Good _____ and thank you for inviting me.SB background.Board of 3 REITs; keeps me in day-to-day deal flow.Former competitors.What is happening in the U.S. real estate capital markets is representative of what is happening globally.
October 7, 2007: when we talked about too big to fail and the sub-prime mortgage crises among many issues and problems.Today: do you want the gloom speech or the doom one?
This is only a partial list including financial market centric events.Risk severity now comes at us from new and unexpected directions.The real estate industry and capital markets have endured quite a bit over the last 4 years.In 2007, sub-prime crises.In 2008, 34 days from hell when…In 2009, the global capital markets collapsed.In 2010, we started to sift through the wreckage.In 2011, as the Beatles said: “I’ve got to admit it’s getting better, a little better all the time”.
The real estate industry and capital markets have endured quite a bit over the last 4 years.In 2007, sub-prime crises.In 2008, 34 days from hell when…In 2009, the global capital markets collapsed.In 2010, we started to sift through the wreckage.In the first 8 months of 2011, as the Beatles said: “I’ve got to admit it’sgetting better, a little better all the time”.
Let’s be different this time; let’s start with some conclusions.
Now let’s do Q & A; why wait?
Spreads for 10-year prime mortgages which got as low as 105 over Treasuries are back in the 200 to 250 range, where they have always belonged on a risk adjusted basis.
Nothing overcome systemic risk.Global capital markets remained inexorably linked.Tails…weren't the 34 days from Hell the equivalent to 8-1,000 year floods.
Shows banks easing lending standards on all major types of loans, save single family residential real estate. But…while lending standards are improving, demand remains weak.Banks on net eased standards on CRE loans. Demand for CRE loans strengthened as well; a 32.7% of respondents said that demand was “moderately stronger”.
$545+/- billion of fixed-rate CMBS loans are due to mature by 2017.Someone is going to be crowded out of the market.
NREIonline “Commercial Mortgages Held by Life Insurance Companies Weather the Storm”, 7/6/2011.Life insurers have mitigated their troubled loans with “active management”, namely: modifying loan terms or selling under-performing loans to third-parties.
Aspart of my preparation for speaking engagements such as today’s, I speak with a wide array of industry players and ask them to rank the solutions available to lenders; the results are not that surprising when you think about it.
How are financial institutions dealing with most of their distressed loans?
Some $15.6 of distressed property traded in the US in H1’11, more than double the H1’10 level as lenders increasingly chose to liquidate as opposed to modify and restructure troubled mortgages. A year ago, half of all workouts were accomplished via loan modifications, dubbed “extend and pretend.” That ratio had shifted dramatically to favor liquidations by six-to-one over modifications. As credit conditions and property prices have improved, lenders are moving more aggressively and decisively away from pretend-and-extend. Still a $100+ billion problem.
U-3: The normal unemployment rate we hear about each month; the “official” rate.U-6: total unemployed, plus all persons marginally attached to the labor force, plus total employed part-time for economic reasons.Pretty depressing way of looking at things.
WSJ 1/3/2011.A listing of potential dark clouds that could dim a relatively sunny outlook for the first half of 2011; none are close to being “sure” bets.First two would certainly upset the financial markets, causing interest rates to increase.Third bullet is obvious.Home price declines means a worsening homebuilding industry and mortgage situation, hurting consumer spending.Each $1 rise in gas prices means $2.6 billion per week spent at the gas pump versus the department store.And…
The regulatory “Corn Maze” continues with a seemingly endless number of “sons and daughters” of Dodd-Frank, Sarbanes-Oxley, Basel III, and Solvency II for the real estate and financial capital markets to adjust to. Lobbying becomes a literally full time business for all facets of the real estate industry in hopes of protecting the status quo .It’s not just Dodd-Frank; it’s the SEC, Treasury, Congress, FDIC, IRS, OCC, NAIC, OTS, FASB, the European Union, the Basal Committee, and others
A 367-page rule drafted over 8 months by the: FDIC; FRB; OCC; SEC; Federal Housing Finance agency; and HUDIssuers can avoid retaining a 5% stake if loans meet “pristine” underwriting standards set by the regulators Other ways to fulfill the 5% requirement include:Retain a “vertical slice” equal to 5% of the offeringRetain a 5% stake in the riskiest tranche (a “horizontal slice”A combination of the twoRetain a “representative sample” of loans from the poolCreation of a cash reserve equal in par value to 5% of the securities issued
In a nutshell, what the REITs planted in 2009 and 2010 will bear fruit in 2011 and 2012.Re-equitized through dilutive secondary offerings.Reduced dividends.Reduced leverage through asset sales.Reduced operating expenses and G & A expense.Stopped acquisitions and development.Extended lines of credit and term loan facilities.Ready to take advantage of whatever comes along.
Now let’s turn to the public real estate debt capital markets.For those of you who like mazes, here’s a schematic diagram of the CMBS credit model.
Trepp, LLC September 30, 2011.In 12 months, increase from 9.05% to 9.56%; high-water marked could be in the 10% - 11% range
Pretty much done.Rating agency remains as unfinished business.Stop the lobbying; implement “skin-in-the-game”.Seeing clearer underwriting standards, best practice reporting, and resolution of conflicts.Regulatory and accounting uncertainties will be with us for a while, regardless of what the industry does.Investors appear to be increasingly able to reconcile investment in this era of low rates and relative value.
Global private equity fundraising fell to a 7-year low in 2010; $35 billion, down 30% from 2009’s $50 billion.Fundraising in 2009 and 2010 was slow due a wide array of issues including legacy performance and investor caution.Signs are that the market is thawing as more funds both come to market and those on the road raise very respectable amounts of capital.
Preqin survey, 5/2011.2/3rd believe U.S. will present the best opportunity over the coming 12 months.50% believe Asia, with its developing markets, will present attractive opportunities next year.1/3rd believe Europe and South America will offer attractive opportunities.
Preqin.“It’s the economy stupid!”Once you get past leverage and financing, none of the issues seem that important.
Updated as of September 2011.Market conditions have caused a shift in strategic preferences of institutional investors.Higher risk strategies are viewed less favorably; there has been an increase in appetite for lower risk core funds.Appetite for value added and opportunistic strategies have decreased over the past 12 months; and while there has been a decline in appetite for core funds, they are still the most favored strategy.
NCREIF: 6,057 properties, $238 billion; up 5.8% on a trailing 12-month basis.RERC survey had shown quarterly declines in capitalization rates beginning in the third quarter of 2008 and continuing through yearend 2010.Transaction volume in 2009 equaled about $55 billion so $125 billion in 2010 is clearly good news.
Insurance companies are serious investors in real estate with an average allocation of $1.9 billion versus a target allocation of $2.4 billion, thereby allowing room to take advantage of today’s markets to grow their portfolios.
Preqin September 2011.Among life insurers, value added and opportunistic strategies are the most prevalent, followed by low risk core and core plus alternatives.
In a word: improving as stronger balance sheets and income statements are allowing financial institutions to deal more aggressively with delinquencies and defaults.Underwriting standards remain strict and stringent, which is where they should be.
After a sluggish to flat first quarter of 2011, the recovery in delinquencies seems to have resumed.
This gives you a picture of the magnitude of the refinancing problem facing the U.S. real estate industry between 2010 and 2013.This is the source of the often quoted $250 billion per year in required refinancing.On a cumulative basis, it’s truly frightening:2012 - $873 billion2014 - $1.4 Trillion2017 - $2.2 Trillion2020 - $2.4 Trillion
While insurance companies have certainly seized the moment, taking advantage of the distress holding back other lenders, to gain both market share as well improve, if necessary, their portfolio quality, they can not single handedly solve the real estate industry’s refinancing problem.
Time for a breather.
Lastly…6 homework problems and answers are included.
Real Estate Finance 201: The Realities (Stephen Blank) - ULI Fall Meeting 102611
Urban Land Institute Real Estate CapitalMarkets: Real Estate 201 – “The Realities” tenuous ten∙u∙ous [ten-yoo-uhs] -adjectiveStephen BlankSenior Fellow, FinanceULI – the Urban Land InstituteOctober 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 EstateIndustry• 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 LoweredTo 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
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
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 LostDecade (2000 – 2009)
Risk Premiums: Capitalization Rates to 10-Year Treasury Yields 10 Year Treasury Yield Cap Rate 10% 9% 8% 7% 6% 5% 4% 3% 2% 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009Source: Cornerstone Research, NCREIF, and the Federal Reserve Board.
Decline in Commercial Real Estate PropertyValues (44%) Source: Moody’s/REAL.
Spreads for 10-Year ―Prime‖ CommercialMortgages to Treasury Yields
And Investors Convinced Themselves! Collateralized Debt Obligations of Sub-Prime Residential Mortgage-Backed Securities Estimated 3-Year Credit Rating Actual Default Rate 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.
Lesson Learned? ―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
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 MarketsReturns as of 3Q 2011One-Year Expectation: Real Estate V. Capital Markets Returns 3Q 2007 3Q 2008 3Q 2009 3Q 2010 3Q 2011Real 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.
But…Bank Commercial Real Estate MortgageLoan 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%
Preferred Strategies for ―Resolving‖ MaturingCommercial Real Estate Loans60% 54%50%40%30% 25%20% 15%10% 6%0% Extend with Extend w/o Sell to 3rd Party Foreclose and Mortgage Mortgage Dispose Modification Modification
Additional Lender Workout Strategies Include… Source: Real Capital Analytics.
“It has been said that the only purpose ofeconomic forecasts is to make astrology lookrespectable”
All You Need to Know: Job Growth Drives theReal Estate Economy Monthly Job Job Growth Gain on a Growth Benchmark 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/LaborUtilization Dec May June July March April May June July 2009 2010 2010 2010 2011 2011 2011 2011 2011Normal 9.9% 9.7% 9.5% 9.5% 8.8% 9.0% 9.1% 9.2% 9.1%(U-3)BroadMeasure 17.2% 16.6% 16.5% 16.5% 15.7% 15.9% 15.8% 16.2% 16.1%(U-6)
Forecast: Blue Skies Ahead, But Watch for DarkClouds 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.
Potential Impact of Dodd-Frank on CommercialReal 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
Financing and Investing in Real Estate• The Sudoku approach to structuring real estate investments 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 45
Financing and Investing in Real Estate• The Sudoku approach to structuring real estate investmentsA-1 A-2 A-3 A-1 A-2 A-3 Lender’s Lender’s Lender’s Loan-to-Value Mortgage Lender’s Investment Required Rate Weighted Cost Ratio Constant Weighted of Return of Capital Return on CapitalB-1 B-2 B-3 B-1 B-2 B-3 Equity Investor’s Investor’s Equity Investor’s Investor’s Investors Required Rate Weighted Cost Investors % Required Weighted Investment of Return of Capital Investment Return on Return on Equity EquityC-1 C-2 C-3 C-1 C-2 C-3 Total Equity Total Cost of Total Equity Total Return on and Debt Capital and Debt Invested Capital Investment (Capitalization Investment (Capitalization Rate) Rate) 46
Financing and Investing in Real Estate• The Sudoku approach to structuring real estate investments A-1 A-2 A-3 A-1 x A-2 = A-3 B-1 x B-2 = B-3 B-1 B-2 B-3 A-1 + B-1 = C-1 A-3 + B-3 = C-3 C-1 C-2 C-3 47
Assume a property is offered for sale. Net operating income is projected tobe $92,700 in year 1. A lender has indicated that it would make a loanequal to 65% LTV at a 8.87% constant. The equity investor requires a10% return on investment. What capitalization rate should you use tovalue 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 48
A broker calls you about a property. Net operating income is projected tobe $92,700 in year 1. A lender has indicated that it would make a loanequal to 65% LTV, interest-only at 8.00%. The equity investor requires a10% return on investment. How much could he bid for the property andstill 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 49
A broker calls you about a property. Net operating income is projected tobe $92,700 in year 1. A lender has indicated that it would make a loanequal to 75% LTV, interest-only at 8.00%. The equity investor requires a10% return on investment. How much could he bid for the property andstill 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 50
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. Alender 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% = $95,000Step 1: 7.92% - 5.62% = 2.30% $95,000 – 67,470 = $27,530Step 2: 2.30% / 35% = 6.57% $27,530 / $420,000 = 6.55% 51
A broker calls you about a property. Net operating income is projected tobe $92,700 in year 1. The equity investor requires a 12% return oninvestment. Assuming the property is offered for sale for $950,000, whatloan 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% = $92,720Step 1: 9.76% - 3.60% = 6.16% $92,700 – 34,200 = $58,500Step 2: 6.16% / 70% = 8.80% $58,500 / 665,000 = 8.80% 52
A property is offered for sale for $1,500,000. First year NOI is projectedat $127,500. A lender has expressed interest in a 70% LTV loan with a8.45% constant. The buyer is willing to invest $300,000. Assuming theinvestor requires an 9.0% return on investment, what current rate ofreturn 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%) = $127,500 – (88,725 – 27,000) =0.78% $11,775Step 2: 0.78% / 10% = 7.80% $11,775 / $150,000 = 7.85% 53
Real Estate Investment and Capital MarketsStrategies Real Estate Commercial Mortgage-Backed Investment Trusts Securities Core, Value-Added, Whole Loans, and Opportunistic Bridge Loans, and Property Investments Mezzanine Debt
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)$350,000$300,000$250,000$200,000$150,000$100,000 $50,000 $0 U.S. ($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 2.0: Finished and Unfinished Business1. Refinancing will continue to affect the industry well into the coming decade2. Cleaning up the system and eliminating legacy assets from balance sheets to allow lending to re-start3. Restore credibility of rating agencies4. Improve product structure5. Improve transparency6. Resolve regulatory and accounting uncertainties7. 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 StructuresLegacy CMBS New Issue CMBSLTV-based sizing at risk to changing valuations Debt yield/cash flow-based sizing • Pro-forma underwriting • In-place income • Above market rent credit • Market vacancyB-piece investors B-piece investors • B-piece investor and special servicer may be • B-piece investor and special servicer are same entity separate entities • Actual losses • Appraisal controlled out • Accrued interest • Interest accrual stopped • Senior bondholders had limited options to • Senior bondholders can replace the special replace the special servicer servicer through a votePublic transactions mean more available information 144A means more information available to those that sign confidentiality agreementsNo audit procedure of special servicer Trist advocate/adviser to auditAnonymous bondholders in trustee hands Bondholders registry and votingSource: 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 Investment80%70%60%50%40%30%20%10%0% North America Asia Europe South America Middle East
Key Issues in the Private Real Estate Market25%20%15%10%5%0%
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 • Average allocation to real 15% estate: – 6.8% of total assets 23% • Average target allocation 62% to real estate: – 10.4% of total assets North America Europe Asia and Rest of World
Investment Strategy Preferences of InsuranceCompanies70%60%50%40%30%20%10%0%
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 forU.S. Banks and Thrifts Q2 Q2 Q2 Q1 Q2 2011 2008 2009 2010 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-accrualsSource: FDIC; Trepp, LLC
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 CapitalMarkets: Real Estate 201 – “The Realities” tenuous ten∙u∙ous [ten-yoo-uhs] -adjectiveStephen BlankSenior Fellow, FinanceULI – the Urban Land InstituteOctober 26, 2011
Weighted Cost of Capital―Homework‖ Problems 89
Assume a property is offered for sale. Net operating income is projected tobe $105,000 in year 1. A lender has indicated that it would make a loanequal to 75% LTV at a 7.76% constant. The equity investor requires a10% return on investment. What capitalization rate should you use tovalue the property? What would you pay for the property? Percentage Proof: Dollar Proof 90
A broker calls you about a property. Net operating income is projected tobe $99,500 in year 1. A lender has indicated that it would make a loanequal to 60% LTV, interest-only at 7.50%. The equity investor requires a8.0% return on investment. How much could he bid for the property andstill earn a 8.0% return on investment? Percentage Proof Dollar Proof 91
A broker calls you about a property. Net operating income is projected tobe $125,000 in year 1. A lender has indicated that it would make a loanequal to 70% LTV, interest-only at 7.75%. The equity investor requires a6.5% return on investment. How much could he bid for the property andstill earn a 6.5% return on investment Percentage Proof: Dollar Proof: 92
A broker calls you about a property which is offered for sale for$1,500,000. Net operating income is projected to be $145,000 in year 1. Alender has indicated that it would make a loan equal to 70% LTV at 8.25%constant. What return on investment will the equity investor receive? Percentage Proof: Dollar Proof: 93
A broker calls you about a property. Net operating income is projected tobe $112,500 in year 1. The equity investor requires a 10% return oninvestment. Assuming the property is offered for sale for $1,050,000, whatloan constant can the investor pay a lender who is willing to make a 75%LTV, 25-year amortizing, loan? Percentage Proof: Dollar Proof: 94
A property is offered for sale for $1,350,000. First year NOI is projected at$118,000. A lender has expressed interest in a 75% LTV loan with a 7.95%constant. The buyer is willing to invest $250,000. Assuming the investorrequires an 7.5% return on investment, what current rate of return can he offer amezzanine investor? Percentage Proof: Dollar Proof: 95
Answers to WeightedCost of Capital Problems 96
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 to75% LTV at a 7.76% constant. The equity investor requires a 10% return oninvestment. What capitalization rate should you use to value the property? Whatwould you pay for the property? Percentage Proof: Dollar Proof 75% x 7.76% = 5.82% $1,262,000 x 75% = $946,500 25% x 10.0% = 2.50% $1,262,000 x 25% = $315,500 $946,000 x 7.76% = $73,448 8.32% $315,500 x 10.0% = $31,500 $104,948 97
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 to60% LTV, interest-only at 7.50%. The equity investor requires a 8.0% return oninvestment. How much could he bid for the property and still earn a 8.0%return on investment? Percentage Proof Dollar Proof 60% x 7.50% = 4.50% $1,292,300 x 60% = $775,380 40% x 8.0% = 3.20% $1,292,300 x 40% = $516,920 775,380 x 7.5% = $58,154 7.70% $516,920 x 8.0% = $41,354 $99,508 98
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 to70% LTV, interest-only at 7.75%. The equity investor requires a 6.5% return oninvestment. How much could he bid for the property and still earn a 6.5% returnon investment Percentage Proof: Dollar Proof: 70% x 7.75% = 5.43% $1,693,767 x 70% = $1,185,637 30% x 6.50% = 1.95% $1,693,767 x 30% = $ 508,130 $1,185,637 x 7.75% = $91,887 7.38% $ 508,130 x 6.50% = $33,028$125,000 / 7.38% = $1,693,767 $124,915 99
A broker calls you about a property which is offered for sale for $1,500,000. Netoperating income is projected to be $145,000 in year 1. A lender has indicatedthat it would make a loan equal to 70% LTV at 8.25% constant. What return oninvestment will the equity investor receive? Percentage Proof: Dollar Proof:$145,000 / $1,500,000 = 9.67% $1,500,000 x 70% = $1,050,000 $1,500,000 x 30% = $ 450,00070% x 8.25% = 5.78% $1,050,000 x 8.25% = $86,62530% x ___% = 3.89% $ 450,000 x 12.97% = $58,3653.89% / 30% = 12.97% $144,990 100
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 constantcan the investor pay a lender who is willing to make a 75% LTV, 25-yearamortizing, loan? Percentage Proof: Dollar Proof: $1,050,000 x 75% = $787,500$112,500 / 1,050,000 = 10.71% $1,050,000 x 25% = $262,500 $787,500 x 10.95% = $86,231 25% x 10% = 2.50% $262,500 x 10.00% = $26,250 10.71% - 2.50% = 8.21% $112,481 8.21%/75% = 10.95% 101
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 constantcan the investor pay a lender who is willing to make a 75% LTV, 25-yearamortizing, loan? Percentage Proof: Dollar Proof: $1,050,000 x 75% = $787,500$112,500 / 1,050,000 = 10.71% $1,050,000 x 25% = $262,500 $787,500 x 10.95% = $86,231 25% x 10% = 2.50% $262,500 x 10.00% = $26,250 10.71% - 2.50% = 8.21% $112,481 8.21%/75% = 10.95% 102
A property is offered for sale for $1,350,000. First year NOI is projected at$118,000. A lender has expressed interest in a 75% LTV loan with a 7.95%constant. The buyer is willing to invest $250,000. Assuming the investor requiresan 7.5% return on investment, what current rate of return can he offer amezzanine investor? Percentage Proof: Dollar Proof:$118,000 / $1,350,000 = 8.74% 75.00% x $1,350000 = $1,012,500$250,000 / $1,350,000 = 18.52% 18.52% x $1,350,000 = $ 250,02075.00% x 7.95% = 5.96% 6.48% x $1,350000 = $87,48018.52% x 7.50% = 1.39% $1,350,000 $1,012,500 x 7.95% = $ 80,494 5.96% + 1.39% = 7.35% $ 250,020 x 7.50% = $ 18,752 8.74% - 7.35% = 1.39% $87,480 x 21.45% = $ 18,764 1.39% / 6.48% = 21.45% $118,010 103