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Pimco Commercial Real Estate - June 2010
 

Pimco Commercial Real Estate - June 2010

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    Pimco Commercial Real Estate - June 2010 Pimco Commercial Real Estate - June 2010 Document Transcript

    • PIMCO U.S. Commercial Real Estate June 2010 Project 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 1,000 CMBS Super Senior 215 words, the current yield at which a property trades) and 900 DJ Equity REIT Index Spread to Swaps (bps) 800 190 per-square-foot values close to the peak prices seen in 700 Index Value 165 2006 and 2007. 600 500 140 Buyer demand has also returned for multifamily 400 115 properties financeable through Fannie Mae and Freddie 300 200 90 Mac’s longstanding lending programs. While loan terms have become significantly more conservative in 0 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 -1 -0 0 0 -0 -0 -0 1 -1 0 1 r-1 -0 r-0 l -0 g- p- b- n- n- ay ay ov ec ar ar ct M 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. 3
    • 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 = 100 210 properties and Agency-debt eligible multifamily 190 properties should not be considered a leading indicator 170 of a broad-based recovery in CRE asset values. Recent 150 transactions imply a rapid recovery to 2007 pricing 130 levels; however, these asset classes face risk of future 110 value declines. In the case of the aforementioned 90 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 5
    • 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 (%) 6.0 Consider Japan, where zombie banks – financial 5.0 institutions that continue to operate despite severely 4.0 Cap Rate impaired balance sheets – held on to underwater loans 3.0 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 1 20 1 20 1 20 1 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 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 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) 50 Bearish Projection - Japan style recovery ways to avoid marking loans to their current value. 0 For example, several brokers told our analysts of cases 00 01 02 03 04 05 06 07 08 10 9 E E E E E E E E E E E E 0 11 12 13 14 15 16 17 18 19 20 21 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 7
    • 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 (%) 1.0 2.0 sectors; however, these measures fail to capture the 0.5 0 1.5 extent of the concessions landlords are offering to -0.5 attract and retain tenants. 1.0 -1.0 0.5 -1.5 National Average National Average -2.0 0 Yearly Rent - 2007 Yearly Rent - 2009 % Change 4 4 4 4 4 4 4 4 4 4 4 4 4 -Q -Q -Q -Q -Q -Q -Q -Q -Q -Q -Q -Q -Q Apartment (per unit) $16,238 $15,142 -6.8% 85 87 89 91 93 95 97 99 01 03 05 07 09 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 10 Office Rent Growth (%) Interviews with retail property owners also highlight 5 the continued challenges landlords face. Retail owners 0 may have been able to prop up occupancy levels by -5 converting struggling tenants to a percentage rent -10 structure; however, performing anchor tenants will -15 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. 9
    • 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 11
    • PIMCO 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