Real Estate Finance 201: The Realities (Stephen Blank) - ULI Fall Meeting 102611

Urban Land Institute Real Estate Capital Markets: Real Estate 201 – “The Realities”

tenuousten∙u∙ous

[ten-yoo-uhs]

-adjective

Stephen Blank

Senior Fellow, Finance

ULI – the Urban Land Institute

October 26, 2011

Definition:

1. thin or slender in form, as a thread.

2. lacking in sound basis, as reasoning; unsubstantiated; weak: a tenuous argument.

3. thin in consistency; rare or rarefied.

4. of slight importance or significance; unsubstantial: He holds a rather tenuous position in history.

5. lacking in clarity; vague: He gave a rather tenuous account of his past life.

October 7, 2007: Financial institutions were said to be “too big to fail”

October 14, 2011: Dodd-Frank reform legislation is said to be “too big to read”

Timeline of an Increasingly Cyclical, Uncertain, and Tenuous Capital Markets and Real Estate Industry

• 1997: Asian Financial Crises, aka “Asian Contagion”, or “Asian Flu”

• 1998: Russia defaults on Sovereign debt; Long-term Capital Management “rescued” by Federal Reserve/Wall Street

• 1999: Worldwide preparation for Y2K• 2000: Bursting of the dot.com, aka “dot.bomb”, bubble• 2001: September 11th

• 2002: Start of corporate governance/accounting scandals• 2003: Euro-corporate governance scandals• 2004: Fannie Mae accounting scandal

• 2005: GM/Ford debt downgraded by rating agencies

• 2006: Trading breakdown in Japan

• 2007: U.S. Sub-Prime Mortgage Crises gains momentum

• 2008: “34-Days from Hell” (Lehman bankruptcy; AIG rescue; Fannie Mae/Freddie Mac conservatorships; Goldman Sachs/Morgan Stanley “restructured” as commercial banks; Merrill Lynch, Washington Mutual, and Wachovia acquired)

• 2009: Global capital markets faced period of “Shock and Awe”

• 2010: “Sorting Through the Wreckage” began

• 2011: January 1st through August 4th

“I’ve got to admit it’s getting better, a little better all the time” (Getting Better, The Beatles)

“United States Long-Term Debt Rating Lowered To 'AA+'; Outlook Negative”

• On August 5th at 20:13:14 EST– Global capital markets received a “Shake-up Call”, i.e., a

wake-up call to the 10th power• Implications of downgrade were immediate and far reaching

– Volatility increased in the equity and debt capital markets– Industry participants hit the “pause” button– CMBS spreads widened as capital withdrew from market– Equity and debt underwriting standards tightened– Transaction velocity slowed; “MAC” clauses were invoked– By mid-September, the European Flu was threatening both

the U.S.as well as Asia

Query: Will the U.S. Credit Downgrade a 3-Month or 3-Year Problem?

• Will the capital markets, including real estate, repeat 1998?– The flight to safety and liquidity caused by Russia’s default

on it Sovereign Debt, combined with the Federal Reserve’s engineered rescue of Long-term Capital Management, lasted thorough December

– Or, will the capital markets repeat mid-August 2007 and remain closed for the next three years

9

December 2010: The Arab Spring began in Tunisia

September 2011: “Occupy Wall Street” began a Financial Markets Spring in New York; by October 9, similar demonstrations had been held or were ongoing in over 70 cities

11

2012: Observations

• “Smaller” industry with lower profits• Lower, more rational, return expectations• Less development• Lower availability of credit• Lenders can finally afford to recognize losses; borrowers have

no choice• Markets begin to come off the bottom• Some “Generational” buying opportunities if you have cash• Refinancing available for owner’s with stabilized properties• Plenty of “Rescue Capital” to assist in restructurings• Buyers and lenders remain highly selective

• Banker’s focus on top tier properties in strongest markets• CMBS continues its Lazarus-like rise• Refinancing remains a problems for the rest of the decade• “Duration” is added to real estate borrower’s vocabulary• Opportunity funds may have “finally” learned that big

returns require high leverage and high risk• Non-bank lenders and mezzanine investors re-emerge• Institutional investors continue to increase allocations to

real estate; be mindful of the potential for the denominator affect to surface

• Transaction volume continues to increase…slowly• The economy…as always, it remains all about jobs

Q & A

• What should I focus on? What should I invest in? “Restructuring Debris”

• Are there really opportunities in the distressed space? Yes, but the playing field is very competitive

• What’s your best strategy advice? Financing distressed owners needing “Rescue Capital” due to overleveraging

• What skills will I need? An ability, and the patience, to work through complexity

• Are banks selling distressed assets? Yes Virginia, they finally are• What about land? In general, still too expensive• Is financing becoming more readily available? Yes, especially for

larger players (it figures)

• What about secondary and tertiary markets? “Capital chasing yield”; not a good idea

• With the exception of the gateway markets, why are investors reticent to commit? “They are waiting for the train to run them over so they can be sure it’s on the tracks”

• What about retail property? “We’re not over-retailed; we’re under-demolished”

• How would you approach the secondary markets? Buy the “A” property and hope someone comes along to take you out

• Will smaller REITs become merger and acquisition, consolidation, targets? Yes they will– Note: this is said at every conference; therefore it will

eventually happen and someone will be proved right

Best Ideas for 2012

• Development: multifamily apartments…that’s it!• Investment:

– the gateway markets; the technology centers– value-added; properties with opportunities for renovation,

rehabilitation, re-leasing, repositioning…• Finance:

– Lock-in long-term, fixed rate debt…now!• Rescue Capital

– Strategic investments in troubled borrowers, not troubled properties

• Buy your own debt back from the lender at a discount; while you at it, buy someone else’s debt back at a discount…if you like the property

• Learn how to “Green” your space; there’s a lot of low hanging fruit to be picked

• Buy land...if you have the patience• Property sectors

– Multifamily…obviously– Fortress malls and in-fill shopping centers…obviously– Industrial/distribution space in port cities– Business center hotels, any trophy office building as yet

un-bought, and medical office properties

Welcome to the “Naughts”, America’s Lost Decade (2000 – 2009)

Risk Premiums: Capitalization Rates to 10-Year Treasury Yields

2%

3%

4%

5%

6%

7%

8%

9%

10%

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

10 Year Treasury Yield Cap Rate

Source: Cornerstone Research, NCREIF, and the Federal Reserve Board.

Source: Moody’s/REAL.

(44%)

Decline in Commercial Real Estate Property Values

Spreads for 10-Year “Prime” Commercial Mortgages to Treasury Yields

And Investors Convinced Themselves!

Collateralized Debt Obligations of Sub-Prime Residential Mortgage-Backed Securities

Credit Rating Estimated 3-Year Default Rate Actual Default Rate

AAA 0.001% 0.10%

AA+ 0.010% 1.68%

AA 0.040% 8.16%

AA- 0.050% 12.03%

A+ 0.060% 20.96%

A 0.090% 29.21%

A- 0.120% 36.65%

BBB+ 0.340% 48.73%

BBB 0.490% 56.10%

BBB- 0.880% 66.67%

Source: Donald MacKenzie, University of Edinburgh.

“The Bible, the Koran, early Christianity, the Romans—everyone learned the perils of debt.

What happened to that wisdom?

Business schools!”

Nassim Nicholas Taleb

Author: “The Black Swan – The Impact of the Highly Improbable”

Distinguished Professor of Risk Engineering at New York University

Lesson Learned?

Myths and Legends “Exposed”

• Diversification overcomes systemic risk• High (credit) ratings equals high quality (see AIG)• Global capital markets have become “decoupled”• “Tails” on bell-shaped curves do not require adjustments to

strategy• “Black Swan” events are totally accidental, random, and

unpredictable• Risk of borrowing “short” and investing in illiquid assets can

be hedged effectively• Unfortunately…myths and legends are likely to return, but in a

different form

Real Estate Yields vis-à-vis Capital Markets Returns as of 3Q 2011

One-Year Expectation: Real Estate V. Capital Markets Returns

3Q 2007 3Q 2008 3Q 2009 3Q 2010 3Q 2011

Real Estate Yield 8.2% 8.7% 10.0% 9.3% 8.9%

10-Year Treasury Bond 4.8% 3.8% 3.6% 2.9% 2.6%

Yield Spread in excess of:

10-Year Treasury Bond 3.4% 4.9% 6.4% 6.4% 6.3%

Source: RERC Investment Survey; Federal Reserve.

Senior Loan Officer Opinion Survey (3Q 2011)

But…Bank Commercial Real Estate Mortgage Loan Portfolios Continued to Decline in 2011

• Footings of commercial real estate mortgage loans at 100 largest banks declined – Decline due to a combination of loan write-offs,

foreclosures, run-off of maturing loans, and limited originations

• Decrease stemmed entirely from decline in construction and land loans– Commercial real estate mortgages and multifamily

mortgages were virtually unchanged

Life Insurance Lending Circa 3Q2011

• Prepared to go head-to-head with anyone on Class A, gateway/24 hour city located, top tier property

• Able to form clubs with other insurers to tackle “super-sized” mortgages

• Starting to compete with Fannie Mae and Freddie Mac for multifamily mortgage loans

• Highly selective with “harsh” underwriting standards– Did not get into trouble this time and mean to keep it that

way• Interest rates: many insurers now have floor pricing:

– 5 year term: 3.50%; 10year term: 4:00%

Continuing “Black Hole”: Floating-and-Fixed Rate CMBS Maturities (2011 – 2020)

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020$0

$20

$40

$60

$80

$100

$120

$140

$160

CMBS (Fixed and Floating Rate) in $ Billions

Mirror, Mirror on the Wall, Who’s Commercial Mortgages Held up Best of All? Insurance Companies

Bank Real Estate Loan Delinquency Rates

CMBS Loan Delinquency Rates

Preferred Strategies for “Resolving” Maturing Commercial Real Estate Loans

Extend w

ith M

ortgag

e Modifica

tion

Extend w

/o M

ortgag

e Modifica

tion

Sell t

o 3rd Part

y

Foreclo

se an

d Dispose

0%10%20%30%40%50%60% 54%

6%

25%15%

Source: Real Capital Analytics.

Additional Lender Workout Strategies Include…

Distressed Property Sales

“It has been said that the only purpose of economic forecasts is to make astrology look respectable”

All You Need to Know: Job Growth Drives the Real Estate Economy

Monthly Job Growth

Job Growth Benchmark

Gain on a Percentage Basis

-0- 0.00%

126,000 October 2003 1.15%

136,000 10-Year Average 1.26%

190,000 30-Year Average 1.75%

245,000 1990s Expansion 2.27%

Source: Torto Wheaton Research: “TWR About Real Estate”.

Two Measures of U.S. Unemployment/Labor Utilization

Dec 2009

May 2010

June 2010

July 2010

March 2011

April 2011

May 2011

June 2011

July 2011

Normal (U-3) 9.9% 9.7% 9.5% 9.5% 8.8% 9.0% 9.1% 9.2% 9.1%

Broad Measure (U-6)

17.2% 16.6% 16.5% 16.5% 15.7% 15.9% 15.8% 16.2% 16.1%

Forecast: Blue Skies Ahead, But Watch for Dark Clouds and Unexpected Storms

• Resolutions to raise the debt ceiling and/or appropriate funds could be held “hostage” by one side or another or fail to be enacted

• “Fed” bashing continues as concerns about Fed’s continued independence increase

• The recovery remains stubbornly “Jobless”• Homes price decline continues and possibly accelerates• Gasoline prices increase to as much as $5 a gallon• And…sovereign defaults, municipal bond defaults, currency

“wars”, government debt and deficits, prospects for fiscal discipline, etc.

41Regulatory “Corn Maze”

Potential Impact of Dodd-Frank on Commercial Real Estate Lending

• Volker Rule: prohibits banks from proprietary trading, investing in hedge funds, private equity

• Risk Retention: CMBS issuers retain at least 5% of “something”…maybe the offering

• Impact:– Lower credit rated borrowers will find it more difficult to

obtain bank loans– Risk retention requirements will negatively impact

amounts allocated to underwriting and warehouse lines– Transaction cost increases will be passed on to borrowers

• Hey…someone has to pay them

What about Fannie and Freddie?

• Option 1: Minimum government role

+ Lowers risk throughout the system

+ Reduces taxpayer’s exposure to private mortgage losses- Lower mortgage availability, higher mortgage cost- Inability of government to support industry during a crises

- Option 2: Government plays a role during a housing crises

+ Government support stabilizes markets during crises periods

- Can government move quickly enough during a crises

What about Fannie and Freddie?

• Option 3: Government the re-insurer

+ Probable lowest increase in mortgage costs

+ Highest liquidity

+ Levels the playing field for smaller banks- Increases taxpayer risk exposure to private mortgage losses

- Option 4: “Kick the can down the road” until after the 2012 Presidential election

45

Financing and Investing in Real Estate

8 2 9 4 6

3 5

9 3 5

3 8 1 6 9

2 9 8

4 8 2 7 1

4 7 5

3 7

9 7 2 1 4

• The Sudoku approach to structuring real estate investments

46



A-1

Lender’sInvestment

A-2

Lender’s Required Rate

of Return

A-3

Lender’s Weighted Cost

of Capital

B-1

Equity Investors

Investment

B-2

Investor’s Required Rate

of Return

B-3

Investor’s Weighted Cost

of Capital

C-1

Total Equity and Debt

Investment

C-2 C-3

Total Cost of Capital

(Capitalization Rate)

A-1

Loan-to-Value Ratio

A-2

Mortgage Constant

A-3

Lender’s Weighted Return on

Capital

B-1

Equity Investors % Investment

B-2

Investor’s Required Return on

Equity

B-3

Investor’s Weighted Return on

Equity

C-1

Total Equity and Debt

Investment

C-2 C-3

Total Return on Invested Capital

(Capitalization Rate)

47



A-1 A-2 A-3

B-1 B-2 B-3

C-1 C-2 C-3

A-1 x A-2 = A-3

B-1 x B-2 = B-3

A-1 + B-1 = C-1

A-3 + B-3 = C-3

48

Assume a property is offered for sale. Net operating income is projected to be $92,700 in year 1. A lender has indicated that it would make a loan equal to 65% LTV at a 8.87% constant. The equity investor requires a 10% return on investment. What capitalization rate should you use to value the property?

65% LTV x 8.87% = 5.77% $650,000 x 8.87% = $57,655

35% Equity x 10.00% = 3.50% $350,000 x 10.00% = 35,000

9.27% $92,655

49

A broker calls you about a property. Net operating income is projected to be $92,700 in year 1. A lender has indicated that it would make a loan equal to 65% LTV, interest-only at 8.00%. The equity investor requires a 10% return on investment. How much could he bid for the property and still earn a 10% return on investment?

65% x 8.00% = 5.20% $692,586 x 8.00% = $55,407

35% x 10.00% = 3.50% $372,931 x 10.00% = 37,293

8.70% $92,700

$92,700 / 8.70% = $1,065,517

50

A broker calls you about a property. Net operating income is projected to be $92,700 in year 1. A lender has indicated that it would make a loan equal to 75% LTV, interest-only at 8.00%. The equity investor requires a 10% return on investment. How much could he bid for the property and still earn a 10% return on investment

75% x 8.00% = 6.00% $817,941 x 8.00% = $65,435

25% x 10.00% = 2.50% $272,647 x 10.00% = 27,265

8.50% $92,700

$92,700 / 8.50% = $1,090,588

51

A broker calls you about a property which is offered for sale for $1,200,000. Net operating income is projected to be $95,000 in year 1. A lender has indicated that it would make a loan equal to 65% LTV at 8.65% constant. What return on investment will the equity investor receive?

65% x 8.65% = 5.62% $780,000 x 8.65% = $67,470

35% x ____ = ____% 420,000 x ____ = $______

$95,000 / $1,200,000 = 7.92% $1,200,000 x 7.92% = $95,000

Step 1: 7.92% - 5.62% = 2.30% $95,000 – 67,470 = $27,530

Step 2: 2.30% / 35% = 6.57% $27,530 / $420,000 = 6.55%

52

A broker calls you about a property. Net operating income is projected to be $92,700 in year 1. The equity investor requires a 12% return on investment. Assuming the property is offered for sale for $950,000, what loan constant can the investor pay a lender who is willing to make a 70% LTV, 25-year amortizing, loan?

30% x 12.00% = 3.60% $285,000 x 12.00% = $34,200

70% x ______ = _____ $665,000 x _____ = ______

$92,700 / 950,000 = 9.76% $950,000 x 9.76% = $92,720

Step 1: 9.76% - 3.60% = 6.16% $92,700 – 34,200 = $58,500

Step 2: 6.16% / 70% = 8.80% $58,500 / 665,000 = 8.80%

53

A property is offered for sale for $1,500,000. First year NOI is projected at $127,500. A lender has expressed interest in a 70% LTV loan with a 8.45% constant. The buyer is willing to invest $300,000. Assuming the investor requires an 9.0% return on investment, what current rate of return can he offer a mezzanine investor?

$127,500 / $1,500,000 = 8.50% $1,500,000 x 8.50% = $127,500

70% x 8.45% = 5.92% $1,050,000 x 8.45% = $88,725

20% x 9.00% = 1.80% $300,000 x 9.00% = $27,000

10% x ____% = ___%

Step 1:8.50% - (5.92% + 1.80%) = 0.78%

$127,500 – (88,725 – 27,000) = $11,775

Step 2: 0.78% / 10% = 7.80% $11,775 / $150,000 = 7.85%

Core, Value-Added, and Opportunistic

Property Investments

Whole Loans, Bridge Loans, and Mezzanine Debt

Real Estate Investment Trusts

Commercial Mortgage-Backed

Securities

Real Estate Investment and Capital Markets Strategies

56

Real Estate Investment Trusts: 3Q2011

• REITs posted declines, underperforming the broader market (S & P Index) during the 3Q2011

• Key performance drivers included:– Macro concerns such as the U.S. credit downgrade,

concerns about the U.S. as well as global economy, real estate fundamentals, and European sovereign debt issues

• Outflows from REIT-centric mutual funds• Flattening yield curve has historically correlated with lower

REIT returns– On the other hand, REITs provide high dividend returns as

compared to other investment alternatives

CMBS Issuance: 1995 – 2011 (Projected)

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

2011$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

U.S. ($Mil.) Non-U.S. ($Mil.) Global ($Mil.)

CMBS 2.0: Situation Analysis

• Conduits are starting to step up originations after this summer’s pullback

• While spread volatility is “easing” for super-senior bonds, it remains wide for all other classes

• Since the “Summer Swoon”– Conduits have increased rates in response to wider spreads

overall; think “6.0%”– Many originators are limiting originations to a maximum

of $75 million due to aggregation risk– Conduits are telling borrowers that rates quoted are subject

to “upward adjustment” if bond spreads widen further

CMBS 1.0 Delinquencies

CMBS 2.0: Finished and Unfinished Business

1. Refinancing will continue to affect the industry well into the coming decade

2. Cleaning up the system and eliminating legacy assets from balance sheets to allow lending to re-start

3. Restore credibility of rating agencies

4. Improve product structure

5. Improve transparency

6. Resolve regulatory and accounting uncertainties

7. Restore investor demand

CMBS’ Pipeline “Shallow”

• Only three transactions totaling $2.6 billion are in the pipeline for the fourth quarter :– October: 1 transaction for $1 billion– December: 2 transactions for $1.6 billion

• Issuance slowdown reflects pullback in lending by conduits due to increased volatility in the credit markets– Conduits have widened lending spreads significantly in

response to widening trading spreads which in turn makes them less competitive with traditional lenders

Changes in CMBS Transaction Structures

Legacy CMBS New Issue CMBS

LTV-based sizing at risk to changing valuations Debt yield/cash flow-based sizing

• Pro-forma underwriting • In-place income

• Above market rent credit • Market vacancy

B-piece investors B-piece investors

• B-piece investor and special servicer may be same entity

• B-piece investor and special servicer are separate entities

• Actual losses • Appraisal controlled out

• Accrued interest • Interest accrual stopped

• Senior bondholders had limited options to replace the special servicer

• Senior bondholders can replace the special servicer through a vote

Public transactions mean more available information 144A means more information available to those that sign confidentiality agreements

No audit procedure of special servicer Trist advocate/adviser to audit

Anonymous bondholders in trustee hands Bondholders registry and voting

Source: J.P. Morgan.

Private Real Estate Equity Capital Markets

• Fundraising, in general, was slow in 2009 and 2010, primarily due to investor caution, little sense of urgency to commit, and legacy performance– Two-thirds of 2006 vintage funds and 79% of 2007 vintage

funds are currently producing negative IRRs• Many fund managers (correctly) are focused on asset

management and debt restructuring• Consolidation and contraction of private equity real estate

platforms is expected to continue in 2012• Institutional investors evidencing interest in co-investment and

“club” structures as a means of exerting control

Regions Viewed as Providing the “Best” Opportunities for Private Real Estate Investment

North America Asia Europe South America Middle East0%

10%

20%

30%

40%

50%

60%

70%

80%

Key Issues in the Private Real Estate Market

Valuati

ons

Economy/V

olatility

Leve

rage/Fi

nancin

g

Fees; T

erms

Transp

arency

Illiquidity

Strate

gy-to

-mark

et fit

Fund Perfo

rman

ce

Regulati

on

Alignment o

f Interests

0%

5%

10%

15%

20%

25%

Investment Strategy Preferences of Private Real Estate Funds

Source: Preqin.

Core

Value Added

Opportunisti

c

Core PlusDebt

Distresse

d

Fund of F

unds0%

10%20%30%40%50%60%70%80%90%

100%

Sept. 2010Sept. 2011

Quarterly Transaction Volume

U.S. Average Capitalization Rates

2012: Improving Prospects

• NCREIF National Property Index +16.7% on trailing 12-month basis

• Capitalization rates continued to “firm” with the Real Estate Research Corporation quarterly survey showing seven consecutive quarters of declines, from 8.40% to 7.24%

• Transaction volume, while “light” by historical standards, continued to increase sequentially; according to Real Capital Analytics, volume should exceed $150 billion for 2011

• Not out of the woods yet…

Insurance Companies

62%23%

15%

North AmericaEuropeAsia and Rest of World

• Average allocation to real estate:– 6.8% of total assets

• Average target allocation to real estate:– 10.4% of total assets

Investment Strategy Preferences of Insurance Companies

Value Added

Opportunisti

cCore

Core PlusDebt

Distresse

d

Fund of F

unds

Seco

ndaries

0%

10%

20%

30%

40%

50%

60%

70%

76

Lending Environment

• Lenders are becoming more active versus a year ago due to stronger balance sheets and income statements– Underwriting standards stringent and precise; focus on

“quality, quantity, and durability” of income– Loan-to-value and debt service coverage ratios, and debt

yield requirements are “reverting to the mean”, i.e., the long-term historical average

– Focus is on “bankable borrowers” with stabilized properties• Foreign banks, like the Bank of China, are focused solely on

institutional quality properties located in 24-hour gateway markets owned and managed by best-in-breed sponsors

Total Delinquency and Non-Accrual Rates for U.S. Banks and Thrifts

Q2 2008

Q2 2009

Q2 2010

Q1 2011

Q2 2011 (Est.)

Construction Loans

-Total Delinquency* 8.1% 16.3% 19.2% 18.2% 17.1%-Non-accrual 5.7% 12.1% 14.8% 13.8% 12.7%Commercial Mortgages

-Total Delinquency* 1.9% 4.1% 5.4% 5.4% 5.0%-Non-accrual 1.1% 2.6% 3.7% 3.9% 3.6%* Includes 30+ days past due and non-accruals

Source: FDIC; Trepp, LLC

Maturing Commercial Mortgages: Real Estate’s Current and Future “Black” Hole

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020$0

$50

$100

$150

$200

$250

$300

$350

46 56 55 64 67103 114

139

4111 12

224241 251 240

199155 115

96

76

51 33

CMBS BanksSource: Trepp; Foresight Analytics; Mortgage Bankers Association; UBS; Deutsche Bank.

Current Lending Environment

Property Type

Mid-Point of Fixed Rate Commercial MortgageSpreads For 10 Year Commercial Real Estate Mortgages

12/31/10 3/31/11 8/11/11 8/24/11 9/30/11

Multifamily - Non-Agency +190 +180 +240 +240 +240

Multifamily – Agency +200 +185 +245 +230 +235

Regional Mall +175 +180 +240 +255 +250

Grocery Anchor +190 +185 +230 +250 +240

Strip and Power Centers +250 +260 +255

Multi-Tenant Industrial +190 +190 +240 +250 +250

CBD Office +180 +180 +240 +255 +250

Suburban Office +190 +190 +260 +260 +255

Full-Service Hotel +290 +230 +275 +275 +300

Limited-Service Hotel +330 +260 +295 +280 +325

10-Year Treasury 3.47% 3.45% 2.23% 2.16% 2.01%

Source: Cushman & Wakefield Sonnenblick Goldman.

Insurance Companies

• Life insurance companies continue their laser-like focus on high quality property located in primary markets

• Traditionally the most conservative players, life companies have seized the initiative, financing only the “Best and the Brightest”

The “Kitchen Sink” of Ideas

• Repaying maturing debt at a discount in exchange for a preferred position

• Paying down maturing debt to secure an extension (in exchange for an interest in the property)

• Providing rescue capital to pay debt services and/or property level expenses (in exchange for an interest in the property)

• Buying out defaulting partners/paying capital calls for defaulting partners

• “Control your enthusiasm”; buy cash flowing assets with prospects for appreciation as markets improve

• Lock-in leverage; rates can’t get any lower and cyclical bottoms are the optimal time to add leverage

• Focus initially on global gateways and 24-hour markets; watch for signs that pricing is “getting out of control”, then switch to secondary markets

• Focus on in-fill over fringe• Patience…value-added and opportunistic will appear but don’t

expect RTC-like pricing or returns• Buy or hold REITs; a 3-peat is possible• Buy land…if you’re prepared to wait• Distressed loans (direct from lenders or via auction)• Patience…value-added and opportunistic will appear but don’t

expect RTC-like pricing or returns• Development opportunities will be few and far between; use

your skills to workout problem deals or in markets outside the U.S.

• Buy or hold multifamily; sector benefits from positive demographic trends, and if it has a roof, Fannie or Freddie will finance it

• In-fill grocery anchored shopping centers and fortress malls hold value even when consumers are careful with each buck

• Buy and hold CBD office buildings in gateway, 24-hour markets; suburban commodity office buildings will remain hard to rent until the economy really recovers

• Buy full service hotels in CBDs; watch out for high capital expenditure resorts and commodity limited service

• Well leased industrial maintains its place as a cash flow generator

Investment Opportunities?• Today:

– Acquire properties in “next tier” markets perceived by investors and lenders as “must have” markets

– Originate debt in secondary and tertiary markets at premium interest rates and conservative LTVs and DSCRs

• Tomorrow– Acquire properties and /or loans from distressed

owners/lenders at bargain prices• Never:

– Avoid “priced-to-perfection” trophy property in gateway markets; think of them as “priced-to-disappoint”

– Avoid current offerings in secondary/tertiary markets; they will be cheaper in the future

Urban Land Institute Real Estate Capital Markets: Real Estate 201 – “The Realities”

tenuousten∙u∙ous

[ten-yoo-uhs]

-adjective

Stephen Blank

Senior Fellow, Finance

ULI – the Urban Land Institute

October 26, 2011

89

Weighted Cost of Capital“Homework” Problems

90

Assume a property is offered for sale. Net operating income is projected to be $105,000 in year 1. A lender has indicated that it would make a loan equal to 75% LTV at a 7.76% constant. The equity investor requires a 10% return on investment. What capitalization rate should you use to value the property? What would you pay for the property?

Percentage Proof: Dollar Proof

91

A broker calls you about a property. Net operating income is projected to be $99,500 in year 1. A lender has indicated that it would make a loan equal to 60% LTV, interest-only at 7.50%. The equity investor requires a 8.0% return on investment. How much could he bid for the property and still earn a 8.0% return on investment?

Percentage Proof Dollar Proof

92

A broker calls you about a property. Net operating income is projected to be $125,000 in year 1. A lender has indicated that it would make a loan equal to 70% LTV, interest-only at 7.75%. The equity investor requires a 6.5% return on investment. How much could he bid for the property and still earn a 6.5% return on investment

Percentage Proof: Dollar Proof:

93



94

A broker calls you about a property. Net operating income is projected to be $112,500 in year 1. The equity investor requires a 10% return on investment. Assuming the property is offered for sale for $1,050,000, what loan constant can the investor pay a lender who is willing to make a 75% LTV, 25-year amortizing, loan?


95



96

Answers to WeightedCost of Capital Problems

97

$104,948

$946,000 x 7.76% = $73,448

$315,500 x 10.0% = $31,5008.32%

$1,262,000 x 75% = $946,500

$1,262,000 x 25% = $315,500

75% x 7.76% = 5.82%

25% x 10.0% = 2.50%

Assume a property is offered for sale. Net operating income is projected to be $105,000 in year 1. A lender has indicated that it would make a loan equal to 75% LTV at a 7.76% constant. The equity investor requires a 10% return on investment. What capitalization rate should you use to value the property? What would you pay for the property?

Percentage Proof: Dollar Proof

98

$99,508

775,380 x 7.5% = $58,154

$516,920 x 8.0% = $41,3547.70%

$1,292,300 x 60% = $775,380

$1,292,300 x 40% = $516,920

60% x 7.50% = 4.50%

40% x 8.0% = 3.20%

A broker calls you about a property. Net operating income is projected to be $99,500 in year 1. A lender has indicated that it would make a loan equal to 60% LTV, interest-only at 7.50%. The equity investor requires a 8.0% return on investment. How much could he bid for the property and still earn a 8.0% return on investment?

Percentage Proof Dollar Proof

99

$124,915$125,000 / 7.38% = $1,693,767

$1,185,637 x 7.75% = $91,887

$ 508,130 x 6.50% = $33,0287.38%

$1,693,767 x 70% = $1,185,637

$1,693,767 x 30% = $ 508,130

70% x 7.75% = 5.43%

30% x 6.50% = 1.95%

A broker calls you about a property. Net operating income is projected to be $125,000 in year 1. A lender has indicated that it would make a loan equal to 70% LTV, interest-only at 7.75%. The equity investor requires a 6.5% return on investment. How much could he bid for the property and still earn a 6.5% return on investment


100

$144,9903.89% / 30% = 12.97%

$1,050,000 x 8.25% = $86,625

$ 450,000 x 12.97% = $58,365

70% x 8.25% = 5.78%

30% x ___% = 3.89%

$1,500,000 x 70% = $1,050,000

$1,500,000 x 30% = $ 450,000

$145,000 / $1,500,000 = 9.67%



101

8.21%/75% = 10.95%

$112,48110.71% - 2.50% = 8.21%

$787,500 x 10.95% = $86,231

$262,500 x 10.00% = $26,250 25% x 10% = 2.50%

$1,050,000 x 75% = $787,500

$1,050,000 x 25% = $262,500$112,500 / 1,050,000 = 10.71%



102

8.21%/75% = 10.95%

$112,48110.71% - 2.50% = 8.21%

$787,500 x 10.95% = $86,231

$262,500 x 10.00% = $26,250 25% x 10% = 2.50%

$1,050,000 x 75% = $787,500

$1,050,000 x 25% = $262,500$112,500 / 1,050,000 = 10.71%



103

$87,480 x 21.45% = $ 18,764

$118,010

8.74% - 7.35% = 1.39%

1.39% / 6.48% = 21.45%

$1,012,500 x 7.95% = $ 80,494

$ 250,020 x 7.50% = $ 18,752 5.96% + 1.39% = 7.35%

6.48% x $1,350000 = $87,480

$1,350,000

75.00% x 7.95% = 5.96%

18.52% x 7.50% = 1.39%

75.00% x $1,350000 = $1,012,500

18.52% x $1,350,000 = $ 250,020

$118,000 / $1,350,000 = 8.74%

$250,000 / $1,350,000 = 18.52%

