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Transcript of THE PAUL MILSTEIN CENTER FOR REAL ESTATE Professor Chris Mayer Columbia Business School Hedge Funds,...
THE PAUL MILSTEIN CENTER FOR REAL ESTATE
Professor Chris MayerColumbia Business School
Hedge Funds, Private Equity and Real Estate:
Valuations Now and in the Future
Flood of new money into real estate
• Great returns for 7+ years• Institutions have historically underinvested in real
estate• Seemingly strong risk-return characteristics work
well in many portfolio models• Outlook for other asset classes is not as attractive• Hedge against inflation• Real estate provides good diversification• Earnings growth projections are very strong
Want to understand the key features of current real estate market
• Cap rates at or near all-time lows• Spread between cap rates in superstar markets and
other markets has never been wider• Repeated take-private LBOs over last several years• Private equity continues to raise ever larger funds to
invest in US and abroad (oten with few restrictions in what they can invest in)
Asset values look quite high by historical standards
-50%
0%
50%
100%
150%
200%
250%
300%
350%
1997-2006 1997-1999 2000-2007
Re
turn
NAREIT Composite Index S & P 500
REITs outperform S&P 500 by 120% in the last decade
“Tech Boom”
“REIT Boom”
Source: NAREIT & Standard and PoorsNAREIT vs. S&P 500 ReturnsCurrent as of Apr. 24th, 2007
Overall
24
68
10
1985q4 1995q4 2006q4
ATLANTA
24
68
10
1985q4 1995q4 2006q4
BOSTON
24
68
10
1985q4 1995q4 2006q4
CHICAGO
24
68
10
1985q4 1995q4 2006q4
DENVER
24
68
10
1985q4 1995q4 2006q4
HOUSTON
24
68
10
1985q4 1995q4 2006q4
LOS ANGELES
24
68
10
1985q4 1995q4 2006q4
SAN FRANCISCO
24
68
10
1985q4 1995q4 2006q4
WASHINGTON, DC
Source: Global Real Analytics & St. Louis Federal ReserveSpread Between Apartment Cap Rate & Real Interest Rate
Current as of Quarter 4, 2006
Spread Long Run Avg.
Apartment cap rate spreads to real rates are near their lows in 1980s!
02
46
8
1985q4 1995q4 2006q4
ATLANTA
02
46
8
1985q4 1995q4 2006q4
BOSTON
02
46
8
1985q4 1995q4 2006q4
CHICAGO
02
46
8
1985q4 1995q4 2006q4
DENVER
02
46
8
1985q4 1995q4 2006q4
HOUSTON
02
46
8
1985q4 1995q4 2006q4
LOS ANGELES
02
46
8
1985q4 1995q4 2006q4
MANHATTAN MIDTOWN
02
46
8
1985q4 1995q4 2006q4
SAN FRANCISCO
Source: Global Real Analytics & St. Louis Federal ReserveSpread Between Office Cap Rate & Real Interest Rate
Current as of Quarter 4, 2006
Spread Long Run Avg.
Office cap rate spreads are also quite low!
20
40
60
80
10
0
1985 1996 2006
ATLANTA
20
40
60
80
10
0
1985 1996 2006
BOSTON
20
40
60
80
10
0
1985 1996 2006
CHICAGO
20
40
60
80
10
0
1985 1996 2006
DENVER
20
40
60
80
10
0
1985 1996 2006
HOUSTON
20
40
60
80
10
0
1985 1996 2006
LOS_ANGELES
20
40
60
80
10
0
1985 1996 2006
NEW_YORK
20
40
60
80
10
0
1985 1996 2006
SAN_FRANCISCO
Source: Global Real Analytics & FREDOffice Rent
Current as of Quarter 4, 2006Figures in $2006
Good news: Real office rents are still quite low by historical standards
ATLANTA
BALTIMORE
BOSTON
CHARLOTTE
CHICAGO
DALLAS
DENVER
HOUSTON
LOS ANGELESMANHATTAN DOWNTOWN/NYC
MINNEAPOLIS-ST PAUL
NEW YORK
ORANGE COUNTY
ORLANDO
PHILADELPHIA
PHOENIX
RIVERSIDE-SAN BERNARDINO
SACRAMENTO
SAN DIEGOSAN FRANCISCO
SEATTLE
TAMPA/ST. PETERSBURG
WASHINGTON, DC
.04
.05
.06
.07
.08
.09
Cap
Rat
e (%
)
-4 -3 -2 -1 0Real Rent Growth (%)
Source: FRED, Phil Fed, Global Real AnalyticsCap rates (2006) vs. Real rent growth (1986-2006) :: Office
Current as of Quarter 4, 2006
Cap rates have become much more compressed in historically high rent
growth markets
Comparing public and private market valuations
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
4020
0-2
0R
etur
n
NAREIT NCREIF
Source: NCREIF & NAREITNAREIT vs. NCREIF Yearly Returns
Current as of Apr. 24th, 2007
Public real estate appears more volatile (but is this really true?)
But at least real estate is lower risk and provides a good hedge against
the rest of the market
Or does it???
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
6040
200
-20
-40
Ret
urn
NAREIT S&P 500
Source: S&P & NAREITNAREIT vs. S&P 500 Return
Current as of Apr. 24th, 2007
During the tech boom, real estate provided great diversification
Avg '97-'040.32
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1/97
7/97
1/98
7/98
1/99
7/99
1/00
7/00
1/01
7/01
1/02
7/02
1/03
7/03
1/04
7/04
1/05
7/05
1/06
7/06
1/07
REIT betas have increased to exceed 1.0 the last several years!
Sources: Oak Hill REIT Management, BloombergBETA (RMS vs SPX), Rolling 2-yr Avg.Current as of Apr. 24th, 2007
BETA (RMS vs. SPX)
0.5
11.
52
2.5
Per
cent
1994 1996 1998 2000 2002 2004 2006 2008Date
Source: BloombergSPX 120 Day Return Volatility
Current as of Apr. 24th, 2007
We have heard a lot about how stock market volatility has fallen
SPX Return 120 Day Volatility
0.5
11.
52
2.5
Per
cent
1994 1996 1998 2000 2002 2004 2006 2008Date
Source: BloombergRMS 120 Day Return Volatility
Current as of Apr. 24th, 2007
But REIT volatility has steadily risen!
RMS Return 120 Day Volatility
0.5
11.
52
2.5
Per
cent
1994 1996 1998 2000 2002 2004 2006 2008Date
Source: BloombergRMS & SPX 120 Day Return Volatility
Current as of Apr. 24th, 2007
Now REITs are more volatile than the S&P 500
SPX Return 120 Day Volatility
RMS Return 120 Day Volatility
$-
$2,000,000
$4,000,000
$6,000,000
$8,000,000
$10,000,000
$12,000,000
$14,000,000
$16,000,000
$18,000,000
3.00
%4.
00%
5.00
%6.
00%
7.00
%8.
00%
9.00
%
10.0
0%
11.0
0%
12.0
0%
13.0
0%
14.0
0%
c
NOIP
Low cap rates & convexity lead to volatility!
REITs help us compare real estate return potential to other asset
classes
10-yr Treasury
Fwd AFFO Yld
0%
2%
4%
6%
8%
10%
12%
14%
1/90
1/91
1/92
1/93
1/94
1/95
1/96
1/97
1/98
1/99
1/00
1/01
1/02
1/03
1/04
1/05
1/06
1/07
Per
cen
tREIT earnings yields are at record lows compared to 10-yr Treasuries
-110 bp
Sources: Green Street Advisors and Federal Reserve
Current as of Apr. 24th, 2007
Fwd S&P Earnings Yld
Fwd AFFO Yld
0%
2%
4%
6%
8%
10%
12%
14%
1/90
1/91
1/92
1/93
1/94
1/95
1/96
1/97
1/98
1/99
1/00
1/01
1/02
1/03
1/04
1/05
1/06
1/07
Per
cen
t
-220 bp
But REIT earnings yields are also at record lows compared to the S&P 500
Source: Green Street Advisors and Standard & Poors
Current as of Apr 24th, 2007
Can we get enough growth?
Can REIT earnings growth outperform the S&P 500 by enough?
• REIT Earnings estimates are strong– AFFO Growth 2007: 8.5 to 9.0%– AFFO Growth 2008: 9 to 11%
• S&P 500– Earnings growth 2007: 11.6%– Earnings growth 2007: 3.4 %
• But historical NOI growth for real estate averages slightly below inflation in most markets, so rent growth will moderate beyond 2008 in most property types
Why is there such a disconnect between public and private
valuations?
-30%
-20%
-10%
0%
10%
20%
30%
40%
1/93
1/94
1/95
1/96
1/97
1/98
1/99
1/00
1/01
1/02
1/03
1/04
1/05
1/06
1/07
Per
cen
t
Long-term Average = 6.6%
REITs trade at a historical discount to private RE on an NAV basis!
Source: Green Street Advisors, Current as of Apr 24th, 2007
REITs have not increased leverage as debt costs have fallen
Source: Green Street AdvisorsREIT Leverage Ratio: debt as % of asset value)Current as of Apr. 24th, 2007
40%
43%
45%
48%
50%
53%
55%
1/01
4/01
7/01
10/0
1
1/02
4/02
7/02
10/0
2
1/03
4/03
7/03
10/0
3
1/04
4/04
7/04
10/0
4
1/05
4/05
7/05
10/0
5
1/06
4/06
7/06
10/0
6
1/07
4/07
Date
Per
cen
t REIT Leverage Ratio
05
1015
2025
Per
cent
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007year
AA A BBBBB B
Source: Bear Sterns Trepp LLC & Moody'sCMBS SubordinationCurrent as of Apr 24th, 2007
Subordination levels fallen a lot!
010
020
030
040
050
0B
asis
Poi
nts
Jan 1999 Jan 2001 Jan 2003 Jan 2005 Jan 2007date
AAA AA A BBB BB
Source: Bear SternsCMBS 10 Year Swap SpreadCurrent as of Apr 24th, 2007
And CMBS spreads have fallen a lot, especially for non-investment grade bonds
But why did we see the recent jump?
The housing market may yet come back to bite commercial real estate
020
040
060
080
0B
asis
Poi
nts
Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan 2007date
AAA AAA BBB
Source: Bear SternsABS CBO SpreadsCurrent as of April 24, 2007
CDO spreads have jumped up with the mess in subprime loans
Non-investment grade CLO spreads also increased
020
040
060
080
0B
asis
Poi
nts
Jan 1999 Jan 2001 Jan 2003 Jan 2005 Jan 2007date
AAA AA ABBB BB
Source: Bear SternsCLO SpreadsCurrent as of April 24, 2007
Securitization has led to substantial increases in leverage
and greater systemic risk throughout the entire financial
system
Where should do things go from here?
• Real estate has benefited more than almost any other asset class from the flood of global liquidity
• Very risky time in real estate– Debt market changes– Recession risk– Congress may raise taxes on carried interest
• Need to find sustained areas of real growth• REITs must eventually come back in favor at
attractive prices compared to other companies