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Delivering Alternative Investments to the Broker-Dealer Community
Key Themes as of Q1 2009CRE Fundamentals dramatically weaker across most major property segments and markets
Price declines of 35%-45% (or more) expected, exceeding those of early 1990sRent declines and vacancy rates may approach those of the early 1990sCurrent downturn is recessionary demand induced versus over-supply induced downturn of early 1990
Conduit collateral performance deteriorating at historically fast paceTotal delinquency rate close to 2003 peak, and likely to exceed 3.5% by year-endMay reach 6% by 2010 (peak delinquency rates in early 1990s were 6%-7%)
However, by far the greatest risk facing CMBS is maturity default/extension risk, not term default risk
Large percentage of CMBS loans made in 2005-2008 will not qualify for refinancing without substantial equity injections due to:
Much tighter underwriting standardsMassive price declinesDeclining cash flow
Source: Deutsche Bank
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Key Themes (cont)Government programs needed to avoid hundreds of billions of dollars of distressed CRE hitting the market and perpetuating a downward spiral on CRE Prices
Damage to bank portfoliosDamage to insurance company portfoliosOther financial institutions
TALF and PPIPLegacy AAA CMBS bonds to be added to TALF (financial details sketchy)Expect AAA spreads to tighten and cash synthetic basis to compress
How bad it gets in CRE depends on how bad the economy gets
Source: Deutsche Bank
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How Did We Get Here? – Shadow Banking System Failure
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Depositors
Commercial Banks,Saving
Institutions,Credit Unions
Residential Mortgages
Consumer Credit
Commercial Mortgages
C&I Loans
Asset-Backed
Conduits
Finance Companies
RMBS
ABS
CMBS
CLO
CDOs:High-Grade,Mezzanine,
Synthetic
Money Market
Repo Market
SIVs
Broker-Dealers
Hedge Funds
Pension Funds,
Insurance Cos
The Traditional Banking SystemLoans are largely funded by deposits
The Shadow Banking SystemOriginated loans are pooled and their cash flows and risks are traced and distributed to
a wide range of investors, many of whom use short –term funding to invest in them
• Securitization did not spread risk and the sub-prime housing debacle became a catalyst for the financial crisis as liquidity fled the market driving down asset values
Sources: Zandi, Financial Shock 2008
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How the Shadow Banking System Failure Lead to the Beginning of a Downturn in Commercial Real
EstateCMBS market froze as investors hurt by sub-prime exposure fled to the sidelines
Banks hit hard by asset write-downs shut down conduit lending operations
As financing became increasingly difficult for Commercial Real Estate owners, the volume of acquisitions came to an almost virtual halt
When broader credit froze, and the economy declined, negotiating power shifted from the landlords to the tenants, and sellers to buyers
Previously loose underwriting standards got a sober awakening as rental growth needed to support amortizing loan payments (often after interest only periods) never materialized, causing loan delinquencies, reduced returns and weakened balance sheets
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Commercial Real Estate: It’s the RTC Days But Worse
Value declines most likely will exceed those of the early 1990’s Analysts are currently predicting 35%-55% price/value declines Substantial decreases in rents and occupancies projected as commercial real
estate catches up to the rest of the economic downturn Low demand with excess supply is likely to continue well into 2010 and possibly
2011
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Source: Deutsche Bank Commercial Real Estate Outlook March 2009
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Commercial Real Estate: It’s the RTC Days But Worse
Value declines most likely will exceed those of the early 1990’s Analysts are currently predicting 35%-55% price/value declines Substantial decreases in rents and occupancies projected as commercial real
estate catches up to the rest of the economic downturn Low demand with excess supply is likely to continue well into 2010 and possibly
2011
Delinquency rates on commercial real estate debt is rising rapidly Total delinquency rate likely to be 3.5% by the end of 2009 and possibly 6% by
2010
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Source: Deutsche Bank Commercial Real Estate Outlook March 2009
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Commercial Real Estate: It’s the RTC Days But Worse
Value declines most likely will exceed those of the early 1990’s Analysts are currently predicting 35%-55% price/value declines Substantial decreases in rents and occupancies projected as commercial real estate
catches up to the rest of the economic downturn Low demand with excess supply is likely to continue well into 2010 and possibly 2011
Delinquency rates on commercial real estate debt is rising rapidly Total delinquency rate likely to be 3.5% by the end of 2009 and possibly 6% by 2010
Greatest risk facing Borrowers is inability to satisfy loans at maturity Large % of loans made in 2005/2008 will not qualify for refinancing without substantial
equity injections due to: Much tighter underwriting standards Massive price declines Declining cash flows/debt service coverage ratios
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Source: Deutsche Bank Commercial Real Estate Outlook March 2009
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Why it is Just Starting to Get Bad, and Going to Get Worse
The lag from unemploymentOn a year over year basis, U.S. non-farm payrolls have fallen over 2%Many expect continued retraction in US Economy until middle to late 2009Labor Market, which lags behind the broader economy, is expected to contract until late 2010The correlation of payroll growth to absorption in commercial real estate indicates that commercial real estate will continue to see a decline well into 2010, and possibly early 2011
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Year-over-Year % Change in Non-Farm Payrolls (NFP) Vs. % Net Absorption
Source: Barclays Capital Dec. 08
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30-day and 60-day delinquency rates up 300% to 400% in 6 monthsExpected aggregate delinquency rate will be in excess of 3.5% by end of 2009 and 5-6% by late 2010
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Monthly delinquencies are at a historic highTotal dollar amount of delinquent loans has grown by an average of 22% per month since October 2008
Sources: Deutsche Bank March 2009; Intex; Trepp
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As property prices continue to decline, more vintages will face refinancing
issues
Price declines that have already taken place may pose significant problems for 2006 and 2007 loans that mature during the 2011-2012 periodFurther price declines would likely create significant problems for earlier vintages
Price Decline from October 2007 Peak
12%24%37%41%
Takes Prices Back To:
Early 2006Early 2005Early 2004Early 2003
Source: Deutsche Bank
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For loans maturing through 2012, even lenient underwriting requirements imply the majority (56.8%) of loans will not qualifyOut of $154.5 billion of maturing loans, $87.7 billion do no qualifyOffice and multifamily are most severely impacted segments
Source: Intex, Trepp
Property Type # Loans
Balance($BB)
# Defaulted
Loans
Defaulted Balance ($BB)
% Not Qualifying
(Count)
% Not Qualifying (Balance)
Hotel 475 7.4 183 3.9 38.5 52.8
Industrial 1,189 5.8 356 2.1 29.9 36.4
Multifamily 3,793 24.4 1,959 16.5 51.6 67.5
Office 2,629 40.9 1,196 27.1 45.5 66.3
Retail 4,156 44.6 1,612 22.7 38.8 50.8
Multi Propetry 672 22.0 249 10.4 37.1 47.2
Other 1,545 9.4 513 5.1 33.2 54.0
Aggregate 14,459 154.5 6,068 87.7 42.0 56.8
Loans Maturing 2009 – 2012
Refinancing Requirement: LTV < 80%
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For loans maturing through 2012, conservative refinancing assumptions imply approximately two-thirds of maturing loans will not qualify for refinancingFewer than 25% of multifamily loans and 25% of office loans qualify under this scenario
Source: Intex, Trepp
Property Type # Loans
Balance($BB)
# Defaulted
Loans
Defaulted Balance ($BB)
% Not Qualifying
(Count)
% Not Qualifying (Balance)
Hotel 475 7.4 200 4.2 42.1 57.3
Industrial 1,189 5.8 438 2.7 36.8 45.8
Multifamily 3,793 24.4 2,170 18.4 57.2 75.2
Office 2,629 40.9 1,459 31.0 55.5 75.7
Retail 4,156 44.6 2,181 28.5 52.5 64.0
Multi Propetry 672 22.0 300 11.9 44.6 54.1
Other 1,545 9.4 667 5.9 43.2 62.5
Aggregate 14,459 154.5 7,415 87.7 51.3 66.4
Loans Maturing 2009 – 2012
Refinancing Requirement: LTV < 70%
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These estimates are regarded as lower bounds because of the following factors
PPR NOI projections are optimistic The minimum LTV is more likely to be in the 60%-65% range, NOT 70%These estimates are imposing only value (LTV) constraints, not cash flow coverage constraints (DSCR)
In imposing DSCR constraints, need to take account of much higher financing costs relative to financing costs of existing loansDSCR constraints would likely result in vastly more loans failing to qualify for refinancing.
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This recession has created tremendous opportunities to invest in real estate.
No competitive real estate marketInability to refinance many propertiesQuality off-market, distressed-owner propertiesReal Estate has consistently been a top performer
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Private Real Estate Has PerformedPrivate Real Estate Has PerformedPrivate Real Estate - compared to Public Real Estate, Stocks and Bonds – has provided the highest average returns over the past 3, 5 and 10 year periods.
Source: National Council of Real Estate Investment Fiduciaries. The chart above shows the average returns of different investments. Each of the respective investments possess different features, including investors’ expectations, investment objectives, risks, costs and expenses, liquidity, safety, guarantees or insurance, fluctuation of principal, returns (if any), and tax features, which must be considered when evaluating the performance of such investments. The index returns are shown for illustrative purposes only, you cannot invest in directly in an index. Past performance is no guarantee of future results.
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* Chart Benchmarks: Direct real estate is represented by the Transactions-Based Index of Institutional Commercial Property Investment Performance (TBI) from the MIT Center for Real Estate. REITs are represented by the FTSE NAREIT Equity REIT Index, large cap stocks are represented by the S&P 500, small cap stocks are represented by the performance of the Dimensional fund Advisors, Inc. (DFA) United States Micro Cap Portfolio, and international stocks are represented by the Morgan Stanley Capital International Europe, Australasia, and Far East.(EAFE) index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
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Small CAP Stocks(Russell 2000) 0.26 0.64 0.80 1.00
Int’L Stocks(MSCI) 0.21 0.44 0.74 0.59 1.00
* Chart Benchmarks: Direct real estate is represented by the Transactions-Based Index of Institutional Commercial Property Investment Performance (TBI) from the MIT Center for Real Estate. REITs are represented by the FTSE NAREIT Equity REIT Index, large cap stocks are represented by the S&P 500, small cap stocks are represented by the performance of the Dimensional fund Advisors, Inc. (DFA) United States Micro Cap Portfolio, and international stocks are represented by the Morgan Stanley Capital International Europe, Australasia, and Far East.(EAFE) index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
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Real Estate may be able to Lower Risk and Increase Returns
Hypothetical Portfolio Allocation 1989-2008
0
50%40%
10%
45%
10%10%
35%
40%
10%
20%
30%
WITH NO REAL ESTATE HOLDINGS
WITH 10% REAL ESTATE HOLDINGS
WITH 20% REAL ESTATE HOLDINGS
Return 8.3%Risk 8.2%
Return 8.4%Risk 7.6%
Return 8.5%Risk 7.1%
Source: Morningstar (Data as of 12/31/08 – This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. Stocks are represented by the S&P 500, which is an unmanaged group of securities and considered to be representative of the stock market in general. Bonds are represented by the 5-yr US Govt. Bond, Treasury bills by the 30-day US Treasury bill, and direct real estate by the Transactions-Based Index of Institutional Commercial Property Investment Performance (TBI) from the MIT Center for Real Estate. The average return and risk are represented by the arithmetic average return and standard deviation respectively. Standard deviation measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability and thus risk of the investment returns.
Stocks
Bonds
T-Bills
Real Estate
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We do not know what the future holds. We learn from the past and apply key learning to future investing. Real estate is predicated on population growth and demographic trendsEach sector benefits variously to:
overall population growthemployment growthdemographic changes infrastructure developments.
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Consider, that current valuations may not provide for an accurate reflection of overall asset values and where we are in the cycle.
This is similar to the cycle during the 1990's, when there were huge price drops at the bottom of the market, but on very low volume. At the very “bottom” of the market, transactional velocity was at a standstill and it was nearly impossible to find “market bottom” assets to buy.
It was also the same in the stock market in March 2009, when the Dow hit of low of 6,443. At that moment, everyone had lost a ton of money on paper, but it quickly rebounded, as buyers re-entered the market. Just three weeks later the market was at 7,924 (up 23% from its low) and by June it was above 9,000 (up 40%).
In both cases, those investors who waited for the “bottom” of the market may have missed it. And, since market data often has a significant lag, investors not only missed the bottom, but much of the trough of the cycle.
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Prices are down, but they aren't inherently what they appear and the perception of opportunity may be skewed.
When are we in the "bottom" of the market? Who is to say that we aren't in it now?
Some data suggests increased volume and a slowing of price declines.
With huge money on the sidelines starting to come into the market, massive funds and REITs having to invest, TARP and other government assistance, a recovering economy, potential inflation, supply constraints, etc, combined with banks who are doing everything not to take assets back, it is possible that the meltdown in commercial real estate make not be as pronounced as the media suggests, and that the very low prices will be short lived and on small volume.
What will hundreds of billions of dollars slated for "opportunistic" investment do to prices, when there is a relatively limited supply?
Negative factors include lack of accessible credit, delinquencies and defaults, the disconnect between buyers and sellers, economic pressures, and investor sentiment.
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Many indicators suggest that we are near the “bottom” of the cycle and that prices will stabilize and slightly rebound in early 2010.
Prices may stay down for a while, but as credit loosen up, the economy improves, and the large cache of funds is released on the market, values will rise. This will be positively impacted by inflation and the lack of new supply on the horizon.
Those who wait for news that he market has bottomed will have missed much of the opportunity.
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Implement portfolio constraints to maximize cash flow•Allocate by property types and asset classes (Loans & Property)
•Allocation of Equity•Investment Timeline & Holding Period
Hold to Stabilize & Reposition/Exploit Market Conditions •Sell into up cycles•Repositioning / Renovations•Bail out Distressed Owners/Lenders•Supply “gap” equity to venture partners
•Hold through down cycles•Strong Asset Management•Aggressive Management
We take a 360 degree view of real estate, and then narrow in on two of our primary targets, preservation of investor capital and cash flow. Our tools are due diligence, risk management and portfolio allocation. Important to this investment approach are:
1. Property Segment Analysis
2. Rent Roll/Tenant AnalysisRollover timeline and tenant baseTenant interviews and market presence are key to assessing income stability
3. Economic, Market and Submarket AnalysisBroader economy sings the chorus while local economy sings the lead Focus on data; bottom up, quantitative approach
4. Rigorous Due Diligence and UnderwritingSite visits, tenant interviews, local market presence, experienced due diligence teamProperty condition, environmental, and energy efficiencyStress testing multiple scenariosLeverage, financing terms, capital costs, tenanting costs
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Exploit Changing Market Conditions & Achieve Capital Gains
Without straying from our focus on capital preservation and cash flow, we are well aware that some of the most intriguing returns in real estate are provided by focusing on capital gains through value appreciation. To take advantage of this opportunity we overlay additional investment approaches:
1. Assessment of unique market characteristicsNeighborhoods in transitionCatalyst events that trigger an upside situation in a submarket or micro-marketMarket presence, expertise and experienced partners are key to finding opportunities
Delivering Alternative Investments to the Broker-Dealer Community
Exploit Changing Market Conditions & Achieve Capital Gains
Without straying from our focus on capital preservation and cash flow, we are well aware that some of the most intriguing returns in real estate are provided by focusing on capital gains through value appreciation. To take advantage of this opportunity we overlay additional investment approaches:
1. Assessment of unique market characteristicsNeighborhoods in transitionCatalyst events that trigger an upside situation in a submarket or micro-marketMarket presence, expertise and experienced partners are key to finding opportunities
2. Implementation of portfolio constraints aimed at maintaining portfolio cash flow
Allocation of Equity (analyzing investment dollars and aggregation of cash flows)Investment timeline and holding period
Delivering Alternative Investments to the Broker-Dealer Community
Exploit Changing Market Conditions & Achieve Capital Gains
Without straying from our focus on capital preservation and cash flow, we are well aware that some of the most intriguing returns in real estate are provided by focusing on capital gains through value appreciation. To take advantage of this opportunity we overlay additional investment approaches:
1. Assessment of unique market characteristicsNeighborhoods in transitionCatalyst events that trigger an upside situation in a submarket or micro-marketMarket presence, expertise and experienced partners are key to finding opportunities
2. Implementation of portfolio constraints aimed at maintaining portfolio cash flow
Allocation of Equity (analyzing investment dollars and aggregation of cash flows)Investment timeline and holding period
3. Strategies aimed at adapting to various market conditions that drive opportunities
Renovations, repositioning, aggressive management and other value added strategiesGreening retrofits and renovations aimed at reducing exposure to rising energy costs and retaining tenants who want, or are required to be in, green buildingsBailing out distressed owners/managers/lendersProviding gap (later stage) equity to venture partners to enable completion of acquisitions and projects
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