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Eye on the Market, July 5, 2011

There was a time early in the recession when residential property prices had begun to collapse, but commercial property prices were still holding in. We cut our allocations to commercial property (red dot), although given the illiquidity of the asset class, this was more of a benefit to newly funded portfolios than existing ones. By the end of 2009, commercial property prices, when measured on a national level, fell even more than residential property prices. The primary driver of the collapse: a massive expansion in the use of debt, which contributed to skyrocketing prices. The 2nd chart shows commercial real estate credit extended by private markets (banks, insurance companies) and by public markets (e.g., rated property-backed debt, securitized commercial real estate loans). It almost doubled as a percentage of GDP from 2000 to 2007.

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Any silver linings? Unlike residential property, the oversupply of office property was less severe. To illustrate this, consider the chart below (left), on the three expansions in office property since the Volcker disinflation of the early 1980s:

[1] The first was the worst: the tax boom. The 1981 Economic Tax Recovery Act ushered in accelerated depreciation allowances for real estate and the ability to offset active income with passive losses. This fueled a massive expansion in commercial property construction. The 1986 Tax Reform Act then ended this tax arbitrage. Unoccupied buildings never needed in the first place drove vacancies to 30%-40% in some cities, prices collapsed, and banks suffered losses of 15% or more on commercial property loans.

[2] The next was the tech boom, when markets were pricing in 5% perpetual GDP growth and the elevated payroll growth/ office space needs that it implies. The tech sector played a large role (as one sign of optimism, Cisco traded at 150 times earnings), but it wasn't just tech that was expected to expand; everybody was (Merck traded at 35 times earnings). As a sign of how things have changed, both Cisco and Merck now trade closer to 10 times earnings.

[3] The third episode was the recent credit boom, when the cheapest and most abundant credit in history (see below for more details) pushed office construction higher, although the peak this time was lower than the prior two. While office vacancy rates are still elevated, they are starting to stabilize (see chart), as are national measures of office rents per square foot. The retail expansion did match prior peaks, a reflection of the consumer credit boom and bust.

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As a result, we have been more active over the last 2 years in commercial property investing than residential, as the latter suffers from worse oversupply. Since the onset of the recession, we have been opportunistically adding exposure to commercial real estate through distressed property funds, mezzanine financing and commercial mortgage backed securities. To be clear, there are plenty of impaired properties after the construction boom shown on the prior page; but there are just as many valuable ones that are simply over-leveraged, or held by banks that need to shrink their exposure to the sector.

The attached document walks through the troubled history of the CMBS markets, the resulting opportunities for mezzanine lending to commercial real estate owners, REITs vs private market purchases, the widening divergence between prices for trophy and distressed assets, the opportunities created in commercial property by the Great Deleveraging in Europe, some war stories from the commercial property front, and where commercial real estate fits in the recent history of flawed "firewall" thinking.

Michael Cembalest
Chief Investment Officer

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