31 October 2009

Which Way Morgan Stanley?

Wall Street Journal

Morgan Stanley may decide to take its final lumps on its unsuccessful $6.5 billion acquisition of Crescent Real Estate Equities Co., the latest of several setbacks for the firm known as one of Wall Street's largest property investors and managers.

Morgan Stanley already has taken about $700 million in write-downs and other losses from Crescent, which owned 54 office buildings, resorts and housing projects at the time of the firm's 2007 top-of-the-market buyout.

Now the investment bank is under pressure to turn the portfolio over to Barclays Capital, which provided a $2 billion loan to help finance the Crescent deal. The debt is due on Nov. 2.

With commercial-property values tumbling and rent rolls declining, Morgan Stanley likely will give up Crescent's properties to the Barclays PLC unit, according to people familiar with the matter.

Capital Infusion?

At the same time, the firm also is considering other options such as putting in more capital to keep the investment afloat, these people said. Negotiations with Barclays could extend beyond the Nov. 2 deadline.

As of the end of the second quarter, Morgan Stanley carried the Crescent properties on its books with a value of $2.8 billion and debt of $2.5 billion, according to a research report by analysts at Citigroup Inc., based on their meeting with Morgan Stanley Chief Finance Officer Colm Kelleher in July.

That would mean the firm's remaining equity in the deal is about $300 million, which would be wiped out should Morgan Stanley opt to turn over the keys to Barclays and walk away from the investment.

Representatives at Morgan Stanley and Barclays declined to comment.

Shareholders of Morgan Stanley will likely get a more detailed picture of the firm's Crescent position when it reports third-quarter earnings Wednesday. In its second-quarter report with the Securities and Exchange Commission, Morgan Stanley said a subsidiary of the firm "is currently in discussions with the lender regarding the orderly transfer of collateral and asset operations and other related matters."

The Crescent deal underscores the problems faced by U.S. financial institutions as a result of their aggressive push into commercial real estate when credit was easy and prices were rising.

The latest third-quarter earnings from U.S. banks show that commercial real estate is becoming a bigger drag on the economy as well as banks' bottom line.

At Bank of America Corp., one of the nation's largest lenders to commercial-property developers and investors, nonperforming commercial real-estate loans reached $6.9 billion in the third quarter, or 9.6% of its total such loans outstanding. That figure more than doubled the level in the year-earlier period.

Mounting Trouble

Commercial real-estate problems began mounting last year as the credit crisis made refinancing debt difficult. But the situation is worsening because thousands of hotels, office buildings, stores and other properties are suffering declining incomes and can no longer pay debt service on the money they borrowed when times were good.

Morgan Stanley may soon have this problem with Crescent, some analysts say. Cash flow from Crescent's office properties, which make up the bulk of the portfolio, will likely fall below the amount required to pay debt service next year, according to an analysis by Matthew Anderson, partner at Foresight Analytics.

At the time of the acquisition, the properties were generating cash flow that was 2.5 times debt service, he said. That "debt-service coverage ratio" has fallen to 1.3 this year and will likely drop to between 0.8 and 0.9 in 2010, he said.

To be sure, Morgan Stanley has been selling Crescent properties to reduce debt since the deal was completed in August 2007. As a result, the kind of buildings in the Crescent portfolio have changed over time, which could have affected the cash flow.

Morgan Stanley's plans for Crescent ran off the track soon after it bought the portfolio from Richard Rainwater, the renowned Texas investor.

Morgan Stanley originally planned to put the properties in one of the real-estate funds it manages for institutions and wealthy individuals. But fund investors balked at buying the buildings at top-of-the-market prices, forcing Morgan Stanley to keep the properties on its own balance sheet.

The Barclays debt originally was due Aug. 3, but the bank agreed to a three-month extension.

When to Buy?

Investment firms without the balance sheets of large investment banks typically don't buy property for real-estate funds until the money has been raised.

The benefit of buying before the money is in place -- as Morgan Stanley did with Crescent -- is that it allows investment banks to move quickly. But they risk losing investor commitments if the property they buy becomes undesirable.

Morgan Stanley has been one of the most active real-estate fund managers.

The firm announced raising at least $14 billion in 2006 and 2007 for its series of real-estate funds known as MSREF, which have taken some big hits as the property market has soured.
Calstrs's Paper Losses

The California State Teachers' Retirement System, for instance, reports its $400 million investment in Morgan Stanley's MSREF VI International LP fund was down 80% as of March 31, and that its $137 million net investment in the MSREF V U.S. LP fund was worth $300,000. Other Calstrs real-estate investments with Morgan Stanley have fared better.

MSREF's bad bets include an investment in North Carolina developer Crescent Resources (unrelated to Crescent Real Estate Equities), which filed for bankruptcy protection in June, and a $3 billion portfolio of German office buildings.

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