2011 Overview of Houston Office Building Investment Market and Capital Markets

1. Jay Nowlin
President
Nowlin Interests
O’Connor & Associates
January 12th, 2011
J y ,

2. Let’s talk golf….
The Commercial Real Estate Market in 1Q 2011 shares many characteristics with the game of golf.
The conditions are sometimes unpredictable and may change at any time
Golf – weather, course conditions
CRE – Capital Markets, Supply Demand Fundamentals, Regulatory Issues
You have to know your environment/market
Golf – Course management matched with ability and risk /reward decisions
CRE ‐ Understand the market, capitalize on strengths and make appropriate risk reward decisions
You sometimes end up off the original game plan
Golf – literally off the fairway, in the rough, the woods or even under water
CRE ‐ financing constraints, occupancy challenges, market fundamentals and ….underwater!
You can recover from the rough
Golf – having a recovery plan, practice, getting help and executing the shot
CRE – having a recovery plan, good support staff and vendors and execution
Attitude, focus and discipline are essential
d f dd l l
Golf – a cluttered mind usually leads to lots of poor decisions. Practice and course management.
CRE – Striving for positive solutions, clear focus, disciplined management & financial controls

3. Current Economic (Weather) Conditions
Current Economic (Weather) Conditions
Houston Economy: ‐
Created 9,500 jobs 11/09‐11/10 (lost 103,500 jobs previous 12 months)
Created 9 500 jobs 11/09 11/10 (lost 103 500 jobs previous 12 months)
Trade continues to grow $173 billion through port (top 5 in country)
PMI 14 months of positive growth
Rig count up over 1,700 since bottoming in June 2009 at 876. We engineer the
Ri t i b tt i i J t 8 6 W i th
world from Houston. $90 oil is good. Gas $4.50 is stable, above $5.50 will grow
jobs.
4.9% forecasted oil service employment growth 2011.
50% of Houston companies are small companies occupying less than 3,500 SF.
Texas Economy
Employer friendly, inexpensive, central time zone, sunbelt, improving education
Employer friendly inexpensive central time zone sunbelt improving education
system.
Has added over 430,000 since June, 2008. and 192,100 in Nov. 10‐Nov. ‘11
Cu e t U e p oy e t s 8. % ( at yea to yea ) ve sus 9.4% US (do
Current Unemployment is 8.1% (flat year to year) versus 9.4% US (down 0.6%)0.6%)
State projects to grow 2.8% in FY 2012 and 3.4% in 2013.
Benefits from high tech manufacturing growth.
Texas to add 1.5M jobs by 2016 and grow at 2.1% annually
Budget deficit of $15 billion in 2012‐2013.

4. Current Market (Course) Conditions
Current Market (Course) Conditions
Houston Office Market: ‐
Values dependent on future expectations of income
Values Reflect relative health of tenant base
Dependent on absorption, which is directly tied to job growth
Class “A” – looks pretty good with corporate profits high and
corporations with lots of cash and low debt levels. Energy job
corporations with lots of cash and low debt levels Energy job
growth expected to be 4.9% in 2011.
Class “B” & “C” – looks a little less certain. Dependent on
small business, local and regional company growth. These
companies have been hit hard by lack of financing. December
p y g
small business growth was positive, but still a lot of pain and
lack of financing for struggling companies (and real estate)

5. Houston Fundamental Demand Driver
Houston Fundamental Demand Driver

6. Forecast for 2011 (gradual warming)
Forecast for 2011 (gradual warming)
Economy improving…but slowly
Rig count above 1,711 up from 1,282 one year ago and 876 in June, 2009. (Peak 2,031 September 08)
Rig count above 1,711 up from 1,282 one year ago and 876 in June, 2009. (Peak 2,031 September ‘08)
Hiring to be lead by Corporate hiring. Corporations have strong balance sheets, lots of cash, cheap debt and
starting to reinvest in core business.
Small business growth to pick up in response to corporate growth. Also, new business growth through
startups has been slow with curtailed small business lending. This is anticipated to slowly improve as the
p g p y p
economy is viewed to have bottomed.
Capital Markets improving, but slowly
More new lenders. All looking for cash flowing properties. Too many lenders looking for the
same things putting squeeze on interest rate margins. Big banks will win over new conduits,
same things putting squeeze on interest rate margins Big banks will win over new conduits
credit companies on rate, not on dollars.
Conduits will return and provide safe securitized debt with good yields. Underwriting loans
on much lower basis. Most underwriting to a 10% yield to the debt contant.
Life companies continue to be stable. Hard to find enough strong borrowers with stabilized
f b bl d f d h b h bl d
properties.
Equity starts to play the distressed game in earnest. Shut out of the “A” market by PF’s and
REITs’ that have cheaper cost of capital, equity dives in at new “bottom” basis. Invests through
g
seasoned sponsors and directly to take advantage of the play.
Portfolio’s continue to extend and rework/recapitalize loans reducing exposure in the future.
Unregulated lenders (Hard money), “debtquity” and private equity fill part of the gap.
Participating loan structures will emerge as we start to see upward value movement.
P ti i ti l t t ill t t t d l t

7. Forecast for 2011
Forecast for 2011 (gradual warming)
(gradual warming)
Transactions up
More properties come to market as lender s start to realize stabilized value and capitulate.
More properties come to market as lender’s start to realize stabilized value and capitulate
More buyer’s emerge recognizing that values have stabilized (bottom out) and see opportunity.
Sales pick up with right pricing (bid/ask narrows) leasing picks up more in 2nd half
Opportunity buys…BIG discounts in vacant properties.
Quality Leased Assets sell at BIG premium to current market basically at full value compared
to pre‐crisis.
Lenders return to market in recovering markets that show sustainable job growth and
reasonable supply/demand fundamentals. Red line certain markets
reasonable supply/demand fundamentals Red line certain markets
Seller’s become lenders, some to enhance value, some to sell at all.
Offering 80% debt at 5‐6% for 10 years to enhance value for buyer’s, close bid/ask gap.
(lower’s cost of capital to 8.0% = (20% equity x 20%)= 4.0% + (80% x 5%) = 4.0%
versus 11.6% = (40% equity x 20%)= 8.0%) + (60% debt x 6%) = 3.6%
Occupancies vary
Class “A” captures most absorption.
Corporations expand
p p
Class “B” big boys, move up at attractive rates (although rates are not down as much as they expect)
Class “B” & “C” depend on small business growth. Expect choppy first half as continued failures offset
growth. 2nd half increased absorption.
Retail surprisingly strong
p gy g

8. Office Building Class Divergence
g g

9. Houston Office Occupancy by Class
p y y
Class "A"
Houston Office Market Occupancies Class "B"
B
Class "C"
100.0%
95.0%
90.0%
90 0%
85.0%
80.0%
75.0%
70.0%
70 0%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

10. US Transaction Volume
US C
S CRE Transaction Volume (
(Billions)
) Deal Volume CMBS Issuance
600
500
400
300
200
100
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

11. Houston Transaction Volume
Houston CRE T
H Transaction V l
i Volume (Milli
(Millions)
) Deal Volume
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

12. Bid Ask Gap in Real Estate
Similar to bond dynamics 2 years ago
Similar to bond dynamics 2 years ago

13. Typical Value/Debt Scenario
Loan from 80% to 108% LTV but narrowing
L f 80% t 108% LTV b t i
Value
Distressed Asset Debt
120
100
80
60
40
20
0
2006 2007 2008 2009 2010 2011

14. Overregulation of the Capital Markets?
Is the Fed smarter than the average bear?
Can you put too much honey into the system? Inflation or stimulus

15. Typical Value/Debt Scenario
yp /

16. Typical Value/Debt Scenario
yp /

17. Total Cost of Capital
p
Weighted Equity Cost
Capital Structure Costs
p Weighted Debt Costs
16.00%
14.00%
12.00%
12 00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
2007
00
2008
2009
2010
2011
2007 2008 2009 2010 2011
Equity Required in Deal 20.0% 40.0% 40.0% 35.0% 30.0%
Equity Total Cost 22.0% 25.0% 25.0% 20.0% 18.0%
Equity Deal Cost 4.4% 10.0% 10.0% 7.0% 5.4%
Debt Required 80.0% 60.0% 60.0% 65.0% 70.0%
Debt Costs 6.75%
6 75% 7.00%
7 00% 6.50%
6 50% 5.75%
5 75% 5.50%
5 50%
Debt Deal Cost 5.4% 4.2% 3.9% 3.7% 3.9%
Weighted Average Deal Cost of Capital 9.8% 14.2% 13.9% 10.7% 9.3%
% change 44.9% -2.1% -22.8% -13.9%
-5.6%

18. Total Cost of Capital
p
The previous slide shows the general overall cost of capital in CRE in an effort to show the impact on values
via affordability. Targeted returns increased as a function of risk perception. As risk of further declines is
y g p p
reduced, the overall capital costs have also come down as have expectations.
In the residential market, a similar dynamic was at play. Lower interest rates drove people to purchase
more expensive homes because they could “afford it”. They were focused more on payments than total cost.
p y y p y
Part of the overall fed strategy for the economy is to keep rates low to allow for recovery, in essence, a
workout for the American consumer. Those with strong credit are able to benefit, while those not able to
q
qualify are not.
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This also translates into the business environment. The primary beneficiaries of the lower cost of capital in
the debt markets have been corporations that have de‐leveraged, refinanced at lower rates and are in a
much healthier position today.
p y
Small business credit has not been as easy to attain and thus, the small business sector, which traditionally
has led the way to recovery in previous cycles, is lagging in its growth abilities. Small business job growth
is anticipated to pick up 12 18 months later than usual. Capital from private equity and through M&A will
is anticipated to pick up 12‐18 months later than usual. Capital from private equity and through M&A will
help as will increased business activity from corporate customers. New technology and startups will likely
provide more than anticipated job growth as these ventures mature over the next 2‐3 years.
This should parlay into a lag in the class B and C real estate sector, however, depending on the location
This should parlay into a lag in the class “B” and “C” real estate sector, however, depending on the location
and the operator, there will be wide variance in performance.

19. BUYER PROFILES
SAFETY RETURN
Classified Core Core & Core Plus Quality Value Add Middle Market Opportunistic
Profile Risk Averse Strong CRE Asset Higher Risk
Sleep Well Management Reward Focused
More Golflf function and
f d Intensive Mgmt
No Mgmt property Hard Work
management Asset Mgmt
platform Patient
ROE/ROI
/ Current Income Income oriented Income & Income & more IRR Driven
Target Return of equity Appreciation upside
5‐8% 7‐12% 8‐15% 12‐20% 15‐30%+
Income Profile NNN Income Stable long term Gross Rents
Long Term Lease Quality credit
Lease Profile 10 Years + 7 years + Varies Varies
Strategic rollover Upside in leaseup Caters to local and
regional business
Bond Equivalent AAA Bond AA BBB+ BBB and down Junk Bond
Stock Equivalent Income Blue chip
p Blue Chip
p Large Cap
g p Mid‐Cap/Small Cap
p/ p Small Cap Value
p
Total Return Total Return Total Return
Buyers Institutions & Institutions Institutions & Private Institution with Private
Private Private partners
Investment Size $500,000‐$5 billion
b ll $50‐$500m $25m‐$500m $2m‐30m Varies
Properties Bond leases “A” multi‐family , A & B multi‐family , A & B Value add All classes
10+ years industrial, office, industrial, office, opportunities, Distressed Debt
Industrial Retail, full service Retail, full service, multi‐family , Distressed ORE
Office hotel upscale Ltd service industrial, office, Foreclosures
Retail hotel Retail, full service Land
Medical hotel, mini‐storage All Property types
Development

20. Opportunistic Value Add Core Plus Assets Core Assets
“Distressed” General RE Location & Quality Location & Quality
General RE >80% occupancy
p y Market Income Q
Quality Income
y
< 80% occupancy Market Income Increasing Demand High Demand
No Demand Low Demand Institutional & Private Institutional
Private Private $25mm and up $50mm and up
$25mm and under $25mm and under Scarcity of Product
Costly to finance Conventional debt
The Target from the tee
Risk versus Reward
Risk versus Reward
Still market efficiency, just wide spread

21. The Current Fairway ‐ Buy Core
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Seeking Safety by buying Core Assets
Location
Quality
Most predictable &
Stable income stream
Most predictable value
Willing to Accept lower return
Willi t A t l t
Problem: not enough supply to meet demand
Result: Low caps, lower overall ROI
R l L l ll ROI

22. The Next Fairway Core Plus
The Next Fairway – Core Plus
Seeking Safety but also want more yield
g y y
Location
Quality but with accept some occupancy risk
Less guaranteed income
Long Term Value
Seeking higher returns
Problem: not enough product to go around

23. The Next Fairway – Value Add
The Next Fairway Value Add
Seeking Safety but also want more yield
g y y
Location
Quality but with accept some occupancy risk
Less guaranteed income
Long Term Value
Seeking higher returns
Problem: Bid Ask spread.
P bl Bid A k d
Hard to underwrite lease‐up and forecast
turnaround, exit cap rates and get attractive
turnaround exit cap rates and get attractive
financing.

24. The Next Fairway – Opportunistic
y pp
Seeking higher returns
Taking advantage of underperforming assets
Operational underperforming
Occupancy challenges
Curable Physical problems
Distressed Seller
Sometimes Lender
S ti L d
Sometimes owner
Problem: Hard to wade through the
P bl H d d h h h
junk/ seller bid/ask spread.

25. Playing today has its risks…, but they are identifiable hazards.
Sponsor Risk – Can be mitigated. Many high
quality operators in each product type
Market Risk ‐ Mostly dependent on job growth in
every sector
Asset Risk – changing tenant market dynamics,
functionality, quality
Financing Risk – Rollover of oustanding debt to
make financing more difficult.
Value Risk‐ Mitigated by low entry basis

26. So even when things are looking dark

27. Or all hail is breaking loose

28. Or you are not sure how to navigate the hazards…..

29. Or you are up to it with alligators

30. Or you feel like you are going to the birds ….
or they are coming after you!
or they are coming after you!

31. Or you are just being dogged on…..

32. Knowing what you have and having a executable plan

33. With a strong management team….

34. And good financial controls

35. Even if you are a little under water

36. Or even lost in the rough

37. Like golf……you can recover from the “rough”

38. And sometimes….

39. With focus, hard work and persistence…..

40. You can come out ahead.

41. Texas Real Estate Center
Mark Dotzur speech 12/01/10
CBRE Global Consulting & Research Team
Brian Stoffer Capital Market Presentation
B i S ff C i l M k P i
Grubb & Ellis 2011 Houston Forecast
Dallas Federal Reserve
Costar
O’Connor & Associates
Q10 Kinghorn Driver Ray Driver
Driver, Ray Driver
Graham Investments, Dean Castelhano

42. Strategic Real Estate Execution
Capital
Acquisitions
Dispositions
Tenant Representation
Portfolio Management
f
Asset Management
Development
Consulting
Contact:
Jay Nowlin, President
713‐409‐1157
jnowlin@nowlininterests.com
www.nowlininterests.com