Tiring and Boring???

Thomas J. Barrack, Jr.

It seems last week I caused a bit of a stir in an article on my thoughts about the current state of the US real estate
market. I indicated that as a global financial investor I am feeling as though I enter the octagon every day,
training with the top Ultimate Fighters in the world. Tap outs and submissions do not come quickly or without
learning the art of “taking a punch.” This is applicable to every aspect of life.
Business is anything but boring and the challenges on every continent are manifold while the visibility,
transparency and predictability of all asset classes in all regions is a blur. I indicated that the US real estate
market in particular was tiring and boring and the greatest tool kit today was to be well versed in hand-to-
hand combat. Some reporters and pundits believed I had committed a mortal sin by not waxing poetic about
the invigorating, refreshing and unlimited upside attributes of real estate speculation at this cyclical inflection
point. Let me shed a bit of lucidity on my point of view, which was intended to properly align expectations
with reality – something we do not do often enough in the global investment world.
Real estate investing is a complex, cyclical business made up of trillions of dollars of disparate non-
homogeneous assets. The industry today does not lend itself to speculative trading based upon cheap and
plentiful debt and euphoric future rental growth projections. Let’s start with the basic and very general
premise that US commercial real estate fundamentals are still poor and recovering slowly, if at all. This is of
course a generalization; however, with soaring deficits, weak GDP growth, massive unemployment and
continuing corporate contraction of G&A, it could be no other way.
There are intermittent signs of hospitality occupancy rates leveling, regional mall sales resuming and an
occasional sale of an asset at nosebleed levels. However, according to Moody’s All Property Real Estate
Index, US values are still off 40% from their peak in late 2007 (see chart below). The nominal CAGR for real
estate values since the beginning of the decade is just over 1%.

Moody’s All Property Real Estate Index

Note: As of March 2010, Indexed to December 2000 – 100

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For the most part, the fundamental law of supply and demand is alive and well, which largely explains why
real estate rents and revenues in current dollar terms have been flat since 1994 (see chart below).

$ / SF / Yr Real Asking Rents (1994 Dollar Terms) $ / Unit / Mo

$30 $1,050
$25 $1,000
$20 $950
$15 $900
$10 $850
$5 $800
$0 $750
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Office Retail Warehouse Apartment (RHS)

Source: PPR

Additionally, zero interest rates and the regulatory relaxation of mark to market requirements for banks has
all but abated the flow of troubled commercial debt to be recycled through the system. Rather than a
tsunami, it has been a knee-high wave.
To make matters worse, capex has been scarce in many projects since 2007 and the amount of deferred capex in
most property types is significant. Thus cash flow for leasing commissions, tenant improvements, key money
and deferred maintenance is nowhere to be found in a still opaque and weak new real estate lending
environment.
The disposition of distressed commercial mortgages has not happened at a scalable level as a result of
relaxed mark-to-market regulations; untested special servicers and CMBS waterfalls; tranche warfare
amongst holders of various classes of debt; zero interest rates; “pray and delay” and “extend and pretend”
strategies. Consequently, the anticipated recycling profits from a massive macro correction in debt has been
slow to come and many funds have been frustrated by the lack of product at what they believe to be attractive
discount pricing. As a result, there are very few market clearing transactions for non-strategic, long-term
buyers.
Many owners realize their equity value is gone but in many cases, due to historically low floating interest
rates, can still make debt service if the term of the loan is extended. Everyone is playing for option value
and it is a slow moving train, which becomes a bit “Japanese-esque,” and the tea leaves tell me that this
stage will be here for a while.
Commercial banks feel no pressure to mark the loans to market value because the regulatory requirements
have provided a relaxation of LTV mark-to-market tests if sufficient debt service is still available.
Consequently, a loan originated in 2007 on a $100 property at 70% LTV and 1.0x DSC with a 5.5%
interest rate can still be “OK” at an LTV of 150% because artificially low interest rates are driving up
coverage ratios to acceptable levels (see chart below); thus the dawning of “extend and pretend” and “delay
and pray.”

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 Floating Rate CRE Loan Surviving Because of Low LIBOR
2007 Origination PURGATORY Today
Annual Cash Flow $5.0 $3.5
Cap Rate 5.0% 7.5%
Property Value $100 $47
Loan $70 $70
Loan-to-Value (LTV) 70% 150%
(1)
Loan Coupon Rate 5.50% 1.50%
Annual Interest Expense $4.8 $2.9
DSCR 1.0x 1.2x
(1): Floating rate assumes L+100 bps with 30-year amortization

Real estate equity is moving slowly because a substantial disparity between most buyers and sellers still
exists. Buyers have been anticipating price corrections as a result of the market downturn and continued
deterioration in fundamentals while sellers who are not under bank or mortgage pressure are simply holding
their ground. In most cases they have little incentive to sell, and due to their own debt issues, more likely than
not, have lots of reasons to hold.
With the cost of their liabilities near zero, banks have been earning money in recent quarters and reserves are
building. A more vibrant flow of private treaty real estate loans is beginning to materialize and we expect, as
loans get closer to term limits in 2011 and 2012, there will be significantly more loan sales coming to market.
In an environment where the government continues to print money and create massive accumulating deficits,
inflation will surely return at some point. However, the deleveraging cycle in real estate must first run its course.
A resurgence of demand for product will coincide with better pricing power, which will once again drive values.
After we experience deflationary correction across our economy we will then be in the wake of significant
inflation. The only non-printable currency is hard assets and over time hard assets will carry the day.
In summary, solid risk-adjusted returns will be made by true real estate professionals with the tools and the
teams to plow and hoe. By being in the marketplace, we will sense when that next repricing opportunity
exists and will avail ourselves of it. The business is not about inventing the next iPad or launching the largest
leverage buyout. It is about showing up, doing a good job, harvesting reasonable returns for our investors
(which will look strong in hindsight against other asset classes), and waiting for the repricing moment.
The fast money, high velocity, handsomely leveraged, quickly appreciating days of real estate investment are
not in the near-term tea leaves. Real estate has returned to the hands of real estate professionals, not financial
arbitrageurs, and most real estate opportunities in the US involve hand-to-hand combat on restructurings or
intensive value-added implementation. In either of those two circumstances, the process is slow and low. It is
an era of what real estate is supposed to be – singles and doubles. Home runs will be few and far between,
while the World Series is still a bit in the future and only after a very long season of individual games, made
up of individual innings, made up of individual at-bats.
If my rendition of the above has been a bit tiring and boring, then I have effectively conveyed my message.
Thankfully, the business has finally returned to the real real estate business.
Bottom line, there’s nothing new. As in all aspects of life, expectations based on anything other than reality
will always lead to disappointment. Reasonable expectations are the key to peace of mind.