Pimco Commercial Real Estate - June 2010

U.S. Commercial Real EstateProject

PIMCO

In 2005, PIMCO’s Investment Committee dispatched the firm’s

mortgage team to the top 20 U.S. housing markets in a boots on

the ground effort to assess the leverage-fueled housing boom.

The Housing Project was born and it led to our forecast for an

unprecedented decline in residential home prices. What we

learned was critical to PIMCO’s navigation of the credit crisis

on behalf of our clients.

The commercial real estate market shares most of the sins of

its residential cousin – extremely weak loan underwriting,

excessive leverage and the absence of risk management from

both banks and rating agencies. So PIMCO undertook

the Commercial Real Estate Project to understand

local real estate dynamics on the

front lines in ways not revealed

in the published data, to better

understand how the current cycle

is different from previous cycles

and to inform asset selection in

local markets.

June 2010

PIMCO U.S. Commercial Real Estate Project

2June 2010 3

Recognizing that commercial real estate (CRE)

property-level fundamentals continue to decline and

capital markets are changing rapidly, PIMCO portfolio

managers and analysts fanned out across 10 cities to

conduct on the ground research. Our teams met with

over 100 industry representatives, including local

investment sales advisors, leasing brokers, CRE lenders,

special servicers, real estate developers and property

owners across the largest commercial sectors – office,

industrial, retail, hotel and multifamily. Through

these meetings, we developed a real-time view of local

conditions and insights into key assets.

Summary of Key Findings: 1. Capital is clearly returning to commercial real

estate, helping to stem the value decline in the

sector. But optimism should be tempered, because

national price indices are misleading when

transactions are limited and fail to reflect the

significant uncertainty around property valuations.

2. Changes in the structure of capital markets –

notably the proliferation of complex securitizations

since the last CRE crisis in the early 1990s – will

lengthen the deleveraging process and suppress

a recovery. The impaired ability to transfer CRE

risk out of the banking system relative to previous

cycles makes a stable, let alone a V-shaped, recovery

unlikely. Instead, many CRE assets likely will not

return to 2007 prices until the end of this decade.

3. Macroeconomic headwinds such as limited GDP

growth in the U.S., elevated unemployment,

potential re-regulation and a secular increase in the

savings rate will force the market to re-evaluate the

assumptions it has used to price CRE. These trends

severely affect the outlook for rents, vacancies and

capitalization rates, highlighting the downside

risks that remain in CRE.

We believe that the CRE market faces significant

uncertainty around valuations that will affect the

prospects for recovery. Investors therefore should

proceed with caution when examining the complex

opportunities that are surfacing. Considering the

complexities introduced by capital markets since

the last CRE crisis, any approaches to analyzing

and investing in this market will need to depart

significantly from those of previous cycles.

All That Glitters Is Not Gold Capital has returned to CRE and high levels of bidding

activity in certain sectors have made many observers

and participants optimistic. Transactions have

generally been limited and capital flows have been

concentrated in trophy properties and in properties

where below-market Agency financing is available.

This has provided a false sense of clarity on the real

level of property values. A significant volume of weaker

and distressed assets has yet to be liquidated and this

foreshadows further pressure on values. Against this

backdrop, we caution against the presumptions that a

rapid broad-based recovery is underway.

Capital is BackAccommodative monetary policy and increasing levels

of liquidity have ushered in the return of both equity

and debt capital to the commercial real estate sector.

Not surprisingly, capital has returned to the most liquid

sectors of CRE first – public equities through Real Estate

Investment Trusts (REITs) and commercial mortgage

backed securities (CMBS). REITs were successful in

raising over $24 billion of equity and issuing $10 billion

of debt in 2009. As shown in the chart following, from

the first quarter of 2009 to the first quarter of 2010, the

inflow of capital into REITs and CMBS drove REIT prices

up over 96% and tightened super senior CMBS tranche

spreads (the most senior class of CMBS) by nearly 70%.

3

Capital is Chasing CRE Assets

Spre

ad to

Sw

aps

(bps

)

Inde

x Va

lue

CMBS Super SeniorDJ Equity REIT Index

1,000

900

800

700

600

500

400

300

200

215

190

165

140

115

90

Mar-09

May-09

Apr-09

Jun-0

9

Jul-0

9

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Feb-10

Jan-1

0

Mar-10

Apr-10

May-10

Source: Bloomberg, PIMCO

On the debt side, insurance companies are actively

looking to finance quality properties, former Wall Street

investment conduit groups are re-forming and several

private debt vehicles are raising capital.

Transaction activity has resumed in earnest for

relatively liquid assets such as stable, trophy properties

in major markets. Investors and lenders have

aggressively returned to major markets, including

Manhattan and Washington, D.C., where demand

from foreign capital has led to recent office trades that

have been completed at capitalization rates (annual net

operating income divided by property value, or in other

words, the current yield at which a property trades) and

per-square-foot values close to the peak prices seen in

2006 and 2007.

Buyer demand has also returned for multifamily

properties financeable through Fannie Mae and Freddie

Mac’s longstanding lending programs. While loan

terms have become significantly more conservative in

CRE over the past two years, Fannie Mae and Freddie

Mac continue to offer financing terms reminiscent of

those offered in 2007. This attractive financing has led to

transactions pricing at 2005-2007 levels in the 5% to 6%

cap rate range.

Values Bottom, But Recovery Will Be SlowIn response to the recent surge in bidding levels for

lower-risk “trophy” CRE assets, both equity and debt

capital have begun to migrate along the risk curve

in search of yield. Indeed, well capitalized REITs

are once again looking to acquire assets and several

private equity funds are actively searching for new

acquisitions, even in challenged markets.

Today, buyer yield requirements imply that CRE asset

values have generally declined 35% to 45% from their

peak levels in 2007 - a marked improvement over early

2009, when buyer yield requirements spiked to levels

that implied a value decline of over 50% from 2007. We

caution against the presumption, however, that this

implied improvement in CRE asset values portends

a rapid recovery in actual CRE asset prices. Instead,

as over $500 billion of over-leveraged CRE properties

slowly reach the market through lender dispositions or

restructurings, we expect general CRE asset prices to

remain 30% to 40% below 2007 peak pricing levels for

three to five years.


4June 2010 5

Have We Reached Bottom?

Moo

dy's

CPP

I Lev

el, D

ec 2

000

= 10

0

90

110

130

150

170

190

210

Source: Moody’s CPPI, Real Estate Analytics LLC as of 5/31/10 Dec

-00

May-01

Oct-01

Mar-02

Aug-02

Jan-0

3

Jun-0

3

Nov-03

Apr-04

Sep-04

Feb-0

5

Jul-0

5

Dec-05

May-06

Oct-06

Mar-07

Aug-07

Jan-0

8

Jun-0

8

Nov-08

Apr-09

Sep-09

Feb-1

0

The point here is that transaction activity in trophy

properties and Agency-debt eligible multifamily

properties should not be considered a leading indicator

of a broad-based recovery in CRE asset values. Recent

transactions imply a rapid recovery to 2007 pricing

levels; however, these asset classes face risk of future

value declines. In the case of the aforementioned

Washington, D.C., office properties, for example,

PIMCO met with several local investors who were

perplexed by the extent of non-U.S. capital funneling

into their market. This reliance on non-U.S. capital

for rapid appreciation highlights the potential for

exogenous factors to drive CRE values at the local level.

For multifamily properties, a small change in loan

terms would have an immediate effect on multifamily

asset prices given the significant reliance on Fannie Mae

and Freddie Mac for financing.

Misleading Indices National price indices such as the Moody’s Commercial

Property Price Index (CPPI) can provide misleading

indications of a recovery in CRE asset price levels. Since

November 2009, the index has rebounded 3%.

While it is natural to draw comparisons between the

CPPI and the S&P/Case-Shiller index used to gauge

residential home prices, we caution that indexes such as

the CPPI are relatively meaningless in today’s limited

transaction environment – commercial real estate

transaction volume fell nearly 90% from 2007 to 2009.

Our ride along meetings highlight another limitation

of the CPPI. Based on repeat transactions, the index

excludes the truly distressed or overpriced properties

acquired in the past few years that have yet to trade, and

is instead skewed by the high proportion of trophy asset

and Agency-financed multifamily transactions. In fact,

for every broker story regarding a bidding frenzy for a

trophy asset or multifamily property, our team heard

of multiple instances of owners embroiled in workouts

5

on properties they believe to be worth less than 50%

of peak valuations. When these distressed properties

finally do trade, they will have a disproportionate

effect on the CPPI. For example, the CPPI index price

change in March 2010 was based on only $1.7 billion

of transactions. By contrast, a single deal, the highly

publicized Stuyvesant Town property in Manhattan,

sold for $5.4 billion in 2006. If this property were to

liquidate today (the property is currently in default),

many estimate that it would sell for 60% less than its

2006 purchase price.

The Long, Long Road to RecoveryThe development of increasingly complex capital

structures since the 1990s without accompanying

policies to efficiently resolve conflicts implies that the

deleveraging process will take far longer to play out in

this cycle. In addition, as regional banks are forced to

recognize losses on their construction loan portfolios,

eventual dispositions will do little to speed a recovery

or clarify property values. The drawn out resolution

process for both complex securitization structures and

regional loan portfolios makes the prospects for a quick,

V-shaped recovery unlikely. Instead, many assets may

not return to their peak 2007 values until the 2020s.

Deleveraging: A Messy Unwind The often byzantine debt and equity structures that

evolved over the last decade will take significantly

longer to unwind than the distressed CRE inventory

of the 1990s, because securitization has changed

the primary holders of CRE risk. This prolonged

deleveraging process is expected to result in a sustained

period of limited price transparency and risk aversion.

In the last major crisis, CRE was relatively isolated from

the broader economy. The rally and subsequent fall

was spurred by tax-driven oversupply. Furthermore,

CRE capital structures were straightforward,

consisting of senior lenders (savings and loans, thrifts

and banks) and private borrowers. Considering the

relative isolation of CRE risk holders, the FDIC was

able to contain the fallout. The FDIC spearheaded the

rapid transfer of CRE risks through the creation of

the Resolution Trust Corporation (RTC), which used

tools such as bulk sales, equity partnerships with a

private sector partner and, ultimately, securitization to

restructure and sell risk.

Flash forward: the evolution of CMBS, large loan

syndications, mezzanine debt vehicles, collateralized

debt obligations (CDOs) and private equity funds has

greatly added to the complexity of the capital landscape.

As such, the risk holders on a property today frequently

include hundreds of direct and indirect owners across

the capital structure, often with conflicting interests.

In CMBS, for example, subordinate bond classes have

approval rights regarding loan workouts that lead


6June 2010 7

to a preference to extend loans rather than initiate

foreclosure proceedings. Conflict arises when a

foreclosure would maximize recovery to the trust but

would wipe out the subordinate bondholder’s principal.

All of this will serve to limit the speed and effectiveness

of previous deleveraging strategies, dragging the

unwinding process out for years and limiting visibility

on the level of a bottom in property values. Indeed,

many of the CRE law firms that we met with said

their loan restructuring assignments have become

significantly more complicated than previous cycles due

to the higher number of participants within a property’s

capital structure.

Higher Cap Rates Here For the Long TermWe expect that the spread between cap rates and 10-year

Treasuries will remain above its average of 265 basis

points seen since 1995, as the litigious deleveraging

process leads to a sustained period of risk aversion in

the sector.

As shown in the accompanying chart, the 10-year

forward curve implies that 10-year Treasuries will

approach 5% over the next several years. If cap rate

spreads remain above their average, the market can

expect long term cap rates near or above 8%. In this

case, even if properties with floating rate debt can

successfully avoid defaults in the short term, rising

longer term rates will create a floor for cap rates and

limit recoveries.

Small Loan Dispositions Offer Little ClarityWhile evolving U.S. guidelines and a low fed funds rate

allow banks to employ a “pretend and extend” strategy

for the resolution of troubled commercial loans, large

volumes of construction loans are expected to force

a day of reckoning for many regional banks. Banks

cannot keep listing construction loans as performing

when the reserves they must carry against them are

depleted and borrowers refuse to contribute new

capital. Similarly, CMBS special servicers will likely

sell portfolios of small non-performing CMBS loans, as

these loans are not profitable for the servicer to resolve.

Loan portfolio dispositions will likely lead to an

increase in transaction volume relative to 2009;

however, portfolio sales of small, non-performing loans

give little clarity to values overall. For example, in an

FDIC sale that took place in early 2010, only 41.5% of

a $1 billion portfolio consisted of loans backed by

traditional commercial real estate properties. The rest of

the loans were backed by assets such as land, car washes,

churches and funeral homes – not exactly a useful

comparable for assessing the value of office buildings.

A Brief Comparison to JapanThe broader success of transferring CRE risk out of the

banking system will also drive the timing of recovery.

Consider Japan, where zombie banks – financial

institutions that continue to operate despite severely

impaired balance sheets – held on to underwater loans

for years because they were not forced to mark to market.

This led to a sustained period of limited price discovery

and a prolonged downturn where values did not bottom

for more than 10 years after the decline began.

Higher Expected Treasury Yields Put a Floor on Cap Rates

Perc

ent (

%)

Cap Rate 10-Year UST Yield

Source: Bloomberg, Property and Portfolio Research

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

1995

Q1

1997

Q1

1999

Q1

2001

Q1

2003

Q1

2005

Q1

2007

Q1

2009

Q1

2011

E

2013

E

2015

E

2017

E

2019

E

7

Where’s the V?

Inde

x Le

vel

0

50

00 01 02 03 04 05 06 07 08 0910E11

E12

E13

E14

E15

E16

E17

E18

E19

E20

E21

E

83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

100

150

200

250

200

Source: Moody’s, MTB-IKOMA Real Estate Investment Index, ESRI, Bank of Japan, PIMCO as of Q4 2009

U.S. Timeline

Japan Timeline

Bearish Projection - Japan style recovery

Bullish Projection - 1990's U.S. style recovery

U.S. CPPI Index: Actual 2000-2007 (bottom axis)

Japan MTB-IKOMA CRE Index: Actual 1983 - 2004 (top axis)

We hope that the lessons learned from the Japan crisis

will help the U.S. avert some of the fiscal and tax

policies that led to Japan’s “lost decade.” Parallels can

certainly be drawn, though, between Japan’s policies

regarding bank recognition of CRE loan losses and the

U.S. government’s recently relaxed bank guidelines.

As we learned through meetings with CRE brokers

and consultants, many regional banks continue to find

ways to avoid marking loans to their current value.

For example, several brokers told our analysts of cases

where a bank loan officer would specifically direct a

broker to provide only a verbal opinion of value on a

property financed by the bank, presumably to avoid any

documentation that would force recognition of a loss.

The accompanying chart extrapolates and compares

a recovery that mirrors Japan’s CRE lost decade cycle

versus a recovery scenario based on the U.S. recovery

in the 1990s, where the FDIC forced a rapid transfer of

CRE risk through the Resolution Trust Corporation.

Interestingly, as veterans of the 1990s will attest, even

that recovery was far from V-shaped in CRE.

Avoiding the PitfallsThe credit crunch of 2007 and 2008 encompassed a

large set of problems – corporate, residential, consumer

lending and, of course, commercial real estate. As

a result, CRE will most likely not benefit from the

surge of economic growth that typically follows a

cyclical downturn. Instead, the market – and indeed

the broader economy – will be exposed to a whole

new set of obstacles to recovery on the path to a New

Normal: limited GDP growth in the U.S., a stubbornly

high unemployment rate, potential re-regulation and a

secular shift in the savings rate that results in reduced

consumption. Accounting for and understanding the

effect these macroeconomic

trends will have


8June 2010 9

Of�ce/Industrial Net Operating Income Lags GDP

Qua

rterly

NO

I Gro

wth

(%)

Qua

rterly

GD

P G

row

th (%

)

85-Q

487

-Q4

89-Q

491

-Q4

93-Q

495

-Q4

97-Q

499

-Q4

01-Q

403

-Q4

05-Q

407

-Q4

09-Q

4

1.5

1.0

0.5

0

-0.5

-1.0

-1.5

-2.0

2.5

2.0

1.5

1.0

0.5

0

Quarterly NOI Growth (2yr lag) Quarterly NOI Growth Quarterly GDP Growth (RHS)

Source: Bloomberg, Property and Portfolio Research

Source: Property and Portfolio Research

National AverageYearly Rent - 2007

National AverageYearly Rent - 2009 % Change

Apartment (per unit) $16,238 $15,142 -6.8%

Office (per square foot) $26.99 $24.28 -10.0%

Retail (per square foot) $20.02 $17.76 -11.3%

Industrial (per square foot) $5.26 $4.63 -12.0%

on rents, vacancies and cap rates will be key to avoiding

the pitfalls to recovery in CRE, where many assets will

continue to decline in performance and value over the

next three to five years.

Rents Are Down More Than Reported…Market reports on industry fundamentals such as

vacancy rates and rental rate changes are misleading

in a limited leasing environment. PIMCO’s interviews

with leasing brokers and property owners across the

country paint a significantly more sobering picture of

the rental environment than market reports show.

Property and Portfolio Research (PPR) reported

meaningful declines in nationwide asking rents,

shown in the accompanying table. These clearly

illustrate a decline in performance across all real estate

sectors; however, these measures fail to capture the

extent of the concessions landlords are offering to

attract and retain tenants.

Effective office rents, (rents net of concessions such as

free rent and temporary rent breaks) have dropped

much further than asking rents. According to Reis Inc.,

a commercial real estate information provider, asking

rents in the Manhattan office market were down more

than 20% at the end of 2009 from the peak in the fall

of 2008. However, our interviews with leasing brokers

suggested that effective rents in those same areas have

declined by as much as 40%. Not surprisingly, landlords

are hesitant to disclose concessions because doing so

could incentivize savvy tenants to negotiate better

terms. This makes accurately tracking effective rents

nearly impossible.

…With More Declines to ComeAlthough nominal GDP growth turned positive during

the third and fourth quarters of 2009, property cash

flows are poised to decline for the next one to two years

as expiring leases reset at lower levels. This lag effect is

evident in the office and industrial sectors, where the

strongest historical correlation between nominal GDP

and cash flows occurs on a two year lag.

In addition to the demonstrated lag effect between

GDP and CRE cash flows, severe real estate value

corrections can create other, less obvious sources of

rent pressure. For example, sophisticated tenants have

become increasingly concerned about zombie buildings

where the current owner has negative equity and little

incentive to maintain a property. In fact, several leasing

brokers told us that, for the first time in their careers,

they are seeing tenants demanding detailed financials

on the landlord. Over-leveraged properties financed

with CMBS loans are particularly vulnerable to being

deemed as zombies, because brokers representing

9

Annual Rent Growth Rises as Vacancies Fall

15

10

5

0

-5

-10

-158 10 12 14 16 18 20 22

Offi

ce R

ent G

row

th (%

)

Vacancy Rate (%)

Vacancy Rateas of 1Q 2010

Vacancy Rate15-year Average

Source: Property and Portfolio Research top 54 MSA rent and vacancy averages

large tenants are able to access the specific financial

information for these assets. Thus, potential tenants

will be able to actively avoid these buildings, further

pressuring property values.

Should foreclosures accelerate and more landlords give

back the keys on underwater properties, the lower cost

basis for buyers of these distressed properties would

reduce the rent required to generate desirable returns.

These basis resets would have a marked effect on local

area rents, requiring special attention to potential

property value shocks and a detailed knowledge of

equity positions in nearby properties.

Interviews with retail property owners also highlight

the continued challenges landlords face. Retail owners

may have been able to prop up occupancy levels by

converting struggling tenants to a percentage rent

structure; however, performing anchor tenants will

eventually demand rent reductions as well. Several

retail owners that we met with indicated that even

performing anchors are attempting to negotiate lower

rent structures, as these tenants recognize that they are

often the key to a property’s viability.

Elevated Vacancies Lean on ValuesGiven the sharp drop in real estate values, commercial

real estate development (i.e., new supply) is expected

to remain limited for several years. Long term changes

in employment will result in depressed demand as

well, stifling absorption of vacant supply. In markets

such as Phoenix, finance- and real estate-led growth

in office employment will remain muted for years, as

many of these jobs were ancillary to the construction

industry. Thus, secular changes in office-using

employment will keep vacancy rates above historical

averages for several years, even in a limited

supply environment.

According to PPR, vacancy rates in the first quarter of

2010 were almost 20% on a national level, the highest

level in 20 years and well above the average 15% rate

seen over that same period. Even with limited new

supply, we expect vacancy rates to stay consistently

above trend, ultimately limiting office rent growth

over the secular horizon. As the accompanying table

highlights, rental growth doesn’t meaningfully increase

until vacancies fall well below the historical average.

A Rising Tide Will Not Lift All Boats Long term changes in consumption and savings

patterns have specific implications for properties tied

to consumer spending, such as the luxury hotel and

upscale retail sectors. PIMCO’s expectation for a long-

term increase in the savings rate suggests the potential

recovery for these asset classes will be constrained as

consumers reduce discretionary spending habits.

Despite recently reported increases in hotel revenues

relative to the first quarter of 2009, many luxury hotels

may not see their room rates reach 2007 levels for

several years and many full-service hotels will

struggle to maintain profitability in low margin

business lines such as spa and restaurant services.


10June 2010 11

* EstimateSource: SEC

2008 2009 YOY

ChangeYOY

Change

Saks Inc.

Tiffany & Co.*

Nordstrom, Inc.

Macy's

Retailer Sales per Square Foot

-14.4%

-9.6%

-5.2%

-5.0%$152

$368

$2,759

$351-6.6%

-10.7%

-10.8%

-5.3%$160

$388

$3,051

$410

To the extent hotel revenues decline further, the

negative effects on property net cash flows will become

increasingly amplified as fixed costs consume a greater

proportion of operating expenses. Many of the full-

service hotel operators that we met with confirm that

they have already “squeezed out” most of the possible

fixed cost savings in 2008 and 2009, as certain costs

such as insurance and real estate taxes cannot be

reduced further.

Certain retail properties could also struggle in the New

Normal. Many retail properties built in anticipation

of large housing developments will simply suspend

operations, because sustained reductions in the home

ownership rate mean that many planned housing

developments will not restart for years.

Luxury retail properties may also struggle in this

environment. Retail rents are often structured to

include a base rent and a percentage rent (overage) that

is tied to store sales. This direct link between rental

rates and store sales highlights the sensitivity of luxury

retail properties to both short term drops in sales

and long term reductions in discretionary spending.

The chart below illustrates the challenges that luxury

retailers faced in 2009.

Re-regulation: Another RiskAn increasingly uncertain regulatory environment may

also constrain the recovery of CRE values. Recently

proposed regulatory and accounting rule changes

(such as FAS 166 & 167, which impact the off-balance

sheet treatment for securitized assets) may reverse, or

at least limit the re-emergence of traditional conduit

lenders. Federal proposals to date have not clearly

addressed risk retention requirements for CMBS

issuers and the uncertainty around future regulatory

pressures may negatively affect the economics of new

securitization. Without further clarity on these issues,

limited securitization will deprive CRE markets of an

important source of capital.

Spotting the Opportunities As the deleveraging cycle unfolds, attractive

opportunities are likely to be available to investment

platforms with the flexibility to access CRE

opportunities across the capital landscape and who can

provide liquidity over the long term. The slow recovery

cycle, however, favors patient investors who understand

the relative value dynamics of both capital structures

and asset profiles.

We conclude by looking at some of these opportunities:

FDIC Dispositions – Regional and community

banks are particularly sensitive to both national and

local economies and have been acutely affected by

the distress in residential and commercial real estate

markets. There were 140 bank failures in 2009 and

an additional 78 through May 2010, representing

approximately $240 billion in assets.

Troubled banks have suffered losses on their CRE loan

portfolios and eventually will be forced to transfer

these risks off their balance sheets either through

11

FDIC assisted transactions or voluntarily ahead of

receivership. Historically, intensive risk transfer

environments have provided opportunities for

investors to acquire distressed loan portfolios. Recently,

the FDIC has also indicated that it will consider

securitizations of bank CRE loan portfolios.

While bank loan dispositions may offer compelling

opportunities to acquire loan pools at discounts, we

caution that these opportunities are complex. The

limited transaction time frames and non-institutional

nature of the underlying collateral requires investors

to have both the experience and infrastructure to

underwrite and manage large pools of loans efficiently.

Restructuring of Large CRE Loans – Most of the

private-equity-fueled mega deals of 2006 and 2007 are

just beginning to unwind. As large CRE loans mature,

lender syndicates that own the debt will look to exit or

restructure. Property recapitalizations, including loan

restructurings (where a new investor contributes capital

in exchange for a reduced senior loan principal balance

and a preferred equity position), can provide investors

with a lower cost basis and a share of the upside

returns. However, these types of restructurings are

complex transactions that will require investors to have

substantial capital to participate in larger deals, as well

as relationships with both lenders and borrowers.

CMBS Opportunities – Many traditional buyers of

subordinate CMBS tranches, including mortgage

REITs and special servicer affiliates, have disappeared,

creating an opportunity for new investors to acquire

discounted subordinate positions and potentially

influence the outcomes of CMBS-securitized loans.

Also, constantly shifting spreads among bond classes

create arbitrage opportunities for investors who

understand the relative risks between various bond

classes and CMBS deals.

Relative Value Opportunities – Capital flows alone

should not be a gauge of where attractive investment

opportunities lie. As mentioned earlier, many owners

in primary markets are perplexed by the extent of

non-U.S. capital flowing into their markets. With this

in mind, new investors should not expect a continued

rapid appreciation in pricing for trophy assets in these

markets. Conversely, owners of grocery-anchored

retail assets in smaller markets express frustration in

securing financing today, despite strong tenant profiles

and positive demographics. As capital returns to CRE,

we expect this yield spread (as reflected by cap rates)

between trophy assets and less liquid, quality assets in

smaller markets to eventually tighten.

As with any market that is undergoing unprecedented

change, attractive opportunities will exist for the

prudent and disciplined investor. Though difficult

to measure in a limited transaction environment,

commercial real estate valuations have clearly returned

to more rational relationships with property-level

fundamentals. However, the deleveraging cycle and

structural headwinds will result in a slow recovery

with pockets of volatility to be expected. Extreme

discipline in assessing both the asset level and

macroeconomic risks will be critical to making the

right investment decisions.

840 Newport Center Drive Newport Beach, CA 92660 949.720.6000

Past performance is not a guarantee or a reliable indicator of future performance. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Investing in distressed loans and bankrupt companies are speculative and the repayment of default obligations contains significant uncertainties.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO. CRE001-051410

Commercial Real Estate TeamPIMCO

John Murray, Commercial Real Estate Portfolio Manager and PIMCO’s CRE/CMBS Team:

Dan IvascynScott SimonJosh AndersonJohn MurrayChristian StrackeJon Yip

Kent SmithStefanie EvansRussell GannawayJesse BrettingenBryan TsuSean McCarthy

Josh OlazabalJennifer BridwellCarrie PetersonRyan MurphyJoyce Chang

Pimco Commercial Real Estate - June 2010

Real Estate

Transcript of Pimco Commercial Real Estate - June 2010