Expectations & Market Realities In Real Estate 2011 - A Deloitte whitepaper

1. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2 0 1 1
BALANCING RISK AND RETURN IN AN ERA OF UNCERTAINTY
DELOIT TE | R E a L E s TaT E R E s E a R c h c O R p O R aT I O n | R E a L c a p I Ta L a n a Ly T I c s

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of this report are not engaged in rendering legal or accounting services. This report does not constitute an offer to sell or a solicitation of an offer to buy any
securities, and the authors of this report advise that no statement in this report is to be construed as a recommendation to make any real estate investment
or to buy or sell any security or as investment advice. The examples contained in the report are intended for use as background on the real estate industry as
a whole, not as support for any particular real estate investment or security. Neither Real Estate Research Corporation (RERC), Deloitte, nor Real Capital Ana-
lytics (RCA), nor any of their respective directors, officers, and employees warrant as to the accuracy of or assume any liability for the information contained
herein. Unless otherwise noted herein, the data presented in this report is sourced from RERC and RCA.
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3. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2 0 1 1
BALANCING RISK AND RETURN IN AN ERA OF UNCERTAINTY
DELOIT TE | R E a L E s TaT E R E s E a R c h c O R p O R aT I O n | R E a L c a p I Ta L a n a Ly T I c s

4. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y
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New York City, San Jose, London, Singapore and The Hague. Started in 2000, the firm’s
proprietary research is focused exclusively on the investment market for commercial real
estate. In addition to collecting transactional information for current property sales and
financings, RCA analyzes and interprets the data, providing valuable insight on commer-
cial real estate investment. Covering all markets globally, RCA’s investment market data
and analysis is relied upon by all segments of the real estate community: buyers, develop-
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FOREWORD
April 2011
Dear Readers,
As we put the finishing touches on our annual forecast report, Expectations & Market Realities in Real Estate 2011, we are
struck by the challenges facing the commercial real estate industry in this uncertain world. Despite our experience and sense
of having been through this all before, we remain cautious with our expectations and about the investment environment over-
all. The recovery that took hold in the second half of 2010 continues, but we are well aware of the headwinds that could quickly
derail both the growth of our economy and the markets.
As such, Real Estate Research Corporation (RERC), Deloitte, and Real Capital Analytics (RCA) are pleased to present this fun-
damental guide for Balancing Risk and Return in an Era of Uncertainty. Our collective viewpoints, commentary, and analy-
ses offer you an unbiased look at what you can expect regarding the expanding economy, capital markets, and individual
property markets throughout 2011 and beyond.
Thank you to everyone who has contributed to this report, including research analysts and data providers, economists, busi-
ness associates, research survey respondents, and the many others who have shared your information and ideas. We also
thank you—our readers, clients, and consultants—for your interest in our report, and we hope you find Expectations & Market
Realities in Real Estate 2011—Balancing Risk and Return in an Era of Uncertainty helpful as we navigate through a still-
fragile recovery.
Sincerely,
Matthew G. Kimmel, CRE, FRICS, MAI Kenneth P. Riggs, Jr., CFA, CRE, FRICS Robert M. White, Jr., CRE, FRICS
Principal & US Real Estate Services Leader President & CEO Founder & President
Deloitte Financial Advisory Services LLP Real Estate Research Corporation Real Capital Analytics, Inc.
© 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 5

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ACKNOWLEDGEMENTS
SponSoRing FiRmS & ChAiRS RERC EDitoRiAL boARD
matthew g. Kimmel, CRE , FRiCS, mAi Deloitte Financial Advisory Services LLP Stephen blank Urban Land Institute
Kenneth p. Riggs, Jr., CFA, CRE, FRiCS Real Estate Research Corporation David blankenship AEGON USA Realty Advisors, Inc.
Robert m. White, Jr., CRE, FRiCS Real Capital Analytics, Inc. nicholas g. buss INVESCO Real Estate
Susanne Cannon DePaul University - The Real Estate Center
geoffrey Dohrmann Institutional Real Estate, Inc.
Stephen Furnary ING Clarion Partners
ContRibuting AuthoRS michael gately Cornerstone Advisers
David geltner MIT Center for Real Estate
Jacques gordon LaSalle Investment Management, Inc.
barb bush Real Estate Research Corporation
John Levy John B. Levy & Company
Sam Chandan, phD. Real Capital Analytics, Inc.
mary Ludgin Heitman Capital Management, LLC
todd J. Dunlap, mAi, mRiCS, Senior manager
Dennis martin RREEF/DB Real Estate
Deloitte Financial Advisory Services LLP
glenn mueller University of Denver
David garcia Deloitte Financial Advisory Services LLP
Scott muldavin The Muldavin Company, Inc.
Kenneth W. Kapecki, mAi, CRE, FRiCS, Senior manager
Joseph pagliari University of Chicago
Deloitte Financial Advisory Services LLP
Richard Sokolov Simon Property Group
Lindsey Kuhlmann Real Estate Research Corporation
Allan Sweet AMLI Residential Properties, LLC
Andy miller, manager Deloitte Financial Advisory Services LLP
R. brian Webb UBS AgriVest, LLC
Doug murphy Real Capital Analytics, Inc.
Charles Wurtzebach DePaul University-The Real Estate Center
peter Slatin Real Capital Analytics, Inc.
Sam Zell Equity Group Investments, LLC
patrick terriault Real Capital Analytics, Inc.
nina turner Real Capital Analytics, Inc.
brian Velky, CFA Real Estate Research Corporation
morgan Westpfahl Real Estate Research Corporation
EDitoRiAL oVERSight
peter Slatin Real Capital Analytics, Inc.
DESign & LAyout
Luke baldwin 21Fingers
Jeff Carr Real Estate Research Corporation
othER DiStinguiShED ContRibutoRS
Robert bach Grubb & Ellis
Ronald Johnsey Axiometrics, Inc.
Robert mandelbaum PKF Hospitality Research
R. mark Woodworth PKF Hospitality Research
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CONTENTS
1 | intRoDuCtion
Balancing Risk and Return in an Era of Uncertainty .............................................................................................................................8
2 | thE CApitAL mARKEtS
Capital Begins to Flow .............................................................................................................................................................................11
3 | thE pRopERty mARKEtS
Perspective and Analysis ........................................................................................................................................................................21
4 | outLooK FoR 2011 AnD bEyonD
Uncertainty and the Need for Balance ..................................................................................................................................................39
SponSoRing FiRmS
................................................................................................................................................................................................................... 44
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1 | INTRODUCTION
balancing Risk and Return in an Era of uncertainty
When Real Estate Research
Corporation (RERC), Deloitte, and
Real Capital Analytics (RCA) first dis-
cussed partnering together to publish
this forecast report, a distinct sense of
uncertainty about the economy, about
the capital markets, and about com-
mercial real estate dominated our
conversation. Our unease was under-
standable—we were barely out of the
longest and most severe recession
since the Great Depression, the level
of U.S. debt was reaching epic propor-
tions, and the number of new bank
failures attributed to their exposure to
bad commercial real estate loans was
increasing weekly.
It seemed that the invest-
ment environment was finally start-
ing to turn around when a new Con-
gress came to town and tax cuts were
extended for businesses and individu-
als. We were thrilled when the stock
market finally began to grow by leaps
and bounds, and even more thrilled environment, although improv- in Real Estate 2011—Balancing Risk
when institutional real estate returns ing, remains uncertain. Risk is ever- and Return in an Era of Uncertainty.
increased to approximately 13 percent present and returns seem to be fleet- In this first introductory chapter to
in fourth quarter 2010, according to the ing for all asset classes, as investors the report, we have focused on the
National Council of Real Estate Invest- try to balance these opposing forces. economy and the various risk factors
ment Fiduciaries (NCREIF). associated with our fragile recovery as
As such, investors are focusing the backdrop for investing in commer-
As 2011 got underway, we on why they invested in real estate in cial real estate. Chapter 2 examines
looked for additional signs of recovery, the first place. Real estate is a tangible the debt and equity markets, as well
but major world crises during the first alternative to the more volatile stock as the banking practices/new regula-
few months of this year—the earth- market, and is more transparent than tions affecting the availability of capi-
quake, tsunami, and nuclear power stocks. It offers reasonable income tal. In Chapter 3, we take a close look
disaster in Japan, the unrest spread- returns, which investors are seeking at the office, industrial, retail, apart-
ing throughout the Middle East, the today, instead of the glitz and glamour ment, and hotel markets, and analyze
sovereign debt crisis in Europe and of Wall Street. No one wants, or can volume, pricing, capitalization rates,
the downgrading of those nations’ afford, to make mistakes, and by focus- vacancy/occupancy rates, and rental
credit ratings, continued threats of ing on the fundamentals of their prop- rates/revenue for the specific property
terrorism, to name a few—reminded erty investments, investors are keeping sectors. In our final chapter, we offer
us how quickly real events can temper things simple and direct. our collective assessment and invest-
optimism. Now, as the year unfolds, ment outlook for the risk and return
the economy still faces a series of That is what we have tried to do associated with the major property
speed bumps, and the investment in Expectations & Market Realities markets for 2011 and beyond.
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consumers have recaptured a measure
of confidence. Banks and other lend-
ers, emerging from unprecedented
upheaval, have loosened the strictures
on credit, supporting a modest renewal
of investment and spending. And
whereas the initial return to growth
was powered by a dramatic and costly
surge in public activity, the private sec-
tor has now taken the place of the gov-
ernment in sustaining the expansion.
However, employers have a long
way to go in replacing the 8.7 million
jobs lost in 2008 and 2009. Through
early 2011, we have measured the
slowest progress in the labor market’s
recovery following any post-World War
II recession. For most of the past year,
the absence of robust payroll growth
has followed from slack in the utiliza-
tion of currently employed workers and
strong gains in productivity. In recent
economic history, these are typical fea-
tures of a recovery in the labor market
For policymakers and businesses alike, new threats to geopolitical and that lags the broader economy’s emer-
global macroeconomic stability have added to the prevailing headwinds… gence from recession.
commercial property investors and lenders have nonetheless powered
forward, albeit unevenly, anticipating stronger fundamentals…. But exacerbating the expected
lag in payroll gains, businesses have
been navigating a more complicated
thE EConomy of the recovery has precluded a singu- route in the current recovery, manag-
lar focus on the issues that are within ing the aforementioned uncertain-
A “Qualified” Recovery Presents New our control. In the face of this remark- ties around the regulatory and policy
Challenges able opacity, commercial property environment and, more recently, an
investors and lenders have nonethe- increasing incidence of mismatch
In the aftermath of this genera- less powered forward, albeit unevenly, in required skill sets and the skills
tion’s deepest and most destabilizing anticipating stronger fundamentals as present in the unemployed labor pool.
recession, many of our foundational the recovery progresses. In 2010, com- Job openings remain extremely low
assumptions about the American mercial property sales doubled from by any historic norm, but have been
economy and investment environ- the previous year’s nadir. The market’s increasing in recent months. However,
ment have been upended. While the momentum has carried over into 2011, in many of the sectors that are most
economy has resumed its expansion, with broad metrics relating to liquid- crucial for a recovery in spending and
questions about the speed and dura- ity and credit availability reflecting direct space demand, hiring has not
bility of the recovery have coincided investors’ optimism in the sector’s kept pace.
with profound uncertainties relating trajectory.
to the direction of monetary and fiscal The most recent data suggest
policy and the changing relationship A Fragile Economic Recovery that hiring may accelerate modestly
between government, business, and over the course of 2011. Barring any
the American people. For policymak- Even as investor activity has disruptive shocks, the consensus esti-
ers and businesses alike, new threats picked up, the economy and labor mar- mates suggest that payrolls at midyear
to geopolitical and global macroeco- kets have measured qualified gains. may be expanding at a fast enough
nomic stability have added to the pre- The recession has been over for longer pace to offset new entrants to the
vailing headwinds; the broader context than it lasted, and businesses and labor force, thereby reining in broader
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measures of unemployment. Still, have curtailed their lending. This when some of the most aggressively
property investors with heady expecta- improvement in mortgage availabil- underwritten loans have yet to mature,
tions for job growth and space absorp- ity has been necessary for a broader remains an issue for the market. While
tion must contend with the possibility move towards normalization in the a sudden outpouring of distress would
that stresses on cash flow may persist. sector’s capital markets. inevitably provide opportunities for
Rebalancing Investment
The qualified economic tra-
jectory has prompted investors to
assign unusually large premiums to
the liquidity of assets. As a result, the
industry’s headline statistics belie a
striking and persistent unevenness of
the recovery in investment and credit
trends. In a flight to quality, investors
over the past year have focused their
efforts on acquiring properties in the
nation’s most visible and most liquid
markets. This focus has resulted in
a concentration of capital in a small
subset of markets—New York City, Coinciding with the improving distress investors, it would do so by
Washington, D.C., and San Francisco position of many lenders, the dominant undermining the price stability that
foremost amongst them. It is in these role of agency financing in the apart- has been crucial in driving improve-
markets that competition for assets ment sector has moderated as other ments in sales and credit.
has been most intense, supported by institutions have begun to compete
a diversity of domestic and foreign more aggressively for lending opportu- The Year Ahead
investors, with domestic investors nities. In major markets, in particular,
frustrated by the absence of opportu- institutional and securitized lenders’ Whether in primary markets
nities in distress and foreign investors readiness to provide new acquisition or further afield, the positive trends
less dependent on mortgage financ- financing on performing assets has in headline transaction volume may
ing. In some cases, pricing threatens to supported the shift in investor activity continue into 2011, barring a serious
decouple from the fundamental basis away from the agency and private buy- reversal in the underlying economic
for value. ers that dominated activity in 2009 and and labor market recovery. But in
early 2010. measuring this recovery, investors will
Underpinning gains in major have to remain vigilant, particularly as
markets and for the highest quality As an important facilitator of concerns the magnitude of job growth,
properties, the availability of credit this healthier new acquisition financ- the regulatory and policy environ-
in support of significant property ing environment, additions to distress ment, and the complex, nonlinear rela-
sales, as well as for the refinancing of nationally fell to their lowest levels in tionship between broad interest rates
maturing debt, has improved sharply 2 years in third quarter 2010, reflect- and cap rates.
in recent quarters. Buoyed by the ing a slower pace of deterioration in
aforementioned pricing trends and legacy mortgage pools and the positive In the realms of public and pri-
nascent recovery in property funda- impact of more stable economic and vate markets, and at their juncture,
mentals in major markets and some credit market conditions. Of course, significant risks may continue to exert
property sectors, a broader range of slower inflows to distress and the drags on consumer and business con-
lenders—including commercial mort- absence of distress investment oppor- fidence in a way that is material for the
gage-backed securities (CMBS) con- tunities do not mean that deteriorating commercial property outlook. Given
duit originators, foreign banks, and mortgage performance is not a feature this unique environment of uncer-
life companies—has re-engaged with of the market landscape. Rather, dis- tainty, and in planning for the future,
commercial real estate investors in tress has been heavily intermediated, investment strategies that anticipate
the latter half of 2010, albeit on terms left unresolved, or is residing on bank the need for flexibility (as opposed to
that remain conservative by historic balance sheets. The question of how we relying on a rigid and deterministic
standards and even as smaller banks manage to draw down these balances, outlook) remain critically important.
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2 | THE CAPITAL MARKETS
Capital begins to Flow
responding to RERC’s institutional
investment survey have seen the
availability of capital for commercial
real estate investment increase sig-
nificantly from its low in third quarter
2008 (see Exhibit 2-1). In fourth quarter
2010, the availability of capital began
to overtake discipline for the first time
since the financial crisis began. Capi-
tal flows increased from virtually every
sector, including private investors,
pension funds, real estate investment
trusts (REITs), institutions, foreign
investors, and others. Many respond-
ents to RERC’s investment survey also
stated that they intend to direct more
capital toward commercial real estate
during 2011 than they invested in 2010.
This changing sentiment is
Despite a residential market that of this will likely be directed toward also reflected in the Buy-Sell-Hold
is still in decline, anemic employment commercial real estate, investors recommendations noted by RERC’s
growth, and a record-high federal debt,
the U.S. economy saw positive growth Exhibit 2-1. RERC Historical Availability and Discipline of Capital
throughout 2010 and is expected to
continue to grow, if slowly, over the 10
next few years. This is no small feat,
9
given the recent near-collapse of our
nation’s financial system and a reces-
8
sion more severe than any since the
Great Depression. It is a tribute to the 7
nation’s economic resilience to have
survived this crisis, and although a 6
Rating
great deal of uncertainty continues in
the economy, the geopolitical land- 5
scape, and the markets, we are hopeful
that the broader recovery holds posi- 4
tive prospects for forward momentum Discipline
in commercial real estate investment. 3
Availability
2
Capital has become increasingly
accessible, as companies, funds, and
1
individuals continue to regain some
1
2
04
05
06
07
08
09
10
3
0
0
0
20
20
20
20
20
20
20
20
20
of the wealth lost in the crash; accord-
20
4Q
4Q
4Q
4Q
4Q
4Q
4Q
4Q
4Q
4Q
ing to some estimates, corporations
Ratings are based on a score of 1 to 10, with 10 being high.
are holding as much as $2 trillion in source: RERc, 4q 2010.
reserve. Although only a percentage
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institutional investment survey Exhibit 2-2. RERC Historical Buy-Sell-Hold Recommendations
respondents (Exhibit 2-2). The Hold
reference retains the highest-rated 10
recommendation, reflecting quite
9
clearly the dominant strategy within
the market. But more interesting, and
8
perhaps more relevant, is the narrow-
ing gap between the Buy and Sell rec- 7
ommendations, indicating increasing
agreement on pricing and valuation. 6
Rating
While we have seen transactions in the
top-tier markets for high-quality prop- 5
erties at record high prices during the
past few quarters, demand is starting 4
to extend to core properties in some of
3 Hold
the secondary and tertiary markets as
well, as investors move out on the risk Sell
2
spectrum. Buy
1
01
02
03
04
05
06
07
08
09
10
LEnDing StAbiLiZES AnD
20
20
20
20
20
20
20
20
20
20
4Q
4Q
4Q
4Q
4Q
4Q
4Q
4Q
4Q
4Q
iSSuAnCE piCKS up
Ratings are based on a scale of 1 to 10, with 10 being high.
source: RERc, 4q 2010.
As commercial real estate own-
ers continue to deleverage, many key
lending sources have become more approximately 23 percent of banks Still, certain commercial real
flexible in the treatment of existing tightened their lending standards estate loan terms tightened in 2010. The
debt, but have been less accommo- (this was down significantly from a Federal Reserve’s January 2011 Senior
dating concerning new loan origina- high of 87 percent in fourth quarter Loan Officer Opinion Survey on Bank
tion. Commercial mortgage origi- 2008, immediately following the col- Lending Practices further stated that
nations, though increasing, remain lapse of Lehman Brothers). about 40 percent of domestic banks on
significantly below peak-market levels. net reported having tightened loan-to-
While new issuances from alternative Buttressing the warming trend, value ratios, and a moderately smaller
sources remain minimal, new lending about 10 percent of domestic banks fraction tightened debt service cover-
is expected to continue at subdued lev- on net reported increased demand age ratios and maximum loan sizes
els in the near term. However, stabili- for commercial real estate loans in during fourth quarter 2010.
zation is apparent and signs of revitali- fourth quarter 2010, the strongest
zation are evident. reading since early 2006. Foreign Despite examples of tighten-
banks also reported that net demand ing, according to preliminary esti-
Bank Lending had strengthened, according to the mates from the Mortgage Bankers
Federal Reserve. Association’s (MBA) Quarterly Survey
Banks initially responded to
the financial crisis by rapidly tight-
ening underwriting on commer-
cial loans, but in general, approval
standards began to ease in 2010. The
January 2011 Federal Reserve’s Sen-
ior Loan Officer Opinion Survey on
Bank Lending Practices noted that in
fourth quarter 2010, approximately
69 percent of banks left their lending
standards for commercial real estate
basically unchanged, approximately 8
percent of banks eased standards, and
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13. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y
of Commercial/Multifamily Mortgage
Bankers Originations, mortgage bank-
ers originated $110 billion of commer-
cial and multifamily mortgages during
2010, up a healthy 36 percent from 2009
originations.
The threat to banks associ-
ated with bad loans remains great,
but according to the Federal Deposit
Insurance Corporation (FDIC), the
number of bank failures should
decline in 2011. Although 157 banks
failed in 2010 (the most since 1992
during the savings and loan crisis) and played in the financial crisis, issuance required to execute. Additional fund-
884 banks remained on the FDIC’s list dropped to nearly zero in 2009 (just ing sources are also emerging, includ-
of problem banks at the end of fourth $720 million was issued in 2009). But ing covered bonds, which consist of
quarter 2010, the FDIC expects to see last year, lenders issued a total of $11.6 securities issued by banks and backed
fewer bank failures in 2011. (For com- billion of CMBS, and improved condi- by a “cover pool” of mortgage or public-
parison, there were no bank failures tions have led most analysts to expect sector loans. This vehicle is one of the
in 2006 and only three in 2007.) $35 billion to $45 billion of CMBS issu- oldest forms of capital in the European
ances in 2011 according to Standard & bond market, and could provide a new
Other Sources of Mortgage Poor’s (S&P’s) estimations. However, funding mechanism as the industry
Originations that is still far off the market’s peak of attempts to rebound. Another simple
$230.5 billion in 2007. and direct throwback that is being uti-
Life insurance companies were lized is seller financing, in which the
a leading source of lending in 2010, Securitized loans issued in 2009 seller provides a secured loan to the
with originations volume 155 percent and 2010 have been dubbed CMBS 2.0, buyer to finance a portion of a prop-
higher than 2009 levels, although the and are characterized by simpler struc- erty’s purchase price.
dollar volume was low in absolute tures that involve greater subordina-
terms. Significantly, the MBA reported tion levels, fewer classes and loans, A breakdown of 2010 investment
that originations for CMBS conduits and thicker tranches, all designed in commercial real estate by investor
increased more than 10-fold in 2010, to reduce the level of due diligence type is shown in Exhibit 2-3.
and that government-sponsored enti-
ties (GSEs) also saw strong volumes, Exhibit 2-3. Commercial Real Estate Investor Groups (2010)
with increases in production for FHA/
Ginnie Mae offsetting a decline in User/Other
Private
production for Fannie Mae/Freddie 9%
30% Cross-Border
Mac. Although the low absolute levels
7%
dramatically inflated the growth per-
centage, there were clearly positive
changes in borrowing and lending for
commercial real estate.
Institutional
Going forward, the expectation 13%
Non-Listed
is that more favorable market condi-
REIT 9%
tions for both lenders and borrowers
will likely help boost CMBS issuance in
the near term, although the level will
remain below the 2007 peak over the Listed/REIT Equity Fund
18% 14%
longer term. In 2008, CMBS accounted
for 25.6 percent of commercial mort-
gage loans; however, due to the cen-
source: Rca, february 2011.
tral role these and similar securities
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14. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y
Commercial Mortgage Debt Exhibit 2-4. Fixed-Income Lender Composition
According to the Federal Reserve Govt. Sponsored Entities
Flow of Funds, the level of commercial/ Savings Institutions 16% Other
6% 5%
multifamily mortgage debt outstand-
ing decreased to $3.15 trillion in fourth
CMBS, CDO and
quarter 2010 from third quarter totals. other ABS
As demonstrated in Exhibit 2-4, the 9%
largest holder of commercial debt con-
Commercial Banks
tinues to be commercial banks. 44%
high DEbt mAtuRitiES
REmAin A ChALLEngE
Life Insurance
While lenience by banks has Companies
20%
helped cushion commercial real estate
from a more severe downturn, the high
Fixed Income Markets - $3.15 Trillion
level of maturing debt remains a signif- Lender Composition
icant barrier to full recovery. The core
of the dilemma is that debt incurred at
source: federal Reserve, 4Q 2010.
The peak year for maturities is Stanley estimates that modifica- the market in 2007 and 2008 is set to
expected to be 2013, when $367.7 tions have pushed CMBS maturities mature in 2012 and 2013. The peak year
billion will come due, before the from the 2009-2011 range out to the for maturities is expected to be 2013,
amount decreases modestly to 2013-2017 time period. As the major- when $367.7 billion will come due,
$333.0 billion in 2015, and then ity of commercial real estate loans are before the amount decreases modestly
subsides to less than $100 billion for a period of 5 years, a majority of to $333.0 billion in 2015, and then sub-
by 2020. the debt incurred during the peak of sides to less than $100 billion by 2020.
Exhibit 2-5. Commercial Real Estate Maturities Set to Peak in 2013
the top of the market is now coming due
at a time when economic uncertainty $400
and barely recovering commercial Other
real estate fundamentals are making it $350
harder for borrowers to generate cash Life Cos
flow needed to make debt payments. In $300
fact, Trepp, LLC noted that as much as CMBS
60 percent of current commercial real $250
Banks
estate loans maturing between 2011
Billions
and 2015 are considered “underwater,” $200
indicating the amount of debt exceeds
the market value of the property itself. $150
How Big Is the Dilemma? $100
Trepp, LLC predicts that an $50
estimated $1.7 trillion in commer-
cial real estate debt is set to come due
$0
between 2011 and 2015, a figure that
11
12
13
14
15
16
17
18
19
20
could turn out to be even higher once
20
20
20
20
20
20
20
20
20
20
the impact of “amend and extend” is
source: Trepp, LLc, 4Q 2010 update.
considered (see Exhibit 2-5). Morgan
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15. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y
impact of “Amend and Extend”
One of the main reasons for the unique nature of this has been reached, and further delaying the inevitable may
downturn is the way banks have approached troubled cause a more severe downturn in the future.
debt. In their efforts to stem write-downs, banks have
taken a longer-term approach to potential losses, working guidance by regulators has certainly shaped banks’ re-
to modify and extend soured commercial real estate loans sponse to their troubled loan portfolios. In October 2009,
in anticipation of improving values. In previous cycles, the the federal financial Institutions Examination council
combination of sharply declining property values and the (ffIEc), which includes the federal Reserve, fDIc, and
comparatively short duration of commercial real estate the comptroller of the currency, responded to concerns
loans (generally 5 years) resulted in substantial write- about commercial property losses and debts coming due
offs for lenders and increased foreclosures for owners. by issuing a policy statement suggesting that performing
however, this downturn has been characterized by a new loans would not be declared troubled solely because of a
willingness by banks to modify and extend the terms of decline in the value of underlying collateral.
loans unlikely to return full value on principal and interest
accrued. This “amend and extend” strategy commonly in- While the ffIEc guidance was intended chiefly to improve
volves permitting below-market interest rates and stretch- consistency and flexibility in the treatment of commercial
ing out maturities for borrowers with troubled loans. real estate loans, the initial result was greater confusion
in the market, with some lenders misinterpreting the
This has enabled owners to retain properties rather than guidance as a form of forbearance and an incentive to
lose assets and investment, and it has also prevented the restructure maturing loans. In response, in May 2010, the
investment market from being flooded with deeply dis- ffIEc held a conference call with 1,400 bank executives,
counted properties—to the frustration of some opportun- explicitly stating that it did not intend for investors and
istic investors. banks, in turn, have been able to delay and bankers to interpret the guidance as a call to amend and
even reduce write-offs on commercial real estate loans extend existing loans.
until favorable conditions return, which helps to classify
some troubled loans as performing, thereby minimizing since the ffIEc’s original guidance, lenders have favored
the amount of reserves banks must set aside. workouts over foreclosures. This is an encouraging sign
that widespread commercial real estate foreclosures may
The main disadvantage for this practice is that a protract- be delayed until the economy improves; however, it also
ed period of restructuring limits returns on commercial indicates that a significant number of maturing loans have
real estate. In addition, such extensions put a floor under yet to be included in the process.
the market, making it difficult to know when the bottom
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16. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y
Underlying Factors: Moderating Exhibit 2-6. Delinquencies Remain Elevated, but Starting to Decline
Delinquencies and Defaults
11
Although a high level of com- 10
Delinquency Rate
mercial real estate debt remains in dis- 9
tress, the recent uptick in restructuring Charge-O Rate
and resolution of commercial loans is 8
a positive sign and the pace of defaults 7
and delinquencies has begun to sub-
6
side, as shown in Exhibit 2-6.
Percent
5
While the majority of outstand-
4
ing commercial real estate maturi-
ties are from loans issued by banks, 3
loan delinquencies from other lending 2
sources indicate a similar trend of lev-
eling off but not subsiding. For exam- 1
ple, Trepp, LLC reported that 30+ day 0
delinquencies on CMBS loans climbed
-1
rapidly from 4.36 percent in Septem-
01
02
03
04
05
06
07
08
09
10
ber 2009 to 7.61 percent in March 2010,
20
20
20
20
20
20
20
20
20
20
4Q
4Q
4Q
4Q
4Q
4Q
4Q
4Q
4Q
4Q
before leveling off between 8.5 per-
source: federal Reserve, november 2010.
cent and 9.3 percent from June 2010
through January 2011. Analysts expect
CMBS delinquencies to continue rising 2008 and 2010 but at a slower pace in the keys for buildings valued below the
at a modest pace, ultimately peaking recent quarters. amount of debt, and since commercial
between 10.0 percent and 12.0 percent. loans are non-recourse, it is actually
(Moodys forecasts that this rate will Although commercial real easier for commercial owners to walk
reach 9.5 percent to 11.0 percent by the estate defaults may be moderating away from their loans than for home-
end of 2011.) overall, there also have been more owners. While this may seem like an
reports of strategic defaults, a trend extreme step, it is often the result of
Aided by loan extensions, com- that has migrated from the residen- a pragmatic business decision to exit
mercial real estate mortgage defaults tial to the commercial property sector. profit-draining investments in order to
have followed a similar trend as delin- Some of the nation’s largest property divert funds to performing projects or
quencies, climbing rapidly between owners have recently chosen to return to shareholders.
There has been a shift in direc-
tion, however. As demonstrated in
Chapter 3 of this report, although
properties continue to go into default,
there was an inflection point with the
pace of resolutions beginning, how-
ever slowly, to eat away at the moun-
tain of distressed assets during fourth
quarter 2010.
REit REbounD ContinuES
Commercial real estate funda-
mentals may be in the early stages of a
slow recovery, but REITs have already
experienced a strong rebound. This
disparity has occurred because while
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17. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y
Exhibit 2-7. REIT Rebound Underway Competitive Performance
40 Recently REITs have also out-
performed competing asset classes,
30 making the category more attractive to
investors looking for vehicles with the
20 potential to provide a hedge against
the type of volatility that can be found
10 in the stock market. For example, as
demonstrated in Exhibit 2-8, for the
Percent
0 period of January 1 to December 31,
2010, REIT returns of 27.6 percent
-10 outperformed the Russell 2000 Index
return of 26.9 percent, the NASDAQ
-20
Composite return of 16.9 percent, the
S&P 500 Index return of 15.1 percent,
and the Dow Jones Industrial Average
-30
(DJIA) Index return of 11.0 percent.
The only investment types that have
-40
performed more favorably than REITs
06
07
08
09
10
recently have been the U.S. dollar and
20
20
20
20
20
gold, both of which perform well in
source: naREIT, December 2010.
times of turmoil.
operating fundamentals such as occu- equity offerings propelled the group REITs Raising Funds for External
pancy, rent growth and values are to a gain of 27.5 percent in 2009, Growth Opportunities
closely linked to the sluggish economy, according to the National Associa-
REIT gains have been driven by inves- tion of Real Estate Investment Trusts The share-price rebound for
tor perception of performance rela- (NAREIT). Even more equity and debt public companies has been driven by
tive to competing asset classes such as issuance and their aggressive acqui- investors’ realization that REITs not
stocks and bonds. Return on invest- sition programs gave REITs another only took on far less debt than private
ment for REITs has outperformed the 28-percent gain in the past year (see real estate investors during the com-
securities markets, as well as commer- Exhibit 2-7). Much of the growth was mercial property market’s run-up from
cial real estate in general, during the driven by the performance of apart- 2005 to 2007, but also that they had
recovery. Public companies have been ment, lodging, retail, self-storage, and sold at (and in some ways defined) the
taking advantage of the spotlight by office REITs. However, the industrial top of the market while private equity
raising both equity and debt at histori- segment lagged. investors continued to buy. Conversely,
cally low costs, and that, in turn, has
led to increased acquisition activity for Exhibit 2-8. REITs Outperforming Competition
the sector. In 2010, according to RCA,
U.S.-based listed REITs acquired $24.7 Asset Class 2007 2008 2009 2010
billion of properties in all main prop- Public REIT (All REIT Index) (17.83) (37.34) 27.45 27.58
erty types, up from $4.7 billion in 2001;
their acquisition market share rose to Russell 2000 (1.57) (33.79) 27.17 26.86
18 percent of all transaction activity in
2010 from 6 percent in 2009. NASDAQ 9.81 (40.54) 43.89 16.91
S&P 500 5.49 (37.00) 23.46 15.06
Robust Returns
Private Real Estate
15.85 (6.46) (16.85) 12.55
Following a 7-year run of posi- (NCREIF Property Index)
tive results, return on investment
for REITs dipped in 2007, and then DJIA 6.43 (33.84) 18.82 11.02
dropped sharply to a loss of 37.3 per-
source: naREIT, December 2010.
cent in 2008. A wave of successful
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