Has Anything Changed?

Lessons the Financial Crisis

Should Have Taught Real
Estate Investors & Lenders

Jim Clayton
Vice President, Research
Cornerstone Real Estate Advisers LLC
jclayton@cornerstoneadvisers.com

TABE
September 14, 2010
 Institutional Property Returns Turn Positive
After the Worst Year on Record Property Values Bottoming in 2010 as Investors Begin to
Price the Upside of the Economic Recovery and Capital Returns to the Sector
Quarterly NCREIF Returns, 1978:1-2010:2
8%
Income Return Capital Return Total Return
6%

Painful but quick; from worst

4% quarterly return ever in 4Q08
back to positive territory in
1Q10 as property values
bottom; capital (or
2% appreciation) return turned
positive in 2Q10.

0%

-2%

-4%

-6%

Massive overbuilding
in and a slow write-
-8%
down of property
values

-10%
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: NCREIF

1
 Institutional Real Estate Returns and the Economy
After the Worst Year on Record Property Values Bottoming in 2010 as Investors Begin to
Price the Upside of the Economic Recovery and Capital Returns to the Sector

Unlike in the 1990s, property values adjusted quickly
Real Estate Returns More Tightly Linked to the Business Cycle Today in this down cycle, exhibiting an unprecedented
decline.
Forecast

The sharp drop in real estate returns closely followed
the decline in real GDP during the current downturn.
12 Real GDP Growth** NCREIF Total Returns less Inf lation* 20

The combination of rapid property price write-downs
10

NCREIF Returns less % Change in CPI (4 Quarter Rolling)

15 and the absence of an excess supply overhang
suggest that prices should firm as GDP growth
8
Real Annualized Quarterly GDP Growth (%)

10 resumes; unlike in the early 1990s.

6

Annual returns mask the continued improvement in
5 property valuations that took place during 2009;
4
NCREIF returns remained negative throughout the
2 0 2009 but steadily improved each quarter ultimately
entering positive territory in 1Q10
0 -5 Value Appreciation Drives Strong 2Q10 Returns
-2 (Total Quarterly NCREIF Returns)
-10
4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10
-4
4%
Property returns lagged -15
-6 GDP growth as a result of
2%
massive overbuilding and a
slow write-down of property -20
-8

Quarterly Total Return

values. 0%

-10 -25 -2%

1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
-4%
*4 quarter rolling sum of NCREIF total returns less the percent change in CPI, through 2Q10.
Source: NCREIF
** Actual real GDP figures through 2Q10, forecasts thereafter. -6%
Source: Cornerstone, NCREIF, Bureau of Economic Analysis (BEA) and Economy.com as of 9-7-10.
-8%

-10%

2
Property Values Follow Bond Market with a Lag

Gap Between Property and Bond Pricing (was) Closing

10 Year Treasury Baa Corporate Bond Real Estate (Cap Rate )

10%

9%

8%

7%

6%

5%

4%

3%

2%
2002.01 2003.01 2004.01 2005.01 2006.01 2007.01 2008.01 2009.01 2010:1

Treasury and corporate bond yields are monthly through August 2010. Real estate cap rate is quarterly through 2Q10 and
represents an equally weighted average cap rates from appraised values of properties in the NCREIF index. 3
Sources: Cornerstone Research, NCREIF, and Federal Reserve Board.
NCREIF Transaction Cap Rate & 10 Year Treasury Yield

10 Year Treasury Yield Average Cap Rate

10%

9%

8%

7%

6%

5%

4%

3%

2%
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
 Property Prices are Bottoming
2.3
NCREIF Property Index (NPI)*

2.0 MIT Transaction-Based Index (TBI)

Moody's/REAL Property Price Index

1.8
Indices (Jan. 2002 =1)

1.5

1.3

1.0

0.8
2002 2003 2004 2005 2006 2007 2008 2009 2010

* Denotes equally weighted cash flow based NCREIF appreciation return component.
Notes: NCREIF and TBI are quarterly indices through 2Q10. Moody’s/REAL is a monthly index through June 2010.
Sources: Cornerstone Research based on data from NCREIF, MIT Center for Real Estate and Moody’s Investors Service.

5
REIT Prices Predicted Property Price Floor

2.50 NCREIF Property Index (NPI)

MIT Transaction-Based Index (TBI)

2.25
Moody's/REAL Property Price Index

2.00 NAREIT Equity REIT Price Index

Indices (Jan. 2002 =1)

1.75

1.50

1.25

1.00

0.75

0.50
2002 2003 2004 2005 2006 2007 2008 2009 2010

* Denotes equally weighted cash flow based NCREIF appreciation return component.
Notes: NCREIF and TBI are quarterly indices through 2Q10. Moody’s/REAL is a monthly index through June 2010.
Sources: Cornerstone Research based on data from NCREIF, MIT Center for Real Estate and Moody’s Investors Service.
6
 AND … Aggregate Indices Mask Market Bifurcation

Distressed Property Sales Weigh On Moody’s/REAL Index

Institutional investors are currently focused on core assets
with strong cash flow. Competition for the bond-like
characteristics of well leased core property, in the face of
Since October 2007 Peak: limited product offered for sale, is putting strong upward
200 Moody's/REAL CPPI -41% pressure on prices.
190 "Healthy" Properties Index -34%
Distressed Properties Index -56%
The prices of properties facing financial distress and
180 values of properties with riskier cash flow profiles (e.g.
170 vacancy risk) are being discounted. A version of the
Moody’s/REAL CPPI based only on non-distressed or
160 “healthy” properties is up almost 3% year-to-date, while the
150 overall index is essentially flat due to a nearly equivalent
Widening gap in pricing
between distressed and drop in prices of distressed assets. The extent of
140 appreciation in values of properties in the NCREIF index
non-distressed
130
depends crucially on current vacancy.

120
Year to date % change through June
110 Distressed Properties
Moody’s/REAL NCREIF Property
100 Healthy Properties Commercial Property Index Capital
90 4% Price Index
CPPI Return
80 3%
2.99%
70
Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10
2% 2.44%

1%
The Moody’s/REAL Index (CPPI) is the published monthly aggregate index derived from repeat sales Vacancy
(i.e. matched pairs) of properties. The “Distressed Property Index” is derived from only sales of Distressed > 10%
properties classified by Real Capital Analytics (RCA) as distressed in the firm’s Troubled Asset Radar 0%
Healthy Vacancy -0.86%
product. Distress refers to properties that have debt related issues including default, transfer to CMBS < 10%
special servicer and sponsor bankruptcy. “Healthy Properties” for the purpose of this chart are those not -1%
classified as distressed. Data through June 2010.
-2%
Source: Geltner Associates LLC based on data provided by Real Capital Analytics (RCA). -2.72%
-3%
So urce: Co rnersto ne Research, M o o dy's, Geltner A ssociates and NCREIF.

7
Vacancy Appears to Have Peaked in the NCREIF Property
Index Portfolio …
 Broader Market Vacancy and Unemployment
Historical and forecast vacancy rate by property sector follows US
unemployment

Unemployment, currently 9.7%, is expected

20 FORECAST to rise over the next two quarters and peak
near 10% in late 2010 as job growth
reawakens and discouraged workers re-
enter the workforce

Apartment vacancy continues to improve

15 reflecting pent up renter demand as
OFFICE household formation rates pick up in
concert with hiring, and supply growth
subsides
INDUSTRIAL
Vacancy %

Industrial demand will soon reflect

10 RETAIL increased export activity and
manufacturing in some markets, and
broader improvement will become apparent
with increasing foreign trade and consumer
UNEMPLOYMENT spending in 2011
5

Retail vacancy rates will remain elevated
APARTMENTS into 2011 as stressed chains consolidate
storefronts and stronger players move to
capture dominant locations

0
Office vacancy is peaking ahead of

expectations because of limited supply and
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 increasing demand. The recovery in office
rents will be more muted, however.

Source: CBRE-EA Summer 2010 Outlook, Cornerstone Research 7-13-2010

9
Stress Remains … it is a lackluster, fragile recovery
 AAA CMBS Pricing Improves Dramatically …

1,600 8,000

AAA CMBS (10 Year Super Senior)

1,400 7,000

Baa Corporate (7-10 Year)

AAA CMBS & Baa Corp. Spreads (bps)

1,200 6,000
BBB CMBS (10 Year)

BBB CMBS Spreads (bps)

1,000 5,000

800 4,000

600 3,000

400 2,000

200 1,000

0 0
07 07 07 07 07 08 08 08 08 09 09 09 09 10 10 10
/ 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20
1/
5 30 22 14 /7 29 23 15 /7 30 24 17 /9 1/
1 26 18
3/ 6/ 9/ 12 2/ 5/ 8/ 11 1/ 4/ 7/ 10 3/ 6/
Transfer of CMBS Loans into Special Servicing Continues

11.3% of CMBS
Loan Balance
Maturity/Balloon Risk & “Equity Gap” a Concern
(Slow) Return of CMBS …

DDR TALF CMBS Deal Nov-09

Pricing Swap
Class Rating $Am ount Subord. (ytm) Spread
A AAA 323.5 19.3% 3.8% 1.40%
B AA 41.5 8.8% 5.8% na
C A 35 0.0% 6.3% na
400

weighted average yield 4.22%

spread to 5 yr Treasury 2.09%

5yr Treasury 2.13%

5yr Swap 2.48%
spread 0.35%
 Credit rating & CMBS structure... A Real 2005 CMBS Deal
Morgan Stanley Capital I Trust, 2005-IQ10

Amount Rating Rating Subord. Coupon Dollar Yield Avg. Life Spread
Class ($Mil) (Moody's) (S&P) (%) (%) Price (%) (Years) (bp)
A-1 75.150 Aaa AAA 20.00 4.914 100.249 4.801 2.99 S+10
A-1A 231.768 Aaa AAA 20.00 8.68
Multiple A-2 50.000 Aaa AAA 20.00 5.126 100.549 5.007 4.97 S+23
AAA A-3-1FL 75.000 Aaa AAA 20.00 L+24 100.000 6.47 L+24
A-3-1 78.000 Aaa AAA 20.00 5.251 100.547 5.169 6.47 S+35
tranches A-3-2 50.000 Aaa AAA 20.00 5.253 100.545 5.175 6.66 S+35 Invst.
Invst.
A-AB 75.000 Aaa AAA 20.00 5.178 100.549 5.102 6.91 S+27
A-4A 527.250 Aaa AAA 30.00 5.230 100.548 5.186 9.57 S+28
grade
A-4B 75.322 Aaa AAA 20.00 5.284 100.546 5.243 9.81 S+33 bonds:
A-J 129.549 Aaa AAA 11.63 5.446 100.547 5.305 9.89 S+39 BBB and
B 30.938 Aa2 AA 9.63 5.495 100.548 5.357 9.96 S+44 above
C 11.601 Aa3 AA- 8.88 5.513 100.384 5.397 9.97 S+48
Mezzanine D 25.137 A2 A 7.25 5.513 99.855 5.467 9.97 S+55
tranches E 13.535 A3 A- 6.38 5.513 99.181 5.557 9.97 S+64
F 19.335 Baa1 BBB+ 5.13 5.513 97.697 5.777 10.31 S+85
G 11.602 Baa2 BBB 4.38 5.513 96.624 5.943 10.87 S+100
H 17.402 Baa3 BBB- 3.25 5.513 92.296 6.513 11.62 S+155
High J 3.867 Ba1 BB+ 3.00 12.06
K 7.734 Ba2 BB 2.50 No coupon or yld 12.57
yield L 5.801 Ba3 BB- 2.13 shown → bonds are 13.12
tranches M 5.801 B1 B+ 1.75
privately placed. 14.12
N 3.867 B2 B 1.50 14.56
O 5.801 B3 B- 1.13 14.85
P 17.403 NR NR 0.00 17.99
X-1(IO) 1,546.863* Aaa AAA 0.043 0.481 7.653 8.46 T+325
X-2(IO) 1,502.744* Aaa AAA 0.233 0.704 5.040 6.08 T+70
X-Y(IO) 139.729* Aaa AAA 9.10
* Notional Amount
Source: Commercial Mortgage Alert, October 14, 2005.
 What Happened??

Sentiment + Leverage = Liquidity Illusion => “Minsky Meltdown”

“The externalities to high leverage are greater than they

appear, because on most days everything runs smoothly.
But as we have seen time and again, in
the instances where it really matters the
liquidity that is supposed to justify the
leverage will disappear with a resulting
spiral into crisis.”

From A Demon of Our Own Design:

Markets, Hedge Funds, and the
Perils of Financial Innovation,
by Richard Bookstaber,
Hoboken, NJ: John Wiley & Sons, 2007.
 Significant Deleveraging & Recapitalization Required But Pace Slow to Date
The CRE Leverage Cycle Strikes (Again)
Again …
4.0 0.30
Recent
Total U.S. Debt as a Proportion of GDP (left axis) recession
3.5 Commercial & Multifamily Mortgage Debt as a Proportion of GDP
(right axis) 0.25
LCFIs
3.0 ’90-91
recession
0.20
2.5 ’73-75

Mortgage Debt/GDP
Total Debt/GDP

recession

2.0 Massive 0.15

Overleveraging

1.5
Massive 0.10
Overbuilding
1.0
Securitization
Revolution 0.05
0.5

0.0 0.00
1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

Through to 1Q10.
Source: Cornerstone Research, Federal Reserve Board Flow of Funds and Bureau of Economic Analysis.
The CRE Leverage Cycle …
 A positive feedback loop between commercial real
estate capital appreciation, liquidity and commercial
mortgage capital supply.
• Individual investor
decisions (micro) vs.
aggregate (macro) or
market-wide impacts
• Optimal micro
decisions not
necessarily socially
optimal
⇒ potential for excess
debt

** Role of Appraisals ** FIRE SALE

EXTERNALATY
 What Happened??

Rating Agency Shopping/Arbitrage => Originate to Distribute

CMBS (Weighted Average) Subordination Levels

Source: Stanton and Wallace, NBER Working Paper July 2009

 What Happened??

Regulatory Arbitrage => Securitization Incentive

• In 2001the FDIC and State Insurance Regulators changed the rules

 It became much more onerous from a Risk-Based Capital (RBC)
perspective to hold whole mortgage loans compared to AAA CMBS

Source: Stanton and Wallace, NBER Working Paper July 2009

 Lessons that “we” should have learned

#1: Asset markets are NOT efficient

Arbitrage is imperfect (limited) especially for newer “innovations”

Economics, psychology meet learning and evolution

#2: Market-wide liquidity is a sentiment indicator

Unusually high liquidity (either high or low) predicts a turning point

Price-based risk measures (spreads, asset price volatility) provide “false” signals in
market upswings

#3: Financial leverage destroys liquidity and flexibility in a downturn

 Cheap debt can be addictive and lead to bad outcomes
 Investors, lenders and regulators have to consider the macro environment (fire sale
externality) when making micro level decisions
Others??
About Cornerstone

Hartford CT based Cornerstone Real Estate Advisers LLC,
with offices in the US, UK, Europe and Asia, is one of the
world's largest real estate investment advisers. It provides
core and value-added investment and advisory services,
including a comprehensive suite of real estate debt, equity
and securities expertise and services, to institutional and
other qualified investors around the globe. Cornerstone is a
subsidiary of Babson Capital Management LLC, a member
of the MassMutual Financial Group. To learn more, visit
www.cornerstoneadvisers.com.
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This analysis does not make any recommendation about your investments,
and should not be considered investment advice. Any opinions expressed
herein reflect our judgment at this date and are subject to change. Certain of
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Opinions and estimates offered herein are subject to change without notice,
as are statements of market trends, which are based upon current market
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