Commercial Real Estate Fundamentals

1. Commercial Real Estate Fundamentals June 1, 2010

2. 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?

3. 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)

4. 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?

5. 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

6. 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

7. 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

8. 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

9. 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?

10. 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?

11. 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

12. How does debt effect returns? • When returns are higher than the cost of debt, leverage 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%

13. 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

14. Where does equity come from • Public companies • 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 • Largely private equity funds • Receive fees + promote • Finite length of investment • Highly levered to meet investor demands • Core, Core+, Value Add, Opportunity

15. 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