yeah, no, no. But that was the perfect and I think certain investors understood that. And they played that arbitrage, so.

- And maybe we should talk a little bit just again for the audience. The difference between liquidity and solvency is?

- Cash. So you-

- Well, I was going to say.

- Balance sheet, you could be solvent on a balance sheet basis.

- Right.

- But if you don't have enough money to make payroll next week.

- Right. No.

- It doesn't matter.

- Actually, the value of GGP's assets that, you know, fundamental, from a fundamentalist standpoint, were always greater than the value of its debt, but it didn't have any money. And it couldn't roll over, I mean, is, you know, part of it with the GFC, but they couldn't roll over their loans.

- Couldn't refinance it. Yeah.

- And you know, what I would love to know is who is giving them the really bad advice to be funding long-term real estate with short-term debt?

- I don't know. I don't know. It's, you know, because the short-term debt was very attractive pricing and I'm speculating, but I assume they figured they'll just keep playing that game and-

- Yeah, it got Orange County into trouble in 1993.

- Yeah, most lenders require you to hedge your variable rate debt, so.

- Yeah, yeah, yeah. So, okay. So, I mean, that's a great story. And I didn't know you were in the midst of that particular deal. It was a very successful outcome.

- Oh, it was. It was.

- And so I think that story has some pretty powerful lessons for where we are today in terms of real estate and debt markets. Wouldn't you agree?

- I think so, but I think some of the stresses on the market, they're a little different than what was stressing the market then.

- Okay well, so let me be a little more. So, okay. I'm not talking about office right now, which is just the fundamentals are bad and-

- No, no. I'm thinking more about residential too.

- But on residential. So yeah. So, I guess maybe, so we have a lot of apartments out there that got financed sometime between 10 and five and 10 years ago, and their loans are rolling over something called a maturity cliff, right? And they are cash flowing. They're occupied. They're earning decent rent.

- Yep.

- And they're in trouble.

- Right. Right.

- So, you know, tell us why. And then tell us why what this is is different from what you experienced in 08, 09.

- Yeah, so I, you know, multifamily was kind of, was the darling of the COVID era investment. Everybody was, you know, couldn't build multifamily, not here in Southern California, but in many other places fast enough. So a lot of places got overbuilt. A lot of the, you know, Southeast markets in particular. And everybody was expecting rents to continue to, you know, grow at some, you know, very fast clip and operating expenses to kind of, you know, grow at a normal rate. And of course we know that that changed. Operating expenses went through the roof, insurance, utilities, other labor and rents moderated. And while these properties, while they can service the debt, they can't, when the loans mature, they can't refinance them at a value that will take out the debt. The only way they can refinance them is sponsors, borrowers will have to come out of pocket. And that's something most are loath to do either because that's just not what they're going to do if these are non-recourse loans nor that do they necessarily have the capital to do that or they don't want to partner with somebody just as a matter of principle. So we've got a lot of maturities in markets that are, you know, that's what a lot of lenders are dealing with right now. I've been doing a lot of work with Fannie Mae. Usually, you know, that's a little focused on a lower quality. It's not institutional quality apartments for the most part, but they're, those assets are affected by what's going on in the market. So as rents come down on the A quality assets, it's going to affect the B and C quality assets too.

- Right. Well, there's actually evidence that. So in Austin, which has had the biggest rent drops and which had tremendous amount of building while rents at the top have fallen, they've actually fallen more further down the chain, to your point about sort of B property that might be financed by Fannie being in trouble. But so I mean, if you were the Zarina of refinancing right now, what would you do? How would you fix this problem? Or is there no real fix to it?

- Listen, I think there's the amend and extend is a rational approach to it. I do think there's some situations where the values are fundamentally lower and it's better just to rip off the bandaid and understand what the economics are. So I think it's understanding really what, not trying to paper over what really is potential value decline. But if there is, if the property fundamentally cash flows, it's stabilized, it doesn't have significant CapEx required and it's not, it's worth more than the loan amount, I think it makes imminent sense to be able to extend that. Maybe structure it as a very common remedy is to structure as what I'll call an AB note, where you write down the debt to what a market financeable amount would be at customary loan to value and debt coverage ratios. And then you have a subordinated B note that only gets, it picks interest and it only gets paid if the cash is available. And so, you know, there's time that, you know, and that's not due until the modified loan matures and that allows, you know, values to catch up. So that gives all the parties some breathing room, but potentially gives the lender some upside in terms of a pick interest rate that could be a higher yield overall.

- So by the way, the Cain's quote is, "Markets can remain irrational longer than you can remain liquid."

- Very, that's perfect. Yeah.

- Yeah, yeah but in this case, I mean, and that clearly was what was going on. And I would say in commercial real estate in general in 09, 2010, because commercial real estate assets were not as troubled as the housing market and not as troubled as they are right now. You didn't have the sort of existential phenomenon in office that you have.

- Yeah, no, I was working for a lot of home builders and with a lot of developers and with a lot of, you know, land options that were totally out of the money and didn't work anymore. So, my client base was very different during the GFC than it is now.

- Yeah, yeah. Yeah, yeah. So let's move on to a topic that lots of people in real estate are talking about, which is data centers. And just, okay, I'm just gonna ask you for your thoughts and then we can have a conversation about data centers.

- Yeah, yeah, listen, and I have to preface this by saying I'm not an expert on data centers. I haven't been involved in the financing. I'm reading probably the same things and maybe less than you are, Richard, but it's of concern. They're proliferating. There's significant dollars by major players. And our economic, the reason that the economy and stock market and everybody is still doing reasonably well in the midst of-

- Well, not everybody, but the stock market, yeah.

- But generally, I mean, it's attributed to-

- Yes.

- You know, AI, and the consequent investments that have been made in data centers. And you know, I think there's a lot of concern about, one, will we be oversupplied? Two, is it gonna work? I mean, I just saw that Blackstone announced a new REIT for stabilized data centers. That's gonna be the, they're gonna be, you know, launching, you know, imminently. So it's, and then there's, and at the same time, there's concern that, you know, people's 401k by virtue of various investment funds are actually invested in these. So there's a lot of concern about, I think, the magnitude of it and the fact that if it doesn't, you know, pan out as everyone expects, then it seems like all the stars need to align for that to happen. And maybe they will, maybe we're completely, completely underestimating the need for them. But it feels risky to me. And the counterparties, it's a different, as I understand, arrangement with counterparties. It's not like a traditional lease. You've got the landlord and then you've got the tenant and you collect, you know, rent from the tenant and hopefully the tenant's business, you know, is sustainable and, you know, they renew their lease. There's more complexity in terms of all the participants involved in these arrangements as we understand.

- Yeah, apparently these leases have and now this is, maybe I have enough knowledge to be dangerous, but not enough to know what I'm talking about. Sort of duty to perform clauses that say the following, that if the world changes, you've got to rip out everything inside and put new stuff in. And the thing that could.

- And then that's the landlord's requirement?

- Yes.

- The tenant's obligation.

- No, no, no, no, no. It's the tenant could go to the landlord and say if you want rent.

- Okay. Well, that's obviously very different.

- So I, something I think about all the time with it. So one, I'm less worried about the oversupply per se than I used to be because you have all these communities basically saying no.

- Right, right. They may correct, self-correct.

- And for once land use regulation may actually help and keep us out of trouble. But the other thing that I'm concerned about that I think about a lot is I've been playing with computers one way or another since I was 11 or 12 years old, which means 54 years, 55 years, something like that. There have been nine storage media in those 55 years, starting with the punch card. And so that's about one every six years. And when one comes along, it completely blows out what was there before.

- Yeah.

- Right? I remember thinking, "I'm not going to use the cloud." I remember thinking that. Why would I do that? And part of it, you had no idea that you're going to want to store all this data somewhere. I remember when the Solid State Drive came along, I thought, "Man, this is the best thing ever. Oh my God, this is so much faster than those hard drives." Which when they came along, I though, wow, I love the, I mean, compared to, what could be better? You get the idea and so I can't imagine that these things are going, not going to be obsolete.

- Yeah.

- In six, seven, eight, you know, I don't know exactly when, but it's not going to be 20 years.

- No, no.

- And it's hard to make any kind of building work if it's not usable for 20 years.

- Right, no, you've got to have to have some expectation of a continuing rental stream, right, to underwrite it. And I know actually I was reading some commentary about the Blackstone REIT and just about underwriting it. If you're just an independent view of it, making sure there's enough, you're underwriting with sufficient provision for CapEx because that will be a major, major requirement.

- Yeah, yeah, yeah. So along those lines, I mean since we were talking about debt, we've been talking about data centers, I mean, private debt funds are more important than they used to be. I've been trying to find a good estimate of how much private debt funds are financing at the moment. It's probably something on the order of $2 trillion. Maybe a little more than that.

- No, I think I saw a similar estimate. That's all types of debt funds, not real estate specific.

- Yes, that's all private debt. Yeah, yeah, yeah. No, no, no, not just real estate. But I mean, do you have any thoughts about whether we should be worried about these funds in the years to come?

- I mean, I think obviously concern about private credit is heightened.

- Yeah.

- There were a couple of defaults just announced. I've just seen some news on it today. And I think the fundamental concern is the opacity of them, and we really don't know what's going on under the hood. So the default rates that nobody really knows what the default rate is. Things that I've seen reported are relatively low, but those don't take into account anything that's been restructured and extended or pick interest. Those, that doesn't count as a default. So, you know, I think it's entirely my expectation that defaults are running much higher than whatever is being reported. And things are probably much worse than everything's being reported. Is it going to you know, create, you know, an economic crisis of some type? I don't know that I would go that far in terms of what the, you know, potential contagion effects are. But the lack of transparency is a concern. And I think even in this low regulation environment that we're in right now, I think you're gonna, you're already hearing about more transparency, more regulation in terms of understanding what's really happening.

- Yeah, I think, you know, there's a famous Hemingway quote about you go bankrupt very slowly and then all at once. And so, I mean, I think about before the GFC default losses for Fannie and Freddie in 2006 were still pretty minuscule. And then it was like, boom.

- Yeah. Yeah.

- So, it really is, it's hard to see these things. The one thing I will say, and I'd be curious just to your view on this, is something that haunts me was something I got really wrong about the run up to the GFC is on the one hand, I'm very proud of the fact that I though in, I don't know, 2006, that we were going to have residential mortgage losses in, on the order of half a trillion dollars. And I was very close to getting that right. But I made the following mistake. I said, you know, it's about a $14 trillion economy. The savings and loan crisis was a $200 billion of losses and a $4 trillion economy. That led to a mild recession. So this will lead to a mild recession. It won't be a big deal. What I didn't see was how all of that got blown up by the derivatives market and that synthetics became something like 50 times. The notional value of the synthetics became something like 50 times the size of the underlying mortgage market. And that counterparties unable to meet their contracts led to the failure of these, you know, firms like New Century, which I, whatever especially countrywide, right? Had these really devastating effects on the broader economy. When I look at private credit, it's hard for me to see that kind of danger that we had from, that I missed from the GFC. But maybe I'm wrong about that.

- Yeah, I mean, I'm not aware of what, you know, the counterparty risks are and what derivatives are behind the curtain. And clearly when you've got those types of transactions kind of hidden away there potentially are very significant effects, but I don't have that, that same sense either. But I mean, I think there's certainly more to come. And you know, things are, I don't think things are as rosy as all of the sponsors are telling us. I would, I think I can feel pretty confident about that.

- So let me change the, so to end our conversation, let me change the subject matter completely. And so I've lived in California now for 18 years. You've just said that you've lived your whole life here. How are you feeling nowadays about the future of California?

- Oh, it's I love California. I can't imagine living anyplace else.

- I'm with you. I mean, yes, I plan on dying in California. So we'll stipulate that.

- Thank you, Richard. Thank you, Richard. But it's, we've got challenges, right? And I, you know, it's incredibly expensive. And, you know, living here all my life, I just, it just sort of creeps up on you and we've obviously got our financial and economic base is challenged. So, and how do you deal with the, you know, the environmental issues and the social equity issues? I mean, there are some really big challenges that we face. And I'm still waiting to hear leadership, you know, talk about where we can go. And I keep thinking that people will, you know, people go to other areas and then they'll realize, oh, these areas aren't so great and they'll, you know, reverse course and the U-Hauls will start coming back this way. But you know, I have concerns, but I think it's an extraordinary state in terms of what it offers its residents and businesses.

- So, Jonathan Lasner in the Orange County Register had a statistic that I found really interesting, and I can't help myself, so I checked to make sure he was right, and he was, which is relative to its population, relatively few people are leaving California. We're a third from the bottom in terms of the share of people who are leaving the state. However, in terms of the share of people coming to the state relative population, we are the worst in the country. So this narrative about everybody fleeing is not really true. The narrative is nobody is coming. And I think there's a very good reason for that, which is they look at what their house is worth and they look at what a house costs here.

- Yeah. Yeah.

- And they say to themselves, "I can't do that."

- It's crazy. It's crazy, I mean, and if somebody leaves for various reasons, and it may not because of, because of economics, they may not be able to come back. Yeah, no, but I mean, the anecdotal stuff that I hear is people leaving and like I know a lot of people who have, who have left, and I, it's like in my, probably my bubble, you know, and taxes are driving a lot of it.

- No, I was, I was surprised. I was surprised at that number when Jonathan produced it. But it is, as I said, I went to the source material, which is the census estimates of domestic in and out migration and it was correct. I mean, we do have domestic out migration and it's a lot, but it's because nobody is coming here.

- [Cynthia] Yeah. Yeah.

- It is kind of interesting that this surprised me too, is South Florida now has domestic out migration. Florida as a state. Florida as a state doesn't, okay. But Miami County, Miami-Dade County, Broward County, Palm Beach County all have domestic out migration. So there is something about, you know, I think, and what are they? They're expensive. So we have this phenomenon of cities just becoming-

- [Cynthia] Yeah.

- Too expensive for people to move to.

- Right, right. But I mean, New York is too expensive for people to move to and like.

- Oh, they have domestic out migration too in New York. Yes. So so, okay. So, you know, we have been talking sort of about gloomy stuff for the last 50 minutes or so. Tell me some, tell me some things to feel good about.

- Oh. The Olympics are coming. I think that's very exciting.

- Okay.

- Some people, not everybody does, but I think that we've got some extraordinary things, like, you know, LACMA just opened. We've, you know, got the new, the Lucas Museum for Narrative Art is going to be open in September.

- That's true.

- We've got some really, obviously, the World Cup. I mean, I think we just, we have some very exciting, I think, community building investments happening that hopefully will lead to kind of a shared sense of culture and energy and investment here locally.

- What about in the national real estate market? Do you see any offers, I mean, in particular, people who are on the-

- In terms of investment opportunities.

- Yeah. Yeah, yeah. But no, I mean, that was a fine answer, but I- Yeah. Where do you see the opportunities?

- Sure. No, okay. So listen, I think, you know, office for the right kind of play, if you've got the capital and you've got the time, I think there could be some really interesting office acquisitions. So I think there's a sense, and you don't really know this till, you know, maybe you've missed the opportunity that we probably hit bottom. There's been enough price discovery. And there's a real bifurcation in the office market. So if there's, and lenders really do not want to take properties back. I mean, they will if they have to. But if-

- So people can buy distressed debt at a very low cost right now.

- I think so. I mean, I haven't seen huge. I'm not hearing huge discounts to what the out, you know, the loan amount is, but lenders are, you know, have been actively liquidating loans. They're taking that route now as opposed to foreclosing and then liquidating REO. I mean, lenders just do not have substantial amounts of REO on their books right now.

- Well, and why don't you tell us about how regulators treat the difference between REO and just selling a loan off at a discount.

- Oh, well, I mean, and I, there's risk-based capital requirements for lenders if you're FDIC regulated, and you actually have to have more capital if your assets are riskier in REO. And I don't know what the exact standards are, but.

- It's I think a 200% risk weight on REO.

- There you go. So it's very inefficient. You do not want to own a lot of REO. You want to be making performing loans. So you want them to be accrual loans. Non-accrual is not good. REO is not good.

- Yeah, and it might help the audience again. Tell us a little bit, what is bank capital?

- I'm sorry, I didn't hear you, Richard.

- Oh, yeah. So just to clarify for the audience, what is bank capital?

- Oh, well, it's the amount of assets over deposits, liabilities in terms of what's available in terms of their value. And I'm probably not describing that exactly.

- I'm just trying to get. So the key is, so it's generally money raised through stock offerings plus retained earnings over the years. And the problem with it is, of course, it doesn't earn any money. And so money that you can't deploy to earn money is very expensive to you as a bank. And if you take a property back in foreclosure, you have to have a lot more of that non-earning money available to protect depositors. Whereas if you just sell the loan, right? Even if you take a loss on it, you just write off the loss and you're done. You don't have to set aside capital as a result of that.

- Oh, you've gotten that capital or substantial portion of it back.

- Yeah.

- Redeploy.

- Yeah. Yeah. And so there's got to be, just thinking about it, there's got to be a very powerful incentive if a bank could sell a loan right now to sell it as opposed to keep going and hope. Well, and again, if it's not performing, regulators aren't happy with that either.

- No, no. I mean, you've got to have additional capital in those instances as well.

- Okay, so we're looking at office and we're looking at maybe acquiring office via acquiring debt that is secured by that office building. And then by the way, and so then do you foreclose on the office building owner as the holder of the debt and acquire the building? Or what's the next step for you?

- So I mean, I think there's a few ways that investors can look at that. One, you could come in and work with the sponsor borrower to modify, restructure the loan with the lender, bring in capital perhaps in a preferred equity structure at some relatively high yield. So your position is protected. Make sure that the loan you have makes sense in terms of the eventual exit and that you're comfortable that the value's going to get there. But being able to provide the capital, the sponsors really need that. And investors can actually get a very attractive yield when they're providing that type of rescue capital. So that's one mechanism with sort of the existing lenders. I've also seen a lot of situations where a buyer will come in and there'll be a deed in lieu with the borrower and the lender. And then the investor will structure a deal with the borrower in terms of some type of debt and some type of equity participation so that it can get the yield that it needs for its money. And there are variations of this, but those are the two situations that I've been seeing.

- Okay, so we've talked about residential, we've talked about office. Let's just quickly go through the other food groups. Retail, any opportunities there?

- Retail is doing really well compared to where it was before. Everybody was the death of the regional mall, that's not quite transpired. However, there's a lot of malls that aren't malls anymore and they've been redeveloped and repositioned. Grocery anchored retail is very desirable right now. So just that essential type of retail is attractive in the market and continues to do well. I think people have gotten over the shock of the internet and now it's really a multi-channel market for retail. And markets have adjusted to that.

- Yeah, I think groceries are really interesting because it seems that that's an area where retail really. I mean, it's made some inroads, Instacart as a business, but I was asking my students a couple of weeks ago whether they liked grocery shopping or not. And they also, they liked, well, not all of them, but the vast majority of them said they enjoyed grocery shopping. And I think-

- Oh, okay.

- No, I enjoy grocery shopping.

- It's very tactile.

- It is very tactile. I like looking at my-

- Feel the tomato.

- I want to look at my tomato right before I buy it. And you have, you know, and I was thinking, you know, we talk in economics about the lemons problem, which is adverse selection, which is if you're not well-informed, you get the bad product. And I'm thinking that really applies to grocery shopping because if you can't pick out your own lemons, you might get one.

- This is true, I always wonder how those shoppers are going to pick your produce.

- Yeah, yeah. I want to pick my own produce. I want to pick my own meat. But cat food you can send to me in the mail.

- That's okay.

- That's okay.

- Yeah. It's a free model.

- Don't tell my cats I said that. And finally, what about industrial?

- Industrial is still pretty viable, though it's soft. Vacancies have gone up. Pricing has kind of plateaued, but there's too much distribution space in certain areas. But I mean, industrial is still pretty viable from everything that I've seen. I have not had an industrial portfolio or asset or owner of industrial assets in a bankruptcy or restructuring, just for whatever.

- That's a very informative thing.

- Yeah. Yeah.

- I mean, that, yeah. Yeah.

- And all the other food groups I have.

- Yeah, what? Hotels?

- Hotel, I was just going to say we haven't talked about hotels. I mean, hospitality is actually kind of challenged right now. Obviously, it got decimated during COVID, then it's come back. There was revenge travel and people started flying and traveling for business. And hotels were really, people were very upbeat on hotels. And now it's challenged in some ways below the luxury level. There's a lot of concern about international travel. I mean, we're not getting-

- I was going to ask about that.

- Nope, Canada's staying home, or at least they're not coming to the US. Las Vegas is down double digits. I actually do get hotel assets in terms of the bankruptcies and restructurings I deal with. And they're not the luxury high-end properties. I mean, some of them in development, but there's other issues related to that. But there's some concern about hotel markets right now.

- And so I am curious, but the luxury market is still doing. I mean, when I look at luxury hotel rates, they're insane.

- Yeah, I know, I agree. But it's-

- My wife and I used to splurge every now and then and spend a weekend at a Four Seasons somewhere, and now we just don't. It's just crazy.

- It's crazy. Well, point systems and loyalty programs are huge. So, finding, I think those are our building brand loyalty has been a big part of it too.

- Well, I was going to say that, yeah, so I stay at Marriott's with points a lot and I appreciate that, but that's Marriott's, not Four Seasons but that's your-

- But they have high end Marriott.

- But that's your K-shaped economy again, right?

- Yes, yes. Yes, yeah. And I think you're seeing that in retail to some extent too, although you still need grocery stores.

- So I saw that. I haven't paid attention to this in a while. I saw luxury watches were way down from peak during poker. Are they still? Do you know?

- Oh, I don't know. I don't know.

- Okay, all right.

- I didn't have the metric to follow.

- I was just throwing that out there for that K-shaped economy. I haven't looked at it in a while. So, okay. Well, Cynthia Nelson, thank you for spending an hour of your Friday afternoon with us for a very informative conversation.

- Oh, thank you, Richard.

- And we'll be posting this in a couple of weeks or a week or so. Chase will work his magic on it and take out anything we said that wasn't smooth, although he won't censor us. And it's been a pleasure having you on. And to everybody else, this has been "Lusk Perspectives." We look forward to seeing you on our next episode.

- Thanks so much, Richard.