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Legacy Commercial Real Estate: What Shareholder Equity?

RE Finance Journal Article-(Here) 

If you’re an equity shareholder in commercial real estate (i.e. you own stock in a REIT, or real estate fund) there are a few things that qualitative logic and simplified math can project on your strategic investment decisions.  For example, let’s start with the premise that an equity REIT raised or had direct equity to invest of 1 billion in 2007.  To follow the logic through from a shareholder perspective, let’s assume that in 2007 there were exactly 10 million shares issued (and outstanding) at $100 per share, or $1 billion of equity.

As the Investment Entity moves into the market to deploy the $1 billion of equity it takes a conservative approach and borrows 60% loan-to-value against assets it purchases, in this case it purchases $2.5 Billion in assets ($1B of equity + $1.5B of debt).  At that point in time (2007) let’s assume that on average all assets of core quality are trading/selling at a 7.0% Cap Rate.   For non-practitioners a Cap Rate is the yield a buyer will transact in price for an expected annual net income from operations. Since the Investment Entity acquired $2.5 billion in assets, this assumes that 7.0% of the $2.5 billion in asset value is income, or $175 million.

Now by applying simple math we can illuminate how macro changes affect equity shareholder value and why.

See the following Exhibits:

Exhibit I-(Here)

As Exhibit I demonstrates, a 10% decline in income and a 1.0% increase in CAP Rate (which is not unrealistic today) requires the Investment Entity to issue an additional 8.9 million shares or forfeit the assets to the bank. Of course if higher leverage did exist this would be another option, yet this option is rarely available today and does not change or mitigate the loss to shareholders, it simply exchanges equity for debt (i.e. the same loss would result).

To further simplify, Exhibit II demonstrates the relational effect in terms of $1 dollar of equity invested, or 1, and thus can be scaled and applied to fit any Investment Entity size and investment capital structure.

Exhibit II-(Here)

But now you ask, “How does this apply to today’s market?” If we look to a recent story reported by the Wall Street Journal (WSJ) on April 14, 2010 “Morgan Stanley Property Fund Faces $5.4 Billion Loss,” it notes that MSREF VI reported a $5.4 billion dollar loss on $8.8 billion invested. This equity loss therefore in percentage terms is -61.36%.   By applying our logic from above, this would suggest that if MSREF VI purchased assets at a 7.0% Cap Rate and used 70% loan-to-value (as pension fund consultants suggest) this would imply (given our Model) that Morgan Stanley may have only faced a -6.75% decrease in income and a 1% increase in Cap Rate. However small these changes appear, their affect on value and MSREF VI’s ability to therefore re-finance or re-margin its debt from 70% (2007 Value) to 55% (Today’s Value) is clear. The debt re-margin shortfall, given our logic, may have been in the vicinity of -$837MM.

The questions this raises for a shareholder that invested in 2007 is “if your Investment Entity is not set up to issue new shares or find a lender to replace the shortfall with high-leverage debt, you are not only facing an equity loss similar to MSREF VI, but also facing an Investment Entity that may be insolvent.”

Of course there are always two sides of a trade, those that buy wrong, and those that buy right; the latter will none-the-less find great opportunity from the former.

Disclosure: We currently have no positions in the Funds discussed