1 Commercial Real Estate Risk and Opportunities. Real Estate Capitalization Comparisons Source: U.S....

1

Commercial Real EstateRisk and Opportunities

Real Estate Capitalization Comparisons

Source: U.S. Federal Reserve, Flow of Funds, Table B100, B102 and L4

Market Value (in $USD billions) 2007 2011 Q4 2012 Q3 2012 Q3 (%)

U.S. Real Estate (Equity and Debt) 23485.8 18296.9 19450.7 32.31

U.S. Corporate (Equity and Debt) 22842.4 22513.1 24820.5 41.23

U.S. Government Securities 10312.6 15116.9 15932.1 26.46

32.31%

41.23%

26.46%

3

“Risk” and return of various investments

Table 2. Summary Statistics of Asset Returns: 1990 – 2012

NCREIF NAREIT 3-M Treas Yield. 10-Yr. Treas Yield. S&P

Avg. Return (E[R]): 7.87% 12.30% 3.30% 7.48% 10.11%

Variance (Sigma^2): 0.81% 4.19% 0.05% 0.82% 3.35%

Risk (Sigma): 9.01% 20.48% 2.18% 9.08% 18.30%

Why do the NCREIF and NAREIT have similar average returns,

yet wildly different standard deviations?

REIT Performance

4

1989 1994 1999 2004 2009 2014$0.00

$100.00

$200.00

$300.00

$400.00

$500.00

$600.00

$700.00

$800.00

$900.00

$1,000.00

S&P

NAREIT

Source: Yearly NAREIT/Standard & Poor

Calibrated to Jan 1990 = 100

5

Recent REIT Performance

4/28/2007 9/9/2008 1/22/2010 6/6/2011 10/18/20120

0.2

0.4

0.6

0.8

1

1.2

1.4

HYG US EquityLQD FNERS&P 500REIT Index

Systematic Risk of Real Estate

Important point: not all real estate is alike Estimated betas across property types, using 1980-

2011 return dataHotels: 1.2 (0.09)

Regional Malls: 1.0 (0.09)

All Equity REITs: 0.9 (0.05)

Office & Industrial: 0.8 (0.12)

Multifamily: 0.5 (0.09) Why do these differ?

7

Real Estate Investments

Real Estate Risks Real Estate Investment Vehicles

8



9

Real Estate Investment Risks

Real Estate Risks Asset pricing fundamentals

High sensitivity to interest rates Especially in high-growth markets

No longer insulated from world capital markets Priced as if no risk

Credit shortages Demand/supply fundamentals

Overbuilding leads to cycles Real Estate Investment Vehicles

10







11

Expected Core Real Estate Returns

Real Rf 1.7 percent

β 0.8 (offices)

Equity risk premium 4.0 percent

Liquidity premium 2.0 percent

Expected rent growth (g) 0.0 percent

Yield (cap rate) 1.7 + 0.8*4.0 + 2.0 - 0.0 = 6.9

Multiple (1/yield) 14.5

12

Lower real interest rates raise asset prices

Since P/R is approximately 1/cap rate, prices rise when interest rates fall

Real Rf+ Risk

premium - Real g = cap rate P/R

City 1 3.7% 5.2% 0% 8.9% 11.2

City 1 2.7% 5.2% 0% 7.9% 12.7

13

Asset prices are more sensitive tointerest rate changes when rates are low As interest rates fall, each successive decline has a

larger percentage effect on a lower base Leads to an accelerating effect of falling interest rates And a cooling effect of rising real rates

Real Rf+ Risk


City 1 3.7% 5.2% 0% 8.9% 11.2

City 1 2.7% 5.2% 0% 7.9% 12.7

City 1 1.7% 5.2% 0% 6.9% 14.5

14

US Treasury Yield

2/27/1988

11/23/1990

8/19/1993

5/15/19962/9/1999

11/5/20018/1/2004

4/28/2007

1/22/2010

10/18/2012

0

1

2

3

4

5

6

7

8

9

10

1-Yr

5-Yr

10-Yr

US Daily Treasury Yield, 1990 – Feb 2013

15







16

High rent-growth cities (the coasts)have lower cap rates

Future growth in rents reduces required cash yield Generates more volatility in hot markets Assuming risk is the same

Real Rf+ Risk


City 1 3.7% 5.2% 0% 8.9% 11.2

City 1 1.7% 5.2% 0% 6.9% 14.5

City 2 3.7% 5.2% 3% 5.9% 16.9

City 2 1.7% 5.2% 3% 3.9% 25.6

17







18

0

5

10

15

20

25

30

35

2002 2003 2004 2005 2006 2007

Bill

ions

Other

Latin America

Euro

Pac Rim

Canada

UK

Australia

Mid East

German

Foreign Acquisitions of US Property(trailing 12 months, office, industrial, apartment, retail properties)

Source: Real Capital Analytics, January 2008 rcanalytics.com

19







20

21

...not just in the US

Office Prices ($/Sq. Ft.)

$621

$324

$1,081

$641 $627

Office Cap Rates

4.8%

6.6%

4.8%

5.3%

4.3%

Source: Real Capital Analytics, January 2008– rcanalytics.com

22

Subordination levels over time

Source: Moodys; Christopher Mayer

23

CMBS has brought cheaper debt to real estate: CMBS spreads have fallen since 2001

Source: Bear Stearns, CMBS alert

24

CMBS Issuance

Source: Bloomberg

National CPPI Indices

25

Source: Real Capital Analytics, Geltner & Associates

26

Real estate never goes down

CNBC Interview with Ben Bernanke July 1, 2005: When asked about a housing bubble Bernanke responded: Well, I guess I don't buy your premise. It's a pretty unlikely possibility. We've never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don't think it‘s gonna drive the economy too far from its full employment path, though.”

27







28

…. and then increased sharply

Source: www.crenews.com

1/14/2004

5/28/2005

10/10/2006

2/22/2008

7/6/2009

11/18/2010

4/1/2012

8/14/20130

500

1000

1500

2000

2500

3000

3500

CMBSAAASCMBSAAAJCMBSAAAM

Historical CMBS Issuance

29

19871988

19891990

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20130

50

100

150

200

250

300

All USAll Non-US

30

NCREIF Cap Rates


31

Source: Bloomberg

12/6/1999

4/19/2001

9/1/2002

1/14/2004

5/28/2005

10/10/2006

2/22/2008

7/6/2009

11/18/2010

4/1/2012

8/14/20130.8

1

1.2

1.4

1.6

1.8

2

CPPI - National OfficeCPPI National All - PropertyCPPI - National IndustrialMoodys/RCA CPPI National All-PropertyCPPI - National Apartments

32







33

Supply and Demand

34

Supply and Demand

35

Supply and Demand

36

Supply and Demand

37

Supply and Demand

38







39



REIT CMBS

40

Real Estate Investment Trusts (REITs) Overview

Real Estate Investment Trusts Publicly-traded real estate company Creation of the Internal Revenue Code Typically owner-operators of income-producing

properties (Equity REITs) Also:

Mortgage Hybrid Health care, etc.

41

Real Estate Investment Trusts (REITs) Overview

Goal: to enable small investors to invest in real estate Mimics favorable features of partnerships

Pass-through entity Single level of taxation (shareholder only)

42

REIT Operating Restrictions

REITs do not pay taxes at the corporate level, but…

75%+ of assets must be invested in real estate assets, cash, or government securities Other REIT shares are considered real estate assets

75%+ of gross income must be derived from rents, mortgage interest, or gains from the sale of real estate Can have taxable REIT subsidiaries

90%+ of GAAP taxable income must be distributed annually to shareholders

43

Growth of REIT Market Capitalization

Source: NAREIT

*Data through Dec 31, 2011

1980 1985 1990 1995 2000 2005 20100.00

100,000.00

200,000.00

300,000.00

400,000.00

500,000.00

600,000.00

700,000.00

ALL REITS

Equity REITs

REIT Market Capitalization ($Millions), 1980-2012

REIT Performance

44

Recent Performance - NAREIT

45

Investment Performance by Property Sector and Subsector

FTSE NAREIT

Sector Feb 2013 Total Return(%) 1Y Total Return(%) Dividend Yield (%) Market Cap

All Equity REITs 0.45 14.44 3.31 573.34B

Equity REITs 0.48 12.87 3.58 480.43B

Industrial/Office 0.9 12.01 3.27 98.06B

Retail 0.1 17.7 3.31 148.36B

Residential 0.2927 1.99 3.25 80.37B

Diversified -1.89 3.47 4.52 41.79B

Mortgage REITs 1.0294 8.87 12.17 69.59B

REITS in S&P 500 MKT CAP in $MM(Oct, 2012)

Date in S&P500

AIMCO $2,846 1/17/1905AvalonBay Communities $9,893 4/29/1918Boston Properties $13,060 9,139.00Equity Residential $16,980 11/21/1925HCP, Inc. $19,510 7/16/1924Health Care REIT Inc. $12,816 12/31/1913Host Hotels & Resorts $11,296 8/24/1920Kimco Realty Corporation $8,255 5,661.00Plum Creek Timber, Inc. $6,881 10/29/1916ProLogis $6,880 9/30/1917Public Storage, Inc. $23,880 12,609.00Simon Property Group $46,378 22,772.00Ventas, Inc. $18,642 5,911.00Vornado Realty Trust $14,762 8/28/1931

14 REITs in the S&P(Constituent Information as of October, 2012)

47

REITs and Real Estate exposure

Estimate linear regression of return on REITs as a function of stock and real estate market returns Plus various control variables

, ,

, , , ,

( )

[ ( ) ] [ ( ) ]

i t F t

i t F t i t F t

R REIT R

R RE R R Stock R

REIT i return, year t

Stock market return, year t

Real estate shadow portfolio return for REIT i,

year t

Risk-free rate, year t

48

REIT vs. Shadow Portfolio

Office

0.33

0.21

0.26

0.16

0.19

0.2

0.3

0.22

0.2

0.22

0.18

0.23

0.17

0 0.05 0.1 0.15 0.2 0.25 0.3 0.35

Shadow Portfolio Coefficient

S&P 500, Termstructure, Core CPI, Growth in IndustrialProduction

S&P 500, Termstructure, Inflation, Growth in IndustrialProduction

S&P 500, Termstructure, Core CPI, Growth in Production,Exchange Rate, Growth in Industrial Production

S&P 500, Termstructure, Growth in Production, ExchangeRate, Inflation, Growth in Industrial Production

S&P 500, Credit Spread

S&P 500, Termstructure

Credit Spread

Termstructure

Wilshire 2000

Nasdaq

Dow Jones

S&P 500

AloneBold, italicized numbers are statistically significant

49

-0.14

-0.16

-0.17

-0.13

-0.16

0.09

0.08

0.11

0.03

0.17

0.31

0.1

0.32

-0.2 -0.1 0 0.1 0.2 0.3 0.4


OfficeS&P 500, Termstructure, Core CPI, Growth in Industrial Production

S&P 500, Termstructure, Inflation, Growth in Industrial Production

S&P 500, Termstructure, Core CPI, Growth in Production, Exchange Rate, Growth in Industrial ProductionS&P 500, Termstructure, Growth in Production, Exchange Rate, Inflation, Growth in Industrial ProductionS&P 500, Credit Spread


Credit Spread

Termstructure

Wilshire 2000

Nasdaq

Dow Jones

S&P 500

AloneBold, italicized numbers are statistically significant

Dependent Variable: Change in NAV

50

Dependent Variable: Unlevered REIT (lagged) – Risk-free rate

Bold, italicized numbers are statistically significant

51


Retail

0.38

0.23

0.29

0.27

0.22

0.04

0.36

0.04

0.21

0.02

-0.15

0.03

0.11

-0.2 -0.1 0 0.1 0.2 0.3 0.4 0.5


S&P 500, Termstructure, Core CPI, Growth inIndustrial Production

S&P 500, Termstructure, Inflation, Growth inIndustrial Production

S&P 500, Termstructure, Core CPI, Growth inProduction, Exchange Rate, Growth in IndustrialProductionS&P 500, Termstructure, Growth in Production,Exchange Rate, Inflation, Growth in IndustrialProductionS&P 500, Credit Spread


Credit Spread

Termstructure

Wilshire 2000

Nasdaq

Dow Jones

S&P 500

Alone


52


Apartment

0

-0.12

-0.04

-0.13

-0.13

-0.21

-0.01

-0.17

-0.12

0.02

-0.08

-0.19

-0.14

-0.25 -0.2 -0.15 -0.1 -0.05 0 0.05


S&P 500, Termstructure, Core CPI, Growth in IndustrialProduction

S&P 500, Termstructure, Inflation, Growth in IndustrialProduction

S&P 500, Termstructure, Core CPI, Growth in Production,Exchange Rate, Growth in Industrial Production

S&P 500, Termstructure, Growth in Production, ExchangeRate, Inflation, Growth in Industrial Production

S&P 500, Credit Spread


Credit Spread

Termstructure

Wilshire 2000

Nasdaq

Dow Jones

S&P 500

Alone


53


Industrial

0.35

0.23

0.28

0.29

0.23

0.15

0.36

0.13

0.46

0.51

0.31

0.22

0.27

0 0.1 0.2 0.3 0.4 0.5 0.6


S&P 500, Termstructure, Core CPI, Growth inIndustrial Production

S&P 500, Termstructure, Inflation, Growth inIndustrial Production

S&P 500, Termstructure, Core CPI, Growth inProduction, Exchange Rate, Growth in IndustrialProductionS&P 500, Termstructure, Growth in Production,Exchange Rate, Inflation, Growth in IndustrialProductionS&P 500, Credit Spread


Credit Spread

Termstructure

Wilshire 2000

Nasdaq

Dow Jones

S&P 500

Alone


54

International Evidence

Dependent Variable is REIT return

Parameter t - statistic

Intercept 8.0 1.65

Local stock market return .35 2.6

Local real estate market return .57 1.6

Adjusted R2 .21

55

-5 -4 -3 -2 -1 0 1 2 3 4 5

0.57 (1.6)

2.18 (3.43)

-3.74 (-1.35)

1.85 (1.24)

3.89 (2.02)

0.08 (1.54)

Local Real Estate Market Return

Ireland

Netherlands

Canada

France

United Kingdom

All Markets

Return

T stat in paren-theses

REIT vs. RE Market Return

Parameter on Real Estate Return

56

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5

0.35 (2.6)

0.15 (.37)

0.06 (.18)

1.85 (1.2)

3.89 (-.5)

0.44 (1.08)

Local Stock Market Returns

Ireland

Netherlands

Canada

France

United Kingdom

All Markets

Return

T stat in paren-theses

REIT vs. RE Market Return

Parameter on Stock Market Return

57

REITs should have predicted the decline

0

50

100

150

200

250

12/1/20

00

9/1/200

1

6/1/200

2

3/1/200

3

12/1/20

03

9/1/200

4

6/1/200

5

3/1/200

6

12/1/20

06

9/1/200

7

6/1/200

8

3/1/200

9

BBG REIT APARTMENTINDEX

CPPI APARTMENT

0

50

100

150

200

250

300

350

12/1/20

00

9/1/200

1

6/1/200

2

3/1/200

3

12/1/20

03

9/1/200

4

6/1/200

5

3/1/200

6

12/1/20

06

9/1/200

7

6/1/200

8

3/1/200

9

BBG REIT INDUSTRIALINDX

CPPI INDUSTRIAL INDX

0

50

100

150

200

250

12/1/20

00

9/1/200

1

6/1/200

2

3/1/200

3

12/1/20

03

9/1/200

4

6/1/200

5

3/1/200

6

12/1/20

06

9/1/200

7

6/1/200

8

3/1/200

9

BBG REIT OFFICEPROPERTY

CPPI OFFICE PROPERTY

0

50

100

150

200

250

300

350

400

12/1/20

00

8/1/200

1

4/1/200

2

12/1/20

02

8/1/200

3

4/1/200

4

12/1/20

04

8/1/200

5

4/1/200

6

12/1/20

06

8/1/200

7

4/1/200

8

12/1/20

08

8/1/200

9

BBG REIT RETAILINDEX

CPPI RETAIL

58

REIT Summary

REIT structure trades flexibility for tax savings Low correlation with other asset returns Worth a 5-10 percent asset allocation in a portfolio Locate in tax-advantaged account

REITs provide only limited exposure to the underlying real estate markets!!!

59



REIT CMBS

60

What a MBS Looks Like [Simplified]

Mortgages

Investors(Bond

Holders)

Originator/Pooler

Master Servicer/Trust

Debt Service Bond Payments

Makes Loans

Bond Proceeds

Special Servicer

Rating

61

Borrowers (Mortgagors)

Originators (Sellers)

Depositor (SPV)

Trust (Mortgage

Pool)

Underwriter (Investment Bank)

Investors Divided into

Tranches

Rating Agency

Custodian

Trustee

Master Service

r

Special Servicer

Primary Servicer

Loan Proceeds

Loans

Loans Offering Proceeds

Loans Certificates

Delivery of Loan Documents

Confirmation of Document Delivery

Offering Proceeds

Certificates

Certificates Offering Proceeds

Often purchasers of first class bonds/Controlling Class representative

Pooling and Servicing Agreement

Property Inspection

Monthly P & I

Monthly P & I

Property Inspection

Monthly P & I

Payment on Certificates

(Not Simplified!)

62

Structured Products - CDO

When a tranche gets fully repaid, money flows to the lower tranches

Individual bonds or mortgages

63

Structured Products – CDO2

64

Rating of Structured Products

Mistakes multiply Modest imprecision in default risk estimates can result

in large errors for a structured product

Reduce diversifiable risk but increase systematic risk Holding more structured products does not help

Tailor products to meet the minimum rating requirements No margin for error

65

Credit Default Swaps

Real estate cannot be sold short Solution: securitize equity Solution: securitize debt

CMBS cannot be sold short Solution: CDS

No CDS reserve requirements Solution: require reserves against CDS

66

…. and then increased sharply

Source: www.crenews.com

1/14/2004

5/28/2005

10/10/2006

2/22/2008

7/6/2009

11/18/2010

4/1/2012

8/14/20130

500

1000

1500

2000

2500

3000

3500

CMBSAAASCMBSAAAJCMBSAAAM

Historical CMBS Issuance

67

19871988

19891990

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20130

50

100

150

200

250

300

All USAll Non-US


68

Source: Bloomberg

12/6/1999

4/19/2001

9/1/2002

1/14/2004

5/28/2005

10/10/2006

2/22/2008

7/6/2009

11/18/2010

4/1/2012

8/14/20130.8

1

1.2

1.4

1.6

1.8

2

CPPI - National OfficeCPPI National All - PropertyCPPI - National IndustrialMoodys/RCA CPPI National All-PropertyCPPI - National Apartments

69

Historical CMBS Issuance plus CMBS Maturity – Exhibit 4

Source: Commercial Mortgage Alert and Morningstar

1995 2000 2005 2010 2015 2020$0

$50,000

$100,000

$150,000

$200,000

$250,000

0

2,000

4,000

6,000

8,000

10,000

12,000

Issuance

Maturity (# Loans), (Right Axis)

Maturity ($Mil)

70

How to Securitize Going Forward

The power of markets to aggregate information Standardized and liquid instruments

The ABX index declined in June, 2006, before defaults increased

Transparent instruments and trade reporting requirements

Everybody needs to have “skin in the game” Tie compensation to long-term performance Require sufficient equity at risk

It’s all about INCENTIVES

71



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