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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%.
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1) Where shouldcommercial real estate be valued?- Lower than many people think
2) Where willit be priced?
Even lower than that
3) Will there be opportunities?
- Enormous onesequity will be king
Three Questions
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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, its the path for cap rates thisdecade
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 dont know where prices are for surenothing is tradingwethinktheyre down 35-40%
Where Should Real Estate be Valued?
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Source: Moodys.
Baa-Rated Long-Term Corporate Bond Y ields
7.8%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
1-86
1-88
1-90
1-92
1-94
1-96
1-98
1-00
1-02
1-04
1-06
1-08
Avg '92-'02 = 8.1%
Avg '03- Sept '08 = 6.5%
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.
Where Should Real Estate be Valued?
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Cap rate is an average of the five major sectors: Apt, Industrial, Mall, Office, & Strip Center.
Source for corporate bond yields: Moodys.
Cap Rates & Corporate Bond Yields
8.8%
7.8%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
1-86
1-88
1-90
1-92
1-94
1-96
1-98
1-00
1-02
1-04
1-06
1-08
Cap Rate Baa-rated Long-term Corp Bonds
Our cap rates assumethat values have
dropped by 35-40%
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%.
Where Should Real Estate be Valued?
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Estimated Indexed '09-'12 NOI Growth
Major Property Sector Average
97
115
113
110
93 92 9490
100
110
120
'08 '09 '10 '11 '12
9/07
3/08
9/08
6/09
Where Should Real Estate be Valued?
Punch #2: Growth prospects have worsened
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Proxy for IRR expectations = economic cap rates + intermediate-term growth + long-term growth (expected inflation less 110 basis points). Inflation source: Survey ofProfessional Forecasters. Source for Mortgage Rates: American Council of Life Insurers and Green Street.
IRR Expectations vs. Commercial Mortgage Rates
9.2%
7.5%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
1-86
1-88
1-90
1-92
1-94
1-96
1-98
1-00
1-02
1-04
1-06
1-08
IRR Expectations Commercial Mtg Rate
Key assumption underlying IRRs:
Prices are already down by 35-40%.
Thats more than most think.
By combining historic cap rate, intermediate growth, and inflation
expectations, it is possible to construct a time series of the unleveragedreturns that real estate investors historically have expected to achieve.
Where Should Real Estate be Valued?
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Return Premiums on Real Estate
Unleveraged IRR Expectations minus Borrowing Rates
172 bp
Avg = 180 bp
0 bp
50 bp
100 bp
150 bp
200 bp
250 bp
300 bp
350 bp
400 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
Historically, return (IRR) expectations have substantially exceeded borrowing
rates. Assuming that values are down 35-40%, the spread is now about backto normal. Real estate is fairly valued if prices are down this much.
Where Should Real Estate be Valued?
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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 whatoccurred in the early 90s
Where Should Real Estate be Valued?
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REITs are trading at an implied cap rate (the cap rate at which NAV equals the
current share price) of almost 9%.
Where Should Real Estate be Valued?
Implied Cap Rates & Corporate Bond Y ields
8.8%
7.8%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
1-98
1-99
1-00
1-01
1-02
1-03
1-04
1-05
1-06
1-07
1-08
1-09
Implied Cap Rate Baa-rated Long-term Corp Bonds
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Where Should Real Estate be Valued?
Two approaches to answering this question lead to the sameconclusion:
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 valuedare two different questions
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Broad capital markets are recovering, but real estatecapital markets are a mess
This may persist for yearsmuch 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
Where Will Real Estate be Priced?
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Where Will Real Estate be Priced?
Average LTV in CMBS Originations
66%
65%
66%
67%68%
68%
69%
65%
64%
65%
66%
67%
68%
69%
70%
'00 '01 '02 '03 '04 '05 '06 '07
Actual LTV's rose even more
than this, as appraisal
inflation was rampant.
The '05-'07 CMBS vintages were underwritten at very aggressive loan-to-value
ratios amidst an environment where appraisals were often inflated andborrowing costs were well below current levels.
Sources: Mortgage Bankers Association, Wells Fargo, Eastdil Secured, Green Street
Average Interest Rate on Fixed Rate
Originations
5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
'00 '01 '02 '03 '04 '05 '06 '07
Current market at 60% LTV = 7.5%
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Where Will Real Estate be Priced?
% of CMBS Loans with Full or Partial
Interest Only Feature
20% 21%23%
47%
64%
76%
86%
34%
0%
20%
40%
60%
80%
100%
'00 '01 '02 '03 '04 '05 '06 '07
Watch Out: Interest reserves
on low-cap-rate deals may
begin to dry up 2-3 years
after origination.
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.
Sources: Mortgage Bankers Association, Wells Fargo, Eastdil Secured. Delinquency rates as of the end of the year; 09 is end of 1Q.
CMBS Delinquency Rate
0.0%
0.5%
1.0%
1.5%
2.0%
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09
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CMBS Maturities
$0 BN
$25 BN
$50 BN
$75 BN
$100 BN
$125 BN
$150 BN
$175 BN
2009 2010 2011 2012 2013 2014 2015 2016 2017
'05-'07 Fixed Rate '05- '07 Variable Rate Earlier Vintages
There is a very ugly pig in the
snake in the form of maturing
'05-'07 v intage loans that
mature between 2010 and 2012.
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 and2012, five years after origination.
Where Will Real Estate be Priced?
Assumes extension of extension options on 3-year loans. Sources: Green Street, Mortgage Bankers Association, Wells Fargo, Trepp, Bank of America
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Total Commercial Mortgage Maturities
$0 BN
$50 BN
$100 BN
$150 BN
$200 BN
$250 BN
$300 BN
$350 BN
$400 BN
2009 2010 2011 2012 2013 2014 2015 2016 2017
CMBS Banks Insurance Co.
CMBS maturities are
only the tip of the
iceberg.
CMBS maturities will be ugly, but they're only the tip of the iceberg. Over $1
trillion of maturities occur by '12.
Where Will Real Estate be Priced?
Sources: Green Street, Mortgage Bankers Association, Wells Fargo, Trepp, Bank of America, Deutsche Bank
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Mortgage Proceeds on a Property Valued at $100 Million in '07 vs Now
$100
$63
$75
$38
$0
$20
$40
$60
$80
$100
$120
2007; LTV=75%* 2009; LTV=60%
Property Value Mortgage
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?
Maturities will be a mess: refinancing will require huge checks.
Where Will Real Estate be Priced?
* LTV calculated off the appraised value would have been lower. Appraised values were often inflated during the boom.
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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
ownersreal estate market participants need to hope that the
REIT rally continues
Where Will Real Estate be Priced?
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Opportunity Amidst Distress
Weve been here before. Commercial real estateimploded in the early 90s
New equity primarily in the form of REITs allowedthe industry to recapitalize
That process has now begun
REIT prices have rallied from the trough
Re-equitization is underway
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Opportunity Amidst Distress
The History of Our Future?
The Value of $100 Invested in REITs vs. Private Real Estate at the peak of
the '89 bubble
$66
$69
$50
$70
$90
$110
$130
8/89 2/90 8/90 2/91 8/91 2/92 8/92 2/93 8/93 2/94
REITs (Price Return NAREIT Equity Index)
Private RE (Capital Return NCREIF Index; assumes index is 12 months late)
RTC Formed;
Dissloves '95
KIM IPO;
11/91
Randsworth (infamous JMB
deal) is foreclosed; 2/92
O&Y goes BK; 5/92
TCO IPO;
12/92
87 REIT IPOs occur in '93 & '94
Rockefeller Center
Mortgage Defaults; '95
Where Will Equity Capital Come From? Public Markets Will Play a Big Role
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REIT Equity Issuance and Total Returns in the '90s
17%
99%
38%
14%
19%
31%
15%
20%
3%
15%
35%
20%
0%
20%
40%
60%
80%
100%
120%
'92 '93 '94 '95 '96 '97
0%
10%
20%
30%
40%Equity Issuances as a % of
Market Equity (Left Axis)Total Return (Right Axis)
Opportunity Amidst Distress
Source: NAREIT. Equity issuances as a % of market cap at beginning of the year.
The ability to raise capital was a competitive advantage that helped foster
impressive performance from 92-97.
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Price index version of the MSCI US REIT Index.
MSCI US REIT Index (RMZ)
0
200
400
600
800
1000
1200
1400
1-07
3-07
5-07
7-07
9-07
11-07
1-08
3-08
5-08
7-08
9-08
11-08
1-09
3-09
5-09
REITs are up 55%
from their lows
REIT share prices are up 55% from their recent lows.
Opportunity Amidst Distress
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REIT Equity Issuance this Decade
$1$4
$6$8
$15
$12
$18
$14$12
$32
$0 BN
$5 BN
$10 BN
$15 BN
$20 BN
$25 BN
$30 BN
$35 BN
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 (ann.)
Opportunity Amidst Distress
Sources: NAREIT and Green Street. 09 is amount raised thru June 5 and is annualized.
Equity issuance has picked up.
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Real estate prices are probably down 35-40% already
Thats more than most are willing to acknowledge
Thats 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 mans distress is anothers opportunity Public REITs will be the biggest winners
Low supply creates backdrop for solid recovery
Real Estate is an inflation hedgethat may matter a lot someday
Summary
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Green Street Advisors
567 San Nicolas Drive, Suite 200
Newport Beach, CA 92660
Contact:
Damon Scott, Director of [email protected]
949.640.8780
www.GreenStreetAdvisors.com
Contact Information
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