Accessing US Real Estate:Navigating the Capital Stack Maze

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Investment in US Real Estate & DebtULI/Mayer Brown SeminarFrankfurt, Germany

Paul E. MeyerPartner+1 312 701 7182pmeyer@mayerbrown.com

28 January 2010

COMPLEXITYAccessing US Real Estate: Navigating the Capital Stack Maze

2

ComplexityUS Transaction Volume (2001-2009)

• Transaction volume increased rapidly, doubling between 2004 and2007.

$400

Annual US Transaction Volume – All Core & Hotel

Billions

3

$-

$50

$100

$150

$200

$250

$300

$350

2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Real Capital Analytics

ComplexityUS CMBS Issuance (1990-2008)

• CMBS issuance increased dramatically, tripling between 2004 and2007.

US Commercial Mortgage Backed Securities (CMBS) Issuance

$250

4

Source: Commercial Mortgage Alert and Property & Portfolio Research Data

$-

$50

$100

$150

$200

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

ComplexityTotal Debt Issuance with Breakdown of Financing Sources

GovernmentSponsored

Entities5%

Other14%

Lender Composition ofFixed Income Markets

US$3.4 Trillion - 2008

• CMBS made up approximately22% of commercial real estatedebt, with insurancecompanies and banks issuing

5

CommercialBank43%

CMBS/CDO22%

Insurance Co's9%

SavingsInstitutions

7%

Source: Holiday Fenoglio Fowler, LP 2008

companies and banks issuingand holding more than 52% inaggregate.

ComplexityCapital Stack — Simple Whole loan, 1 Borrower, 1 Lender

LENDER

25% Equity

LOCAL REALESTATE

INVESTOR

6

Mortgage LoanLENDER

(Whole Loan)

75% Debt(Whole Loan)

BORROWER

ComplexityCapital Stack — Two Multiple Mortgages

Senior LoanSENIOR LENDER

LOCALREAL ESTATE

INVESTOR

BORROWER

10% Equity

15%Junior Loan

7

Jun

ior

Loan

JUNIORLENDER

75% SeniorLoan

ComplexityCapital Stack — Two Multiple Mortgages cont’d.

• Inter-creditor issues, increased risk of default and cash flowpressure.

• Junior loans were a way to decrease equity requirement for localreal estate investors.

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ComplexityCapital Stack — Mortgage and Mezzanine Loans

10% Equity

Pledge of Ownership Interestsin Mortgage Borrower

MEZZANINEBORROWER

MEZZANINELENDER

Mezzanine Loan

Sole Owner

15%Mezzanine

Loan

LOCALREAL ESTATE

INVESTOR

9

SoleOwner

in Mortgage Borrower

Mortgage LoanMORTGAGE

LENDERMORTGAGEBORROWER

Sole Owner

75% SeniorLoan

• Mezzanine tranche was added to appease securitization restrictions(different borrower, no additional lien on the real estate assets).

• There are still inter-creditor issues and added pressure on theproperty cash flow, but all of this is “behind the scenes” due to thesecond borrower and equity pledge (rather than real estate pledge).

ComplexityCapital Stack — Mortgage and Mezzanine Loans cont’d.

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ComplexityCapital Stack — JV Equity, Mortgage and Mezzanine Loans

10% Owner 90% Owner

9% Equity from PrivateEquity Fund

1% Equity from LocalReal Estate Investor

15%Mezzanine

Loan

MEZZANINEMEZZANINE

LOCAL REALESTATE

INVESTOR

PRIVATEEQUITY FUND

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75% SeniorLoan

Pledge of Ownership Interestsin Mortgage Borrower

Mortgage LoanMORTGAGE

LENDERMORTGAGEBORROWER

MEZZANINEBORROWER

MEZZANINELENDER

Mezzanine Loan

Sole Owner

• Further reduced the equity requirement of local real estate investor.

• Adding an additional equity source bifurcates the risk.

• Over time, as asset prices increased on the open market, privateequity money took on additional risk (entitlement, construction) toget access to product well in advance of the bidding war that wouldtake place once the asset went to market at stabilization. Many

ComplexityCapital Stack — JV Equity, Mortgage and Mezzanine Loans cont’d.

take place once the asset went to market at stabilization. Manytimes the private equity funds used the fund’s credit to backstopconstruction loans.

• Many private equity funds executed on this strategy so that LPinvestors have small pieces of many deals across the country.Diversification was intended to reduce risk, but seriously hurt the LPswhen the recession hit.

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ComplexityExample Fund Structure

$$

GeneralPartner (LLC) Investors

(offshoreand U.S.tax-exempts)

LimitedPartners

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Real Estate

Administrator

Corp. Master (Offshore)

$

Corporate Feeder(Offshore)

$

$

Limited Partnership orLimited Liability Company (U.S.)

InvestmentManager

tax-exempts)

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ComplexityCapital Stack — Securitization

Owner ofClass BBonds

Owner ofClass CBonds

Owner ofClass DBonds

Owner ofClass XBonds

Owner ofClass ABonds

25% Equity

Class A Bonds

Class B BondsLOCAL

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ORIGINATINGLENDER BORROWERMortgage Loan

Class B Bonds

Class C Bonds

Class D Bonds

Class X Bonds

75%Debt

LOCALREAL ESTATE

INVESTOR

• The originating lender transfers the loan to a securitization trust.Capital market investors purchase securities issued by thesecuritization trust and rated by one or more rating agencies.

• One of the benefits of securitization was the perception that all cashflow is created equal (e.g. one dollar in Des Moines is the same asone dollar in Miami, Washington DC and New York) however, as we

ComplexityCapital Stack — Securitization cont’d.

one dollar in Miami, Washington DC and New York) however, as weare seeing, the quality of the real estate and the market in which it islocated is still important.

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ComplexityCapital Stack — Securitization & Repo Financing

Pledge of Class XBonds as Collateral

Owner ofClass XBonds

REPO LENDERRepo Loan

25% Equity

Class A BondsOwner of

Class BBonds

Owner ofClass CBonds

Owner ofClass DBonds

Owner ofClass ABonds

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ORIGINATINGLENDER

Class B Bonds

Class C Bonds

Class D Bonds

Class X Bonds

75%Debt

LOCALREAL ESTATE

INVESTOR

BORROWERMortgage Loan

• Additional party (repo lender).

• Holder of CMBS tranche that pledges holding as collateral for repofinancing may have to satisfy collateral call by selling their holdings.

ComplexityCapital Stack — Securitization & Repo Financing cont’d.

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ComplexityCapital Stack — JV Borrower, Multiple Lenders

10%Owner 90%

Owner

1% Equityfrom LocalReal EstateInvestor

REPOLENDER

Pledge of ClassA Bonds

MEZZANINELENDER

LOCAL REALESTATE

INVESTOR

PRIVATEEQUITY FUND

MEZZANINEBORROWER Class A Bonds

15% MezzanineLoan

9% Equity from Private

Equity Fund

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SoleOwner

A Bonds

75%SeniorLoan

SENIORLENDER

MORTGAGEBORROWER

Mortgage Loan

Owner ofClass BBonds

Owner ofClass CBonds

Owner ofClass DBonds

Owner ofClass XBonds

Owner ofClass ABonds

Class B Bonds

Class C Bonds

Class D Bonds

Class X Bonds

• Ultimate “fractured capital stack.”

• Nobody has full risk (private equity sponsor generally has the mostto lose, if they have used their balance sheet to obtain constructionfinancing).

ComplexityCapital Stack — JV Borrower, Multiple Lenders cont’d.

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ComplexityLoss of Value

0.60

0.70

0.80

0.90

1.00

Mezzanine

Equity

40% Loss30% Loss

20

0.00

0.10

0.20

0.30

0.40

0.50

2005-2007 Current

Mortgage ValueValue

ComplexityLoss of Value cont’d.

• Just because a tranche is out of the money does not necessarily meanthey are out of the picture (appraisal rights, etc.).

• Additional legal rights and remedies.

• Contractual tensions between different members of the capital stack(hedge fund repo, mezzanine vs. senior lender vs. senior trancheholders vs. junior tranche holders, FDIC vs. lenders, private equityholders vs. junior tranche holders, FDIC vs. lenders, private equityfunds and their limited partner investors, private equity and local realestate investor).

• Construction loans add an additional layer of complexity and potentialfor disagreement.

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ComplexityReal Estate Asset Stress (Fundamentals)

• Office (unemployment, downsizing).

• Retail (drop in consumer spending, lack of small business financing).

• Apartments (children moving home, more people living together tosave on rent).

• Hotels (drop in business, leisure travel).• Hotels (drop in business, leisure travel).

• Condos (no buyers, no lenders).

• Fixed or Increasing Real Estate Taxes.

• Maintenance Costs.

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STAGNATION (2009)Accessing US Real Estate: Navigating the Capital Stack Maze

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Stagnation

Consequences of the Fractured Capital Stack

• All of the players are trying to understand theiroptions and leverage points.

• Nobody wants to move because they don’tknow if it’s the right move.

• There is fear that the wrong move couldresult in liability on the part of the primemover.

• JV parties are reluctant to force out

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• JV parties are reluctant to force outoperating partners (reputational risk,additional asset management responsibility without the necessary team).

• Banks do not want to foreclose (they are not in the real estate business and donot want to write down the value of the asset to the detriment of their requiredcapital reserves).

• Junior tranche holders lose their rights (e.g. right to select special servicer) oncethe value of the underlying real estate declines to the point where their trancheis underwater. Most co-lender agreements include specific appraisalmechanisms to determine which tranche is the most junior tranche that is in themoney.

• FDIC reluctance.

StagnationLoan Maturities

• Approximately $1.2 Trillion in loan maturities over the next 4 years.

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StagnationExtend and Pretend (aka Delay and Pray)

• Maturity defaults - lenders prefer to extend loans that are reachingmaturity rather than foreclose or otherwise take title.

• Fed, FDIC and OCC have validated this strategy (reference “PolicyStatement on Prudent Commercial Real Estate Loan Workouts”).

• FDIC lacked capacity in 2009 to take over failed banks.

• Monetary default/real estate fundamentals and insufficient cashflow will force banks into action, leading to Bank failures.

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StagnationBank Failures

• Approximately 140 bank failures in 2009. Primarily regional bankswith heavy emphasis on construction loans.

• FDIC has seized approximately $80 billion in loan assets (exclusive ofdeposits and other assets) but has only sold approximately $11billion of them.

• FDIC becomes more aggressive as underlying cash flow deteriorates.• FDIC becomes more aggressive as underlying cash flow deteriorates.

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OPPORTUNITY (2010-2015)Accessing US Real Estate: Navigating the Capital Stack Maze

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Opportunity

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OpportunityPredictions

• Deals will get done – assets will be sold, loans will be made.

• Real opportunities existing in understanding the capital stack andhow/why we got here and understanding how to navigate the capitalstack to get to the real estate.

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OpportunityKey Areas of Complexity

• Experienced team of service professionals with unique skill sets willbe critical to tapping these opportunities.

• Specialties include:

– Real Estate and Real Estate Finance (inter-creditor issues)

– Bankruptcy and Workouts– Bankruptcy and Workouts

– Joint Ventures

– Securitization

– Tax Structuring

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