Transcript Why is CRE and important Asset Class?

Commercial Real Estate
Fundamentals
June 1, 2010
Recent CRE transaction
 2000 market street
 29 stories, 665,000 square feet
 Sold for $50,000,000 approximately $80/sq ft
 Building was bought in 2003 for $77 million by DB
 Mortgage was $49,000,000 with prudential
 DB turned down a reported $90 million in 2007
 What happened?
Size of Asset classes
 Stocks $14,000,000,000,000 ($14 trillion)
 Bonds $27,000,000,000,000 ($27 trillion)
 CRE
$5,000,000,000,000 ($ 5 trillion)
Who invests in Real Estate?
 Total value of assets of U.S. Households exceeds $50 trillion
 Most are held for retirement or other specific targets
 Majority of these dollars are held at institutions
 Pension Funds (Calpers $270 billion, $21 billion in CRE)
 Life Insurance companies
 Mutual funds
 Endowments
 The goal of these institutions is what?
Why CRE?
 What are investors looking for?
 Highest return for given level of risk – or
 Lowest risk for a given level of return
 How does RE work from a portfolio perspective?
 CRE is somewhere between stocks and bonds on a
risk/return basis and not highly correlated with either
Risk and return for different asset classes
 Returns (1987-2006)
 Stocks 11.5% (9.2% from price appreciation)
 Bonds 7.3% (mostly all income)
 CRE 9.4% (3.5% from price appreciation)
 Risk (Standard deviation of returns)
 Stocks 16%, Bonds 6%, CRE 8%
 CRE correlation is less than .3 for stocks and negative for
bonds
 Bottom line:
 CRE acts as a hybrid between Stocks and bonds
 Improves performance of long term investment portfolios
Unique features of CRE
 Large transactions are required
 Illiquid by nature (liquidity is time dependent)
 Imperfect markets (each asset is unique)
 Lack of transparency in transactions (90% + privately held)
 Prone to extreme cycles of boom and bust
 Positive correlation with inflation
 Generally highly levered (60-80% debt)
 Many of these features support attractive returns for long
term oriented institutions like pensions and endowments
Where do CRE returns come from?
 Income
 Rents
 vacancies
 determine NOI
 Growth in income
 Growth in rents
 Vacancy compression
 Capital Gains and losses
 Buying and selling prices determined by market conditions
 Capital gains when rents increase and multiples increase
Quick example: Wal-Mart Warehouse
 Assume we have built a 300,000 sq ft warehouse in the
Lehigh value for Wal-Mart
 Wal-Mart has agreed to pay us $7/ft “triple net” annually for
20 years for the entire warehouse with a 2% “rent bump”
each year
 Triple net means Wal-Mart pays all expenses
 Industrial and retail leases are often triple net
 In Office and Multifamily owner handles many expenses
 Assume we are consulting for a life insurance company
 How much would we pay for this warehouse?
Valuing the Wal-Mart warehouse
 20 year Wal-Mart bonds currently yield 4.85%
 Next years cash flow = $2.1 million
 Valuation method 1: Direct Capitalization
 Value = NOI/cap rate
 Cap rate = NOI/value (inverse of P/E multiplier)
 Find comparable cap rate and use on next year’s NOI
 Assume a “7 cap” value = 2.1million/.07 = $30 million
 Any problems with this method?
 Widely used to value assets
 Is cap rate = return?
DCF approach to valuation
 How have you been taught to value financial assets?
 Present value of the cash flows
 First step: Determine cash flows for asset
 Second step discount cash flows by the appropriate discount
rate
 For real estate cash flows are the NOI of the property
 Must determine a terminal value of the property as well
 What is the appropriate discount rate?
 What about our current property?
 See CRE.xls for this property
How does debt effect returns?
 When returns are higher than the cost of debt, leverage
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increases return to equity contributors
Is there a downside to leverage?
See CRE.xlsx for debt on the Wal-Mart example
Assume that we get a loan 10 year loan for 70% of the value
of the property at 6.5%. The amortization period is 25 years
Payments would be a little more than $1.9 million annually
Unlevered IRR is 7.82% levered is 9.36%
Where does the debt come from?
 Commercial banks
 Life insurance companies
 REIT bonds and lines of credit
 Conduits
 CMBS
 Commercial mortgage backed securities
 Commercial loans are made, packaged and sold
 What happens in Defaults?
 Bank or Life companies handle it for direct loans
 Special servicers are in charge of CMBS defaults
 Currently $40 billion + of $450 billion in Fitch rates CMBS loans are
delinquent
Where does equity come from
 Public companies
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Real Estate Investment trusts (REITs)
Tax conduits that do not pay corporate taxes
Brandywine, Liberty, PREIT in our area
Less than 10% of total equity
 The rest comes from private sources
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Largely private equity funds
Receive fees + promote
Finite length of investment
Highly levered to meet investor demands
Core, Core+, Value Add, Opportunity
Where are we now?
 Rents are soft, vacancies are up
 Prices are down 30-50% (but moving up recently)
 Looking forward what does this mean for three components
of returns?
 Do you like CRE as an asset class?
 What are the risks associate with debt and equity related to
CRE?
 Brian DiDonato (equity) and Brent Morris (debt) will give
their outlooks in the second half of class