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Joseph L. Pagliari, Jr. Clinical Professor of Real Estate
November 6, 2013 URBAN LAND INSTITUTE
Urban Development/Mixed-Use Council Chicago, Illinois
Monetary Policy and Its Potential Impact
on Real Estate
1 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
4 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
5 Today’s Rates Imply How Future Rates May Evolve
Assume:
Maturity Rate1 year 2.00%2 years 2.50%
Then:
expected to be ~ 3.00%
x = 3.002%
Today's Market
The implied one-yearrate in 12 months is
( )( ) ( )
( )( )
2
2
1 .02 1 1 .025
1 .0251
1 .02
3.00%
x
x
x
+ + = +
+= −
+
≈
• This represents an equilibrium view on the evolution of future interest rates.
• This view is based on the consensus view of market participants. Trades made at the average expectation.
• The bond market’s consensus view has been wrong in the past!
• The bond market’s consensus view is muddied by Quantitative Easing
9 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
11 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
12 The Role of Quantitative Easing
Interest Rates (i)
Supply of Money (Q)
Demand Supply Supply
under QE
i1
Q1
i2
Q2
• In equilibrium, interest rates are based on the consensus view of market participants. Trades made at the average expectation.
• The bond market’s consensus view is muddied by Quantitative Easing, which serves to reduce interest rates as a means of stimulating the economy.
13 Quantitative Easing & Components of Bond Yields
• In principle, the current yield (i) on bonds equals:
where: rTB = investor’s real-return requirement for Treasury bonds, and E [ρ] = the investor’s expectation of the inflation rate (over the bond’s life).
• The aspiration of QE includes lowering investor’s real-return requirement without increasing the investor’s expectation of the inflation rate. (So far, so good.)
• Ultimately, QE will be unwound. What then?
– rTBs ↑ ⇒ may be bad for commercial real estate (as well as other asset classes)
– E [ρ] ↑ ⇒ may be neutral to good for commercial real estate (provided space markers are in equilibrium (i.e., low vacancy))
( ) [ ]( )[ ]
1 1 1TBs
TBs
i r E
r E
ρ
ρ
= + + −
≈ +
14 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
15 Path of NCREIF Market Values, Incomes & Cap Rates:
Sources: NCREIF and instructor’s calculations.
2.5%
3.5%
4.5%
5.5%
6.5%
7.5%
8.5%
9.5%
$0
$50
$100
$150
$200
$250
$300
$350
$40019
78
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Cap
italiz
atio
n R
ate
Mar
ket V
alue
and
Res
cale
d N
OI
NCREIF Property Index: Market Values, Rescaled NOI and Capitalization Rates Based on a $100 Investment for the Period 1978 through 2012
Capitalization Rates (Right Axis) Market Values Rescaled NOI Average Capitalization Rate (Right Axis)
16 What About “Real Time” Indices?
• The NCREIF Index is appraisal-based. • Other indices show more price recovery, e.g ., Green Street:
Source: Green Street Advisors, Commercial Property Price Index, October 4, 2013
17 What About Differences by Property Types?
• Apartments & malls have recovered most (and hotels the least). • However, all property types show similar recovery:
Apartments & Retail: > 100% of peak prices
Hotels: > 80% of peak
prices
Source: Green Street Advisors, Commercial Property Price Index, October 4, 2013
18 Of Course, Averages Can Be Misleading
• Said another way: significant differences by quality
60%
70%
80%
90%
100%
110%
120%
130%
140%
$50
$75
$100
$125
$150
$175
$200
$225
$250
2000 2002 2003 2005 2006 2007 2009 2010 2011 2013
Rat
io o
f N
on-M
ajor
to M
ajor
-Mar
ket A
sset
Val
ues
(Unl
ever
ed) A
sset
Val
ues f
or C
ore
Prop
ertie
sIllustration of Asset Appreciation in Major v. Non-Major Markets
From December 2000 through August 2013
Major Markets
Non-Major Markets
Ratio of Non-Major to Major Markets
Source: Real Capital Analytics and Instructor's calculations.
19 Fundamental Components of Real Estate Returns
• In principle, the foregoing risks can be priced
• RECALL: In the long run, asset-level returns (ka) are primarily a function of the initial cash flow yield and the growth rate (g):
• In the short run, asset-level returns can be heavily influenced by the effects of shifting capitalization rates :
– ∇ : More easily seen in the following graph.
• Note: cap rate = NOI1/P0 ≠ CF1/P0
1
o
CFP
( )∇
1
0a
CFk gP
= +
1
0a
CFk gP
= + + ∇
21 An Overview of Capitalization Rates
Source: Real Capital Analytics.
4%
5%
6%
7%
8%
9%
10%
01Q1 02Q1 03Q1 04Q1 05Q1 06Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1 13Q1
Cap
italiz
atio
n R
ates
Historical Capitalization Rates by Property Type for the Period 2001-Q3 2013
Apartment Industrial Retail CBD Office Suburban Office
EstimatedEstimated Dividend Estimated
Property Capitalization Pay-Out Cash FlowType Rate (1) Ratio (2) (3) Yield (4)
Apartments 6.25% 80.7% 5.04%
Industrial 7.66% 67.7% 5.19%
Office 6.68% 64.7% 4.32%
Retail 7.12% 69.9% 4.98%
All 6.93% 67.2% 4.66%
(1) Source: Real Capital Analytics, "Quarterly Review," Third Quarter, 2013.
(2)
(3) Source: NCREIF and author's calculations.
(4)
An Illustration: Conversion of Cap Rates to Cash Flow Yields
Represents typical portion of NOI converted to cash flow. The difference represents "cap ex" (i.e. , tenant improvements, leasing commissions and capital improvements).
Represents the product of the capitalization rate and the dividend pay-out ratio.
22 Cap Rates → Cash-Flow Yields
• Significant ambiguities surrounding cap rates. • Apartments have a very different “cap ex” behavior:
23 Fundamental Components of Real Estate Returns: Revisited
• Like bond investors, real estate investors want:
• Can compare what investors want (above) to what they are likely to receive (#19):
• Additionally, we can think of the growth rate (g) as: where: λ = the inflation pass-through rate
• Therefore, we can restate our comparison (from above):
[For simplicity, let’s ignore capitalization rate shifts and express expected inflation as merely ρ.]
( )( ) ( )0
0
11 1 1RE
CF gr g
Pρ
++ + − = +
( )( ) ( )0
0
11 1 1RE
CFr
Pλρ
ρ λρ+
+ + − = +
( )( ), 1 1 1a RE REk r ρ= + + −
g = λ * ρ
24 Fundamental Components of Real Estate Returns: Revisited
• Assume the real estate’s space markets are in equilibrium:
• When markets in equilibrium, our earlier comparison simplifies to:
• With a little bit of math, it can be shown that:
• Note that:
– In equilibrium, real estate values (P0) are unaffected by a change in anticipated inflation (because ρ does not appear above).
– In equilibrium, real estate values (P0) are only affected by a change in the required real return (rRE).
– In disequilibrium , real estate values (P0) are affected by both changes in the required real return (rRE) and a change in the anticipated inflation rate (ρ).
( )( ) ( )0
0
11 1 1RE
CFr
Pρ
ρ ρ+
+ + − = +
1λ⇒ =
0
0RE
CFrP
=
( )1λ =
25 Let’s Revisit the Growth Components of Return
• Recall: long- run asset-level returns (ka) are primarily a function of the initial cash flow yield and the growth rate (g):
• In turn, the growth rate can be viewed as a function of inflation (ρ):
λ = the inflation pass-through rate • Historically, λ ~ 75%
• So, real estate’s ability to (at least partially) hedge inflation may be important
1
o
CFP
1
0a
CFk gP
= +
g = λ * ρ
26 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
1978 1982 1986 1990 1994 1998 2002 2006 2010
Annual Inflation Rates & NCREIF Returns for the Period 1978-2012
Inflation Average = 3.91%
NCREIF Average = 9.37%
Sources: InflationData.com, NCREIF and author's calculations
29 Real Estate’s Correlation with Inflation?
RE’s long-term correlation with inflation ~28%
When Inflation is greater than average, RE’s correlation with inflation ~76%
RE’s real (i.e., inflation-adjusted) return ~5.5%
30 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
31 The Collapse of the CMBS Market
$0
$50
$100
$150
$200
$250
$300
$350
'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 1H '12
1H '13
Annual CMBS Issuance ($ billions)
Non-U.S. U.S.
Source: Commercial Mortgage Alert
33 The Aggressive Vintages Coming Due Later
Source: Morgan Stanley Research, “Commercial Real Estate 2010.”
34 CMBS Loan Delinquencies by Vintage
Source: Moody’s “U.S. CMBS: Delinquency Tracker,” October, 2012
• Decreasing rate of default for CMBS loans:
35 Delinquencies Lead to Workouts or Foreclosure • So far, we’re at ~ $400 billion of workouts or foreclosures • About 1/2 have been resolved
Source: Real Capital Analytics, “Quarter in Review, October 2013”
• But, when do these forbearance agreements expire?
• In the midst of the refinancing wave?
$0
$50
$100
$150
$200
$250
$300
$350
$400
$450
'08 '09 '10 '11 '12 '13
Billions
Cumulative Distress for All Property Types
TroubledREORestructuredResolved
36 Lessening CMBS Underwriting Standards to the Rescue?
Source: Moody’s, “U.S. CMBS Review,” 3rd Quarter 2013.
• Another case of “here we go again”?
37 Real Estate Debt Funds to the Rescue?
Source: Preqin, “The Growth of Real Estate Debt Funds,” Real Estate Spotlight, November 2012.
• Is there enough “powder” here? Not yet!
38 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%19
48
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Ann
ual C
hang
e in
GD
P
Sources: Bureau of Economic Analysis and author's calculations
Historical Growth in U.S. Gross Domestic Productfor the Period 1948 through Q2 2013
39 Return = f(Economy, etc.) | The Long View
-4%
-2%
0%
2%
4%
6%
8%
10%19
48
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Ann
ual C
hang
e in
Con
stan
t GD
P
Sources: Bureau of Economic Analysis and author's calculations
Historical Growth in U.S. Gross Domestic Productin Constant (2005) Dollars for the Period 1948 through Q2 2013
40 Return = f(Economy, etc.) | The Long View
0
2
4
6
8
10
12
Ann
ual U
nem
ploy
men
t Rat
e (%
)
Source: Bureau of Labor Statistics
Historical Unemployment Rate for the Period 1948 through Q2 2013
41 Return = f(Employment, etc.) | The Long View
0
2
4
6
8
10
12
Ann
ual U
nem
ploy
men
t Rat
e (%
)
Sources: Bureau of Labor Statistics and author's calculations
Historical Unemployment Rate for the Period 1948 through Q2 2013
42 Return = f(Employment, etc.) | The Long View
Stylized Normal Distribution (based on historical µ and σ)
~2.5 σ-Event: Financial Crisis
43 In Real Estate, the Local Market Matters!
Source: Jim Costello and Mark Seely, “Industrial, Economic & Workforce Trends,”
CBRE Client Conference, October 28, 2010.
By itself, Detroit accounts for ~ 100,000 jobs lost
Lost Jobs:
44 What Might Derail the Economy? The Long View on Oil Prices
• The economy remains fragile.
• What else might go wrong?
• Possibilities: – Crude oil
prices? – Terrorist
attack(s)? – Contagious
financial crisis?
– Natural disasters (Sandy)?
– Partisan political bickering increases (fiscal cliff)?
$0
$20
$40
$60
$80
$100
$120
1948
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Ann
ual A
vera
ge C
rude
Oil
Pric
es p
er B
arre
l in
Con
stan
t (2
010)
Dol
lars
Source: InflationData.com
Domestic Crude Oil Prices (in Constant 2012 Dollars)for the Period 1948 through Q2 2013
45 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
46 Housing Market’s Correlation with Commercial Real Estate
See: “The US Property Market in 2010,” David Geltner, PREA Quarterly, Winter 2010.
• Residential market slightly led the downturn in the commercial real estate markets • Most commercial real indices showed a similar correction
47 Residential Real Estate Still in the Doldrums
$0
$50,000
$100,000
$150,000
$200,000
$250,000
0
200
400
600
800
1,000
1,200
1,400
Rea
l (20
00 $
) Med
ian
Sale
s Pri
ces
Ann
ual N
ew H
ome
Sale
s (un
its)
Sources: U.S. Census Bureau, Morningstar and Instructors' Calculations
Annual New Homes Sold & Median Sales Prices: 1963 - 2012
New Homes SoldMedian Sales Price ('00 $ - Right Axis)
48 Home Prices| Approaching a “Lost Decade”
Source: S&P Case Schiller Index
$0
$50
$100
$150
$200
$250
$300
Cas
e-Sh
iller
Hom
e In
dex
(Jan
uary
200
0 =
$10
0)Case-Shiller Home Price Indexfor the Period 1987 through 2012
for Selected Markets
San Diego Composite-10
Composite-20 Chicago
Back to fall of 2003 prices.
49 Residential Real Estate Is Highly Localized In addition to the average appreciation rate, volatility matters:
Source: S&P Case Schiller Index and instructor’s Calculations
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
0% 20% 40% 60% 80% 100% 120% 140% 160% 180% 200%
Tota
l Pri
ce D
eclin
e fr
om P
eak
Pric
es
Bubble Growth: Maximum Price Increase from January 2000
"Bubble" Growth and Subsequent Decline for Certain US Housing Markets for the Period 2000 through 2012
Net Annual Appreciation Rate of 4%
Net Annual Appreciation Rate of
2.5%
Net Annual Appreciation Rate of
0%
The Rate of Inflation (ρ)
Phoenix
Detroit
Boston
ChicagoAtlanta
Tampa
Miami
Washington
Denver
San Francisco
San DiegoLos Angeles
Dallas
Portland
Cleveland
New York
Las Vegas
Charlotte
Minneapolis
Composite-20
Composite-10Seattle
50 Can We Have an Economic Recovery without a Housing Recovery?
• Consider the depth of the housing market and its impact on:
– the construction industry: • unemployment is disproportionately male and less-educated
– the banking sector: • when will banks start lending again?
– consumer confidence: • if your largest investment is faltering, how confident will you be?
• The administration has already attempted at directly reviving the housing market;
– however, the positive effects seem to have been little.
• Is there the political will to make another attempt? – Should there be?
• Both parties are advocating some reform of the GSEs – Likely to hurt any short-term rebound in home prices
y = 0.5078x - 884.66R² = 0.468
0
100
200
300
400
500
600
700
800
900
1000
0
50
100
150
200
250
1890 1910 1930 1950 1970 1990 2010
Popu
latio
n (i
n m
illio
ns)
Inde
x or
Pri
ces,
Cos
ts &
Inte
rest
Rat
es
Year
Path of Real Home Prices and Building Costs as well as Population and Interest Rates from 1890
Home Prices
Building Costs
Population
Interest Rates
Source: Robert Shiller - Irrational Exuberance and instructor's calculations.
53 Path of Real Home Prices | The Long View
54 Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances
55 The Financial Strain on State & Local Budgets
• It is no surprise that many state & local budgets are under enormous financial strain. As examples of just two perspectives, consider:
– Muni bond swap (MCDX) rates, and – Muni bond spreads over Treasuries
Sources: Markit, Goldman Sachs.
56 The Residential Real Estate Channel
• The fall in home prices contributes to the current strain on state and local budgets.
– Fall in home prices contributes to declining consumer confidence
• Which leads to a decrease in consumer spending • Which leads to a decrease in sales taxes
– Fall in home prices is accompanied by a fall in the volume of home sales
• Which leads to a decrease in transfer taxes
– But (ad valorem) property taxes are largely a zero-sum game: • If everyone’s property increases by x%, your property tax bill is unchanged.
• As a result of the foregoing, a due diligence/underwriting item of increasing
importance will be the financial condition of state & local entities. – Will be important to:
• Tenants, • Lenders, and • Investors.
57 Increasing Realization: Taxing the Rich Doesn’t Work
• At the state & local levels, “tax the rich” policies are increasingly problematic:
– The income of the rich is more variable than lower brackets
– The rich move to other states (e.g ., Florida and Texas) with lower income taxes
• Calls for “broadening the (income) tax base” will be met with political resistance.
• In order to cope, state & local authorities considering a range of service cuts &/or increasing other forms of taxation (e.g ., property and transfer taxes)
– Both the cuts and the tax increases adversely affect commercial real estate values
Source: Robert Frank, “The Price of Taxing the Rich,” The Wall Street Journal, March 26, 2011
58 Another Symptom of Financial Distress: State Pension Liabilities
Source: Rachel Barkley, “State & Local Pensions 101,” Morningstar, October 19, 2012.
59 Will Aggressiveness Change with State Fortunes?
Source: Jim Costello and Mark Seely, “Industrial, Economic & Workforce Trends,”
CBRE Client Conference, October 28, 2010.
60
Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances • Appendices
– Growth at What Price?
– CMBS Dysfunction
61 How Should We Think About Risk?
The
Req
uire
d R
ates
of R
etur
n: E
(k)
Market-Level Volatility: σ
Pricing Illustration of High- v. Low-Barrier Markets In Order to Produce Identical Risk-Adjusted Returns
E(k)L
E(k)H
σH
rf
σL
• In principle, all investments should offer identical risk-adjusted returns. • Let’s frame the discussion in terms of high- v. low-barrier markets:
E(k)Market
62 Let’s Be a Bit More Specific:
• Identical risk-adjusted rates of return = identical Sharpe Ratios
T
he R
equi
red
Rat
es o
f Ret
urn:
E(k
a)
Market-Level Volatility: σ
Pricing Illustration of High- v. Low-Barrier Markets In Order to Produce Identical Risk-Adjusted Returns
E(ka,L )
E(ka,H )
σH
rf
σL
( ) ( ), ,a H f a L f
H L
E k r E k rσ σ
− −=
Sharpe Ratios
The
Req
uire
d R
ates
of R
etur
n: E
(ka)
Market-Level Volatility: σ
Pricing Illustration of High- v. Low-Barrier Markets In Order to Produce Identical Risk-Adjusted Returns
E(ka,L )
E(ka,H )
σH
rf
σL
( ) ( )1 1
0 0H f L f
H L
H L
CF CFE g r E g rP P
σ σ
+ − + −
=
63 Let’s Be a Bit More Specific (continued):
• We can include the expanded view of returns (assuming constant cap rates):
Sharpe Ratios
64 How Should We Think About Investment Opportunities?
• Based on your beliefs (hopefully supported by research), consider the potential mispricing of markets:
65
Monetary Policy → Commercial Real Estate
• Monetary Policy: Quantitative Easing
– Historical Path of Interest Rates
– Implied Forward Rates
– Nominal v. Real Yields
– Quantitative Easing
• Where Might Changing Monetary Policy Affect Real Estate Returns:
– Commercial Real Estate Pricing
– Inflation & Commercial Real Estate
– Loan Maturities
– The Economy
– The Housing Market
– State & Local Finances • Appendices
– Growth at What Price?
– CMBS Dysfunction
66 CRE Loans: Foreclosures v. Forbearance
• Upon a monetary default, lenders can choose to foreclose v. forbear
• Consider the two sources of most defaults:
1. Commercial Banks: Administration decided to encourage banks to forbear → “extend & pretend” 2. CMBS: the tranched nature of security holders complicates the resolution of
delinquent loans. Consider a simple A/B structure:
Time
Prices
Under-shooting Market
Over-shooting Market
“True” Prices
68 The Effect of Forbearance: Undershooting Market?
This is the buying opportunity
This is not
69 Security Design: Start with a Bundle
0%
2%
4%
6%
8%
10%
12%
14%
16%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Exp
ecte
d R
etur
n
Risk
An Illustration of Security Design: Starting Point
Assume a $2.0billion market capitalization
rf
70 Security Design: Can Unbundle the Bundle
0%
2%
4%
6%
8%
10%
12%
14%
16%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Exp
ecte
d R
etur
n
Risk
An Illustration of Security Design: Separation
Assume a $1.5billion market capitalization
Assume a $0 .5 billion market capitalization
rf
71 Security Design: Can Bundle the Pieces
0%
2%
4%
6%
8%
10%
12%
14%
16%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Exp
ecte
d R
etur
n
Risk
An Illustration of Security Design: Consolidation
Assume a $1.0billion market capitalization
Assume a $1.0billion market capitalization
Assume a $2.0billion market capitalization
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72 Security Design: What About CMBS?
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An Illustration of Security Design: Profiting from Separation ?
Note: Lower returns equateto higher prices
Examples: 1) Treasuries into STRIPS & "zeros,"2) CMBS into multiple tranches,3) GGP's bifurcated emergence from bankruptcy, and4) REITs' (generally) property-type focus.
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