cre distress & opportunities presentation 2009 june ucla anderson - green street

8/14/2019 CRE Distress & Opportunities presentation 2009 June UCLA Anderson - Green Street

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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

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.



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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%.



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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


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.



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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.



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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



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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%.


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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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?


13/27


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13


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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% 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.


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.


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.


* 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



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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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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)


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.



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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.)


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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cre distress & opportunities presentation 2009 june ucla anderson - green street

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