Executive Summary

2010: This will be the year of “acceptance” and the year of “separation”

Acceptance:

• New valuations
• New underwriting
• Less capital available

Separation: The “haves” and the “have nots” will become clear. Properties will be separated by asset class, market, rent roll, and sponsor.

The new opportunity set in 2010

• Distressed debt financing

• Short sales (loan buy backs)

• Gap financing/restructures

The “real issue:” The lack of predictable, reliable first trust mortgage loans.

New thinking on exit strategies:

• Small is the new big - big deals are harder to get done
• Underwriting to recourse take-outs (bank, life companies)
• Underwriting to “debt yields” versus LTV’s or DSC
• Sales exit: Stressed exits will be using double digit cap rates
• Investment basis below the “equity bid”

Underwriting assumptions:

• Vacancy - trending up
• Rents - trending down

Rent roll - the new deep dive:

• Tenant quality

• Tenant term

• Rates marked to market

• Durability of cash flows

CMBS defaults: The big unknown. How will special servicers react? Was not designed to “extend & pretend.” Extensions are costly and short term.

Bank failures and the great asset chase: Not as many as you’d think. Prediction: The Administration will support ailing community banks. For those that do fail, the assets will not be readily available to you. The FDIC will structure “loss sharing” with existing banks, before they let you buy them at a deep discount.

JCR Capital 2010 Market Forecast: In Depth

2010: The Year of Acceptance

2010 will be the year of “acceptance” in the commercial real estate capital markets. The market will begin to accept the following:

• The capital markets are dislocated and will remain so for some time.

• Values really have fallen and they will fall further before stabilizing.

• We are not going back to the way it was.

How each investor, sponsor, lender, etc. will fare in this new paradigm will depend on the following:

1. Their current liquidity situation.
2. The asset classes in which they are invested.
3. Their short term debt maturities
4. Their lender profile: Big bank, regional bank, community bank, non-bank, CMBS, etc.
5. The markets in which they are invested (first tier, second tier, tertiary)
6. The strength of their rent rolls.
7. The basis per square foot/key/room, etc. to the debt amount.

We are entering a “bespoke period” in the commercial real estate industry where one size will no longer fit all.

The 2010 Capital Markets

1.  Securitization (old): Default rates will continue to climb on existing securitizations. This will put pressure on special servicers who are struggling to keep up with the existing work outs. How the special servicers will treat these defaults will be a big story in 2010. While extensions are possible, they are costly and only short term. The securitization model was not made to “extend and pretend.” Many of the foreclosures in 2010 will be from these legacy securitizations’.

2.  Securitization (new): This market is in its re-infancy. Expect the following:

• Very little volume
• Only the highest quality assets and rent rolls will be considered
• Sponsorship will matter
• Transactions will be smaller
• Transactions will be less complicated
• LTV’s will be in the 65% range

3.  Banks: Another huge wild card. There is a tremendous dislocation in Washington regarding the banks.

• Most of the maturing debt is held by the banks.
• The government policy wants to save the banks and have them lend more.
• The FDIC is being tough on banks, especially community banks, demanding they raise more capital, shrink their balance sheets and reduce commercial real estate exposure.

Another big story in 2010 is how the FDIC and the Administration reconcile these differences.

4.  Legacy lenders (non-banks): Legacy lenders will continue to struggle with their portfolios. Do not expect much new activity from them.

5.  Life Companies: They are the most active lenders for non-multifamily properties. After years of fighting the conduit lenders, life companies are now very particular on the deals they will do. Expect the following:

• Low loan to value ratios
• Tough underwriting criteria
• Major markets only
• Class A properties
• Only high quality sponsorship

The New Capital Structure

Well-performing properties are going to have a “trifecta” of issues to deal with as they look for new capital.

1. The new underwriting standard is: 65% LTV and 1.35x DSC. Gone is the 80% LTV and 1.25x DSC.
2. Cap rates used to establish value are now 200-300 basis points higher than at the peak.
3. NOIs have fallen 10-20% due to increased vacancy and a decrease in rents.  Example of the changes:

Old Days

NOI: $1,000,000

Cap rate: 6.5%

LTV: 80%

Loan amount: $12.3 MM

Today

NOI: $850,000

Cap rate: 8.5%

LTV: 65%

Loan amount: $6.5 MM

Delta: $5.8 million less in loan proceeds

This “equity gap” will provide the return opportunity that many are seeking. However, capital will be most successful when working with existing owners to fill this gap.

Those who are waiting for Class A cash flowing properties to be sold at 50% discounts to prior value will be disappointed.

New Capital Entrants

1.  Public Non-Traded REITs: This is a new market player to watch. Its very expensive to launch these vehicles ($10 million to start them up), but if successful, they supply a good source of capital. They typically have to return 8-9% to their investors, so expect loan rates in the 10% range.

2.  Mortgage REITs: As confidence builds and rates stay low, mortgage REITs will gain traction. At first they will primarily focus on mid-term financing of 5-7 years. Investors in these vehicles expect 8-9% yields, with minimum leverage. So this capital will also be priced in the 8-11% range.

3.  Private capital: Expect to see a rebirth of private capital. This will come from a variety of small funds/asset managers across the country. They will all be different, except their cost of capital will be pretty consistent mid-teens IRR for their investors.

Maturing Loans

“Extend and pretend” will continue for bank debt in 2010. Not as much for conduit debt. The following will be a guide as to how assets will be treated.

1.  Cash flowing properties that pay current (maturity defaults): These will be extended by banks and extend by 6-12 months by most conduits.

2.  Cash flowing properties that cannot pay current (term/maturity defaults):

• Option 1: Principal pay down from borrower and extension
• Option 2: Short sale by the borrower to the lender
• Option 3: Internal restructure into A/B note
• Option 4: Note sale to a third party
• Option 5: Foreclosure

Borrowers will find banks much more accommodating. Conduits will require cash and will only provide extensions in short term increments.

3.  Non-cash flowing properties that don’t pay current:

• Option 1: Borrower posts one year interest reserve
• Option 2: Short sale by the borrower to the lender
• Option 3: Note sale to a third party
• Option 4: Foreclosure

Conduits will have little patience in this category, as the prospect for value recovery is much lower.

The Great Asset Divide

In 2010 the haves and the “have not’s” will be clear.

The “Haves:”

• “A” markets
• “A” class properties
• Good sponsorship
• High quality rent rolls (credit, roll over staggered)
• Cash flow debt yields: 12% or higher
• 65% LTV
• 1.35 DSC

The “Have Nots:”

• Secondary and tertiary markets
• B&C properties
• Poor to mediocre rent rolls (short term leases, poor tenant quality)
• Poor to mediocre sponsorship

Opportunities for 2010

1. Capital providers: The credit markets are dislocated, so the best opportunities will be to those who provide capital.
2. Non-performing notes: Banks are realizing that short sales to current borrowers yield higher values than note sales to third parties. Partnering with owners who can buy back their notes will be a 2010 opportunity.
3. Buying assets: “A” quality assets will not be available for purchase at discount prices. For those who want to participate in the “A” assets, they will need to be a gap capital provider. However owners of B&C assets will be forced to sell and there will be “discounted” pricing for these assets.

About JCR Capital

JCR Capital is a private investment fund that provides capital to the commercial real estate industry for distressed and opportunisitc situations. JCR investments can take the form of first trust debt, mezzanine debt, preferred equity and equity.

JCR Capital is now in its final stages of closing the JCR Capital Distressed & Opportunistic Real Estate Fund I. Interested parties who are qualified investors should contact Jay Rollins at 303-618-0530 or jayrollins@jcrcapital.com.

2008, an End of an Era: A Year to Remember and Forget

A Quick Trip down Memory (Nightmare) Lane before We Look Ahead

March 2008:  Bear Stearns fails (many thought this was the end, but as we know it was the beginning)

September 2008:
• Fannie Mae & Freddie Mac are taken over by U.S. government
• Lehman Brothers fails
• Merrill Lynch agrees to be sold to Bank of America
• U.S. government seizes control of AIG
• Morgan Stanley agreed to be converted into bank holding company
• Goldman Sachs agreed to be converted into bank holding company

October 2008: U.S. government approves $700 billion TARP plan

November 2008: U.S. government rescues CitiGroup:
• Guarantees $300 billion for troubled assets
• Injects $20 billion of capital into the company

December 2008:
• Bernie Madoff arrested in a $50 billion Ponzi scheme

It was not pretty, but it was historic and it has changed our business for the foreseeable future.

The painful reality of the greatest evaporation of wealth and liquidity of a generation is now sinking in.

Home Prices: Values have fallen 15%-50%, wiping out home owner’s equity.

Stock Market: Equity investments are down 30-40%. (market portfolios, 401k’s, 529 plans).

Unemployment: All sectors are laying off workers, causing a sudden surge in unemployment.

Zombie Banks: Banks are laden with underperforming assets, and TARP has only given them hope of survival. Banks have no incentive to write down loans to clear the market, as they would be announcing that they are insolvent (stay tuned for the federal government’s next big idea to fix the banks).

Securitization: The largest, most reliable and accessible real estate liquidity provider, CMBS, has evaporated right before our eyes.

The Elephant in the Room

The sudden evaporation of the securitization market is the biggest story not being reported in the mainstream press. The CMBS market is GONE! The repercussions of this are still hard to comprehend. Our entire industry relied on the assumption that there was a reliable and predictable permanent loan market at 80% of value and at 1.25x debt service coverage. Billions of dollars of loans were made on that assumption. Now it’s gone.

CMBS Origination by Volume

Maturity Defaults

The effects of the securitization market evaporation will be the number one cause of the pending maturity defaults. Virtually every loan coming due cannot be refinanced at its current loan balance. Banks are using the “amend, extend and hope” strategy. The continuing story for 2009 will be how the master servicers and special servicers will handle the massive amount of maturity defaults.

Payment Defaults

Prior to the 4th quarter of 2008, commercial real estate problems were thought to be a paper problem, not an asset problem. The recession has changed that. Layoffs, lack of consumer spending, and limited business activity are now affecting real estate cash flows. The economy is now taking its toll on all property types and we all expect to see increasing vacancy, decreasing rents, and a drop in NOI. This will cause a spike in payment defaults, especially on highly leveraged properties and new construction projects.

Future Real Estate Values: A One-Two Punch that is Driving Down Values

1. Capital structure changes: Equity requirements have gone from 10% of total costs to 40% of total costs. This structural change alone will account for a significant decline in value.

2. Cash flow (NOI) decreases: Commercial real estate values depend on cash flows. Declining NOI’s will be the “second blow” to commercial real estate values.

Combined, these two factors will cause commercial real estate to decline 20-40%, depending on asset class, market and location.

2009 Market Forecast

2009 will be a gut-wrenching, shake out year for the commercial real estate industry. There will be less capital, lower prices, and less transaction volume. As the year goes on, the federal government will provide clarity on how they will address the “financial crisis.” The options appear to be:

• Government “aggregator bank” that buys the bad assets from existing banks ?
o Government holding bad assets on the federal balance sheet ?
o Government selling bad assets to the private sector ?
• Government joint venturing bad assets with the private sector ?
• Government providing preferred equity into banks ?
• Government providing common equity into banks ?
• RTC II ?

Our industry will remain in stagnation until the federal government picks a direction, and we all know the new capital market rules.

What’s In and What’s Out

What ever choice the government makes, we can clearly say what’s in and what’s out for 2009.

In: Distressed asset acquisitions
Out: Value added development plays

In: Non-performing note acquisitions
Out: New development loans

In: Equity to recap existing projects to meet new equity requirements
Out: Cash out deals

In: High yield (hard money) bridge lending
Out: Libor plus 250

In: Workouts
Out: 90% acquisition loans.

In: Underwriting declining property performance
Out: Underwriting increasing property performance

Underwriting in a Down Market Environment

2009 Land Underwriting
• The only land that has value today is finished lots. Finished lots are being bought for 50%-75% of the cost
• Therefore, today platted lots have no value. Only long term, very patient investors can invest in platted land.

2009 Condominium Underwriting
• Condos should be valued at their apartment value
• A quick valuation method:
Apartment rent per foot x square foot of space = Total revenues
Vacancy: Subtract greater of 10% or market vacancy (Less vacancy)
Expenses: Use a 40% expense ratio (40% of revenues)
NOI

8.5%
Cap rate: Use 8-9% Value of condo

Income Properties

Commercial asset investing over the next two years will be driven by two basic metrics:

1. Investor basis in the asset: This is typically measured in per square feet, per unit, per door. Investors will seek to have their cost basis below replacement cost. A low basis will allow the investor the ability to lower rents and still be able to achieve an acceptable return on equity.

2. Cap rate to investment basis: This is the same as the cap rate if the investor is buying an asset fee simple with pari pasu equity. This metric is higher (better/safer/more yield) if the investor is entering the deal as preferred equity or as participating debt.

Investors will calculate this metric on an unleveraged basis, and on forward looking, downward trending, “market” assumptions such as lower occupancy and lower rents. Investors will be looking for unleveraged yields of 10-12%, depending on the asset class and the market. This will be achieved via:
• Distressed/opportunistic purchase price
• Subordinate seller financing
• Investors entering a deal either as preferred equity or participating debt

As the commercial market continues to evolve, the above two metrics will be the key to the “go / no go” question.

JCR Capital & You in 2009

JCR Capital is open for business and is currently providing capital for the following transaction types:

Debt Transactions
• Security: First Trust
• Investment Profile: Commercial properties
• Rate: Starting at 13%
• Fees: 1-3%
• Term: 1-2 years
• Investment Strategy: Short term bridge loans with defined exit strategies on income producing assets

Equity/Distressed Transactions
• Security: Joint Venture Equity, Preferred Equity or Participating Debt
• Investment Profile: Commercial properties, land, condominiums, special situations
• Return Requirements: 18-25% IRR, 1.75x minimum profit multiple
• Term: 1-3 years
• Investment Strategy: Non-performing note purchases, project recapitalizations, opportunistic acquisitions, special situations

Contact:

Jay Rollins
1225 17th Street, Suite 1850
Denver, CO 80202
303-531-0202 direct
303-618-0530 mobile
jayrollins@jcrcapital.com

Maren Steinberg
1225 17th Street, Suite 1850
Denver, CO 80202
303-531-0204 direct
720-635-7092 mobile
marensteinberg@jcrcapital.com