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REPORT January 2014




CHARTING THE COURSE 2014: How David Beats Goliath in Business Plus, our Much-Ballyhooed Predictions for 2014


FINDING YOUR PATH Top 10 Real Estate Trends and Predictions for 2014




TRAILBLAZING Grant Street Mansion, Denver, Colorado


NOTABLES AND QUOTABLES Pearls of Wisdom for the New Year



THANKS FOR WRITING IN Thanks for writing in. Please keep those cards and letters coming. If you have expertise in an area that could be of interest to our readers, please email us at info@pathfinderfunds.com with information about your proposed subject matter. We will be happy to consider it for a future edition.

CHARTING THE COURSE 2014: How David Beats Goliath in Business Plus, our Much-Ballyhooed “Bold Predictions for 2014” By Mitch Siegler, Senior Managing Director How David Beats Goliath in Business Best-selling author, Malcolm Gladwell’s latest book David and Goliath: Underdogs, Misfits, and the Art of Battling Giants has profound implications for business. You’ve no doubt heard of and may have read Gladwell’s earlier best-sellers, including The Tipping Point, Blink and Outliers. In David and Goliath, Gladwell makes the contrarian case that David really had the inherent advantages, by virtue of his speed, agility and talent with a slingshot – he was the Special Forces sniper of his day – while Goliath was just “too big and slow and blurry-eyed to comprehend the way the tables had been turned.” A modern-day Gladwell example: Super-lawyer David Boies, dubbed the Michael Jordan of the courtroom, successfully represented CBS and IBM against the U.S. government, the government in its successful antimonopoly suit against Microsoft and Al Gore before the U.S. Supreme Court in the case that decided the 2000 presidential election. Gladwell’s thesis is that

Boies, who suffers from dyslexia, compensated for his difficulties reading by developing extraordinary listening and memory skills, which he exploited as a top trial lawyer. The author chronicles other famous dyslexics, like Cisco’s John Chambers, Gary Cohn, president of Goldman Sachs and Hollywood producer, Brian Grazer and references a 2009 study of over 100 dyslexics who became successful entrepreneurs as further evidence that their dyslexia, even more than plain hard-work and a desire to overcome life’s obstacles helped them reach the top of their game. This is interesting sociological stuff, of course, but tough to prove without a longitudinal study over many decades. But, we like the parallels for businesses and organizations. Jeff Bezos, who founded Amazon, which has revolutionized the way we buy books, videos and pretty much everything under the sun in a garage, coined the “two pizza rule”. His thesis: the more people, the less productive meetings will be. His solution: never hold a meeting where two pizzas can’t feed the entire group. Keeps teams fast and loose and makes Amazon nimble and dynamic. A willingness to reinvest profits into building the company for the long-run doesn’t hurt either. David and Goliath Investing Strategies We’ve built Pathfinder on a few principles, including a willingness to do things others won’t or can’t. We often focus on investments that are a bit off the fairway (we



like to say those “with hair on them”) and those with an odd size (“too big for the little guys and too small for the big boys”). Nothing particularly transformational there but it’s astounding how many rules large institutions must create and how few opportunities – even really interesting, lucrative opportunities – ultimately survive the “does it fit in our box?” test. These boxes often mean they’ll invest in any real estate opportunity, as long as they can (i) deploy a minimum of $20 million in equity, earn at least a 20% internal rate of return, (iii) achieve at least a 1.75 equity multiple, (iv) use a reasonable level of financial leverage (but still put $20 million in equity to work even if they recapitalize with a loan after a few months and (v) invest only in gateway markets within a two-hour flight of corporate headquarters. This list of criteria is an amalgamation of several sets of rules from different investment funds; some have more requirements, some fewer and they’re all different, of course. But, we’d guess that more than two pizzas – many, many pizzas, no doubt – gave their lives to create the various rules that serve to create the various investment criteria boxes. Goliath Banks

others like it that we’ve come to know – has few legacy assets, solid equity capitalization and an ownership with a long-term orientation. They’re also nimble, staffed by bright people who work hard to understand their borrowers and businesses and – remember this? – do what they say they’re going to do. It’s actually not that hard. What distinguishes them from the national and regional banks? They’re a fraction of the size, for one thing. And, we’ll wager that their loan committee could dine on a couple of pizzas, maybe even one. Sure, the banking industry has undergone huge consolidation during the past few decades and a handful of Goliath-sized banks have extraordinary market share today. Undoubtedly, these mega-banks will have huge advantages in certain areas like international trade finance, currency swaps and letters of credit. But, as mobile banking grows, bank branches aren’t what they used to be and if small companies continue to be the job-creating engines of our economy, this new breed of small, entrepreneurial banks will likely enjoy their fair share of growth and success. Ten Predictions for 2014 – a Choppy Year but One of Continued Recovery

Many banks act in a similar fashion. We recall a story from an old friend, a long-time banker and most recently an executive with one of the very largest money center banks (he’s now with a private equity firm) told us a few years ago, about the loan underwriting environment after the financial crisis. His bank had been invited to lend to a large fast food franchisee of a company whose logo is adorned with golden arches for the chain’s new specialty coffee machines. These machines cost around $100,000 apiece and generate margins from mocha cappuccinos and the like that are so off the charts that the investment payback period was ultra-quick, like 24 months. The franchisee had been in business for many years and enjoyed a highly profitable business. He had substantial equity in the restaurants and was prepared to invest considerable equity in the equipment. Solid borrower, check. Good collateral, check. Excellent cash flow, check. Reasonable debt service coverage ratio, check. All boxes checked. Can’t remember why the bank ultimately decided against making the loan but if you don’t want to do something, there are a gazillion reasons not to do it.

The views and predictions below are those of Mitch Siegler and are not to be construed as personalized investment advice. Our predictions are simply that – predictions. They are not guarantees and we could certainly be wrong on every prediction. The information below focuses on general economic conditions, the general business climate and general real estate market conditions. We make no representation whatsoever to the future performance of our individual investment holdings and the commentary should not be construed as an outlook for our investment holdings.

Meanwhile, there’s a new breed of bank emerging from the rubble of the financial crisis. Pathfinder’s bank – and

While we’re not much help on the weightier world issues of the day, that won’t stop us from offering up a few

The future ain’t what it used to be. This wisdom comes to us from Major League Baseball catcher and philosopher Yogi Berra. And how right he was! Will Congress get its act together and finally pass a workable budget? Will the nuclear deal with Iran hold – even for six months? Will the new healthcare.gov website work as intended and will you be able to keep your health insurance if you desire and see reduced healthcare costs under Obamacare, as promised? Pretty unlikely and above our pay grade.



predictions that may provide a roadmap for investing in the months ahead. As prelude, we scored a few touchdowns with several of our 2013 forecasts and fumbled on several others (report card for 2013 predictions at the end of the piece). Without further ado, here are our “Ten Predictions for 2014.” 1. U.S. economy will continue to grow, but at a sluggish pace – The good news is we believe the economy will continue to grow; the bad news is the pace of growth will be sluggish. “The current, mild expectations pale in comparison to previous recoveries.” That pearl of wisdom is not from us, it’s from a recent economic forecast report from the Gary A. Anderson Center for Economic Research at Orange County’s Chapman University. According to the report, the economic recovery is now going on 53 months. In the context of other recoveries, we should now be experiencing accelerating inflation and tightening labor markets. “Yet, there’s no sign of these pressures.” The Chapman economists expect the nation’s GDP to grow 1.7% in 2013 and 2.2% in 2014. While the trend remains positive (it’s the fifth consecutive positive year since 2009’s GDP growth of 2.8%), the forecasted 2013 and 2014 increase is well below the 2.8% growth we saw in 2012. And tapering is a headwind for the economy so as that finally kicks in, it will crimp growth.

be the result of job seekers throwing in the towel, not because they found work. Accounting and consulting firm CohnReznick estimates that had these unemployed remained in the labor force, the November unemployment rate would have remained unchanged. While the economy is improving, we think headwinds from government shutdowns, Obamacare and an imminent slowdown in the Fed’s purchases of mortgage securities will combine to crimp job creation.

4. Consumer spending will be choppy – The economic data is decidedly mixed. The stock market has been on a tear and there’s continued house price appreciation, as evidenced by median home readings from S&P/CaseShiller, up 13.3% for the 12 months ending September 2013, its fastest clip since 2006 (the peak of the housing bubble). Per the Federal Reserve, the net worth of U.S. households (the value of Americans’ homes and stock portfolios) rose 2.6% to $77 trillion in the third quarter, a record high. Another bullish indicator, building permits remain strong (up 6.4% to more than 1 million units in September), led by multifamily construction. Yet, since interest rates moved higher last summer we’ve seen a number of signs of a slowdown in the single-family and commercial real estate sectors. The bulk of the gains in household net worth from the booming stock market and rapid house price appreciation are likely in the rearview mirror and the liquidity boost from mortgage re-financings are also in the past. And several wealth manager friends are taking some chips off the table to position investment portfolios for choppy seas that may lie just ahead. The mall across the street from our office has a full parking 2. The world economy will follow the United States in lot but sale signs abound. The Christmas shopping season recovery – Europe’s recovery has been microscopic but its may tell the tale on consumer-confidence; it fell to a recession has been fading from view. We think the Euro seven-month low in November (to 70.4, down from 72.4 zone will ride the coattails of the U.S. economic recovery in October) and the period between Thanksgiving and in 2014, benefitting from exports but the pace of recovery Christmas is nearly a week shorter than normal, which will be sluggish. Asia will also benefit from Japan’s money- doesn’t bode well for retailers. We’re looking for a mixed printing and China’s economic reforms. consumer spending picture this year and marginally better 2014 performance compared with 2013. 3. The unemployment rate will continue to fall but will still end 2014 at around 5. Look for a correction in U.S. 6.5% – Also in the good news equity markets in the first half which category, the unemployment will position stocks for a rebound, rate declined from 7.2% in taking them higher by the end of October to 7.0% in November, 2014 – We’ll take some heat for this one a five-year low and welcome amid all the bullishness but it’s as much news. However, some of about mean reversion as anything. the improvement seems to The current bull market that began in T HE PAT HFI NDE R R E PO R T: JANUARY 2014


March 2009 has taken the S&P 500 index up 162% since that time; this includes a 40% rally in the past 18 months with no correction. Bank of America Merrill Lynch’s chief investment strategist, Michael Hartnett says “once global central banks stop buying $150 billion of assets a month, volatility will rise.” We think a 15% to 20% correction is in the cards – which would set up another buying opportunity and a continuation of the secular uptrend. Investor John Hussman’s Rule #1 is “Most things will prove to be cyclical”. Hussman’s Rule #2: “Some of the greatest opportunities for gains and losses are when people forget Rule #1.” It’s a trader’s year. 6. We’ve seen the lows on interest rates – The good news is that rates are rising because the economy is improving. While we expect further increases in rates, we don’t expect them to skyrocket in 2014. Incoming Fed Chairman Janet Yellen fears deflation far more than inflation and we won’t see rates returning to their lows (1.4% on the 10-year Treasury in 2013) next year even if the economy’s pace slows and the markets swoon. Now, we don’t expect anything resembling 1981 either – that’s when the 10-year peaked at close to 16% after increasing steadily for decades, before beginning its 30+ year decline. We expect the Fed to stay true to its word (and moneyprinting) to keep the cost of funds very low for the next year or two. Since the 10-year, historically, has equaled real GDP growth (nominal GDP growth plus the rate of inflation), we expect the 10-year this time next year to hover in the 3.75% to 4.0% range (based on 2.5% GDP growth and 1.5% inflation). Sure, that’s a big move in percentage terms but it’s a far cry from the early ‘80s. 7. Housing faces demographic headwinds which will crimp price appreciation – A generation or two ago, folks got married and started families in their 20s. Today, they wait until their 30s, as jobs are harder to find and many young people still live with mom and dad and struggle under a mountain of student loans. And, the bloom is off the home ownership rose as kids have been barraged by years of news headlines about people losing homes to foreclosure and massive increases in personal bankruptcies. These factors combine to impact the desire for the younger set to own a home; the U.S. Census Bureau says home ownership for Americans under the age of 35 was about 37% in the third quarter, down from 42% in the same quarter in 2007. The torrid pace of national house price appreciation in 2013 (8.4% per FHFA and 13.3% per S&P/Case Shiller) will be far more subdued in

2014 – but we’re still predicting a darn respectable 3% to 5% increase in home prices nationally. 8. Regulation will shrink the mortgage market and slow the housing market – To protect consumers from a repeat of the sub-prime lending excesses that brought on the Great Recession, the administration and its friends in Congress are laying the groundwork for the next wave of regulation that promises to contract the housing market, representing 15% of the country’s economy. Banks are exiting the mortgage business in droves. JP Morgan Chase is laying off 13,000 to 15,000 mortgage-banking employees next year, Citicorp will lay off 2,200, Bank of America already cut 2,100 from its mortgage staff in September, SunTrust Banks and Cortland Bancorp halted loans to mortgage brokers this December 31, Wells Fargo ended joint ventures to mortgage brokers in 2013 and Ally Financial exited the mortgage market entirely. This flight is driven by higher compliance costs and increased litigation risks from the Dodd-Frank financial reforms. That would seem to translate into a lower supply of mortgage loans. We think this just can’t bode well for the housing market, job creation or the economy. 9. The seeds are being sown for the next housing bubble – Before the crisis, 58% of all U.S. mortgages were subprime or weakly underwritten. Of these, more than three-quarters, approximately 24 million loans, were on the books of government-sponsored agencies, primarily Fannie Mae and Freddie Mac. You might say that the government has enabled the demand for these low-quality loans. The genesis of this was affordable-housing goals set forth by Congress in 1992 whereby Fannie and Freddie were required by HUD to purchase more loans from borrowers with below-median incomes. As these HUD quotas increased over the next 15 years, Fannie and Freddie responded by loosening their underwriting standards (accepting 3% down payments in the mid-‘90s and 0% down payments in 2000) to find more eligible borrowers. The music stopped with the crash and taxpayers ultimately rescued Fannie and Freddie to the tune of $180 billion. Last month, Rep. Mel Watt (Democrat from North Carolina)



was confirmed as head of the Federal Housing Finance Agency, which regulates Fannie and Freddie. Mr. Watt is a huge proponent of affordable-housing quotas. With him at the helm, we expect to see lower down-payment requirements, reductions in credit scores, a loosening of debt-to-income ratios and a relaxation of restrictions on borrowers who have lost a home to foreclosure. We don’t expect to see the bubble burst in 2014 but we’ll see news stories on the subject soon and fallout won’t be far behind.

hear another story of a company or executive relocating from California. And more often than not, the destination of choice is Houston, Dallas, Austin or elsewhere in Texas. (Denver, Salt Lake City, Reno and Charlotte also make the list from time to time.) Lower taxes (zero state tax in the case of Texas) is generally one of the top reasons as is a booming economy (driven by energy, technology and health care) and cooperative local government. Texas has been America’s fastest-growing state, adding more than 913,000 people, according to real estate consulting firm, 10. Migration from California and other high-cost Redfin. No surprise, since the company estimates that a states to Texas and other low-cost states becomes a home in Houston costs one-third of the same home in major news headline – Every time we turn around, we San Francisco and is typically twice as large. Here’s the report card from last year’s predictions: PREDICTION



Congress will kick the can on As the fiscal cliff approached in 2013, we said “Don’t hold your breath spending cuts for meaningful spending/ entitlement cuts [from Congress].” ‘Nuf said.


Housing market will continue Huge year for housing prices. The S&P/Case-Shiller 20-city home price to improve index rose 11.2% for the four quarters ending September 2013. San Diego rose 20%. Other formerly hard-hit cities in the west like Phoenix and Vegas rose even more.


The U.S. economy will log The data is decidedly mixed and the picture is not yet in focus. Analysts marginal GDP growth this are predicting a big slowdown in Q4 GDP, to 1.5% following Q3’s big year but prepare for another inventory build-up which inflated the numbers that quarter. economic slowdown in 9-12 months


The stock market will be down We completely missed on the equity markets as the major indices for the year, perhaps by double skyrocketed 20-something percent. digits


The unemployment rate will When we popped the bubbly a year ago, the unemployment rate was improve marginally just a tad below 8%. We forecast the rate creeping down to below 7.5% by now (too high – it’s about 7%) and only hitting the Fed’s 6.5% target by mid-2014 (appears on track). Last year, we said “one surprising bright spot for jobs next year will be the hard-hit housing sector…which [will generate] substantial hiring as the year unfolds.” That played out.


We forecast interest rates “remaining at rock-bottom levels in 2013” driven by “more quantitative easing in 2013.” The 10-year bottomed last spring at under 1.5% and jumped over the summer, nearing 2.8% at press-time. We never heard the word QE4 but a rose by any other name smells just as sweet; the Fed purchased hundreds of billions in mortgage securities in 2013.


We’ll have QE4 in 2013





Prepare for further growth in The debacle of the healthcare.gov (Affordable Care Act a.k.a. Obamacare) the welfare state website has captured news headlines for months. The jury’s not in on implementation of Obamacare but it doesn’t appear to be driving down costs – for individual policy-holders or for the government. Gridlock will persist on Main Street as well as in D.C. and the “flight to quality” in investments will continue

We said “uncertainty brought about by the Fiscal Cliff, rising taxes, Obamacare and continued high deficits would cause companies to retain as much capital as possible for the future.” Cash levels on corporate balance sheets are at record levels and GM, Apple and other companies borrowed at rates so low bond traders did the limbo. Last year, we also foresaw “a further flight to quality” in the markets as investors would pile into trophy properties and blue-chip stocks. That came true and cash also spilled beyond blue chips into emerging companies and markets and second-tier properties.

The exodus from California We thought “the recent passage of Proposition 30, dubbed ‘The will accelerate Millionaire’s Tax’, which raised the maximum state income tax rate to 13.3% and boosted the state sales tax by 3.5%, would accelerate the move of California businesses and business owners out of the state to friendlier environs like Texas, Nevada and Washington – which have zero state income taxes, fewer regulations and lower housing prices.” Since 1990, California has lost 3.4 million residents to migration to other states. An estimated 103,000 left from July 2012 to July 2013, per the California Department of Finance.




Overall Grade: B+ We count our blessings and wish you and yours a very happy, healthy and prosperous new year. Mitch Siegler is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Mitch founded and served as CEO of several companies and was a partner with an investment banking and venture capital firm. He can be reached at msiegler@pathfinderfunds.com.




Top 10 Real Estate Trends and Predictions for 2014 By Lorne Polger, Senior Managing Director Happy New Year, everyone! 2013 was a busy year for Pathfinder. We made a bunch of new acquisitions and sold several existing investments. On a personal note, I helped get nine college applications out the door, flew 120,000 miles on Southwest Airlines, lost 10 pounds, joined a Vistage chapter, cooked at least a dozen new recipes for my family, and started running and hiking again. And I resolved to take a photography class and climb a new mountain. Next year. You always need to have a resolution in the back pocket for next year. So how does 2014 look to for the U.S. economy? Will we see the same positive trends that we saw in 2013? Doubledigit home price increases? Significant absorption of retail space? Stabilized interest rates? Increased lending activity? Or will the hangovers from Obamacare and the government shut-down slow us down, or heaven forbid, take us back in the wrong direction? Here are some thoughts on what may lie ahead (and where new opportunities may be found). Commercial real estate absorption ties to job growth The slow pace of job, income and wage growth is still holding back the real estate recovery and that’s not likely to change quickly. That said, cities with technology growth and positive migration (tax-motivated positive migration!) are seeing strong residential and commercial recoveries based on the strength of their economies. Think Seattle, the Bay Area and Austin. Perhaps it’s stating the obvious, but regions with low unemployment and strong job growth should expect stronger and more sustainable recovery in

2014. We’re betting that the rich get richer. We’re counting on the “smile” and that development will expand beyond multifamily Real estate development in the “smile” of the U.S. is back. Washington, Oregon, California, Arizona, Texas, Florida and up through the Northeast. We’re seeing new development activity (not just entitlement, but lots of cranes) across the commercial property spectrum in the smile. All ten of the Urban Land Institute’s top markets for 2014 are in the smile of the U.S.: San Francisco, Houston, San Jose, New York, Dallas, Seattle, Austin, Miami, Boston and Orange County. So expect to see more activity in those areas than in the Midwest. The buyer’s market in residential real estate is gone As inventories have shrunk (in some cases, inventories are down 90% or more from peak highs), the old supply/ demand equation shifted. Did you miss the boat? Too bad. It’s unlikely that we see a buyer’s market like we had from 2008-2011 for a very long time. Smart sellers and their agents who understand the momentum shift can play the game differently, knowing that they can squeeze buyers eager to buy before interest rates rise further. Slowdown of apartment building Even though the amount of multifamily building that occurred over the last three years was still well below historical levels, we expect it to quiet down in 2014, as supply and demand are closer to equilibrium and cap rates could begin to rise. High-rise condos a thing of the past The recovery in the condo market hasn’t matched that of the single-family market and we don’t expect that to change. Our bet is that developers aren’t willing to take the risk of putting up new condo buildings because of the (i) virtual guaranty of rampant, costly litigation; and (ii) tougher financing standards imposed by lenders on buyers. Instead, expect to see more rental buildings that may be converted toward the end of the next cycle (just like we saw in 2004-2006). Unlike the last time though, many of those properties will be deed-restricted because of liability risk mitigation strategies employed by apartment developers.



More lending There’s optimism among those surveyed by the Urban Land Institute that lending standards will loosen next year. Much like the supply/demand balance in the housing market, we think the health of lenders and the growth of the shadow banking sector will lead to greater competition, more lending, higher leverage and lower rates. Shadow banking will continue to play a larger role in the lending market next year. Borrowers going this route will find a number of different unregulated sources that have greatly expanded their capital and geographic and product type reach, including private debt funds, syndicating lenders and family offices. We’re moving from the suburbs back to the city

investors, followed closely by pension funds and other large institutions; private equity funds, hedge funds, opportunistic funds and private investors. Underfunded pension obligations will tug on growth We are worried – really worried – about the long term effect that systemic underfunded pension obligations will have on state, regional and municipal governments. Hard to say how it affects us in 2014, but on a longer term basis, it just can’t be good. And the problem is of such epic proportions across the country that we could see how it slows (or even stops) the recovery in its tracks. Neither the Chargers nor the Padres will win championships in 2014 Hate to be Negative Nancy here, but as a long suffering San Diego area sports fan, I have to ask whether it will ever be our time? Nonetheless, I’ll continue to make my season ticket contributions and cheer ‘em all on. And in any case, I’ve got a good feeling about the San Diego State Aztecs and La Jolla High School Vikings basketball teams this year! I hope that 2014 is a year filled with hope, health and prosperity for all.

I’ve heard it time and time again over the last few years. “Just can’t stand the commute.” We foresee increased retail and mixed use development in the urban core. Development firms have concluded that the millennial generation is focused on urbanism (personally, I feel pretty ancient walking around downtown San Diego these days). Prospects for mixed use urban development are high, as they are tied to the changing demographics, i.e., the shift back to city life. According to the ULI’s survey, urban mixed-use projects had the greatest development prospects in 2014, edging out industrial.

Lorne Polger is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Lorne was a partner with a leading San Diego law firm, where he headed the Real Estate, Land Use and Environmental Law group. He can be reached at lpolger@pathfinderfunds.com.

There’s more equity capital to go around The outlook for capital availability from a wide range of equity sources is expected to improve in 2014. According to respondents to a recent ULI survey, the availability of equity capital will increase the most from foreign




SIGN OF THE TIMES Home Prices Continue to Rise Home prices rose 2% in this year’s third quarter, the first time since 2009 that home prices nationally were above their levels of five years ago. The quarter ending in September also marked the ninth consecutive quarterly price rise. According to the Federal Housing Finance Agency’s (FHFA) House Price Index, home prices in the quarter were higher in 48 states and in the District of Columbia. Prices in Nevada increased the most at 7.2% with other large gains in California (4.5%), Arizona (2.7%), Florida (3.2%) and Washington (3.2%). Although prices remained strong, price appreciation was slowing late in the quarter. In San Diego, Pathfinder’s backyard, yearover-year prices rose 20% from September 2012 to September 2013, though the rate of increase during the quarter was a more tepid annualized 6.4%. This dynamic occurred on a national basis as well; the quarterly 2% increase was well below the 5.5% increase seen in the fourth quarter of 2012 and the 7.1% increase in the first quarter of 2013. Home prices have risen about 7.2%, adjusted for inflation over the last year, according to the FHFA. Bye, Bye Banks As we’ve been predicting since 2009, the number of banks is shrinking and it’s finally being borne out by the data. The 2008 to 2012 period was characterized by weak banks – more than 400 of them – being seized by the FDIC and merged into healthier institutions. Now, we’re learning that small institutions, in record numbers, are leaving the banking industry, bringing the number of U.S. banks to the lowest level since the peak of the Depression. The number of federally-insured institutions fell to 6,891 in the third quarter, the first time there were fewer than 7,000 since 1934 and down from more than 8,000 prior to the Great Recession. The culprits in our

view: low interest rates, a weak economy and DoddFrank and other regulatory pressures. HELOCs: The Sequel What comes around goes around. The home equity line of credit, the poster child of the shoddy loan underwriting that characterized the financial crisis, is making a comeback, according to a recent Bloomberg article. “HELOCs are making a comeback, as the housing market recovers enough to make the junior mortgages a safer bet for banks seven years after the beginning of the housing crash that saddled them with billions of dollars of losses,” Bloomberg reports. HELOC originations will likely total $91 billion this year – a post-2007 high – and are expected to grow to $97 billion next year, according to Moody’s Analytics. The big banks – Bank of America, Wells Fargo and JP Morgan Chase – are the giants in this space. The total amount of HELOCs on U.S. bank books peaked at $674 billion in 2009. Today, nearly 80% of that total remains, at $529 billion. And here’s a shocker: a large portion of those loans are in danger of defaulting. “U.S. borrowers are increasingly missing payments on home equity lines of credit they took out during the housing bubble,” according to Reuters. The typical HELOC has a 10year term. After 10 years, borrowers must start paying principal. On a $30,000 loan, the impact can cause a monthly payment to jump from $81.25 to $293.16. Next year, $29 billion in HELOCS mature at the large banks. Maturities leap to $73 billion by 2017 – what Amy Crews Cutts, chief economist at Equifax, the big consumer credit agency calls “a wave of disaster [with] no easy out.” That about sums it up, since when HELOCs default, banks can lose nearly everything – an estimated 90 cents on the dollar, according to Reuters since HELOCs are behind the first mortgage in a foreclosure. If the home is home isn’t worth the level of the first mortgage, the owner of the HELOC takes a bath.



Why haven’t you heard more about this? Because pursuant to the mark-to-market rules adopted in 2009 during the financial crisis, banks can still carry HELOCs on their books at par value. Is the CMBS Market Rebounding Too Quickly? Wall Street is on track to sell $90 billion in commercial mortgage backed securities in 2013 – an 86% increase from last year and the most since 2007. The rapid regrowth of the asset class that was responsible for the Great Recession has experts asking if underwriting standards are once again getting too lax. “There’s a huge increase in competition,” says Peter Eastham who manages CMBS ratings at Standard & Poor’s. “By default, that tends to push down underwriting standards.” Analysts predict continued growth with CMBS issuances hitting $100 billion next year. The rebound in the CMBS market has been positive for real estate owners and investors as new loans and refinancing options have become more available. With the expectations that rates will rise over the next several years, landlords are racing to lock-in long term debt or to refinance their maturing loans, which in turn increases the number of CMBS issuances. Even so, CMBS activity is still down about 60% from peak levels in 2007. Are Apartments in a bubble? An increase in multifamily permits – leading to greater supply – and a plateau in investor (particularly REIT) demand – driven by higher prices – suggest lower pricing is ahead for apartments. Pricing in 2013 appears to be down from 2012 levels, which may be driven, in part, by

last summer’s rise in interest rates. New construction is starting to roll in and Exhibit 1 below reveals what the tip of the iceberg looks like. The grey bars show that sales of apartment buildings aged two years or less spiked dramatically in 2012, and that 2013 apartment sales will almost undoubtedly end up passing that. What is perhaps more interesting is that pricing in 2013 has fallen from 2012. This does not mean that the market for these types of assets has clearly topped out, but that it could soon. REITs have been raising capital at a torrid pace through IPOs, secondary offerings of equity and debt, with capital raises in 2012 reaching an all-time high, according to CoStar. REITs success in capital markets have been aided by the tremendous returns they’ve generated during the past few years, but that may be changing. Since the beginning of this year, major apartment REITs have generated a total return of -1%, according to CoStar. This compares to gains in the S&P 500 of +25%. This will impact REITs’ ability to raise capital in the near future. Exhibit 2 shows the percentage of sales of apartment buildings aged two years or less to REITs – through midSeptember, they accounted for 40% of the purchases of these newer buildings. So, as development continues, what is likely to be the effect on pricing if REITs raise less capital and buy fewer properties? Prices will probably decline unless other investors step in. And, if prices decline for newer buildings, there’s a good chance the ripple effect will impact the entire apartment market.



TRAILBLAZING: GRANT STREET MANSION, DENVER, CO Repositioning and Reinvigorating an Historic Mansion

Denver’s Capitol Hill neighborhood is known for its combination of historical charm and cosmopolitan ambiance. The neighborhood’s vibe reflects both the opulent lives of its original residents and the energy of its new, young residents. Capitol Hill’s architecture is a collection of remarkably preserved Victorian estates, historical political offices and newly built apartment and condominium projects. Pathfinder, which had previously made several Denver-area acquisitions, was drawn to the Capitol Hill neighborhood because of its improving demographics and unique appeal. Among the historic Victorian estates in Capitol Hill is the Grant Street Mansion, also known as the Dennis Sheedy House. The mansion was designed by E.T. Carr in 1892 and reflects a blend of Sheedy’s personal taste and Carr’s signature architectural technique of combining expansive rooms with sophisticated woodwork. Much like neighboring estates, the mansion’s original charm has been preserved through several restorations and remains in very good condition. The property’s most recent renovation converted the project into 28 office suites within a four-story, 16,000 square foot main house and three office suites within a two-story, 4,000 square foot carriage house.

Pathfinder purchased the converted mansion, through a foreclosure sale, in December 2011. When Pathfinder acquired the project it was just 50% leased, had significant deferred maintenance and lacked professional management. Over the past two years, we have improved and stabilized the operations by curing much of the deferred maintenance and hiring best-in-class property management. Today, the project is 97% leased to a mix of tenants including psychologists, political consultants and holistic healers. We plan to continue to operate the project as a stabilized office investment property for the near-term (or at least until the Mansion’s 122nd birthday).




Pearls of Wisdom for the New Year

“Seek opportunity, not security. A boat in the harbor is safe, but in time its bottom will rot out.”

“Now it is a funny thing about life; if you refuse to accept anything but the best you very often get it.”

- H. Jackson Brown, “The Complete Life’s Little Instruction Book”

- Somerset Maugham, British novelist

“The most important thing to do if you find yourself in a hole is to stop digging.”

“Never lie in bed at night asking yourself questions you can’t answer.” - Charles M. Schulz, Creator of Peanuts comic strip

- Warren Buffet

“Don’t cry because it’s over. Smile because it happened.” - Dr. Seuss



IMPORTANT DISCLOSURES Copyright 2014, Pathfinder Partners, LLC (“Pathfinder�). All rights reserved. This report is prepared for the use of Pathfinder’s clients and business partners and subscribers to this report and may not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, without our written consent. The information contained within this newsletter is not a solicitation or offer, or recommendation to acquire or dispose of any investment or to engage in any other transaction. Pathfinder Partners LLC does not render or offer to render personal investment advice through our newsletter. Information contained herein is opinion-based reflecting the judgments and observations of Pathfinder personnel and guest authors. Our opinions should be taken in context and not considered the sole or primary source of information. Materials prepared by Pathfinder research personnel are based on public information. The information herein was obtained from various sources. Pathfinder does not guarantee the accuracy of the information. All opinions, projections and estimates constitute the judgment of the authors as of the date of the report and are subject to change without notice. This newsletter is not intended and should not be construed as personalized investment advice. Neither Pathfinder nor any of its directors, officers, employees or consultants accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this report or its contents. Do not assume that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended or undertaken by Pathfinder Partners LLC) made reference to directly or indirectly by Pathfinder Partners LLC in this newsletter, or indirectly via a link to an unaffiliated third party web site, will be profitable or equal past performance level(s). Investing involves risk of loss and you should be prepared to bear investment loss, including loss of original investment. Real estate investments are subject to the risks generally inherent to the ownership of real property and loans, including: uncertainty of cash flow to meet fixed and other obligations; uncertainty in capital markets as it relates to both procurements of equity and debt; adverse changes in local market conditions, population trends, neighborhood values, community conditions, general economic conditions, local employment conditions, interest rates, and real estate tax rates; changes in fiscal policies; changes in applicable laws and regulations (including tax laws); uninsured losses; delays in foreclosure; borrower bankruptcy and related legal expenses; and other risks that are beyond the control of the General Partner. There can be no assurance of profitable operations because the cost of owning the properties may exceed the income produced, particularly since certain expenses related to real estate and its ownership, such as property taxes, utility costs, maintenance costs and insurance, tend to increase over time and are largely beyond the control of the owner. Moreover, although insurance is expected to be obtained to cover most casualty losses and general liability arising from the properties, no insurance will be available to cover cash deficits from ongoing operations. Please add msiegler@pathfinderfunds.com to your address book to ensure you keep receiving our notifications. T HE PAT HFI NDE R R E PO R T: JANUARY 2014


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