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