1970’S

1. The EVOLUTION of the INSTITUTIONAL REAL ESTATE MARKET • Sensing a business opportunity, the first real estate investment advisory firms were • formed aimed at the pension fund market. • U.S. Pension Fund Industry enters the real estate market. • They were searching for investment vehicles that would do better than the stock • market because in 1973 and 1974 it lost more than 40% of its value. Bond investing • was even less rewarding because unanticipated inflation created huge losses in most • fixed income portfolios. This same inflation fed returns in real estate, as hard • assets of all kinds rose sharply in nominal value. • The passage of ERISA encouraged fiduciaries to diversify their portfolios. • Modern portfolio theory was used to create an academically grounded way to think • about asset allocation. • The data that existed suggested that real estate returns had a low correlation with • stocks and bonds, and could add to risk adjusted returns when incorporated into • multi-asset class portfolio. • It’s ability to act as a hedge against inflation was demonstrated dramatically in the • 1970’s, and its returns were strong relative to other financial instruments. 1970’S Source: Pension Funds and Real Estate: Still Crazy After All These Years By Bernard Winograd, CEO Prudential Real Estate Investors

2. 1980’S • The number of real estate advisors grew from 15 to 70. • Consultants arrived who specialized in real estate. • Asset allocation recommendations often suggested putting up to 20% of a fund’s assets into real estate. • At the beginning of the decade, the primary investment vehicle was a commingled fund. • Partnerships and other closed-end vehicles became part of the landscape by the end of the decade. • The early investment experience was good, and the diversification benefits were real, which led to more participation. • The National Council of Real Estate Investment Fiduciaries (NCREIF) was created and the NCREIF Index began to be used as a benchmark for measurement of industry performance. • Capital was piling into the industry in the late 1980’s at unsustainable rates from the pension funds and the S & Ls. • The influx of capital led to an unprecedented building boom, nearly doubling the amount of office space in the U.S. Source: Pension Funds and Real Estate: Still Crazy After All These Years By Bernard Winograd, CEO Prudential Real Estate Investors

3. When demand for property collapsed in the recession of the early 1990’s, vacancy rates on office properties in many markets soared to over 20%. • The S & L industry went through a massive restructuring led by the newly created government Resolution Trust Corp. (RTC). The RTC took over hundreds of failed S & Ls and tried to liquidate their assets in a market where there was no liquidity. • All of the other traditional sources of capital for the industry fled the market as insurance companies and banks originated less in new real estate loans. • There was a liquidity crisis. • Investor faith in open-end commingled funds as a vehicle was badly shaken because they could not get out of their investment because of the lack of liquidity. • Investors were feeling betrayed by the advisors they had hired. They concluded that their interests were not well aligned with their advisors’ because the fee structures consisted of basis points for each dollar of assets, so their incentive was to keep assets under management and maximize reported values. These reported values were more subjectively determined than in public markets with daily mark-to-market pricing. In response, many investors came to believe that partnership structures were a better format to create alignment of interest with their advisor. 1990’S Source: Pension Funds and Real Estate: Still Crazy After All These Years By Bernard Winograd, CEO Prudential Real Estate Investors

4. Others decided that the right solution was to retain as much control as possible over the investment process and to use their consultants to help decide when to sell. • Another result of this disillusion was new players entered the market as sponsors of opportunity funds, many of them affiliated with Wall Street real estate investment banking departments that previously had not been in competition for pension fund real estate assets. • The investment opportunities created by the resale of the S & L assets were substantial, and required familiarity with the pricing of securitized investment vehicles. This was a relatively new field for the real estate industry, largely created as a result of the RTC and the Wall Street houses were well suited to it. • Structuring their investment vehicles as highly leveraged close-end limited partnerships, the opportunity funds had a simple investment strategy: buy as much as they could, leverage it as much as they could, and wait for markets to recover. They projected that they could earn substantial returns on the equity invested, 20% and more, and they backed up their views with substantial co-investment commitments by sponsoring firms and investment principals. • By the end of the 1990’s, virtually every major owner-operated real estate investor advisor sold itself to a financial institution, in part motivated by the need to deal with client demands for increasingly substantial co-investment. • The REIT industry started the 1990’s with less than 10 billion in assets because of their past difficulties. 1990’S Cont. Source: Pension Funds and Real Estate: Still Crazy After All These Years By Bernard Winograd, CEO Prudential Real Estate Investors

5. The creation of the UPREIT structure ( umbrella partnership REIT) marked the turning point in the relative importance of the REIT as an investment vehicle. • Traditionally, large private developers of real estate had avoided REITS for tax reasons. Partnerships were the preferred method of owning property, they allowed individuals in the real estate business to shelter huge amounts of income by passing through the depreciation to their personal returns. Contributing their properties to a REIT in order to become a public corporation was a taxable event that triggered so much depreciation recapture as to be economically prohibitive. Thus, the largest pools of quality real estate were essentially cut off from using the public markets for equity because of tax consequences. • The UPREIT solved this problem by admitting a REIT into existing real estate partnerships as a partner, and then selling REIT shares to the public to raise capital to re-capitalize the partnership. The trick was to design the structures so that the REIT investor had the same economic experience as the rest of the partners (other than taxes). • This feat of financial creativity was first achieved by Taubman Centers in its 1992 IPO, and was quickly imitated in a flood of other UPREIT IPOs that brought capital into the industry. Within five years, the market capitalization of the REITS had ballooned to over $125 billion. • Obviously one of the contributors to this success was also the dramatic improvement in the fundamentals of the real estate industry in mid-1990’s. 1990’S Cont. Source: Pension Funds and Real Estate: Still Crazy After All These Years By Bernard Winograd, CEO Prudential Real Estate Investors

6. The economy picked up steam, vacancies began to fall and rents began to increase. • In that same time period, the other public market source of new liquidity was the dramatic growth in commercial mortgage-backed securities (CMBS) as a source of long term debt financing. CMBS issuance began to escalate sharply in 1996. The growth of this market was a direct consequence of the activities of the RTC in working out the seized assets of the S & L industry. • The government effectively pioneered the creation of a technology for pricing pools of real estate assets, one that allowed the rating agencies to pick up where they left off in rating of single assets and to begin issuing credit ratings for pools of mortgages. As a result, institutions that needed obligations with high credit ratings to invest became sources of capital for commercial mortgages on a much larger scale than before. • Up to that point, insurance companies had been virtually the only buyers of long term mortgage debt, with an annual capacity of approximately $20-$25 billion a year. Rated CMBS paper eliminated a number of obstacles that were in the way of other institutional buyers: the complexities of servicing a mortgage, the lack of a secondary market, the problems measuring risk of default without employing a sophisticated and large real estate organization, and the uncertainties of cash flows that resulted from all of these problems. Now, buying the topmost credit tranches of a CMBS issue allowed even the most risk-averse lenders to participate in lending to the real estate industry. 1990’S Cont. Source: Pension Funds and Real Estate: Still Crazy After All These Years By Bernard Winograd, CEO Prudential Real Estate Investors

7. Annual CMBS issuance quickly became a multiple of the lending done by the insurance companies, and CMBS outstanding grew in a mirror image of the growth of REIT market capitalization. • The consequences to the real estate capital markets of these twin sources of public market capital were profound. Liquidity increased significantly, the complexity and range of investment vehicles available to investors in the industry multiplied. Public market volatility introduced new kinds of liquidity risk to real estate investing. • Late 1998, for example, the real estate market was fundamentally sound, yet the disruptions in public markets triggered by the implosion of Long Term Capital Management and the Russian bond default caused liquidity to the industry to dry up virtually overnight. Asset values dropped 15-20% in a single quarter and the real estate industry saw that using public markets as a capital source had drawbacks as well as rewards. • The transparency the public markets created began to have the most important effect. Thanks to the public disclosures of the REITs and the credit analysis of the rating agencies, there was an explosion of information about how real estate of various kinds was faring in the US property markets. Increasingly sophisticated reports on trends in default rates enhanced the markets understanding of risks. • The real estate industry experienced an unusual period of equilibrium that began after the liquidity crisis of late 1998 and continued into early 2001. 1990’S Cont. Source: Pension Funds and Real Estate: Still Crazy After All These Years By Bernard Winograd, CEO Prudential Real Estate Investors

8. Supply and demand stayed in rough balance, leading to sustained low levels of vacancies without a rush of overbuilding such a two year plus period of stability was virtually unprecedented in the industry. • The most plausible explanation for this unusual state of affairs was that transparency had begun to create permanent changes in the volatility of the market. It was the most material change in the environment, and seemed the logical choice as an explanation. 1990’S Cont. 2000 • The year 2000 provided almost ideal ammunition for the advocates of a continued role for real estate in institutional portfolios. For most of the funds that had the exposure, real estate was their top performing asset class. REITS substantially outperformed the broader market for the year, with the NAREIT index up almost 27% while the S&P 500 lost a little more than 9%. For institutional investors looking for income, the asset class remains attractive. Source: Pension Funds and Real Estate: Still Crazy After All These Years By Bernard Winograd, CEO Prudential Real Estate Investors