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
Real Estate Investments
Real Estate Risks Real Estate Investment Vehicles
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
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
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
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
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
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
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
premium - Real g = cap rate P/R
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
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
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
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
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
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
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
National CPPI Indices
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
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
33
Supply and Demand
34
Supply and Demand
35
Supply and Demand
36
Supply and Demand
37
Supply and Demand
38
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
39
Real Estate Investments
Real Estate Risks Real Estate Investment Vehicles
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
Shadow Portfolio Coefficient
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
S&P 500, Termstructure
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
REIT vs. Shadow Portfolio
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
Shadow Portfolio Coefficient
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
S&P 500, Termstructure
Credit Spread
Termstructure
Wilshire 2000
Nasdaq
Dow Jones
S&P 500
Alone
Bold, italicized numbers are statistically significant
52
REIT vs. Shadow Portfolio
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
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
Alone
Bold, italicized numbers are statistically significant
53
REIT vs. Shadow Portfolio
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
Shadow Portfolio Coefficient
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
S&P 500, Termstructure
Credit Spread
Termstructure
Wilshire 2000
Nasdaq
Dow Jones
S&P 500
Alone
Bold, italicized numbers are statistically significant
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
Real Estate Investments
Real Estate Risks Real Estate Investment Vehicles
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
National CPPI Indices
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
Real Estate Investments
Real Estate Risks Real Estate Investment Vehicles