Alternative Investment Vehicles and Real Estate Capital Markets
Session Two
Sustained Investor Demand for Real Estate
Real Estate as an asset class has clearly come of age Real estate is now a “must have” in asset allocation mix of growing number of institutional investors, consultants, high net worth and retail investors The size of institutional quality real estate is large, although it is much smaller than both equity and bond market capitalizations
Alternative Real Estate Investment Vehicles
Alternative vehicles for investing in real estate are a response to investor demand including:
Investor risk-return profiles Liquidity Needs, Diversification, Tax Efficient Needs Transparency Corporate governance
Exhibits 1 and 2 show a classification of alternative investment vehicles for real estate asset and their specific country applications in selected countries, respectively
Exhibit:1 Alternative Real Estate Investment Vehicles
Real Estate Investment
Direct Investment
Indirect Investment
Listed
Property Stocks
Non-listed
Close-End Funds
Partnerships Commingled Funds Syndication, JVs, TIC
REITs
Open-End Funds Fund-of-Funds
Mutual Funds Special Funds Hedge Funds
REITs
Exhibit 2: Alternative Investment Vehicles in Selected Countries
COUNTRY USA PRIVATE (DIRECT) Direct Investment Direct Investment Direct Investment Direct Investment Direct Investment Direct Investment Direct Investment PRIVATE (INDIRECT) Commingled Funds, Syndications Partnerships, Joint Ventures Open-end Special Real Estate Funds, Closed-End Real Estate Funds Unlisted Real Funds PUBLIC REITs, REOCs, CMBS
Germany
Listed Real Estate Companies, REITs* Listed Real Estate Funds Real Estate Companies, REITs* Listed Property Trust (REITs) HK-REITs, Listed Property Companies S-REITs, Listed Property Companies
Netherlands
United Kingdom Australia
Limited Partnerships, Property Unit Trusts Property Syndicates, Property Securities Funds, Unlisted Real Estate Funds Private Property Funds Private Property Funds
Hong Kong Singapore
Real Estate Capital Markets
The proliferation of alternative investment vehicles is shaping both the nature and depth of real estate capital markets Real estate asset has dual capital markets consisting of debt and equity side
Direct or Private Capital Market Indirect or Public Market
There is a feedback mechanism that connects the two markets to allow for market correction The public market is integrating real estate into broader capital markets and thus imposing general capital market discipline
Exhibit 3: Real Estate Capital Markets
(Collection of retail, office buildings, apartment, etc, producing rent) ––illiquid assets (Collection of retail, office buildings, apartment, etc, producing rent) illiquid assets
Helsinki Real Estate Company Helsinki Real Estate Company
(Residual Equity Claim) – Illiquid asset
Private Direct Investment
Private Whole Mortgage Investment
Senior Debt Claim) – illiquid asset
Underlying Real Assets: Privately Traded (Direct Market) Privately Traded Indirect” Market)
Partnerships, CREFS, JVs, Syndication, etc
Fractional Private Equity Investment
Fractional Private Debt Investment Fractional Private Debt Investment
Loan Participation, Loan Syndication Loan Participation, Loan Syndication Real Estate Debt Securitization
“Residual” Liquid Financial Claims
Real Estate Operating Companies Listed Property Companies Real Estate Investment Trusts (REITs) Listed Property Trusts
Real Estate Equity Securitization
Financial Assets: Residential Mortgage Backed Securities Publicly (RMBS) Traded (Indirect Commercial Mortgage Backed Securities Market)
“Senior” Liquid Financial Claims
(CMBS)
Small & Large Investorsl Mutual Funds
(wealthy individuals, developers, institutions) (wealthy individuals, developers, institutions)
Large Investors Large Investors
Small & Large Investors Mutual Funds
Investor Type
Exhibit 5: REAL ESTATE CAPITAL MARKET MATRIX
EQUITY DEBT
PRIVATE DIRECT MARKET
Direct Property Investments, Partnerships, Joint Ventures, Separate Accounts
Wholes Mortgages
PRIVATE INDIRECT MARKET PUBLIC MARKET
Commingled Funds, Private Placements, Venture Capital, Unit Trust, Special Funds REITs, Real Estate Operating Companies (REOCs), Listed Property Trust
High Yield CMBS, Loan Participation, Loan Syndication Investment Grade CMBS REIT Debt
Note: Real estate is perhaps the only asset with where the real underlying assets are traded
Valuation Using Cap Rates and P/E ratios
Example: 100 units; rent/month = $2000; operating expense ratio = 20% of EGI; Vacancy ratio = 4% of PGI; management fees = 8% of EGI; other operating expenses = 10% of PGI
Real Estate Capital Flows
The massive flow of capital into real estate during 2004-2006 In the US sales transactions and CMBS issuance have surpassed previous records The primary channel of capital flow is powered by investor need - Yield, Diversification, and Stability Capital flow have led to new investment strategies – Broader Risk Spectrum, Property type, Financial Structures, and Location Globally there is now a squeeze on capital flow due sub-prime mortgage (SPM) mess
US Commercial Real Estate Capital Market Universe
The universe of institutional quality real estate is driven to higher capitalization levels
High real estate valuation New construction activity Flow of capital
Total U.S. institutional quality real estate market capitalization is approximately $3.5 trillion
Question: How does this compare with stock and bond markets
U.S. Commercial Real Estate Equity and Fixed Income
Exhibit 7 shows the estimated U.S. real estate debt markets as of 2005 Exhibit 8 provides additional perspective on real estate debt holdings Over the past 7 years commercial real estate debt (including multifamily) has nearly doubled -$1.2 trillion to $2.4 trillion Both U.S. and foreign firms have used their huge accumulated cash to deleverage Reduced corporate borrowing has directed more debt capital into real estate – releverage
Exhibit 7: U.S. Commercial Real Estate Fixed Income Mostly from commercial banks and CMBS
U.S. Commercial Real Estate Debt
Collectively commercial banks, CMBS originators and life insurance companies provide most of real estate debt capital Commercial banks are the primary source of bridge and construction loan capital, as well as loan syndication platforms Commercial banks have also used new syndications to take on larger and riskier loans and to build forward pipeline for their CMBS platforms CMBS are becoming an increasing part of real estate debt market – See Exhibit 7 and 8
Exhibit 8: Real Estate Debt Holdings by Types of Lender CMBS is growing
U.S. Real Estate Equity Market
Collectively private investors, pension funds and public REITs provide most of real estate equity capital The abundance of debt capital has pushed the completion of equity transactions to higher levels -- >$200B (2005) REITs record equity capital raising has subsided due market volatility and aggressive pricing
Exhibit 9: U.S. Commercial Real Estate Equity Private Investors, REITs, Pension Funds Key Providers
“Prosperity makes Friends, Adversity Tries them”
In absolute and relative terms real estate investments returns over the last few years have been exceptional –See Exhibit 10
Growing global acceptance of real estate in strategic asset allocation models Proliferation of real estate investment vehicles Improved information flow and transparency due to growth in publicly traded debt and equity quadrants and improved research Investor perception that real estate volatility is low
Friends of Real Estate
Exhibit 10: Total Returns as of 2Q 2005
The Source of Prosperity in Real Estate Markets
Private market total return were 20.06% as of December 2005 according NCREIF index
NCREIF index covers about $165 billion institutional real estate, compared to overall universe of institutional quality real estate of about $3 to $4 trillion
Exhibit 12 shows that a very significant portion of total return over the past 4 years is due to compression in cap rate; very little is due to growth rate in NOI
Real Estate Returns at Highest Level in Several Decades
Exhibit 11: NCREIF Property Return Index (National 1990-2005)
25 20
20.06%
Total Return
15 10 5 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 -5 -10
Annual Return
Calender Year
Exhibit 12: Total Return Attribution Significant portion of the return is due to cap rate compression
What might Cap Rate Compression Imply?
Capital Markets and the Post Cap Rate Compression
Increase in property prices due capital flow has generated significant compression in capitalization (cap) rate This combination of factors has significantly reduced historical yield advantage real estate has over other assets classes Future real estate performance is likely to come from success in increasing property net operating income (NOI), and sustainability of landlord pricing power This links back to health of space market fundamentals, especially given the likelihood of increases in long-term interest rates
Real Estate Cash Flow Yields
The comparison that is often made is between cap rate and P/E ratio, which is appropriate Perhaps a better analog for real estate is the dividend yield of the stock market NOI which is used to calculate cap rate typically excludes capital expenditure and tenant improvements Because of this dividend the yield is about 100 to 200 basis points below cap rate Dividend yield as metric for real estate performance is particularly important for investors who rely on investment cash flow to fund pension liabilities, or those using financial leverage and need cash flow to service debt
Exhibit 13: Cap Rate Mathematics
Cash Flow Yields has Declined Significantly for Most Property Types
Exhibit 14: Cash Flow Yield by Property Type
Current Cash Yield (2Q 2005) CDB Office 4.1% Suburban Office 3.9% Warehouse 3.9% R&D 4.1% Retail Malls 5.4% Retail Power 5.5.% Retail Neighborhood 6.3% Apartment 3.9% Hotel 5.3% U.S. Treasury (10-year) 4.2%
Source: NCREIF, U.S. Treasury
Average Yield Since 1990 5.2% 5.6% 5.6% 6.6% 5.2% 6.1% 6.7% 6.5% 6.4% 6.0%
Exhibit 15: Convergence of Real Estate Cash Flow and Risk-Free Yields
Is the Commercial Real Estate Market at Risk?
Some factor to consider: Sudden upward pressure on long-term Treasury yields either from increase in core inflation or shifts in demand for Treasury bonds Continuing low interest rate and resulting compression in cap rate pose risk of premature real estate construction High energy prices and resulting declines in consumer sentiment and confidence Labor market response to forces of global competition and global labor arbitrage Increasing aggressive use of financial leverage by real estate investors Now the SPM mess
Risk of Premature Development
Low cap rates (high prices) tend encourage developers to bring new supply There are some signs of increased pipeline activity for both committed and planned future construction in U.S. If decision to construct is driven by investor demand rather than space market fundamentals oversupply results As can be seen in Exhibit 16 the degree of construction variance between the current and previous cycles generally matches the declines in cap rate This supports the view that cap rate compression has on the margin contributed to increasing levels of construction
Is there a Risk of Premature Development
Exhibit 16: Cap Rate and Property Completions in Real Estate CyclesThen and Now
Property Sector Discussions
What do you think will happen to the following commercial real estate sectors if the (1) SubPrime Mortgage (SPM) mess, (2) the slump in housing, and (3) the credit squeeze continue? Office Properties Apartment Retail Property Hotels
There is a lot of Volatility in the Property Market
Exhibit 17: NCREIF Pproperty Return (1990-2005)
35 30 25
Total Return
20 15 10 5 0 -5 -10 -15 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Office A partments Industrial Retail Ho tel
Calender Year
Space Market Fundamental Matter Now and Forever
Performance of the economy, in particular the key economic drivers Sustained landlord pricing power Property market equilibrium – supply and demand
Supply cannot be turned off quickly in response declining demand Physically real estate is a long lived asset Over capacity makes real estate a perishable asset Markets with strong local economy and supply constraints will experience strong rental growth Properties with short term leases may benefit in the short term R.E. investment is not just about buying low and selling It is also about actively managing the asset
Global Imbalance and Real Estate Markets
There is now global imbalance in savings, investments and consumption, which affects all asset classes including real estate Increased opportunity for global labor arbitrage allowing the production of goods and other services shifted to emerging markets Export-driven surplus and limited domestic consumption and investment opportunities in emerging markets Deleveraging by global corporations leading to significant cash reserves Low long-term interest rates contributing to high levels of housing activity and monetization of housing wealth leading to high levels of personal consumption