Opportunities in US Distressed Real Estate

7/30/2019 Opportunities in US Distressed Real Estate

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JANUARY 2011

RESEARCH REPORTAccess will be the most important determinant of realestate returns for investments made in 2011. Todays directmarket prices are sufficient to generate acceptable but notexceptional returns over a five-year holding period this willnot be a repeat of the mid-1990s when investors were ableto generate 15%+ IRRs simply by acquiring core assets fromdistressed sellers. Buyers looking for distressed opportunitieswill need to access real estate on a relationship / off-marketbasis, such as direct purchases from banks, or indirectly, viadebt or preferred equity offerings. Size and the ability tomove quickly will provide access to the best opportunities.Private markets currently offer better opportunities comparedto public markets. Office and hotel investments, especially incoastal markets, offer the best U.S. recovery prospects.

GLOBAL ECONOMIC AND PROPERTY MARKET OUTLOOK

The world economy is in the midst of a two-track recovery. Developed markets, includingmost of Europe and the U.S., are just beginning to recover from deep recessions. Untilprivate and public balance sheets are repaired, growth will remain subdued, with jobcreation sufficient to generate positive but not explosive demand for commercial realestate. Emerging markets will also experience lower growth rates than in 2010, butpotential growth in much of Asia and Latin America is now considerably higher thanin developed markets. The strong inventory rebuilding cycle has disproportionatelybenefited Asia Pacific ex-Japan, which continues to lead the global recovery. Althoughthis cycle is fading, intra-regional trade and domestic consumption will be sufficientto maintain healthy economic growth absent another recession in large developedcountries. Risks are skewed to the downside, including both near-term and medium-term sovereign risks, another financial crisis in Europe and/or the U.S., the possibilitythat government austerity measures are coincident and aggressive enough to put many

economies back into recession, and the increasing risks of protectionist measuressparking a global trade war.

Yields have compressed in every major market over the past 12-18 months. However,as of early 2011, the period of yield compression appears to have mostly run its course.The peak-to-trough drop in yields has caused prices in the UK to rise by over 15% in oneyear, even as property incomes declined over the same period. Many other developedmarkets have experienced similar relief rallies that, with the benefit of hindsight,made mid-2009 the best time to buy core operating properties. Although we do notanticipate much if any further yield compression in most markets, low interest ratesmilitate against rising yields for the time being. Even assuming there is a substantialincrease in stabilized properties available for sale, we expect prime yields to remain wellbelow mid-2009 peaks.

OPPORTUNITIES IN

U.S. DISTRESSED REAL ESTATE


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Investment demand for property is strong but not deep.Competition remains heated for stabilized properties intop locations, yet many potential sellers of non-stabilizedassets are unable to get prices they are willing to accept.

Although buyers have more recently begun to ventureinto more secondary locations or take on some lease-uprisk, the bulk of demand, particularly from cross-borderinvestors, is in a few safe haven markets, including NewYork, London and Hong Kong.

CBRE Investors Global House View as of January 20115-Year Outlook

UnitedStates

Canada

Singapore

UnitedKingdom

Australia

FranceHong Kong

Germany

Japan

Central andEastern Europe

China

Nordics

Italy

0

1

2

3

4

5

6

7

8

9

10

0 1 2 3 4 5 6 7 8 9 10

Return

RiskLowest Highest

Lowest

Highest

Source: CBRE Investors

We expect core returns on a five-year hold basis to beacceptable but not exceptional in all major markets. MostEurozone countries are at the lower end of the expected

return range, due to their outlook for a protractedeconomic recovery. Our most positive return outlooks arefor North America and Singapore. On a risk-adjustedbasis, developed markets are generally more attractivethan emerging markets, particularly the U.S. and Canada.

U.S. PROPERTY MARKET OUTLOOK

Total returns over the next five years will be generatedmostly by current income. Average cap rates are 7.0-8.0%for office, industrial and retail and 6.5% for apartments,making the current spreads over bond yields (350 basispoints for apartments and 400-500 basis points for

others) extraordinarily favorable by historical standards.(Note, however, that cap rates in top markets such as NewYork and Washington, DC, are well below these nationalaverages.) Because of this attractive income, there hasbeen fierce competition among investors for core, stabilizedassets, causing prices to rise since the second half of 2009.

Multiple lenders including banks, insurance companiesgovernment agencies and, more recently, conduitsare providing up to 70% LTV debt at very low rates, insome cases sub-4% for apartments and sub-5% for otheproperty types. It is important not to read too much intothis easy credit. Most capital sources, especially banks, areindeed active lenders, but they are refusing to refinance oextend more of their existing loans, and are reducing theinet exposure to commercial real estate. Non-stabilized

properties are still difficult to finance. Owners of theseproperties that need debt may be able to find it, but athigh rates and low LTVs.

Due to regulatory measures to prevent fire sales, we expecbanks will reduce their commercial real estate exposuregradually. This will put a floor under prices and cause asteady flow of orderly liquidations rather than widespreaddistress. Strong demand from income-oriented investorswill be met by this steady flow of bank sales, resulting ina prolonged period of price stagnation in most marketsInvestors interest is gradually spreading to secondaryassets as transaction volumes pick up.

Risks for the U.S. outlook are low by comparison with othecountries. The risk of a double dip recession is still presentbut lower than it was in mid-2010. The near-term risksof oversupply and rent correction are low. Outside of theapartment sector, almost no major new projects are likelyto launch in the foreseeable future and many early-stagedevelopments have been delayed or even cancelled. Highbudget deficits and public debt or, on a more positivenote, a significant acceleration in economic growth, couldpotentially cause a sharp rise in U.S. bond yields. Howeverthe currently high spreads over government bond yieldswould shield cap rates from rising sharply, especially in

comparison with other countries.

OPPORTUNITIES IN DISTRESSED U.S. REAL ESTATE

This section reviews future distress opportunities by 1sector, 2) property type and 3) geography. In our viewthe most important differentiation in todays market is thelevel of pricing efficiency across different sectors. Publicdebt and equity are now more efficiently priced (meaningthere is relatively little distress) whereas private debt andequity have substantial pricing inefficiencies that will createmore opportunities. By comparison, property type andgeography, while important considerations for effectiveinvestment strategies, will be of secondary importance inaccessing distressed opportunities.


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1. Sectoral Opportunities

Public Private

Debt Buy existing CMBS Issue new CMBS

Origination, unleveraged Origination, leveraged Loan pools / Loan-to-Own

Equity

REIT share purchases REIT debt issuances JV with / privatize REITs REIT IPOs

On-market Off-market Secondary fund investments Preferred equity offerings

Bold sectors represent the most favorable distressed opportunities

PUBLIC DEBT LIMITED DISTRESSED OPPORTUNITIES IN2011

Investors can participate in public debt markets by: 1)buying existing CMBS and 2) originating new CMBS. Theopportunity to buy legacy CMBS at distressed prices endedin 2009. Pricing for legacy CMBS has rallied since then,even for vintages such as 2007 that were underwrittenusing very aggressive assumptions, as shown here.

New CMBS originations may yield higher returns. Betweenthe second half of 2008 and late 2009, there were virtuallyno new CMBS issued. Massive liquidity provided by thegovernment through capital injections to recapitalizebanks, ultra-low interest rates, and various programs topurchase securities has helped thaw credit markets. In

2010, $11.6 billion of CMBS was issued and met withstrong investor demand. But originator returns will beconstrained by market discipline and additional regulationsthat require high levels of subordination and retention ofthe lowest tranches. In addition, many originators may findit easier and equally profitable to sell A-piece debt to lifeinsurance companies and others via private placements.

PUBLIC EQUITY (REITS) LIMITED DISTRESSEDOPPORTUNITIES IN 2011

Investors can participate in U.S. REIT markets by: 1)

purchasing REIT common or preferred shares; 2)purchasing REIT debt; 3) joint venturing with or privatizingexisting REITs; and 4) sponsoring REIT IPOs. The strongREIT market recovery has made the first three optionsgenerally unattractive for investors looking for distressedopportunities. Most of the 67% peak-to-trough decline inREIT share prices was due to concerns about companiesbalance sheets, in addition to their ability to maintainoccupancy and rent levels in a recession. Not only has thediscount for solvency risk disappeared, but current REITprices also generally imply a robust recovery in propertyincomes.

Source: Markit

20

40

60

80

100

Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10

AAA

AJ (Junior AAA)

Price Series 1(vintage '05)

Series 5(vintage '07 )



CMBS Prices

As a result, we believe average common and preferredshares are now fairly valued, at best, with the possibleexception of REITs that are positioned to capitalize ondistress either via M&A or opportunistic portfolio purchasesREITs ability to raise debt and their cost of debt has alsoimproved significantly since 2009, as shown here, which isfavorable for them but not for debt investors seeking highereturns. Finally, most REITs are trading at a premium to ouestimate of net asset values, which makes privatizationsgenerally untenable, and REITs ability to access debt avery low rates makes them less willing to seek out JVs focapital infusions. REITs that do not have access to low-cosdebt because of ongoing refinancing challenges may beattractive recapitalization opportunities, but we cautionthat most of these companies do not have best-in-classportfolios or management teams.


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REIT IPOs are a potentially lucrative way to arbitragebetween high valuations in public markets and distressin private markets. However, recent blind-pool REIT IPOshave been met with lackluster demand. Portfolios of qualityproperties may be candidates for listings, but given strongdemand for stabilized properties in private markets, theyare currently expensive to assemble and may not commandenough of a premium to offset IPO expenses.

PRIVATE DEBT SUBSTANTIAL DISTRESSEDOPPORTUNITIES IN 2011 AND BEYOND

Investors can participate in private debt markets by: 1)originating new loans, with or without a leverage overlay;and 2) buying existing loan pools at a discount. Webelieve origination is particularly attractive now because itaddresses a market need at a time when many holdersof commercial real estate debt need to reduce theirexposure. More than $1 trillion of mortgages will maturebefore 2014. Commercial banks have the largest share ofcommercial mortgage debt, currently holding 45% of the$3.2 trillion outstanding, as shown here. Many bank loansare shorter duration, typically three years, which meansmany of their loans have already reached or soon willreach their scheduled maturity dates. Banks will continueto lend, but on net they will reduce rather than expandtheir exposure, especially smaller regional banks. The re-opening of CMBS markets will be insufficient to replace thehuge wave of securitized debt maturing over the next fiveyears and beyond. Life insurance companies and savingsinstitutions will hold or slightly expand their market sharesover the next decade. The fate of government sponsoredentities including Fannie Mae and Freddie Mac is uncertain they will remain active lenders at least for the this year,but thereafter their multi-family lending activities may be

scaled back.

Source: Federal Reserve Flow of Funds Account (Z.1)

Share of Commercial Real Estate Debt

Source: CBRE Global Real Estate Securities

REIT Debt Issuance

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

ShareofCommercialRealEstateDebt

Other

GSE, Agency- and GSE-BackedMortgage Pools

Savings Institutions

Life Insurance Companies

CMBS/CDO and other ABS

Commercial Banks

Debt Issued by U.S. REITs Average Cost of Debt

4

5

6

7

8

9

10

11

0

1

2

3

4

Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10

$Billions

Percent

NONE

This provides an opportunity for private equity, mortgageREITs and other capital sources to fill the gap. Scarcity wilallow originators to dictate high interest rates, substantiaamortization and low loan-to-value ratios, generating coreequity-like returns at a safer position in the capital stackOriginators seeking higher returns can use leverage, eitheby obtaining maturity-matched loans at accretive interesrates, or by selling A-notes via private placements or CMBSissuances.

Buying existing loan and loan pools at a discount, withor without a loan-to-own exit strategy, will become morecommon as banks and other lenders shrink their debtexposure. Although the commercial real estate downturn isalready two years old, there have been very few large loanportfolios sold to date. But more portfolios are beginningto come to the market as banks, the FDIC and othersincreasingly aggressively dispose of loans. Investors wil

need to evaluate whether pricing is sufficiently discountedto generate appropriate risk-adjusted returns.

PRIVATE EQUITY SUBSTANTIAL DISTRESSEDOPPORTUNITIES IN 2011 AND BEYOND

Investors can participate in private equity transactionsby: 1) buying publicly-marketed deals; 2) accessing offmarket deals; 3) investing via the secondary market inexisting funds at a discount to par pricing; and 4) investingin preferred equity offerings by commingled funds. Priceshave risen to the point that there are limited opportunities

to access distress via publicly-available properties andportfolios. Importantly, cap rate compression has beenstrongest in the primary markets, and in particular in threetrophy markets, as shown here. Primary markets offethe best future liquidity prospects and, as discussed latein the Geographic Opportunities section, we generallyexpect them to outperform smaller markets in terms ofrent recoveries over the next five years. Unless there arewidespread distressed sales, which we do not anticipateit will be very difficult to buy assets in these markets atdistressed prices.


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Off-market deals will be an increasingly effective way toaccess distressed real estate. Many opportunity investorshave built up war chests for an expected surge in distressthat has not materialized. Right now, sellers are able todemand a quick close for off-market deals because buyersare finding themselves outbid for publicly-marketed coreassets. Yet as banks begin to force more sales and disposeof REO assets directly, there will be an increase in off-

market deals, with discounted pricing particularly for assetsin need of leasing and/or capital expenditures. Buyers witha demonstrated ability to close without financing will haveaccess to the most deals at the most advantageous prices.

At and immediately following the peak of the credit crisis in2009, there were opportunities to purchase limited partnerinterests in existing funds at steep discounts, including inopen-ended core funds, via the secondary market. (Notethat there is no formally organized secondary marketto buy shares in existing funds in the U.S., but there arededicated placement companies and funds-of-funds thattrack activity.) However, now that fund holdings have

been marked to reflect market values and property priceshave risen from trough levels, most limited partners arechoosing to maintain their ownership interests. Investorscan expect to achieve a good but not exceptional returnon secondary interests bought now, since current pricingdoes not reflect either seller or fund distress, and thereis substantial competition for these interests. That said,over the next few years there will be occasions when fundsponsors, typically banks or other financial institutions,need to reduce or eliminate their co-investments in fundsthey sponsor to comply with new regulatory guidelines or aspart of a sale of their investment management businesses.In these instances, the size of the co-investment interests

may preclude all but a few large investors from bidding,and pricing may be more advantageous to buyers thanmaking smaller secondary investments.

Source: Real Capital Analytics; 3-City Trophy is New York City, Washington, DC andSan Francisco

Moodys/REAL Commercial Property Index

50

60

70

80

90

100

110

120

Oct-07

Dec-

07

Feb-

08

Apr-08

Jun-

08

Aug-

08

Oct-08

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Feb-

09

Apr-09

Jun-

09

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10

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PriceI

ndex(100=October2007)

3-City Trophy

All Cities

Preferred equity offerings by closed-end funds will continueto be a way to access distress. Although property marketfundamentals are close to bottoming out and many fundshave successfully negotiated loan extensions, most closed-end funds that made the bulk of their acquisitions in 2006and 2007 will have liquidity challenges for the next twoyears or longer. The terms of preferred equity offerings areoften very favorable for investors, such as periodic payouts

(i.e., before a funds scheduled liquidation) secured bydiscrete operating properties income streams. In manycases, existing investors are either unwilling or unableto participate. By law these are never publicly marketedand this opacity means preferred equity investors have theability to dictate favorable terms.

2. Property Type Opportunities

All major property types have been hit hard by the GreaRecession. Absorption has collapsed, occupancies have

declined and rents have plummeted in all sectors. Propertyincomes declined throughout 2010 and will keep falling, insome cases, in 2011. We expect income growth to strengthenbeginning in 2012. All property types are now reasonablypriced based on the CBRE Investors Temperature Chart, ashown here, which is a proxy for real property values ovetime.

HOTELS SUBSTANTIAL DISTRESSED OPPORTUNITIES IN2011

Hotels were the first property type to feel the effects of

the global recession because they have the shortest leaseterm, i.e., one night. Therefore they will experience thefastest and strongest recovery in revenue per availableroom (RevPAR) as business and leisure travel have alreadybegun to increase. We forecast RevPAR will turn positive in2011 and increase a cumulative 31% by 2015 from thetrough in 2009, back to its pre-recession peak. Todaysprices do not factor in this upside. However, due to hotelsrelatively quick and strong recovery, we expect the windowto buy properties, portfolios and operating companies adistressed prices will be the shortest of the five propertytypes.


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OFFICE SUBSTANTIAL DISTRESSED OPPORTUNITIES IN2011 AND BEYOND

Although the average office vacancy is now a very high16.4%, it is still below the peaks of previous recessions.Nevertheless, rents have collapsed in many markets.

As demand rebuilds after 2011, rent growth will gainmomentum. Through 2015, we forecast rents to increase23%, bringing rents above their pre-recession peak.

Prices have recently risen for stabilized office properties,but attractive opportunities will increase to buy distressedproperties, particularly off-market.

Rent Index (2000=100)

Note: Revenue per available room shown for hotelsSource: CBRE EA; PPR; CBRE Investors

80

85

90

95

100

105

110

115

120

125

Hotel Office Apartment Retail Industrial

Pre-recession peak Trough 2015 rent

16%

19% 19%

23%

31%rebound


CBRE Investors U.S. Temperature Chart

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

PercentDeviationfromL

ongTermA

verage

Apartment

Retail

Office

Industrial

APARTMENTS MAY BE SOME DISTRESSEDOPPORTUNITIES IN 2011 AND BEYOND

In 2009, apartments experienced their worst absorptionever and rents declined by a record 5%. However,apartment fundamentals have recovered strongly, withrobust net absorption (especially notable given anemicjob growth) and the beginnings of a rent recovery. Thisis good news for existing owners and core investors, butnot for investors looking for distressed opportunities. Todate, Fannie Mae and Freddie Mac debt has preventedwidespread distress, causing prices to hold up much betterthan other property types. However, if the GSEs rein in theircommercial lending activity over the next few years, therecould be opportunities to acquire properties at distressedprices.

RETAIL SELECTED DISTRESSED OPPORTUNITIES IN2011 AND BEYOND

Neighborhood and community centers, which rely onnecessity expenditures that hold up well in recessionshave been relatively defensive investments. We forecastrents to increase 19% by 2015, back above their pre-recession peak. There will be much variation in the retaisector, however, with many retailer consolidations causingpreviously well-performing centers to plummet in value

Affected centers may present attractive repositioningopportunities, but only where quality replacement tenantscan be found. Cutbacks in discretionary spendinginitially hit upscale and luxury retailers hard, but thatsegment has outperformed recently. This bodes well fordominant regional malls, well-conceived lifestyle centersand the countrys true 24/7 CBDs. Although distressedbuying opportunities will be limited in neighborhood andcommunity centers, and regional malls, there may bewindows to acquire underperforming lifestyle centers adeep discounts.

INDUSTRIAL LIMITED DISTRESSED OPPORTUNITIES IN2011 AND BEYOND

The industrial market will be the laggard of the group.Rents have declined 13% since their peak in 2008. Whiledemand will strongly rebound beginning in 2011, theavailability rate will take more than five years to recover toits long term average. We forecast cumulative rent changethrough 2015 will only total 16%, just enough to bringrents back to their pre-recession peak. These nationaaverages include a high degree of product and locationaobsolence, and state-of-the-art facilities in a few strategicgateway markets will outperform. Todays high cap rates

make industrial acquisitions attractive for income-orientedinvestors. However, the slow rent recovery and poooccupancy rates will delay cap rate compression beyondthe investment horizon of most opportunistic investors.


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3. Geographic Opportunities

Property market fundamentals will stabilize and eventually recover over the next two to five years, but the recovery will beuneven across the nation. CBRE Investors Research classifies metro areas in our quarterly Investment Matrix Report basedon their risk/return profile as Blue Chip (high return/low risk), High Yield (high return/high risk), Income (low return/lowrisk) and Contrarian (high return/low risk). We believe investors buying distressed assets should, whenever possible, focuson the Blue Chip markets, shown here.


Los AngelesOrange County

San Francisco

Boston

Long Island

Washington, D.C.

Philadelphia

Dallas

Austin

Houston

Fort Lauderdale

West Palm Beach

Seattle

Oakland

San Jose

Minneapolis

PhoenixSan Diego

Riverside

New York

Denver

retail

office apartment

industrial

12 10

8 13

Our current Blue Chip metro areas are generally large coastal, gateway cities with strong global linkages (Los Angeles,New York, San Francisco Bay Area) or metro areas with robust economic drivers such as technology (Austin, Boston, Seattleor energy (Houston, Dallas). Three metro areas are Blue Chip metros for all four major property types (office, industrial,retail and apartments): Los Angeles, San Francisco and Seattle.

Blue Chip Recovery Markets

Please note that the content of this report is for informational purposes only and should not be viewed as investmentadvice or an offer or solicitation. Any opinions are solely those of CBRE Investors and are subject to change withoutnotice, and may not be consistent with market trends or future events. This report is based on current publicinformation that we consider reliable, but we do not represent it is accurate, updated or complete, and it shouldnot be relied on as such.

DISCLAIMER


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Americas

Los Angeles (HQ)

Atlanta

Baltimore

Philadelphia

Princeton

New York

Boston

www.cbreglobalinvestors.com

EMEA

Amsterdam (HQ)

Madrid

London

Paris

Brussels

The Hague

Luxembourg

Milan

Frankfurt

Prague

Vienna

Stockholm

Budapest

Warsaw

Bucharest

Dubai

Asia Pacific

Hong Kong (HQ)

Singapore

Beijing

Shanghai

Taipai

Seoul

Tokyo

Sydney

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Opportunities in US Distressed Real Estate

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