This is not my headline, but I wish I had written it. It comes from REBusinessOnline which recently published a story about Ethan Penner and his perspective on the commercial real estate market. Penner’s comments are consistent with my view that the stampede into primary markets and core assets is overdone, just like the stampede into the Sunbelt was overdone in 2007. To be sure, San Francisco (where I live) is seeing strong rent growth across the four major food groups, but some investors are paying up for Daly City and Santa Rosa as if they were Pacific Heights and Telegraph Hill.

The article, which you can read here, follows:

Today’s extremely low interest rates pose a danger to commercial real estate investors, particularly those with billions of dollars to deploy such as pension funds and sovereign wealth funds, warns Ethan Penner, founder and president of CBRE Capital Partners. In order to receive a reasonable rate of return, these investors are being “crowded out” of low-risk investments and forced into high-risk investments.

The 10-year Treasury yield, a benchmark for commercial real estate finance, currently is hovering around 2 percent, not far from its record low.

“There is almost no way to invest large amounts of money in today’s market — specifically in today’s real estate market — and not be set up for a major disappointment sometime soon,” remarked Penner during his keynote address at the Commercial Real Estate Investment & Finance 2012 conference. Law firm Morris, Manning & Martin along with France Media’s InterFace Conference Group hosted the day-long event at the Grand Hyatt in Atlanta.

“The major disappointment may take the form of economic non-recovery, it might take the form of very, very high interest rates, which will render your returns very, very inadequate,” explained Penner. “I don’t know what [factor] it is going to be, but I can tell you the byproduct of investing money today for most investors is going to be a lot of crying going forward.”

A disconnect among investors only compounds the problem. Some fund investors, for example, seek low-risk properties that generate double-digit returns. But those returns are more representative of value-add or opportunistic deals.

Penner, a pioneer in the commercial mortgage-backed securities industry who served as CEO of the Capital Company of America/Nomura Capital from 1993 to 1998, said the federal government has engaged in a misguided effort the last few years to bail out the banking system. In his view, government has acted on the belief that in an overleveraged world saving creditors is important.

“Obviously they are wrong. [The government] should have been saving the debtors, not the creditors,” argued Penner. “If we had taken the couple trillion dollars that we wasted trying to prop up the creditors and deleveraged the debtors, we’d already be in a recovery. It’s so obvious that it’s kind of amazing that nobody figured it out.”

Penner supports the idea of providing mortgage debt relief for homeowners. “That could be something that catalyzes a recovery because it’s obvious that it’s needed.”

Who is paying the bill for the efforts to prop up the banking system through low interest rates? The most obvious group is savers, explained Penner, “because people who are older, who are retired, and who were expecting to be able to invest their hard-saved money at a very low-risk investment at a certain rate of return to live a certain way of life are screwed beyond belief.”

When it comes to commercial real estate investment strategies for retail financial advisors, there’s water, water everywhere, but not a drop to drink — particularly if you’re a fiduciary. From a strict asset allocation perspective, publicly-traded REITs and REIT ETFs are often highly correlated to equities, especially over a short-term investment horizon. On the other hand, Non-Traded REITs have a much lower correlation to equities (at least on the surface), but they suffer from egregiously high fees, enormous conflicts of interest and a jaw-slackening lack of transparency. For most financial advisors and their clients, the only other alternative is smaller, illiquid direct investment programs which are generally not professionally managed, not widely distributed and often very expensive.

This Hobson’s Choice confronts advisors and investors every day, but Versus Capital has designed an innovative fund of funds vehicle, the Versus Global Multi-Manager Real Estate Income Fund, to address the dilemma. The fund aims to raise $750 million and operate as a publicly registered, closed-end investment fund. If the launch is successful, advisors will no longer have to choose between publicly traded REITs with a high correlation to equities, and Non-Traded REITs that have a high correlation to simply throwing your money away.

Versus Capital Advisors has teamed up with Callan Associates, one of the top institutional real estate investment advisors in the country; Callan will serve as Sub-Advisor to the fund, and together they have assembled a fund of funds portfolio that will include many of the top institutional real estate fund managers in the United States and abroad, including Heitman, Urdang, Morgan Stanley, Principal, Invesco and Security Capital.

The fund will be income-oriented, and while it will seek diversification by geography, it will primarily pursue a conservative U.S. core/core plus strategy, with an annual dividend yield target of approximately 5% after fees and expenses. A liquidity feature will allow investors to cash out periodically, although there is a 2% penalty for withdrawals in the first year.

The Versus Global Multi-Manager Real Estate Income Fund offers a distinct advantage to smaller investors seeking direct investment exposure to commercial real estate: the ability to circumvent the prohibitive minimum investments required by more efficient, institutionally-managed real estate funds — and get much better liquidity. Under the Versus closed-end fund structure, retail investors with as little as $10,000 can effectively buy shares in top institutional real estate funds that would otherwise require a $5 to $10 million minimum investment and a five to seven year capital commitment.

The Versus “fund of funds” strategy will also provide diversification by manager, asset class and market, but it is not cheap to administer or implement (it carries an approximate 3.45% annual expense ratio, all-in, including distribution fees, account servicing fees, underlying fund fees and expenses, and a 90 basis point asset management fee for Versus). Nevertheless, it delivers value by bringing top institutional fund managers to smaller investors, much broader diversification than direct investment programs involving only one or two distinct assets, and last but not least, the potential for higher risk-adjusted returns.

In my opinion, there’s absolutely no question that the commercial real estate market has bottomed. For retail investors interested in making some money on the recovery, the Versus fund of fund’s combination of transparency, liquidity, diversity, and potential for higher risk-adjusted returns generated by top managers should result in high-quality, non-correlated direct exposure to commercial real estate at a fraction of the usual cost (read the Versus registration statement here).

Last week, RREEF’s Chief Economist and Strategist Asieh Mansour cautiously told investors attending the Pacific Coast Builder’s Conference that the recession is finally over and that businesses have started hiring again. Unfortunately, she also said she’s never had to make a forecast with so many risks to the downside, and the recovery, if it takes hold, will likely be long and slow.

According to Mansour, we “turned the corner” in June after three positive quarters of positive GDP growth. Unfortunately, that would make the 2008-2009 blowout almost 18 months long, which is double the length of the average post-World War II recession. And while steep recoveries often follow steep recessions, Mansour offered no such optimism for this one. Recoveries from financial crises are often slow, and along with the length of the recession and the depth of the job losses (over 8 million jobs were vaporized), she believes a long, moderate recovery is most likely.

She also cited the need for “major government adjustments” as one of the biggest downside risks to her forecast. While she noted that the United States is not Greece, she said there are serious long term risks relative to unrestrained government spending and what’s known appropriately as “debt in the hands of the public”. This relates to the fact that the public will actually have to pay it back someday, just like a certain country in southern Europe.

However, she said that reducing this debt will almost certainly involve higher taxes and spending cuts; both of which are recessionary. Mansour sees no inflation pressure at all, but she did say that we have set ourselves up for much higher inflation in the future. A future of high inflation and slow growth is not particularly appealing, but if we continue on the current trajectory, she warned, “we will wind up in the same place as Greece.”

The buzz around Michael Lewis these days comes from his new book “The Big Short,” which is why he and Ivy Zelman were invited to speak at the Pacific Coast Builders Conference this week. Ivy Zelman, of course, is the now former the Credit Suisse housing analyst who famously asked Toll Brothers CEO Bob Toll on the Q4 2006 Toll Brothers conference call “Which Kool-Aid Are You Drinking?”

She was, as they say on Wall Street, a little early.

As for Lewis, he became a best selling author with his very first book, Liars Poker, which chronicled the implausible deceit, greed and lack of governance at Solomon Brothers, then a leading bond shop on Wall Street. At the time, Lewis thought he was “describing period of absurdity in the financial world that would never be repeated.”

But then the subprime mortgage crash came along, and he got a chance to do it all over again. Lewis was introduced to Zelman while researching his new book (“all roads led to Ivy”), and both agree that the big banks are using an elegant form of theft to rip off tax payers. They imply this theft is being perpetrated with government complicity, and it is being greased with the ultimate form of other people’s money – tax money. In Washington, tax money is easy money, and as Lewis would have said in Lair’s Poker, we are about to get our faces ripped off if we don’t do something about it.

According to Lewis and Zelman, taxpayer-funded Moral Hazard has subsidized hundreds of accident-prone financial firms back to health, via the hundreds of billions of dollars that were pumped into the banking system after the Congress discovered that lair loans were not good credit instruments. The only thing surprising about this discovery was that several members of Congress had actually lied on their own liar loan applications.

The naive among us would hope that Chris Dodd’s Countrywide low interest home loan was simply the result of a fact-finding mission. Sadly, Lewis and Zelman argue implicitly that this was the result of an insidious sense of entitlement, and that this sense of entitlement now permeates the entire country – from Congress on down to the lease option flipper in Phoenix, to Aunt Betty in Birmingham. Furthermore, they wonder, without at least some pain for somebody, how could there be real reform?

The loquacious Lewis has a book to sell, so he was careful not to answer Zelman’s politically sensitive rhetorical questions on this topic directly. However, he did say that the “American Way” dictates consequences for those who make poor choices, yet the politicians seem to want to favor a path that produces no casualties.

Lewis says that the experience he’s had after writing this book was unlike any he’s ever had, and that Capital Hill is out of touch with the popular mood. According to Lewis, the financial reform bill that is now about to emerge from Congress is not just the art of compromise, but the result of politicians not wanting to piss off some of their most munificent donors – the Wall Street firms who helped create the whole mess in the first place. He said the “American Way” was not perpetual re-election (or, as Zelman put it “the entitlement of the strategic defaulter”), but consequences for one’s actions. Zelman contended the administration actually seemed to be welcoming and encouraging this soft approach.

Zelman, interestingly enough, was not willing to give homeowners a free pass either. She correctly pointed out that there were two signatures on each liar loan application, not just one, and that many of them knew exactly what they were doing. It’s hard to know how many were duped by the system or the other way around, but Lewis and Zelman both agree that weak financial services reform will not produce the results it intended. It seems to me that the law of unintended consequences has been in effect since Lehman failed, and with higher taxes and higher inflation almost surely to accompany toothless financial services reform, these unintended consequences are about to get much, much worse for everyone.

Stifel Nicolas picked up coverage of PDM today with a not so flattering “Hold” rating. Piedmont, of course, is the offspring of Wells REIT I, a non traded REIT that went public earlier this year. Stifel said Piedmont was fully valued at its current price ($18.70), but that was the least of their concerns.

According to Stifel, PDM is still suffering from a hangover related to its decade long existence as a non-traded REIT, and it will likely suffer from that hangover for some time. Despite moderate leverage and “generally” forthcoming management, Stifel struggles with PDM’s ability to cover its dividend. At the current rate of $1.26/share, Stifel says the dividend is “unlikely to be supported” by either 2011 or 2012 FFO and FAD. If you’ve been following the astounding news being notched by non-traded REITs recently (I have chronicled one of the most head scratching examples here and here), this won’t come as any surprise.

Referring to management’s focus during its years as a non-traded REIT, Stifel says Piedmont needs to transition from a “capital raising entity” to an operating company with a rational geographic focus that can build “solid local operating teams with an ability to see every deal and add value at the submarket and property level. This will take years.” (As if twelve years were not already enough.)

Stifel also took at well-aimed but gentle poke at the non-traded REIT internalization model that created Piedmont, noting that shareholders paid founder Leo Wells $174 million to relinquish a management contract that was cancellable upon 30 days notice. Of course, this did nothing for the overall economics, and Wells REIT I shareholders would have been much better off if they had just invested in an index fund (Stifel calculated that as of the Wells REIT I closing in 1Q04, investors had received an 18.3% return for the theoretical six year hold, versus a 46.5% gain for the Morgan Stanley REIT index and a 19.7% return for the S&P 500 during the same period.

Green Street Advisors is even less generous. In a report produced on the eve of PDM’s IPO, Green Street noted that Piedmont had raised $5.8 billion in gross equity from 118,000 retail investors. At the IPO price of $18/share, Green Street estimated that PDM’s blended annual total returns since 2002-2003 would have only been about 2%. This is far below the 6% return generated by both the Morgan Stanley REIT index and the office REIT sector. Green Street Advisors blamed an “appalling sales load” and “conflicts of interest” for the below average performance.

I spoke with a hedge fund manager specializing in REITs about today’s Stifel report, and he confirmed that Piedmont “will get little respect from anybody for a while to come.” Piedmont does have a good collection of quality assets, but that’s a bit like saying the Wermacht had a nice collection of impressionist paintings in 1943. Amazingly enough, after twelve years and one long-awaited IPO, this REIT is still not ripe.

During the economically chilling month of April, I typically lose my enthusiasm for labor. Indeed, during this past tax season, REIT Wrecks emitted nary a vowel. Unfortunately, CMBS bankers have no such luxury, lest they have no work at all.

The market for CMBS remains stalled, and the lack of credit availability is stunting what appears to be the beginning of a bottom in commercial real estate, particularly in primary markets. With cap rates moving rapidly down, especially in certain primary markets, now should be the time to make hay with CMBS:

The nascent recovery is causing more investors to take a look at CMBS, including insurance giant Primerica, and that is causing CMBS bankers to start picking up their phones again.

In the first multi-borrower deal since the crash, RBS closed a $310 million deal with stong demand and very competitive pricing in April, but it was a far cry from the halcyon days of 2006. The deal included by only six loans (and none of them were warehoused for more than a week), it had no B-piece and it was privately placed. The small deal size resulted in the deal being over-subscribed, and demand might have been even stronger had the deal been publicly registered.

The RBS deal is not the only sign of life in CMBS. PNC and Bank of America are both resuming their conduit lending programs, and Bridger Commercial Funding announced late last year that it would resume its own conduit program, the first such resumptions since 2008. Most notable of all, JP Morgan is still struggling working on the first multi-borrower CMBS deal since 2008, which could include up to 25 loans worth $1 billion.

The CMBS market is clearly starting to defrost, but it’s by no means thawed. The critical piece in any large revival in the CMBS market is still missing, and that is the B piece buyers. Last month, I spoke to a large but still very much former B piece buyer about the RBS deal. This person remarked that traditional B piece buyers were “thoroughly incapable” of investing in any new deals, which is why the RBS deal did not include a traditional B piece structure.

JP Morgan is still shopping the B piece for its deal, and it appears to be slow going, mostly because this is what happened to B piece buyers who bet wrong. Many B Piece buyers had themselves been using heavy doses of leverage to fund their purchases – and that is no longer available. More importantly, most are buried in legacy portfolios full of defaults, workouts and upside down income streams.

The JP Morgan deal will be a bellwether in the current environment, assuming the firm can find new investors for B pieces. Amazingly, if CMBS credit starts to come back to commercial real estate in a sustainable way, at the same time that the recovery in primary markets continues, all this time spent waiting for Godot may have actually been for naught.

Newcastle Investment Corp., (NCT) a Mortgage REIT managed by Fortress Investment Group, will continue to contribute management fees to FIG’s income statement for at least another year. But whether NCT makes it out of 2010 is an another question. Newcastle is suffering from a host of balance sheet issues, including a portfolio full of CDOs that are struggling to meet their O/C tests and an inability to raise fresh capital.

Newcastle is externally managed by Fortress, and Fortress owns 2.3% of the Newcastle common, so it’s no surprise that one of the first moves Fortress made was to threaten the preferred holders with de-listing unless they agreed to convert into common at about $0.20 on the dollar (cheers: Richard52). However, it turned out that the preferred holders, who were primarily retail investors with limited ability to organize, ultimately prevailed. Their ace in the hole was the right to appoint two members to NCT’s Fortress-sponsored board if NCT failed to pay their dividends for six consecutive quarters. Last week, after two previous attempts to strong-arm the preferred holders and about one month before six consecutive quarters would have elapsed, Fortress and NCT both blinked.

However, with those pesky preferred shareholders now finally out of the way, NCT still faces an incredibly difficult task. After the preferred redemption, which will cost Newcastle $27 million in cash (in addition to the issuance of 9.1 million in new common shares), Newcastle will be left with about $31.5 million in unrestricted cash. (As February 17th, Newcastle had $58.8 million of unrestricted cash available, down from $68.3 million at year end.) This is not a healthy cash cushion for a highly leveraged company that’s in the business of manufacturing net interest income, even if most of that leverage is now non-recourse.

The reason is that in 2010 Newcastle, like Northstar, is going to have an increasingly difficult time managing its CDO overcollateralization tests (see “CDOs Explained“) . However, because its ability to manage the tests is even more limited, Newcastle appears to be at even greater risk than Northstar. NCT’s CDO re-investment periods are not only coming to an end, eliminating Newcastle’s ability to rebalance the CDO asset cushions, but NCT’s CDO trustee also recently notified NCT that it can no longer repurchase individual CDO notes without the approval of senior noteholders (see “CDO Buybacks Explained, Step By Step“).

With at least $1.1 billion of CDO assets under negative watch for possible downgrade by at least one of the rating agencies as of January 31st, and with CDOs IV, V, VI and VII already out of in compliance with their applicable over collateralization tests as of February 17, 2010, NCT’s margin for error is slight. To the extent Newcastle fails to meet its O/C tests on any of the remaining $1.1 billion in CDOs under watch, interest income on those CDOs would be diverted away from the junior noteholders (NCT is a junior noteholder) to the senior noteholders, and NCT’s precariously low cash position would quickly become even more precarious. In certain cases, NCT could also be replaced as Collateral Manager, which would further jeopardize its cash flow.

Certainly, retiring the preferred shares (and paying off the accrued dividend liability) is the first step in recapitalizing the company, but it’s not the last. Newcastle still needs to raise additional capital to eliminate its remaining non-recourse debt, to defuse its ticking CDO time bombs, and to re-invest in new debt instruments that are accretive. The latter third of this proposition is the life blood of a company like Newcastle, and without that NCT’s prospects remain exceptionally unexciting.