Pimco CRE Project

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U.S. Commercial Real Estate                                                June 2010


              In 2005, PIMCO’s Investment Committee dispatched the firm’s
              mortgage team to the top 20 U.S. housing markets in a boots on
              the ground effort to assess the leverage-fueled housing boom.
              The Housing Project was born and it led to our forecast for an
              unprecedented decline in residential home prices. What we
              learned was critical to PIMCO’s navigation of the credit crisis
              on behalf of our clients.

              The commercial real estate market shares most of the sins of
              its residential cousin – extremely weak loan underwriting,
              excessive leverage and the absence of risk management from
                      both banks and rating agencies. So PIMCO undertook
                             the Commercial Real Estate Project to understand
                                            local real estate dynamics on the
                                             front lines in ways not revealed
                                             in the published data, to better
                                             understand how the current cycle
                                             is different from previous cycles
                                             and to inform asset selection in
                                             local markets.
PIMCO U.S. Commercial Real Estate Project

     Recognizing that commercial real estate (CRE)                       We believe that the CRE market faces significant
     property-level fundamentals continue to decline and                 uncertainty around valuations that will affect the
     capital markets are changing rapidly, PIMCO portfolio               prospects for recovery. Investors therefore should
     managers and analysts fanned out across 10 cities to                proceed with caution when examining the complex
     conduct on the ground research. Our teams met with                  opportunities that are surfacing. Considering the
     over 100 industry representatives, including local                  complexities introduced by capital markets since
     investment sales advisors, leasing brokers, CRE lenders,            the last CRE crisis, any approaches to analyzing
     special servicers, real estate developers and property              and investing in this market will need to depart
     owners across the largest commercial sectors – office,              significantly from those of previous cycles.
     industrial, retail, hotel and multifamily. Through
     these meetings, we developed a real-time view of local
                                                                         All That Glitters Is Not Gold
     conditions and insights into key assets.
                                                                         Capital has returned to CRE and high levels of bidding
                                                                         activity in certain sectors have made many observers
     Summary of Key Findings:
                                                                         and participants optimistic. Transactions have
       1. Capital is clearly returning to commercial real
                                                                         generally been limited and capital flows have been
             estate, helping to stem the value decline in the
                                                                         concentrated in trophy properties and in properties
             sector. But optimism should be tempered, because
                                                                         where below-market Agency financing is available.
             national price indices are misleading when
                                                                         This has provided a false sense of clarity on the real
             transactions are limited and fail to reflect the
                                                                         level of property values. A significant volume of weaker
             significant uncertainty around property valuations.
                                                                         and distressed assets has yet to be liquidated and this
       2. Changes in the structure of capital markets –                  foreshadows further pressure on values. Against this
             notably the proliferation of complex securitizations        backdrop, we caution against the presumptions that a
             since the last CRE crisis in the early 1990s – will         rapid broad-based recovery is underway.
             lengthen the deleveraging process and suppress
             a recovery. The impaired ability to transfer CRE            Capital is Back
             risk out of the banking system relative to previous         Accommodative monetary policy and increasing levels

             cycles makes a stable, let alone a V-shaped, recovery       of liquidity have ushered in the return of both equity

             unlikely. Instead, many CRE assets likely will not          and debt capital to the commercial real estate sector.

             return to 2007 prices until the end of this decade.         Not surprisingly, capital has returned to the most liquid
                                                                         sectors of CRE first – public equities through Real Estate
       3. Macroeconomic headwinds such as limited GDP
                                                                         Investment Trusts (REITs) and commercial mortgage
             growth in the U.S., elevated unemployment,
                                                                         backed securities (CMBS). REITs were successful in
             potential re-regulation and a secular increase in the
                                                                         raising over $24 billion of equity and issuing $10 billion
             savings rate will force the market to re-evaluate the
                                                                         of debt in 2009. As shown in the chart following, from
             assumptions it has used to price CRE. These trends
                                                                         the first quarter of 2009 to the first quarter of 2010, the
             severely affect the outlook for rents, vacancies and
                                                                         inflow of capital into REITs and CMBS drove REIT prices
             capitalization rates, highlighting the downside
                                                                         up over 96% and tightened super senior CMBS tranche
             risks that remain in CRE.
                                                                         spreads (the most senior class of CMBS) by nearly 70%.

 June 2010                                                           2
                                    Capital is Chasing CRE Assets                                      operating income divided by property value, or in other
                                                CMBS Super Senior               215                    words, the current yield at which a property trades) and
                                                DJ Equity REIT Index
Spread to Swaps (bps)

                        800                                                     190                    per-square-foot values close to the peak prices seen in

                                                                                     Index Value
                                                                                                       2006 and 2007.
                        500                                                     140                    Buyer demand has also returned for multifamily
                                                                                115                    properties financeable through Fannie Mae and Freddie
                        200                                                     90                     Mac’s longstanding lending programs. While loan
                                                                                                       terms have become significantly more conservative in

                         Ju 9

                         Se 9

                         O 9

                         D 9

                         Ja 9
                         Ap 9

                         M 0

                         Ap 0
                         Ju 9

                         Fe 0

                         M 0
                         N 9
                         M 9

                         Au 9







                            l -0






                              Source: Bloomberg, PIMCO
                                                                                                       CRE over the past two years, Fannie Mae and Freddie
                                                                                                       Mac continue to offer financing terms reminiscent of
                                                                                                       those offered in 2007. This attractive financing has led to
                        On the debt side, insurance companies are actively
                                                                                                       transactions pricing at 2005-2007 levels in the 5% to 6%
                        looking to finance quality properties, former Wall Street
                                                                                                       cap rate range.
                        investment conduit groups are re-forming and several
                        private debt vehicles are raising capital.                                     Values Bottom, But Recovery Will Be Slow
                                                                                                       In response to the recent surge in bidding levels for
                        Transaction activity has resumed in earnest for
                                                                                                       lower-risk “trophy” CRE assets, both equity and debt
                        relatively liquid assets such as stable, trophy properties
                                                                                                       capital have begun to migrate along the risk curve
                        in major markets. Investors and lenders have
                                                                                                       in search of yield. Indeed, well capitalized REITs
                        aggressively returned to major markets, including
                                                                                                       are once again looking to acquire assets and several
                        Manhattan and Washington, D.C., where demand
                                                                                                       private equity funds are actively searching for new
                        from foreign capital has led to recent office trades that
                                                                                                       acquisitions, even in challenged markets.
                        have been completed at capitalization rates (annual net
                                                                                                       Today, buyer yield requirements imply that CRE asset
                                                                                                       values have generally declined 35% to 45% from their
                                                                                                       peak levels in 2007 - a marked improvement over early
                                                                                                       2009, when buyer yield requirements spiked to levels
                                                                                                       that implied a value decline of over 50% from 2007. We
                                                                                                       caution against the presumption, however, that this
                                                                                                       implied improvement in CRE asset values portends
                                                                                                       a rapid recovery in actual CRE asset prices. Instead,
                                                                                                       as over $500 billion of over-leveraged CRE properties
                                                                                                       slowly reach the market through lender dispositions or
                                                                                                       restructurings, we expect general CRE asset prices to
                                                                                                       remain 30% to 40% below 2007 peak pricing levels for
                                                                                                       three to five years.

PIMCO U.S. Commercial Real Estate Project

     The point here is that transaction activity in trophy                                                                   Have We Reached Bottom?

                                                                      Moody's CPPI Level, Dec 2000 = 100
     properties and Agency-debt eligible multifamily
     properties should not be considered a leading indicator
     of a broad-based recovery in CRE asset values. Recent
     transactions imply a rapid recovery to 2007 pricing
     levels; however, these asset classes face risk of future
     value declines. In the case of the aforementioned
     Washington, D.C., office properties, for example,
                                                                                                                 0 1 1 2 2 3 3 3 4 4 5 05 5 6 6 7 7 8 8 8 9 9 0
                                                                                                               -0 -0 t-0 r-0 -0 -0 -0 -0 r-0 -0 -0 l- -0 -0 t-0 r-0 -0 -0 -0 -0 r-0 -0 -1
     PIMCO met with several local investors who were                                                         ec ay Oc Ma ug Jan Jun ov Ap ep Feb Ju ec ay Oc Ma ug Jan Jun ov Ap ep Feb
                                                                                                            D M           A        N      S        D M           A        N      S
     perplexed by the extent of non-U.S. capital funneling                                                       Source: Moody’s CPPI, Real Estate Analytics LLC as of 5/31/10

     into their market. This reliance on non-U.S. capital
     for rapid appreciation highlights the potential for                              residential home prices, we caution that indexes such as
     exogenous factors to drive CRE values at the local level.                        the CPPI are relatively meaningless in today’s limited
     For multifamily properties, a small change in loan                               transaction environment – commercial real estate
     terms would have an immediate effect on multifamily                              transaction volume fell nearly 90% from 2007 to 2009.
     asset prices given the significant reliance on Fannie Mae
                                                                                      Our ride along meetings highlight another limitation
     and Freddie Mac for financing.
                                                                                      of the CPPI. Based on repeat transactions, the index
     Misleading Indices                                                               excludes the truly distressed or overpriced properties
     National price indices such as the Moody’s Commercial                            acquired in the past few years that have yet to trade, and
     Property Price Index (CPPI) can provide misleading                               is instead skewed by the high proportion of trophy asset
     indications of a recovery in CRE asset price levels. Since                       and Agency-financed multifamily transactions. In fact,
     November 2009, the index has rebounded 3%.                                       for every broker story regarding a bidding frenzy for a
                                                                                      trophy asset or multifamily property, our team heard
     While it is natural to draw comparisons between the
                                                                                      of multiple instances of owners embroiled in workouts
     CPPI and the S&P/Case-Shiller index used to gauge

 June 2010                                                        4
on properties they believe to be worth less than 50%             Deleveraging: A Messy Unwind
of peak valuations. When these distressed properties             The often byzantine debt and equity structures that
finally do trade, they will have a disproportionate              evolved over the last decade will take significantly
effect on the CPPI. For example, the CPPI index price            longer to unwind than the distressed CRE inventory
change in March 2010 was based on only $1.7 billion              of the 1990s, because securitization has changed
of transactions. By contrast, a single deal, the highly          the primary holders of CRE risk. This prolonged
publicized Stuyvesant Town property in Manhattan,                deleveraging process is expected to result in a sustained
sold for $5.4 billion in 2006. If this property were to          period of limited price transparency and risk aversion.
liquidate today (the property is currently in default),
                                                                 In the last major crisis, CRE was relatively isolated from
many estimate that it would sell for 60% less than its
                                                                 the broader economy. The rally and subsequent fall
2006 purchase price.
                                                                 was spurred by tax-driven oversupply. Furthermore,
                                                                 CRE capital structures were straightforward,
The Long, Long Road                                              consisting of senior lenders (savings and loans, thrifts
to Recovery                                                      and banks) and private borrowers. Considering the
The development of increasingly complex capital                  relative isolation of CRE risk holders, the FDIC was
structures since the 1990s without accompanying                  able to contain the fallout. The FDIC spearheaded the
policies to efficiently resolve conflicts implies that the       rapid transfer of CRE risks through the creation of
deleveraging process will take far longer to play out in         the Resolution Trust Corporation (RTC), which used
this cycle. In addition, as regional banks are forced to         tools such as bulk sales, equity partnerships with a
recognize losses on their construction loan portfolios,          private sector partner and, ultimately, securitization to
eventual dispositions will do little to speed a recovery         restructure and sell risk.
or clarify property values. The drawn out resolution
process for both complex securitization structures and           Flash forward: the evolution of CMBS, large loan

regional loan portfolios makes the prospects for a quick,        syndications, mezzanine debt vehicles, collateralized

V-shaped recovery unlikely. Instead, many assets may             debt obligations (CDOs) and private equity funds has

not return to their peak 2007 values until the 2020s.            greatly added to the complexity of the capital landscape.
                                                                 As such, the risk holders on a property today frequently
                                                                 include hundreds of direct and indirect owners across
                                                                 the capital structure, often with conflicting interests.
                                                                 In CMBS, for example, subordinate bond classes have
                                                                 approval rights regarding loan workouts that lead

PIMCO U.S. Commercial Real Estate Project

     to a preference to extend loans rather than initiate                                                                                                                                           case, even if properties with floating rate debt can
     foreclosure proceedings. Conflict arises when a                                                                                                                                                successfully avoid defaults in the short term, rising
     foreclosure would maximize recovery to the trust but                                                                                                                                           longer term rates will create a floor for cap rates and
     would wipe out the subordinate bondholder’s principal.                                                                                                                                         limit recoveries.

     All of this will serve to limit the speed and effectiveness                                                                                                                                    Small Loan Dispositions Offer Little Clarity
     of previous deleveraging strategies, dragging the                                                                                                                                              While evolving U.S. guidelines and a low fed funds rate
     unwinding process out for years and limiting visibility                                                                                                                                        allow banks to employ a “pretend and extend” strategy
     on the level of a bottom in property values. Indeed,                                                                                                                                           for the resolution of troubled commercial loans, large
     many of the CRE law firms that we met with said                                                                                                                                                volumes of construction loans are expected to force
     their loan restructuring assignments have become                                                                                                                                               a day of reckoning for many regional banks. Banks
     significantly more complicated than previous cycles due                                                                                                                                        cannot keep listing construction loans as performing
     to the higher number of participants within a property’s                                                                                                                                       when the reserves they must carry against them are
     capital structure.                                                                                                                                                                             depleted and borrowers refuse to contribute new
                                                                                                                                                                                                    capital. Similarly, CMBS special servicers will likely
     Higher Cap Rates Here For the Long Term
                                                                                                                                                                                                    sell portfolios of small non-performing CMBS loans, as
     We expect that the spread between cap rates and 10-year
                                                                                                                                                                                                    these loans are not profitable for the servicer to resolve.
     Treasuries will remain above its average of 265 basis
     points seen since 1995, as the litigious deleveraging                                                                                                                                          Loan portfolio dispositions will likely lead to an
     process leads to a sustained period of risk aversion in                                                                                                                                        increase in transaction volume relative to 2009;
     the sector.                                                                                                                                                                                    however, portfolio sales of small, non-performing loans
                                                                                                                                                                                                    give little clarity to values overall. For example, in an
     As shown in the accompanying chart, the 10-year
                                                                                                                                                                                                    FDIC sale that took place in early 2010, only 41.5% of
     forward curve implies that 10-year Treasuries will
                                                                                                                                                                                                    a $1 billion portfolio consisted of loans backed by
     approach 5% over the next several years. If cap rate
                                                                                                                                                                                                    traditional commercial real estate properties. The rest of
     spreads remain above their average, the market can
                                                                                                                                                                                                    the loans were backed by assets such as land, car washes,
     expect long term cap rates near or above 8%. In this
                                                                                                                                                                                                    churches and funeral homes – not exactly a useful

                                                   Higher Expected Treasury Yields                                                                                                                  comparable for assessing the value of office buildings.
                                                       Put a Floor on Cap Rates
                   9.0                                                                                                                                                                              A Brief Comparison to Japan
                   8.0                                                                                                                                                                              The broader success of transferring CRE risk out of the
                   7.0                                                                                                                                                                              banking system will also drive the timing of recovery.
     Percent (%)

                                                                                                                                                                                                    Consider Japan, where zombie banks – financial
                                                                                                                                                                                                    institutions that continue to operate despite severely
                                                                                                                                                 Cap Rate                                           impaired balance sheets – held on to underwater loans
                                                                                                                                                 10-Year UST Yield
                   2.0                                                                                                                                                                              for years because they were not forced to mark to market.
                                 1             1             1             1             1             1             1      1      1E            3E            5E            7E            9E
                             Q             Q             Q             Q             Q             Q             Q          Q                                                                       This led to a sustained period of limited price discovery
                        95            97            99            01            03            05            07            09 201        20
                   19            19            19            20            20            20            20            20
                                                                                                                                                                                                    and a prolonged downturn where values did not bottom
                             Source: Bloomberg, Property and Portfolio Research
                                                                                                                                                                                                    for more than 10 years after the decline began.

 June 2010                                                                                                                                                                                      6
We hope that the lessons learned from the Japan crisis                                                  Where’s the V?
                                                                                    Japan Timeline
will help the U.S. avert some of the fiscal and tax

policies that led to Japan’s “lost decade.” Parallels can                     200
                                                                                                                Japan MTB-IKOMA CRE Index:
                                                                                                                Actual 1983 - 2004 (top axis)
certainly be drawn, though, between Japan’s policies                          250

regarding bank recognition of CRE loan losses and the                         200                                         Bullish Projection -

                                                                Index Level
                                                                                                                          1990's U.S. style recovery
U.S. government’s recently relaxed bank guidelines.                           150

As we learned through meetings with CRE brokers                               100
                                                                                     U.S. CPPI Index: Actual
and consultants, many regional banks continue to find                                2000-2007 (bottom axis)
                                                                                     Bearish Projection - Japan style recovery
ways to avoid marking loans to their current value.                             0

For example, several brokers told our analysts of cases


                                                                                    10 9

                                                                                    U.S. Timeline
where a bank loan officer would specifically direct a                               Source: Moody’s, MTB-IKOMA Real Estate Investment Index,
                                                                                    ESRI, Bank of Japan, PIMCO as of Q4 2009
broker to provide only a verbal opinion of value on a
property financed by the bank, presumably to avoid any
documentation that would force recognition of a loss.           Avoiding the Pitfalls
                                                                The credit crunch of 2007 and 2008 encompassed a
The accompanying chart extrapolates and compares
                                                                large set of problems – corporate, residential, consumer
a recovery that mirrors Japan’s CRE lost decade cycle
                                                                lending and, of course, commercial real estate. As
versus a recovery scenario based on the U.S. recovery
                                                                a result, CRE will most likely not benefit from the
in the 1990s, where the FDIC forced a rapid transfer of
                                                                surge of economic growth that typically follows a
CRE risk through the Resolution Trust Corporation.
                                                                cyclical downturn. Instead, the market – and indeed
Interestingly, as veterans of the 1990s will attest, even
                                                                the broader economy – will be exposed to a whole
that recovery was far from V-shaped in CRE.
                                                                new set of obstacles to recovery on the path to a New
                                                                Normal: limited GDP growth in the U.S., a stubbornly
                                                                high unemployment rate, potential re-regulation and a
                                                                secular shift in the savings rate that results in reduced
                                                                consumption. Accounting for and understanding the
                                                                                                               effect these macroeconomic
                                                                                                                                 trends will have

PIMCO U.S. Commercial Real Estate Project

     on rents, vacancies and cap rates will be key to avoiding                                                      are hesitant to disclose concessions because doing so
     the pitfalls to recovery in CRE, where many assets will                                                        could incentivize savvy tenants to negotiate better
     continue to decline in performance and value over the                                                          terms. This makes accurately tracking effective rents
     next three to five years.                                                                                      nearly impossible.

     Rents Are Down More Than Reported…                                                                             …With More Declines to Come
     Market reports on industry fundamentals such as                                                                Although nominal GDP growth turned positive during
     vacancy rates and rental rate changes are misleading                                                           the third and fourth quarters of 2009, property cash
     in a limited leasing environment. PIMCO’s interviews                                                           flows are poised to decline for the next one to two years
     with leasing brokers and property owners across the                                                            as expiring leases reset at lower levels. This lag effect is
     country paint a significantly more sobering picture of                                                         evident in the office and industrial sectors, where the
     the rental environment than market reports show.                                                               strongest historical correlation between nominal GDP
                                                                                                                    and cash flows occurs on a two year lag.
     Property and Portfolio Research (PPR) reported
     meaningful declines in nationwide asking rents,                                                                                    Of ce/Industrial Net
                                                                                                                                     Operating Income Lags GDP
     shown in the accompanying table. These clearly                                                                 1.5                                                                          2.5

     illustrate a decline in performance across all real estate

                                                                                                                                                                                                       Quarterly GDP Growth (%)
                                                                                         Quarterly NOI Growth (%)

     sectors; however, these measures fail to capture the                                                           0.5

                                                                                                                      0                                                                          1.5
     extent of the concessions landlords are offering to
     attract and retain tenants.                                                                                                                                                                 1.0
                                  National Average     National Average                                             -2.0                                                                         0
                                  Yearly Rent - 2007   Yearly Rent - 2009 % Change
























       Apartment (per unit)           $16,238            $15,142          -6.8%












                                                                                                                                 Quarterly NOI Growth (2yr lag)           Quarterly NOI Growth
       Office (per square foot)         $26.99             $24.28         -10.0%                                                  Quarterly GDP Growth (RHS)
       Retail (per square foot)        $20.02             $17.76         -11.3%                                            Source: Bloomberg, Property and Portfolio Research

       Industrial (per square foot)    $5.26              $4.63          -12.0%

       Source: Property and Portfolio Research                                                                      In addition to the demonstrated lag effect between
                                                                                                                    GDP and CRE cash flows, severe real estate value
     Effective office rents, (rents net of concessions such as                                                      corrections can create other, less obvious sources of
     free rent and temporary rent breaks) have dropped                                                              rent pressure. For example, sophisticated tenants have
     much further than asking rents. According to Reis Inc.,                                                        become increasingly concerned about zombie buildings
     a commercial real estate information provider, asking                                                          where the current owner has negative equity and little
     rents in the Manhattan office market were down more                                                            incentive to maintain a property. In fact, several leasing
     than 20% at the end of 2009 from the peak in the fall                                                          brokers told us that, for the first time in their careers,
     of 2008. However, our interviews with leasing brokers                                                          they are seeing tenants demanding detailed financials
     suggested that effective rents in those same areas have                                                        on the landlord. Over-leveraged properties financed
     declined by as much as 40%. Not surprisingly, landlords                                                        with CMBS loans are particularly vulnerable to being
                                                                                                                    deemed as zombies, because brokers representing

 June 2010                                                                           8
large tenants are able to access the specific financial         According to PPR, vacancy rates in the first quarter of
information for these assets. Thus, potential tenants           2010 were almost 20% on a national level, the highest
will be able to actively avoid these buildings, further         level in 20 years and well above the average 15% rate
pressuring property values.                                     seen over that same period. Even with limited new
                                                                supply, we expect vacancy rates to stay consistently
Should foreclosures accelerate and more landlords give
                                                                above trend, ultimately limiting office rent growth
back the keys on underwater properties, the lower cost
                                                                over the secular horizon. As the accompanying table
basis for buyers of these distressed properties would
                                                                highlights, rental growth doesn’t meaningfully increase
reduce the rent required to generate desirable returns.
                                                                until vacancies fall well below the historical average.
These basis resets would have a marked effect on local
area rents, requiring special attention to potential
                                                                                                            Annual Rent Growth Rises
property value shocks and a detailed knowledge of                                                               as Vacancies Fall
equity positions in nearby properties.                                                   15
                                                                                                   Vacancy Rate      Vacancy Rate
                                                                                                   as of 1Q 2010    15-year Average

                                                                Office Rent Growth (%)
Interviews with retail property owners also highlight
the continued challenges landlords face. Retail owners
may have been able to prop up occupancy levels by
converting struggling tenants to a percentage rent
structure; however, performing anchor tenants will
eventually demand rent reductions as well. Several                                            22       20      18       16      14     12       10      8
                                                                                                                    Vacancy Rate (%)
retail owners that we met with indicated that even                                            Source: Property and Portfolio Research top 54 MSA rent
                                                                                              and vacancy averages
performing anchors are attempting to negotiate lower
rent structures, as these tenants recognize that they are
often the key to a property’s viability.                        A Rising Tide Will Not Lift All Boats
                                                                Long term changes in consumption and savings
Elevated Vacancies Lean on Values
                                                                patterns have specific implications for properties tied
Given the sharp drop in real estate values, commercial
                                                                to consumer spending, such as the luxury hotel and
real estate development (i.e., new supply) is expected
                                                                upscale retail sectors. PIMCO’s expectation for a long-
to remain limited for several years. Long term changes
                                                                term increase in the savings rate suggests the potential
in employment will result in depressed demand as
                                                                recovery for these asset classes will be constrained as
well, stifling absorption of vacant supply. In markets
                                                                consumers reduce discretionary spending habits.
such as Phoenix, finance- and real estate-led growth
in office employment will remain muted for years, as            Despite recently reported increases in hotel revenues
many of these jobs were ancillary to the construction           relative to the first quarter of 2009, many luxury hotels
industry. Thus, secular changes in office-using                 may not see their room rates reach 2007 levels for
employment will keep vacancy rates above historical             several years and many full-service hotels will
averages for several years, even in a limited                   struggle to maintain profitability in low margin
supply environment.                                             business lines such as spa and restaurant services.

PIMCO U.S. Commercial Real Estate Project

     To the extent hotel revenues decline further, the                 Re-regulation: Another Risk
     negative effects on property net cash flows will become           An increasingly uncertain regulatory environment may
     increasingly amplified as fixed costs consume a greater           also constrain the recovery of CRE values. Recently
     proportion of operating expenses. Many of the full-               proposed regulatory and accounting rule changes
     service hotel operators that we met with confirm that             (such as FAS 166 & 167, which impact the off-balance
     they have already “squeezed out” most of the possible             sheet treatment for securitized assets) may reverse, or
     fixed cost savings in 2008 and 2009, as certain costs             at least limit the re-emergence of traditional conduit
     such as insurance and real estate taxes cannot be                 lenders. Federal proposals to date have not clearly
     reduced further.                                                  addressed risk retention requirements for CMBS
                                                                       issuers and the uncertainty around future regulatory
     Certain retail properties could also struggle in the New
                                                                       pressures may negatively affect the economics of new
     Normal. Many retail properties built in anticipation
                                                                       securitization. Without further clarity on these issues,
     of large housing developments will simply suspend
                                                                       limited securitization will deprive CRE markets of an
     operations, because sustained reductions in the home
                                                                       important source of capital.
     ownership rate mean that many planned housing
     developments will not restart for years.
                                                                       Spotting the Opportunities
     Luxury retail properties may also struggle in this
                                                                       As the deleveraging cycle unfolds, attractive
     environment. Retail rents are often structured to
                                                                       opportunities are likely to be available to investment
     include a base rent and a percentage rent (overage) that
                                                                       platforms with the flexibility to access CRE
     is tied to store sales. This direct link between rental
                                                                       opportunities across the capital landscape and who can
     rates and store sales highlights the sensitivity of luxury
                                                                       provide liquidity over the long term. The slow recovery
     retail properties to both short term drops in sales
                                                                       cycle, however, favors patient investors who understand
     and long term reductions in discretionary spending.
                                                                       the relative value dynamics of both capital structures
     The chart below illustrates the challenges that luxury
                                                                       and asset profiles.
     retailers faced in 2009.
                                                                       We conclude by looking at some of these opportunities:
                   Retailer Sales per Square Foot
                                   YOY                  YOY
                                                                       FDIC Dispositions – Regional and community
                          2008               2009
                                  Change               Change          banks are particularly sensitive to both national and
      Saks Inc.          $410       -6.6%     $351     -14.4%          local economies and have been acutely affected by
      Tiffany & Co.*    $3,051     -10.7%    $2,759      -9.6%         the distress in residential and commercial real estate
      Nordstrom, Inc.    $388      -10.8%     $368       -5.2%
                                                                       markets. There were 140 bank failures in 2009 and
      Macy's             $160       -5.3%     $152       -5.0%
                                                                       an additional 78 through May 2010, representing
     * Estimate
     Source: SEC                                                       approximately $240 billion in assets.

                                                                       Troubled banks have suffered losses on their CRE loan
                                                                       portfolios and eventually will be forced to transfer
                                                                       these risks off their balance sheets either through

 June 2010                                                        10
FDIC assisted transactions or voluntarily ahead of                 understand the relative risks between various bond
receivership. Historically, intensive risk transfer                classes and CMBS deals.
environments have provided opportunities for
                                                                   Relative Value Opportunities – Capital flows alone
investors to acquire distressed loan portfolios. Recently,
                                                                   should not be a gauge of where attractive investment
the FDIC has also indicated that it will consider
                                                                   opportunities lie. As mentioned earlier, many owners
securitizations of bank CRE loan portfolios.
                                                                   in primary markets are perplexed by the extent of
While bank loan dispositions may offer compelling                  non-U.S. capital flowing into their markets. With this
opportunities to acquire loan pools at discounts, we               in mind, new investors should not expect a continued
caution that these opportunities are complex. The                  rapid appreciation in pricing for trophy assets in these
limited transaction time frames and non-institutional              markets. Conversely, owners of grocery-anchored
nature of the underlying collateral requires investors             retail assets in smaller markets express frustration in
to have both the experience and infrastructure to                  securing financing today, despite strong tenant profiles
underwrite and manage large pools of loans efficiently.            and positive demographics. As capital returns to CRE,
                                                                   we expect this yield spread (as reflected by cap rates)
Restructuring of Large CRE Loans – Most of the
                                                                   between trophy assets and less liquid, quality assets in
private-equity-fueled mega deals of 2006 and 2007 are
                                                                   smaller markets to eventually tighten.
just beginning to unwind. As large CRE loans mature,
lender syndicates that own the debt will look to exit or           As with any market that is undergoing unprecedented
restructure. Property recapitalizations, including loan            change, attractive opportunities will exist for the
restructurings (where a new investor contributes capital           prudent and disciplined investor. Though difficult
in exchange for a reduced senior loan principal balance            to measure in a limited transaction environment,
and a preferred equity position), can provide investors            commercial real estate valuations have clearly returned
with a lower cost basis and a share of the upside                  to more rational relationships with property-level
returns. However, these types of restructurings are                fundamentals. However, the deleveraging cycle and
complex transactions that will require investors to have           structural headwinds will result in a slow recovery
substantial capital to participate in larger deals, as well        with pockets of volatility to be expected. Extreme
as relationships with both lenders and borrowers.                  discipline in assessing both the asset level and
                                                                   macroeconomic risks will be critical to making the
CMBS Opportunities – Many traditional buyers of
                                                                   right investment decisions.
subordinate CMBS tranches, including mortgage
REITs and special servicer affiliates, have disappeared,
creating an opportunity for new investors to acquire
discounted subordinate positions and potentially
influence the outcomes of CMBS-securitized loans.
Also, constantly shifting spreads among bond classes
create arbitrage opportunities for investors who

Commercial Real Estate Team
John Murray, Commercial Real Estate Portfolio Manager
and PIMCO’s CRE/CMBS Team: 

Dan Ivascyn               Kent Smith                  Josh Olazabal
Scott Simon               Stefanie Evans              Jennifer Bridwell
Josh Anderson             Russell Gannaway            Carrie Peterson
John Murray               Jesse Brettingen            Ryan Murphy                                                      840 Newport Center Drive
Christian Stracke         Bryan Tsu                   Joyce Chang                                                      Newport Beach, CA 92660
Jon Yip                   Sean McCarthy                                                                                949.720.6000

Past performance is not a guarantee or a reliable indicator of future performance. All investments contain risk and may lose value. Investing
in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Mortgage and asset-backed securities may be
sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private
guarantor there is no assurance that the guarantor will meet its obligations. REITs are subject to risk, such as poor performance by the manager, adverse
changes to tax laws or failure to qualify for tax-free pass-through of income. The value of real estate and portfolios that invest in real estate may fluctuate
due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates,
regulatory limitations on rents, zoning laws, and operating expenses. Investing in distressed loans and bankrupt companies are speculative and the
repayment of default obligations contains significant uncertainties.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This
material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary
research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements
concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from
sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without
express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626.
©2010, PIMCO. CRE001-051410

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