THE PAUL MILSTEIN CENTER FOR REAL ESTATE Professor Chris Mayer Columbia 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

REITs outperform S&P 500 by 120% in the last decade “Tech Boom” “REIT Boom” Source: NAREIT & Standard and Poors NAREIT vs. S&P 500 Returns Current as of Apr. 24 th, 2007 Overall

Apartment cap rate spreads to real rates are near their lows in 1980s!

Office cap rate spreads are also quite low!

Good news: Real office rents are still quite low by historical standards

Cap rates have become much more compressed in historically high rent growth markets

Comparing public and private market valuations

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???

During the tech boom, real estate provided great diversification

REIT betas have increased to exceed 1.0 the last several years! Sources: Oak Hill REIT Management, Bloomberg BETA (RMS vs SPX), Rolling 2-yr Avg. Current as of Apr. 24 th, 2007 BETA (RMS vs. SPX)

We have heard a lot about how stock market volatility has fallen SPX Return 120 Day Volatility

But REIT volatility has steadily risen! RMS Return 120 Day Volatility

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, %4.00%5.00%6.00%7.00%8.00%9.00% 10.00%11.00%12.00%13.00%14.00% Low cap rates & convexity lead to volatility!

REITs help us compare real estate return potential to other asset classes

REIT earnings yields are at record lows compared to 10-yr Treasuries -110 bp Sources: Green Street Advisors and Federal Reserve Current as of Apr. 24 th, 2007

-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 24 th, 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?

REITs trade at a historical discount to private RE on an NAV basis! Source: Green Street Advisors, Current as of Apr 24 th, 2007

REITs have not increased leverage as debt costs have fallen Source: Green Street Advisors REIT Leverage Ratio: debt as % of asset value) Current as of Apr. 24 th, 2007 REIT Leverage Ratio

Subordination levels fallen a lot!

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

CDO spreads have jumped up with the mess in subprime loans

Non-investment grade CLO spreads also increased

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