REITs INVESTMENTS IN A POST SUB-PRIME MARKET. S. Gregory Cope May 1, 2008

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1 REITs INVESTMENTS IN A POST SUB-PRIME MARKET S. Gregory Cope May 1, 2008

2 THE SUB-PRIME MELTDOWN Decreased underwriting and lending standards led to an explosion of sub-prime residential mortgage loans These loans generally were packaged and repackaged in RMBS and CDOs Approximately 80% of sub-prime loans originated have been securitized (WSJ, March 3, 2008) Defaults in sub-prime mortgage loans began to increase significantly in 2007, which led to a decrease in the valuations of RMBS and CDOs Resulted in massive write-downs by financial institutions

3 THE SUB-PRIME MELTDOWN The credit crunch Because of the massive write-downs, financial institutions had less access to the securitization markets, less balance sheet capacity and a diminished appetite for risk. Contagion has spread into other mortgage markets and specialty finance markets Decreased valuations of assets Reduced ability to finance assets

4 IMPACT ON REITs Mortgage REITs and the Margin Spiral - Lower valuations led to credit crunch, which caused forced selling of assets to meet margin calls, which flooded the market with more assets for sale, which caused lower valuations... Equity REITs Decreased market valuations and less financing available, although real estate fundamentals (other than housing) remain relatively sound

5 IMPACT ON REITs Significant reductions in stock market valuations During 2007 through Feb. 1, 2008, REITs down 24% (U.S. News & World Report, Feb. 8, 2008) According to Green Street, REITs trading at 14% below underlying asset values and office REITs trading at 18% discount All Real Estate is Local - Impacting different types of REITs in different markets in different ways. Markets and REIT types most reliant on housing hit hardest

6 IMPACT ON THE MORTGAGE MARKETS Residential Reached every corner of the residential mortgage markets Defaults on sub-prime mortgage loans approximately 20% (WSJ, Nov. 19, 2007) Commercial Less of an impact Defaults on CMBS approximately 0.4% (WSJ, March 3, 2008) CMBX indexes that track CMBS imply a decline in valuations of 20% of more (WSJ, March 13, 2008) Moody s warned in early Jan that the corporate default rate could reach 12% in 2008 (WSJ, Jan. 17, 2008) The reductions in debt cost for REITs have not kept up with the Fed s rate reductions

7 IMPACT ON REITs FINANCING METHODS Reduced capital raising from common stock and debt issuances Lowest number of offerings in 2007 since 2001 & 2002 levels (NAREIT) Nine (9) offerings in Jan. & Feb. 2007, five (5) of which were by equity REITs (NAREIT) Increased balance sheet lending by financial institutions, which often require more cash and have more stringent terms. Due in large part to the reduction in the CMBS market. CMBS market estimated to be half of 2007 levels (Financial Week, Jan. 2, 2008) Life insurers funding more real estate loans and now hold a competitive edge over the securitization market. Expect this to last through 2008 and beyond (UBS REIT team, March 10, 2008)

8 IMPACT ON REITs FINANCING METHODS REITS considering raising opportunity funds and pursuing more JVs Permits REITs to monetize a portion of their interest in properties Permits REITs to retain exposure to these properties and earn management fees Provides large institutional investors with real estate exposure in certain markets and property types without incurring the expense of hiring a management team to manage properties Prevented some REITs from refinancing debt New York City - General Motors building Las Vegas Cosmopolitan Resort Casino Centra Properties Group of Australia short term debt

9 IMPACT ON M&A ACTIVITY Drastic slow-down in going private transactions and M&A deals Beginning in mid- to late 2007, the credit crunch slowed the pace of the acquisition of REITs and commercial real estate by private equity firms During recent years, private equity firms had a significant role in increasing real estate valuations due to their ability to acquire properties or REITs with cheap debt and to resell properties for a quick profit

10 IMPACT ON M&A ACTIVITY Less Deal Volume with Buyers Waiting for Cap Rates to Increase Cushman & Wakefield Capital Markets Executive VP Scott Latham, whom Banc of America Securities REIT team has called a leading investment sales professional in New York, expects all transaction volume to trend down in 2008 as liquidity in CMBS market not expected to re-emerge until 2 nd half of 2008 and expecting basis point increase in cap rates Sam Chandan, chief economist at Reis Inc., a propertyresearch firm based in New York, predicts rent increases will continue to slow over 2008 but that rents and occupancy rates expected to stay relatively firm in 2008 (WSJ, Jan. 2, 2008)

11 IMPACT ON M&A ACTIVITY Goldman Sachs projected a decline of 21% to 26% in commercial real estate values in the next two (2) years (WSJ, March 3, 2008) New York City commercial values have fallen 20% from their peaks per Lawrence Russo of Russo Capital in New York, a commercial real estate advisor. Caused largely by the freeze on commercial real estate lending. The last time REIT readings were this low was just before the multi-year real estate recession in the early 1990s (WSJ, Jan , 2008) Fundamentals in commercial real estate remain stable, but investment fading in 2008 following a record year in Investment dollar volume could drop by 30-40% in 2008, similar to 2006 levels (National Association of Realtors, March 12, 2008)

12 IMPACT ON M&A ACTIVITY Several REITs have announced in the last six (6) months that they had been considering buying other REITs or selling to private equity firms in 2007, but ceased this activity due to the debt market s instability Credit crunch resulted in a reduction of commercial and residential real estate development. Deals underway are continuing, but new projects are being delayed or canceled as financing dries up and housing and economy slow down (SNL Financial, March 27, 2008) Transaction agreements being executed, but some transactions failing to close due to inability to obtain financing Vulture investing on the uptick

13 IMPACT ON M&A ACTIVITY Market conditions have created a call for change in Washington, DC. Many expect the next presidential administration to increase the capital gains tax. As a result, real estate investors beginning to forego 1031 exchanges and pay capital gains taxes now at the current rate (Dow Jones, March 10, 2008) Attractive time to acquire properties? Cheap dollar Demand still relatively high New supply lower than in the past in non-residential sectors Valuations/cap rates becoming more attractive Impacts largely due to cap rate uncertainty, depressed stock prices and difficulty in obtaining debt financing

14 CHANGE IN DEBT TERMS Lenders requiring smaller LTV ratios, larger deposits and escrows for building maintenance and repairs, etc. Lenders tightening covenants, including restrictions on incurring additional debt, debt service coverage ratios, etc. Doc # v. 2