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					Commercial Real Estate: Distress & Opportunity
UCLA Anderson Economic Forecast Conference

June 16, 2009

Pricing data utilized herein consists of closing prices on May 29, 2009. On that date, the DJIA was at 8500, the RMZ was at 447, and the 10-Year Treasury note was priced to yield 3.46%.

Three Questions

1) Where should commercial real estate be valued? - Lower than many people think

2) Where will it be priced? – Even lower than that

3) Will there be opportunities? - Enormous ones…equity will be king

2

Where Should Real Estate be Valued?

Real estate has been clobbered by a powerful one-two punch 1) The “low return world” is done  Cap rates have increased a lot  969 – not a new area code, it’s the path for cap rates this decade 2) Fundamentals are falling apart  Bubble underwriting called for huge growth  Reality is that cash flow is declining  Some sectors (e.g. retail) are in uncharted waters We don’t know where prices are for sure…nothing is trading…we think they’re down 35-40%

3

Where Should Real Estate be Valued?


Punch #1: The end of the low return world – Baa corporate bond yields are much closer to the norms of ’92-’02, as opposed to the bubble levels of ’03’07.
Baa-Rated Long-Term Corporate Bond Yields

12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0%

Avg '92-'02 = 8.1% Avg '03- Sept '08 = 6.5%

7.8%

1-86

1-88

1-90

1-92

1-94

1-96

1-98

1-00

1-02

1-04

1-06

Source: Moody’s.

1-08

4

Where Should Real Estate be Valued?


Rising bond yields result in higher cap rates. Though tough to peg amidst a dearth of transactions, cap rates are probably back to about 9%.
Cap Rates & Corporate Bond Yields

12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0%

Our cap rates assume that values have dropped by 35-40%
8.8% 7.8%

1-86

1-88

1-90

1-92

1-94

1-96

1-98

1-00

1-02

1-04

1-06

Cap Rate

Baa-rated Long-term Corp Bonds

Cap rate is an average of the five major sectors: Apt, Industrial, Mall, Office, & Strip Center. Source for corporate bond yields: Moody’s.

1-08

5

Where Should Real Estate be Valued?


Punch #2: Growth prospects have worsened
Estimated Indexed '09-'12 NOI Growth Major Property Sector Average
120 9/07 3/08 110 9/08 6/09 115 113 110

100 97 90 '08 '09 93 '10 92 '11 94 '12

6

Where Should Real Estate be Valued?


By combining historic cap rate, intermediate growth, and inflation expectations, it is possible to construct a time series of the unleveraged returns that real estate investors historically have expected to achieve.
IRR Expectations vs. Commercial Mortgage Rates

12.0% 11.0% 10.0% 9.0% 8.0% 7.5% 7.0% 6.0% 5.0% 4.0% 9.2%

Key assumption underlying IRRs: Prices are already down by 35-40%. That’s more than most think.

1-86

1-88

1-90

1-92

1-94

1-96

1-98

1-00

1-02

1-04

1-06

IRR Expectations

Commercial Mtg Rate

Proxy for IRR expectations = economic cap rates + intermediate-term growth + long-term growth (expected inflation less 110 basis points). Inflation source: Survey of Professional Forecasters. Source for Mortgage Rates: American Council of Life Insurers and Green Street.

1-08

7

Where Should Real Estate be Valued?


Historically, return (IRR) expectations have substantially exceeded borrowing rates. Assuming that values are down 35-40%, the spread is now about back to normal. Real estate is fairly valued if prices are down this much.
Return Premiums on Real Estate Unleveraged IRR Expectations minus Borrowing Rates

400 bp 350 bp 300 bp 250 bp 200 bp 150 bp 100 bp 50 bp 0 bp Avg = 180 bp

172 bp

1-86

1-88

1-90

1-92

1-94

1-96

1-98

1-00

1-02

1-04

1-06

1-08

8

Where Should Real Estate be Valued?

What is the public market saying?
 Public market is a leading indicator

 REIT prices are off 65% from their ’07 peak
 …even after a 55% rally from their lows (early March)  A decline of this magnitude equates to a 40% decline in unleveraged property values

 The decline in REIT prices is much worse than what occurred in the early ’90s

9

Where Should Real Estate be Valued?


REITs are trading at an implied cap rate (the cap rate at which NAV equals the current share price) of almost 9%.
Implied Cap Rates & Corporate Bond Yields
10.0%

9.0%

8.8%

8.0%

7.8%

7.0%

6.0%

5.0%

1-98

1-99

1-00

1-01

1-02

1-03

1-04

1-05

1-06

1-07

1-08

Implied Cap Rate

Baa-rated Long-term Corp Bonds

1-09

10

Where Should Real Estate be Valued?

 Two approaches to answering this question lead to the same conclusion:
– Forward-looking return expectations relative to bond yields suggests a 35-40% correction
– The public-market says real estate values have (or will) dropped by 40%

 Where real estate should be valued and where it will be valued are two different questions

11

Where Will Real Estate be Priced?

    

Broad capital markets are recovering, but real estate capital markets are a mess This may persist for years…much longer than other credit markets Non-existent CMBS market leaves a huge hole in the financing picture Distress will be common Price corrections often overshoot value corrections

12

Where Will Real Estate be Priced?


The making of a mess: the pace of commercial mortgage originations
exploded between '05 and '07 at the same time that underwriting standards became extraordinarily loose. Think of this as commercial real estate’s version of sub-prime lending.
CMBS Originations
$250 BN $230 $203 $200 BN

$150 BN

The mortgage “factory” was at full output from ’05-’07. It has now shutdown.

$168

$100 BN $71 $52 $50 BN $54

$94 $78

$0 BN '00 '01 '02 '03 '04 '05 '06 '07

Sources: Mortgage Bankers Association, Wells Fargo, Eastdil Secured

13

Where Will Real Estate be Priced?


The '05-'07 CMBS vintages were underwritten at very aggressive loan-to-value ratios amidst an environment where appraisals were often inflated and borrowing costs were well below current levels.
Average LTV in CMBS Originations
Average Interest Rate on Fixed Rate Originations
8.5%

70% Actual LTV's rose even more than this, as appraisal inflation was rampant. 68% 68% 67% 67% 68% 69%

Current market at 60% LTV = 7.5% 8.0%

69%

7.5%

7.0%

6.5%

66%

66%

66% 65%
6.0%

65%

65%
5.5%

64% '00 '01 '02 '03 '04 '05 '06 '07

5.0% '00 '01 '02 '03 '04 '05 '06 '07

Sources: Mortgage Bankers Association, Wells Fargo, Eastdil Secured, Green Street

14

Where Will Real Estate be Priced?


Defaults have recently picked up, despite loose terms that called for little, if any, pay-down of principal. They will soon go “off the chart”.
% of CMBS Loans with Full or Partial Interest Only Feature
2.0%

CMBS Delinquency Rate

100%

80%

Watch Out: Interest reserves on low-cap-rate deals may begin to dry up 2-3 years after origination.

86% 76%
1.5%

64%

60% 47% 40% 23% 34% 21%
1.0%

20% 20%

0.5%

0% '00 '01 '02 '03 '04 '05 '06 '07

0.0% '00 '01 '02 '03 '04 '05 '06 '07 '08 '09

Sources: Mortgage Bankers Association, Wells Fargo, Eastdil Secured. Delinquency rates as of the end of the year; ’09 is end of 1Q.

15

Where Will Real Estate be Priced?


This is just the beginning. A large portion of the ’05-’07 loans – about $185 billion of the $600 billion total – are scheduled to mature between 2010 and 2012, five years after origination.
CMBS Maturities
$175 BN $150 BN $125 BN $100 BN $75 BN $50 BN $25 BN $0 BN 2009 2010 2011 '05-'07 Fixed Rate 2012 2013 '05-'07 Variable Rate 2014 2015 2016 2017

There is a very ugly pig in the snake in the form of maturing '05-'07 vintage loans that mature between 2010 and 2012.

Earlier Vintages

Assumes extension of extension options on 3-year loans. Sources: Green Street, Mortgage Bankers Association, Wells Fargo, Trepp, Bank of America

16

Where Will Real Estate be Priced?


CMBS maturities will be ugly, but they're only the tip of the iceberg. Over $1 trillion of maturities occur by '12.

Total Commercial Mortgage Maturities
$400 BN $350 BN $300 BN $250 BN $200 BN $150 BN $100 BN $50 BN $0 BN 2009 2010 2011 2012 CMBS 2013 Banks 2014 Insurance Co. 2015 2016 2017

CMBS maturities are only the tip of the iceberg.

Sources: Green Street, Mortgage Bankers Association, Wells Fargo, Trepp, Bank of America, Deutsche Bank

17

Where Will Real Estate be Priced?


Maturities will be a mess: refinancing will require huge checks.
Mortgage Proceeds on a Property Valued at $100 Million in '07 vs Now
A 35-40% decline in value combined with tighter loan terms translates into a $37 million shortfall (50% of the original loan amount) on maturity. Who will write this check? $75 $63 $60 $40 $20 $0 2007; LTV=75%* Property Value 2009; LTV=60% Mortgage $38

$120 $100 $80 $100

* LTV calculated off the appraised value would have been lower. Appraised values were often inflated during the boom.

18

Where Will Real Estate be Priced?

Debt maturity problem is massive
 TALF should help, but not enough  We need CMBS originations to be large – not likely  Banks are in de-leveraging/workout mode Values are likely to overshoot  Cap rates will stray from fundamentals  They will be a function of the cost of capital for new owners…real estate market participants need to hope that the REIT rally continues

19

Opportunity Amidst Distress

 We’ve been here before. Commercial real estate imploded in the early ’90s  New equity – primarily in the form of REITs – allowed the industry to recapitalize  That process has now begun
– REIT prices have rallied from the trough – Re-equitization is underway

20

Opportunity Amidst Distress


Where Will Equity Capital Come From? Public Markets Will Play a Big Role

The History of Our Future?
$130

The Value of $100 Invested in REITs vs. Private Real Estate at the peak of the '89 bubble
87 REIT IPOs occur in '93 & '94

$110

Randsworth (infamous JMB deal) is foreclosed; 2/92 KIM IPO; 11/91 TCO IPO; 12/92

$90

Rockefeller Center Mortgage Defaults; '95 RTC Formed; Dissloves '95 $66 O&Y goes BK; 5/92 $69 REITs (Price Return NAREIT Equity Index) Private RE (Capital Return NCREIF Index; assumes index is 12 months late) 2/90 8/90 2/91 8/91 2/92 8/92 2/93 8/93 2/94

$70

$50 8/89

21

Opportunity Amidst Distress


The ability to raise capital was a competitive advantage that helped foster impressive performance from ’92-’97.
REIT Equity Issuance and Total Returns in the '90s
120% 100% 80% 20% 60% 15% 40% 20% 0% '92 '93 '94 '95 '96 '97 17% 38% 31% 3% 14% 19% 10% 15% 20% 20% 99% Equity Issuances as a % of Market Equity (Left Axis) Total Return (Right Axis) 35% 40%

30%

0%

Source: NAREIT. Equity issuances as a % of market cap at beginning of the year.

22

Opportunity Amidst Distress


REIT share prices are up 55% from their recent lows.

MSCI US REIT Index (RMZ)
1400 1200 1000 800 600 400 200 0

REITs are up 55% from their lows

1-07

3-07

5-07

7-07

9-07

1-08

3-08

5-08

7-08

9-08

1-09

3-09

11-07

Price index version of the MSCI US REIT Index.

11-08

5-09

23

Opportunity Amidst Distress


Equity issuance has picked up.

REIT Equity Issuance this Decade
$35 BN $30 BN $25 BN $20 BN $15 $15 BN $10 BN $5 BN $1 $0 BN '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 (ann.) $4 $8 $12 $6 $18 $14 $12 $32

Sources: NAREIT and Green Street. ’09 is amount raised thru June 5 and is annualized.

24

Summary

Real estate prices are probably down 35-40% already
 That’s more than most are willing to acknowledge  That’s awful news for properties financed with 70+% leverage  Assuming bond yields stay put, this is “about right”

The next few years will be ugly
 Maturities of underwater mortgages will force fire sales  Credit markets will recover, but not enough to save the day
 Values may overshoot

Opportunities will Abound
 One man’s distress is another’s opportunity
 Public REITs will be the biggest winners  Low supply creates backdrop for solid recovery  Real Estate is an inflation hedge…that may matter a lot someday
25

Contact Information

Green Street Advisors

567 San Nicolas Drive, Suite 200 Newport Beach, CA 92660 Contact: Damon Scott, Director of Marketing dscott@greenst.com 949.640.8780 www.GreenStreetAdvisors.com

Green Street’s Disclosure Information
Conflicts of interests can seriously impinge the ability of analysts to do their job, and investors should demand unbiased research. In that spirit, Green Street adheres to the following policies regarding conflicts of interest:
• • • •

Our employees are prohibited from owning the shares of any company in our coverage universe. Our trading desk does not commit capital or make markets in any securities. Our employees do not serve as officers or directors of any company in our coverage universe. Companies that we cover do not, in any manner, compensate us for inclusion in our coverage universe.

•
•

A number of companies we cover pay us an annual fee to receive our core research product. We do not solicit this business and, in aggregate, it represents less than 3% of our revenue.
We do not directly engage in investment banking, underwriting or advisory work with any of the companies in our coverage univ erse. However, the following are related potential conflicts that should be considered:
• •

GSA is affiliated with Eastdil Secured, a real estate brokerage and investment bank that sometimes engages in investment banking work with companies in GSA’s coverage universe. Green Street does not control, have ownership in, or make any business or investment decisions for, Eastdil Secured.

GSA has an advisory practice servicing investors seeking to acquire interests in publicly-traded companies. GSA may provide services to prospective acquirers of companies which are the subject(s) of GSA’s research reports. GSA may receive fees that are contingent upon the successful c ompletion of a transaction or other fees for its work on behalf of prospective acquirers.

•

GSA publishes research reports covering issuers that may offer and sell securities in an initial or secondary offering. Broker-dealers involved with selling the issuer's securities or their affiliates may pay compensation to GSA upon their own initiative, or at the request of GSA clients in the form of "soft dollars," for receiving research reports published by GSA. An affiliate of Green Street Advisors is the investment manager of an equity securities portfolio on behalf of a single client. The portfolio contains securities of issuers covered by Green Street’s research department. The affiliate is located in a separate office, employs an investment strategy based on Green Street’s published research, and does not trade with Green Street’s trading desk.

•

While minimization of potential conflicts will remain a very important priority for us, we reserve the right to change any of these policies at any time. We encourage a careful comparison of these policies with those of other research providers, and welcome the opportunity to discuss them. Investment advice proves to be wrong about as often as it is right. While we strive to do better than this, our recommendations will include bad calls and we are certain to make other mistakes as well. This document may well contain errors of fact. We have done our best to utilize data that we believe to be reliable, but no assumption should be made that the data has been verified, or is accurate and complete. This report should not be considered to represent an offer to buy or sell the securities discussed herein, and all opinions are subject to change without notice.
Green Street Advisors is an accredited member of the Investorside Research Association, whose mission is to increase investor and pensioner trust in the U.S. capital markets system through the promotion and use of investment research that is financially aligned with investor interests.


				
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