OPPORTUNITIES IN U.S. DISTRESSED REAL ESTATE

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1 OPPORTUNITIES IN U.S. DISTRESSED REAL ESTATE Access will be the most important determinant of real estate returns for investments made in Today s direct market prices are sufficient to generate acceptable but not exceptional returns over a five-year holding period this will not be a repeat of the mid-1990s when investors were able to generate 15%+ IRRs simply by acquiring core assets from distressed sellers. Buyers looking for distressed opportunities will need to access real estate on a relationship / off-market basis, such as direct purchases from banks, or indirectly, via debt or preferred equity offerings. Size and the ability to move quickly will provide access to the best opportunities. Private markets currently offer better opportunities compared to public markets. Office and hotel investments, especially in coastal markets, offer the best U.S. recovery prospects. JANUARY 2011 RESEARCH REPORT GLOBAL ECONOMIC AND PROPERTY MARKET OUTLOOK The world economy is in the midst of a two-track recovery. Developed markets, including most of Europe and the U.S., are just beginning to recover from deep recessions. Until private and public balance sheets are repaired, growth will remain subdued, with job creation sufficient to generate positive but not explosive demand for commercial real estate. Emerging markets will also experience lower growth rates than in 2010, but potential growth in much of Asia and Latin America is now considerably higher than in developed markets. The strong inventory rebuilding cycle has disproportionately benefited Asia Pacific ex-japan, which continues to lead the global recovery. Although this cycle is fading, intra-regional trade and domestic consumption will be sufficient to maintain healthy economic growth absent another recession in large developed countries. Risks are skewed to the downside, including both near-term and mediumterm sovereign risks, another financial crisis in Europe and/or the U.S., the possibility that government austerity measures are coincident and aggressive enough to put many economies back into recession, and the increasing risks of protectionist measures sparking a global trade war. Yields have compressed in every major market over the past months. However, as of early 2011, the period of yield compression appears to have mostly run its course. The peak-to-trough drop in yields has caused prices in the UK to rise by over 15% in one year, even as property incomes declined over the same period. Many other developed markets have experienced similar relief rallies that, with the benefit of hindsight, made mid-2009 the best time to buy core operating properties. Although we do not anticipate much if any further yield compression in most markets, low interest rates militate against rising yields for the time being. Even assuming there is a substantial increase in stabilized properties available for sale, we expect prime yields to remain well below mid-2009 peaks.

2 Investment demand for property is strong but not deep. Competition remains heated for stabilized properties in top locations, yet many potential sellers of non-stabilized assets are unable to get prices they are willing to accept. Although buyers have more recently begun to venture into more secondary locations or take on some lease-up risk, the bulk of demand, particularly from cross-border investors, is in a few safe haven markets, including New York, London and Hong Kong. Highest Return Lowest CBRE Investors Global House View as of January Year Outlook United Kingdom Source: CBRE Investors United States Canada Australia Singapore Germany Hong Kong China France Japan Nordics Central and Italy Eastern Europe Lowest Risk Highest We expect core returns on a five-year hold basis to be acceptable but not exceptional in all major markets. Most Eurozone countries are at the lower end of the expected return range, due to their outlook for a protracted economic recovery. Our most positive return outlooks are for North America and Singapore. On a risk-adjusted basis, developed markets are generally more attractive than emerging markets, particularly the U.S. and Canada. U.S. PROPERTY MARKET OUTLOOK Total returns over the next five years will be generated mostly by current income. Average cap rates are % for office, industrial and retail and 6.5% for apartments, making the current spreads over bond yields (350 basis points for apartments and basis points for others) extraordinarily favorable by historical standards. (Note, however, that cap rates in top markets such as New York and Washington, DC, are well below these national averages.) Because of this attractive income, there has been fierce competition among investors for core, stabilized assets, causing prices to rise since the second half of Multiple lenders including banks, insurance companies, government agencies and, more recently, conduits, are providing up to 70% LTV debt at very low rates, in some cases sub-4% for apartments and sub-5% for other property types. It is important not to read too much into this easy credit. Most capital sources, especially banks, are indeed active lenders, but they are refusing to refinance or extend more of their existing loans, and are reducing their net exposure to commercial real estate. Non-stabilized properties are still difficult to finance. Owners of these properties that need debt may be able to find it, but at high rates and low LTVs. Due to regulatory measures to prevent fire sales, we expect banks will reduce their commercial real estate exposure gradually. This will put a floor under prices and cause a steady flow of orderly liquidations rather than widespread distress. Strong demand from income-oriented investors will be met by this steady flow of bank sales, resulting in a prolonged period of price stagnation in most markets. Investors interest is gradually spreading to secondary assets as transaction volumes pick up. Risks for the U.S. outlook are low by comparison with other countries. The risk of a double dip recession is still present, but lower than it was in mid The near-term risks of oversupply and rent correction are low. Outside of the apartment sector, almost no major new projects are likely to launch in the foreseeable future and many early-stage developments have been delayed or even cancelled. High budget deficits and public debt or, on a more positive note, a significant acceleration in economic growth, could potentially cause a sharp rise in U.S. bond yields. However, the currently high spreads over government bond yields would shield cap rates from rising sharply, especially in comparison with other countries. OPPORTUNITIES IN DISTRESSED U.S. REAL ESTATE This section reviews future distress opportunities by 1) sector, 2) property type and 3) geography. In our view, the most important differentiation in today s market is the level of pricing efficiency across different sectors. Public debt and equity are now more efficiently priced (meaning there is relatively little distress) whereas private debt and equity have substantial pricing inefficiencies that will create more opportunities. By comparison, property type and geography, while important considerations for effective investment strategies, will be of secondary importance in accessing distressed opportunities. 2

3 1. Sectoral Opportunities Public Private Debt Buy existing CMBS Issue new CMBS Origination, unleveraged Origination, leveraged Loan pools / Loan-to-Own Equity REIT share purchases REIT debt issuances JV with / privatize REITs REIT IPOs On-market Off-market Secondary fund investments Preferred equity offerings Bold sectors represent the most favorable distressed opportunities PUBLIC DEBT LIMITED DISTRESSED OPPORTUNITIES IN 2011 Investors can participate in public debt markets by: 1) buying existing CMBS and 2) originating new CMBS. The opportunity to buy legacy CMBS at distressed prices ended in Pricing for legacy CMBS has rallied since then, even for vintages such as 2007 that were underwritten using very aggressive assumptions, as shown here. New CMBS originations may yield higher returns. Between the second half of 2008 and late 2009, there were virtually no new CMBS issued. Massive liquidity provided by the government through capital injections to recapitalize banks, ultra-low interest rates, and various programs to purchase securities has helped thaw credit markets. In 2010, $11.6 billion of CMBS was issued and met with strong investor demand. But originator returns will be constrained by market discipline and additional regulations that require high levels of subordination and retention of the lowest tranches. In addition, many originators may find it easier and equally profitable to sell A-piece debt to life insurance companies and others via private placements. As a result, we believe average common and preferred shares are now fairly valued, at best, with the possible exception of REITs that are positioned to capitalize on distress either via M&A or opportunistic portfolio purchases. REITs ability to raise debt and their cost of debt has also improved significantly since 2009, as shown here, which is favorable for them but not for debt investors seeking higher returns. Finally, most REITs are trading at a premium to our estimate of net asset values, which makes privatizations generally untenable, and REITs ability to access debt at very low rates makes them less willing to seek out JVs for capital infusions. REITs that do not have access to low-cost debt because of ongoing refinancing challenges may be attractive recapitalization opportunities, but we caution that most of these companies do not have best-in-class portfolios or management teams. 80 CMBS Prices Price Series (vintage '05) AAA Series 5 (vintage '07) Series 1 (vintage '05) PUBLIC EQUITY (REITS) LIMITED DISTRESSED OPPORTUNITIES IN AJ (Junior AAA) Series 5 (vintage '07) Investors can participate in U.S. REIT markets by: 1) purchasing REIT common or preferred shares; 2) purchasing REIT debt; 3) joint venturing with or privatizing existing REITs; and 4) sponsoring REIT IPOs. The strong REIT market recovery has made the first three options generally unattractive for investors looking for distressed opportunities. Most of the 67% peak-to-trough decline in REIT share prices was due to concerns about companies balance sheets, in addition to their ability to maintain occupancy and rent levels in a recession. Not only has the discount for solvency risk disappeared, but current REIT prices also generally imply a robust recovery in property incomes Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Source: Markit 3

4 REIT IPOs are a potentially lucrative way to arbitrage between high valuations in public markets and distress in private markets. However, recent blind-pool REIT IPOs have been met with lackluster demand. Portfolios of quality properties may be candidates for listings, but given strong demand for stabilized properties in private markets, they are currently expensive to assemble and may not command enough of a premium to offset IPO expenses. PRIVATE DEBT SUBSTANTIAL DISTRESSED OPPORTUNITIES IN 2011 AND BEYOND Investors can participate in private debt markets by: 1) originating new loans, with or without a leverage overlay; and 2) buying existing loan pools at a discount. We believe origination is particularly attractive now because it addresses a market need at a time when many holders of commercial real estate debt need to reduce their exposure. More than $1 trillion of mortgages will mature before Commercial banks have the largest share of commercial mortgage debt, currently holding 45% of the $3.2 trillion outstanding, as shown here. Many bank loans are shorter duration, typically three years, which means many of their loans have already reached or soon will reach their scheduled maturity dates. Banks will continue to lend, but on net they will reduce rather than expand their exposure, especially smaller regional banks. The reopening of CMBS markets will be insufficient to replace the huge wave of securitized debt maturing over the next five years and beyond. Life insurance companies and savings institutions will hold or slightly expand their market shares over the next decade. The fate of government sponsored entities including Fannie Mae and Freddie Mac is uncertain they will remain active lenders at least for the this year, but thereafter their multi-family lending activities may be scaled back. This provides an opportunity for private equity, mortgage REITs and other capital sources to fill the gap. Scarcity will allow originators to dictate high interest rates, substantial amortization and low loan-to-value ratios, generating core, equity-like returns at a safer position in the capital stack. Originators seeking higher returns can use leverage, either by obtaining maturity-matched loans at accretive interest rates, or by selling A-notes via private placements or CMBS issuances. Share of Commercial Real Estate Debt 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Share of Commercial Real Estate Debt 0% Source: Federal Reserve Flow of Funds Account (Z.1) Other GSE, Agency- and GSE-Backed Mortgage Pools Savings Institutions Life Insurance Companies CMBS/CDO and other ABS Commercial Banks Buying existing loan and loan pools at a discount, with or without a loan-to-own exit strategy, will become more common as banks and other lenders shrink their debt exposure. Although the commercial real estate downturn is already two years old, there have been very few large loan portfolios sold to date. But more portfolios are beginning to come to the market as banks, the FDIC and others increasingly aggressively dispose of loans. Investors will need to evaluate whether pricing is sufficiently discounted to generate appropriate risk-adjusted returns. $ Billions REIT Debt Issuance Debt Issued by U.S. REITs Average Cost of Debt NONE 0 4 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Source: CBRE Global Real Estate Securities Percent PRIVATE EQUITY SUBSTANTIAL DISTRESSED OPPORTUNITIES IN 2011 AND BEYOND Investors can participate in private equity transactions by: 1) buying publicly-marketed deals; 2) accessing offmarket deals; 3) investing via the secondary market in existing funds at a discount to par pricing; and 4) investing in preferred equity offerings by commingled funds. Prices have risen to the point that there are limited opportunities to access distress via publicly-available properties and portfolios. Importantly, cap rate compression has been strongest in the primary markets, and in particular in three trophy markets, as shown here. Primary markets offer the best future liquidity prospects and, as discussed later in the Geographic Opportunities section, we generally expect them to outperform smaller markets in terms of rent recoveries over the next five years. Unless there are widespread distressed sales, which we do not anticipate, it will be very difficult to buy assets in these markets at distressed prices. 4

5 Off-market deals will be an increasingly effective way to access distressed real estate. Many opportunity investors have built up war chests for an expected surge in distress that has not materialized. Right now, sellers are able to demand a quick close for off-market deals because buyers are finding themselves outbid for publicly-marketed core assets. Yet as banks begin to force more sales and dispose of REO assets directly, there will be an increase in offmarket deals, with discounted pricing particularly for assets in need of leasing and/or capital expenditures. Buyers with a demonstrated ability to close without financing will have access to the most deals at the most advantageous prices. At and immediately following the peak of the credit crisis in 2009, there were opportunities to purchase limited partner interests in existing funds at steep discounts, including in open-ended core funds, via the secondary market. (Note that there is no formally organized secondary market to buy shares in existing funds in the U.S., but there are dedicated placement companies and funds-of-funds that track activity.) However, now that fund holdings have been marked to reflect market values and property prices have risen from trough levels, most limited partners are choosing to maintain their ownership interests. Investors can expect to achieve a good but not exceptional return on secondary interests bought now, since current pricing does not reflect either seller or fund distress, and there is substantial competition for these interests. That said, over the next few years there will be occasions when fund sponsors, typically banks or other financial institutions, need to reduce or eliminate their co-investments in funds they sponsor to comply with new regulatory guidelines or as part of a sale of their investment management businesses. In these instances, the size of the co-investment interests may preclude all but a few large investors from bidding, and pricing may be more advantageous to buyers than making smaller secondary investments. Price Index (100=October 2007) Moody s/real Commercial Property Index 3-City Trophy All Cities Preferred equity offerings by closed-end funds will continue to be a way to access distress. Although property market fundamentals are close to bottoming out and many funds have successfully negotiated loan extensions, most closedend funds that made the bulk of their acquisitions in 2006 and 2007 will have liquidity challenges for the next two years or longer. The terms of preferred equity offerings are often very favorable for investors, such as periodic payouts (i.e., before a fund s scheduled liquidation) secured by discrete operating properties income streams. In many cases, existing investors are either unwilling or unable to participate. By law these are never publicly marketed, and this opacity means preferred equity investors have the ability to dictate favorable terms. 2. Property Type Opportunities All major property types have been hit hard by the Great Recession. Absorption has collapsed, occupancies have declined and rents have plummeted in all sectors. Property incomes declined throughout 2010 and will keep falling, in some cases, in We expect income growth to strengthen beginning in All property types are now reasonably priced based on the CBRE Investors Temperature Chart, as shown here, which is a proxy for real property values over time. HOTELS SUBSTANTIAL DISTRESSED OPPORTUNITIES IN 2011 Hotels were the first property type to feel the effects of the global recession because they have the shortest lease term, i.e., one night. Therefore they will experience the fastest and strongest recovery in revenue per available room (RevPAR) as business and leisure travel have already begun to increase. We forecast RevPAR will turn positive in 2011 and increase a cumulative 31% by 2015 from the trough in 2009, back to its pre-recession peak. Today s prices do not factor in this upside. However, due to hotels relatively quick and strong recovery, we expect the window to buy properties, portfolios and operating companies at distressed prices will be the shortest of the five property types. 50 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Source: Real Capital Analytics; 3-City Trophy is New York City, Washington, DC and San Francisco 5

6 OFFICE SUBSTANTIAL DISTRESSED OPPORTUNITIES IN 2011 AND BEYOND Although the average office vacancy is now a very high 16.4%, it is still below the peaks of previous recessions. Nevertheless, rents have collapsed in many markets. As demand rebuilds after 2011, rent growth will gain momentum. Through 2015, we forecast rents to increase 23%, bringing rents above their pre-recession peak. Prices have recently risen for stabilized office properties, but attractive opportunities will increase to buy distressed properties, particularly off-market. Percent Deviation from Long Term Average 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% CBRE Investors U.S. Temperature Chart -50% Source: CBRE Investors APARTMENTS MAY BE SOME DISTRESSED OPPORTUNITIES IN 2011 AND BEYOND Apartment Retail Office Industrial In 2009, apartments experienced their worst absorption ever and rents declined by a record 5%. However, apartment fundamentals have recovered strongly, with robust net absorption (especially notable given anemic job growth) and the beginnings of a rent recovery. This is good news for existing owners and core investors, but not for investors looking for distressed opportunities. To date, Fannie Mae and Freddie Mac debt has prevented widespread distress, causing prices to hold up much better than other property types. However, if the GSEs rein in their commercial lending activity over the next few years, there could be opportunities to acquire properties at distressed prices. RETAIL SELECTED DISTRESSED OPPORTUNITIES IN 2011 AND BEYOND Neighborhood and community centers, which rely on necessity expenditures that hold up well in recessions, have been relatively defensive investments. We forecast rents to increase 19% by 2015, back above their prerecession peak. There will be much variation in the retail sector, however, with many retailer consolidations causing previously well-performing centers to plummet in value. Affected centers may present attractive repositioning opportunities, but only where quality replacement tenants can be found. Cutbacks in discretionary spending initially hit upscale and luxury retailers hard, but that segment has outperformed recently. This bodes well for dominant regional malls, well-conceived lifestyle centers and the country s true 24/7 CBDs. Although distressed buying opportunities will be limited in neighborhood and community centers, and regional malls, there may be windows to acquire underperforming lifestyle centers at deep discounts. INDUSTRIAL LIMITED DISTRESSED OPPORTUNITIES IN 2011 AND BEYOND The industrial market will be the laggard of the group. Rents have declined 13% since their peak in While demand will strongly rebound beginning in 2011, the availability rate will take more than five years to recover to its long term average. We forecast cumulative rent change through 2015 will only total 16%, just enough to bring rents back to their pre-recession peak. These national averages include a high degree of product and locational obsolence, and state-of-the-art facilities in a few strategic gateway markets will outperform. Today s high cap rates make industrial acquisitions attractive for income-oriented investors. However, the slow rent recovery and poor occupancy rates will delay cap rate compression beyond the investment horizon of most opportunistic investors % rebound Rent Index (2000=100) 23% 19% 19% Hotel Office Apartment Retail Industrial Pre-recession peak Trough 2015 rent 16% Note: Revenue per available room shown for hotels Source: CBRE EA; PPR; CBRE Investors 6

7 3. Geographic Opportunities Property market fundamentals will stabilize and eventually recover over the next two to five years, but the recovery will be uneven across the nation. CBRE Investors Research classifies metro areas in our quarterly Investment Matrix Report based on their risk/return profile as Blue Chip (high return/low risk), High Yield (high return/high risk), Income (low return/low risk) and Contrarian (high return/low risk). We believe investors buying distressed assets should, whenever possible, focus on the Blue Chip markets, shown here. Blue Chip Recovery Markets Seattle Minneapolis New York Boston San Francisco Oakland San Jose Denver Philadelphia Washington, D.C. Long Island Los Angeles Orange County office apartment Riverside San Diego Phoenix Austin Dallas industrial retail 8 13 Houston West Palm Beach Fort Lauderdale Source: CBRE Investors Our current Blue Chip metro areas are generally large coastal, gateway cities with strong global linkages (Los Angeles, New York, San Francisco Bay Area) or metro areas with robust economic drivers such as technology (Austin, Boston, Seattle) or energy (Houston, Dallas). Three metro areas are Blue Chip metros for all four major property types (office, industrial, retail and apartments): Los Angeles, San Francisco and Seattle. DISCLAIMER Please note that the content of this report is for informational purposes only and should not be viewed as investment advice or an offer or solicitation. Any opinions are solely those of CBRE Investors and are subject to change without notice, and may not be consistent with market trends or future events. This report is based on current public information that we consider reliable, but we do not represent it is accurate, updated or complete, and it should not be relied on as such. 7

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