money & real estate

At the Atlanta Urban Land Institute spring council forum in early May, the international council had a fascinating session on Asian banks' present situation and how it related to potential real estate investments in that region. Jack Rodman of E&Y Kenneth Leventhal Real Estate Group and Peter Linneman of Wharton were two of the key presenters who supplied most of the information discussed below.

Although both men have done extensive field research in Asia, they differ on the current potential for American real estate investing there. Linneman sees quite limited potential and is not optimistic about future investment capital flow into Asia. Rodman thinks Asia's investment potential is extensive, and recommends that investors take a hard look at opportunity investing in Asian real estate.

However, both agree that Asian banks' seriously negative financial situation has not been resolved. Therefore, conclusions that the Asian financial crisis has now passed are premature. The most critical phase may have passed, but Asian banks are still heavily loaded with non-performing loans that are inhibiting their ability and willingness to make the new loans that Asiannations need to achieve a meaningful recovery.

Asian banks - including those in Japan - made extensive loans against Asian real properties and businesses in the late-1980s. Japanese banks were especially active because they could raise capital from Japanese savers at extremely low interest rates, then lend it abroad at interest rates which undercut those offered by local banks throughout southeast Asia. The lending banks did not carry out diligent underwriting of the real estate loans they were making with these funds. This "yen-carry" lending procedure lured firms throughout southeast Asia to borrow heavily from Japanese banks to finance often ill-conceived real estate development projects.

The extent of bank real estate lending was initially disguised by the fact that many developers used equity financing to build projects. Since they were not heavily mortgaging their new properties, no one was carefully underwriting those projects. But their supposed equity financing was often based upon enterprise-level borrowing by their firms, rather than upon mortgages against specific properties. So what appeared to be unleveraged equity investments really involved a lot of bank debt in the long run.

Unfortunately, the sharp slowdown in Asian economic growth in the 1990s - and the subsequent tremendous devaluation of many southeast Asian currencies - have made it impossible for many Asian borrowers to repay those bank loans, especially to foreign lenders. This is one reason that so many Japanese banks are loaded with non-performing loans. Even if most borrowers devoted 100% of their cash flows to repaying their bank loans, they could not even afford to pay the current interest, let alone return any principal.

This situation has left most Asian banks with huge amounts of non-performing loans. If they simply wrote all those loans off their books, that would wipe out their entire capital and throw most of them into bankruptcy. But no Asian nation wants to plunge its entire financial system into bankruptcy. Banks are especially crucial in these economies because they have relatively undeveloped bond and stock markets. Therefore, financial authorities in these nations are not compelling their banks to write off all non-performing loans quickly, as American regulators required American banks to do in the early-1990s.

However, the longer the banks postpone dealing with these non-performing loans the more the businesses and properties concerned tend to decline in market value, thus further deepening the banks' adverse financial situation. This occurs because no one is managing these properties intensively, and whoever is managing them cannot raise additional funds to keep them repaired, modernized and operating properly.

Rodman estimates that such collateral declines in value more than 20% per year when not dealt with. Even worse, as long as the banks are mired with such non-performing assets, they are very reluctant to make additional loans, since, in reality, they have no available capital. This hampers true recovery of Asian economies, which - like all capitalist economies - need debt in order to finance economic expansions.

In the United States, we escaped a similar loan default crisis with our savings and loan associations by having taxpayers foot the bill for writing off non-performing loans. We then re-sold those loans to private investors through the Resolution Trust Corporation. Those investors mostly waited for economic recovery to increase the value of the cheapened assets they had just bought and then sold them at much higher prices, enriching themselves at taxpayers' expense.

However, this public sector investment freed the banking system to help finance the next recovery starting in early 1991, a recovery which is ongoing. The total cost to taxpayers of about $250 billion was only about 5% of our gross domestic product. The United States could afford to saddle taxpayers with that burden without imposing a huge penalty on our overall economy.

By contrast, the total amount of non-performing bank loans in Asian countries is a much larger fraction of their gross domestic products. Rodman estimate s that this fraction is now about 20% in Japan, 40% in Korea, 70% in Thailand, and 70% in Indonesia. Clearly, it would be extremely difficult for taxpayers in those last three nations to pay for fully bailing out their banks without severely taxing their economies. The burden imposed upon the rest of society would be intolerable.

But then what will happen to those banks? And how can the economies of these nations recover if their banks are unable to do much additional lending? These remain unanswered questions. At best, the banks will gradually write off these loans over a long period as they start lending more currently.

Concerning real estate investing, Rodman believes there are substantial opportunities for American distressed-asset funds to purchase non-performing loans from Asian banks at large discounts on their face values, and then recover much more from those loans than they paid for them. The best strategy, he says, would be for a purchaser of such discounted loans to approach the original borrowers and agree to close out those loans for big write-downs of the original values but substantially more than the investor paid for those loans. Even if the average loan size is relatively small - a drawback Linneman highlights - the profit rate could be very high per loan. Rodman argues that those who missed the opportunity to carry out this strategy in the United States with the Resolution Trust Corporation in the early-1990s now have a second shot at it in Asia.

However, both commentators warn that the legal and other systems in these nations do not provide the protections available in the United States or Europe. Bankruptcy laws, foreclosure proceedings and other basic financial tools universally available in the United States are difficult to enforce, and are encumbered with delays, pay-offs and even threats of violence in some cases. Therefore, this strategy is not a wise one for fiduciary institutions that must protect the capital entrusted to them from any major losses. Rather, it is suitable only for admittedly high-risk opportunity funds with truly gutsy operators.

Moreover, it is critical for such "vulture funds" to work with local partners in each nation who are familiar with the rules and pitfalls of its politics and financial systems. Finding such partners who are honest, competent and knowledgeable about local customs is not easy, but it is the most essential step in the Asian investment process.

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