Developer Michael Reschke usually doesn`t court publicity. But last week, the 35-year-old wunderkind of Chicago real estate sat in his opulent sales office, under a ceiling painted like the daytime sky, and bared the financial workings of his flagship project, a 50-story office tower under construction on Wacker Drive.
The reason: Kemper Corp., which has provided funding for more than 90 percent of the projects launched by Reschke`s Prime Group Inc. in the last five years, is under fire for its real estate holdings. Kemper`s stock price is down about 16 percent since the end of May, apparently because of concerns that its almost unblemished financial statements might conceal big real estate woes.
To allay these fears, Kemper and some of its real estate partners have been forced to make unusually candid disclosures about their deals. Like the ceiling mural in his 36th floor sales office at 35 W. Wacker Dr., Reschke painted a picture that was mostly clear sky with few clouds on the horizon.
He confirmed that the 77 W. Wacker building, Prime`s first downtown office tower and a joint venture with Kemper, won`t make any money until 1996, four years after its expected opening next spring. But Reschke said the project, which is 91 percent leased, then will generate annual returns of more than 10 percent, even after various costs such as free rent and lease buyouts associated with attracting tenants.
To many of Prime`s competitors, struggling to cope with a severely overbuilt office market, those numbers seem incredible. Seven major downtown buildings that are under construction or recently completed still have substantial amounts of space to lease. None of the other buildings under construction is even half filled, according to real estate brokerage firms here.
Similar real estate problems are taking a toll on the life insurance industry, which holds about $245 billion in commercial mortgages. Delinquency rates on commercial real estate loans held by life insurers climbed 13 percent in the second quarter, to a record 5.41 percent, according to a recent report by the American Council of Life Insurance, a Washington-based trade group.
In this environment, Kemper, a diversified financial services concern with two life insurance units, has attracted attention because of its surprisingly clean real estate record. As of the end of June, the company was reporting that only one $24 million mortgage loan was behind on interest payments, out of a total real estate portfolio of $2.1 billion; it said it has foreclosed on only two loans since 1985.
”Kemper has such a remarkably good real estate portfolio that people are suspicious,” said Reschke. ”It`s like it`s too good to be true.”
Kemper officials say its record reflects prudent investing with a select group of partners, which in Illinois includes Walsh Higgins & Co. and LaSalle Partners as well as Prime. In addition, the company`s portfolio contains no properties in depressed New England and relatively few on the East Coast.
But its largest concentration, 30 percent, is in California, a market where commercial properties have been hit hard. Illinois is its second biggest holding, at 17 percent.
Some analysts have complained that the structure of Kemper`s real estate deals makes it difficult to figure how well the portfolio is performing.
That`s because about 70 percent of its holdings consist of so-called joint-venture mortgages, projects in which Kemper holds a long-term mortgage and is an equity partner. In these deals, Kemper is, in effect, the borrower and the lender, and when a problem develops, the company can avoid loan writedowns by pumping in more money.
The company says the joint-venture approach allows it to monitor its investments more closely. As a partner in what typically are 50-50 real estate ventures, it also can use operating losses on the projects to reduce its taxable income, said John Fitzpatrick, Kemper`s chief financial officer.
”The joint-venture structure gives us upside potential as well as yield,” Fitzpatrick said. ”If you diversify the portfolio as we have, with over 350 different projects, things will generally work out well, although we might have a few clinkers in there, too.”
Kemper attributes the recent hoopla about its real estate holdings to misunderstanding of its accounting procedures. The company apparently tried to educate others on those methods by dispatching Richard Curto, senior vice president for real estate investments at its Kemper Financial Services Inc. unit, to a meeting with analysts in New York last month. The company declined to make Curto available for an interview.
Moreover, Kemper`s recent filings with the Securities and Exchange Commission have contained much more information about its real estate portfolio than prior submissions. In an unusual step, the company amended its regular financial report for the first quarter Aug. 9, six days before it submitted second-quarter documents, to provide additional details about its investments, including real estate and junk bonds.
Fitzpatrick wouldn`t say whether the move was required by SEC officials. An agency spokesman in Washington also declined to comment.
The amended first-quarter filing and Kemper`s second-quarter report acknowledge for the first time that weak economic conditions in certain areas could trigger more non-performing loans and lower real estate values. The second-quarter document also breaks out the company`s ”real estate equity loans,” through which it can prop up its joint ventures.
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The report shows that about 36 percent of the total $111.8 million in such loans went for interest payments and operating expenses of existing ventures. Fitzpatrick pointed out that half of these project overruns
(reflecting Kemper`s 50 percent joint-venture stake) show up on the company`s income statement.
State regulators declined to comment on Kemper`s real estate holdings. Arnold Dutcher, deputy director of the Illinois Insurance Department in Springfield, said his agency is reviewing the company`s real estate investments and mortgage loans along with those of other life insurers, but hasn`t reached any conclusions.
This month, Kemper announced plans to unload in the next five years most of the $800 million in joint-venture properties it holds with California developer Peter Bedford. Kemper, which said it plans to embark on no new real estate projects, also said it would receive first crack at the sales proceeds on what were formerly 50-50 partnerships.
The move was widely viewed as an attempt to appease analysts, who said Kemper officials had told them substantial gains are expected on some of the Bedford properties. In July, as part of a series of real estate-related life insurance downgradings, Moody`s Investors Service Inc. lowered the financial strength ratings of Kemper`s life units to ”good” from ”excellent.”
On Friday, Kemper`s stock closed up 37 cents a share at $31.75 on the New York Stock Exchange, down from $38 at the end of May but far above its 52-week low of $17.12 last fall.
”I don`t have any specific evidence that would lead me to believe that Kemper is hiding something,” said Ron Frank, an analyst at Smith Barney, Harris Upham & Co. in New York. ”In this environment there`s always a degree of uncertainty with regard to the underlying (real estate) asset values that you can`t wish away.”
In the 77 W. Wacker deal, Reschke says the numbers are clear. He points to the project`s extremely favorable financing, involving a $230 million, seven-year balloon loan (the principal is paid at maturity) from four Japanese lenders, Suisse Bank Corp. and Bank of Montreal. The current interest rate is 6.25 percent.
Kemper put up about $41.5 million in equity money and committed another $30 million to finance shortfalls. The total cost of the project is $254 million, and beginning in 1996, it will generate $26 million a year, Reschke said.
The developer declined to disclose net effective rents, though he said concessions required to attract tenants are included in the cost figure.
The numbers don`t include the cost of raw land in Naperville, estimated at $14 million, that Kemper bought from R.R. Donnelley & Sons Co. to induce it to take 10 floors in the building; Reschke said no loss is expected on that purchase.
Kemper also has provided a loan for Prime`s purchase of 2,600 acres along the Northwest Tollway corridor for a planned community that would almost triple the size of the village of Huntley. Reschke expects the first phase of the long-term project, which isn`t a joint venture with Kemper, to begin in about a year, after Huntley approves the annexation of the property.
In another land deal, Kemper and Walsh Higgins are joint partners in a controversial 306-acre multi-use development in Burr Ridge. The partnership bought the land from heavy-equipment manufacturer J I Case Co. (which kept a research facility on the property) without any provisions for zoning changes; it took more than a year to win approval from the village for the project, which will have homes, offices, light industrial plants and stores.
Jack Higgins, the developer`s president, said the venture`s planners had expected an even longer battle over zoning changes. He said plan changes required by the village, such as reduced square footage of office space, weren`t significant.
”It can be successful. These fellows are fine developers,” said developer William Gahlberg, who also had bid for the property, but whose plan didn`t include homes because ”I didn`t want to back up residential onto an old R&D (research and development) building.”
But ”I`m glad I don`t have it,” Gahlberg added. ”This is going to be a painful delivery.”