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Morgan Stanley Real Estate Investing

Synchronicity III? The European Sovereign Debt Crisis and Implications for Commercial Real Estate Investing

By: Paul Mouchakkaa, Executive Director, Morgan Stanley Investment Management

2 Morgan Stanley Real Estate

Things fall apart; the centre cannot hold; Mere anarchy is loosed upon the world, The blood-dimmed tide is loosed and everywhereThe ceremony of innocence is drowned; The best lack all conviction, while the worst Are full of passionate intensity

– W.B. Yeats – The Second Coming

Synchronicity III? The European Sovereign Debt Crisis and Implications for Commercial Real Estate Investing 1

Introduction

Yeats’ words were also an inspiration to the progressive rock band The Police, who wrote the song Synchronicity II. In this song, the protagonist is a beleaguered “provider” who must cross picket lines formed by protesters fighting environmental contamination to go to a thankless job. Swiss psychologist Carl Gustav Jung introduced the concept of “synchronicity” by positing that two or more events occurring simultaneously which may appear unrelated might actually be linked together in a meaningful way. In the song Synchronicity II, at the same time the protesters are fighting against environmental contamination, a monster is lurking in a nearby Scottish loch.

With the Great Recession, we have all seen how interconnected the world has become, no matter how unrelated it may appear on the surface. Are we entering a savage, new economic environment as described in Yeats’ poem? The fear is definitely present and, just as we thought we were emerging out of the darkness, the sovereign debt crisis in Europe hit home very hard. How will the responses by policy makers and banks ripple throughout the global economy?

While it is simply impossible to map out all these effects, we will attempt to discuss the following:

• BackgroundontheEuro;• Thegenesisofthesovereigndebtcrisis;• Theimpactonthebankingsector;and• Implicationsforrealestateinvestors.

When Yeats wrote this passage in 1920, the world had just been through World War I and many

hoped that the kind of destruction experienced would never come to pass again; however, some also

believed it might recur with even greater ferocity. Power-hungry leaders and technological military

advances created a fear that the new peace and stability would soon, once again, be threatened. After

World War II, a new resistance towards totalitarianism actually united a determined group of leaders

led by French Foreign Minister Robert Schuman to form the European Coal and Steel Community

(ECSC) in 1950. In essence, the wares of war would be pooled under a common authority to bring

Europe together. This is widely seen as the first step in the formation of what is now known as the

European Union (EU).


WhentheUnitedStatesabolishedtheBrettonWoods system in 1971, it meant the end of convertibility of currency to gold. The dollar would instead be backed by the full faith and credit of the federal government. European countries that were concerned with exchange rate fluctuations set up the European Monetary System (EMS) in March 1979. The main thrust of the EMS was the creation of a reference currency called the European Currency Unit (ECU), a basket of currencies used as a unit of account. This initiative established a mechanism, whereby each currency had an exchange rate pegged to the ECU that fluctuated within a certain band. Tenyearslater,theBerlinWallcamedownandthe reunification of Germany began to create much more currency volatility. Some members, in particular, Italy and the UK, left the EMS at this time. At the European Council held in Madrid in June 1989, European Union leaders decided to move forward with a plan of economic and monetary union. The plan to form a more economically and politically integrated European economy was ratified under the Maastricht Treaty, signed in 1992.

The Euro arrived on January 1, 1999, when theeleveninitialmembers–Austria,Belgium,Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain – adopted the common currency.1 At the beginning of 2002, Euro notes and coins were issued in the twelve countries and their respective national currencies were withdrawn from circulation, making the Euro the only legal tender. It is worth noting that three of the EU’s member countries: Denmark, the UK and Sweden opted out of participation in the monetary union.

The EU set forth five convergence criteria in order for a member state to swap their currency for the Euro:

• Price Stability – the rate of inflation may not exceed the average rates of inflation of the three member states with the lowest inflation by more than1.5percent;

• Interest Rates – long-term interest rates may not vary by more than 2 percent in relation to the average interest rates of the three member stateswiththelowestinflation;

• Deficits – national budget deficits must be below3percentofGDP;

• Public Debt – may not exceed 60 percent ofGDP;

• Exchange Rate Stability – exchange rates must have remained within the authorized margin of fluctuation for the previous two years.

At present, seventeen countries (the EU-17) use the Euro as their official currency, with the additions of Cyprus, Estonia, Malta, Slovakia and Slovenia to the twelve listed above.

We learn in Economics 101 that there are two key macroeconomic policy tools: a) monetary policy, which directs the size and rate of growth of the money supply which, in turn, affects interestrates,inflationandexchangerates;andb) fiscal policy, which is the use of government spending and taxation to influence the economy. In essence, the EU-17 have given up direct control of their respective monetary policies but each retained sovereignty over its own fiscal policy. The detachment of these two policy instruments is critical to the understanding of the current collapse in Europe. In 2002, the famed economist Milton Friedman was quoted saying: “It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe’s internal contradictions will tear it apart. Euroland will collapse in 5 to 15 years.

Background on the Euro

1 Greece joined the Euro on January 1, 2001.


For any story worth telling, there is a short, simple version and a more complicated one. In its most concise form, the genesis of the sovereign debt crisis could be distilled into a simple miscalculation of risk. Greece, Italy, Spain, Ireland and Portugal all borrowed beyond their means for too long because buyers believed that the linkage to the Euro meant these countries would not default. Similar to the mispricing of U.S. subprime mortgages, the spread between the different risks simply narrowed too much and risk was not appropriately measured or compensated. In Display 1, one can see how after Greece entered the Eurozone in 2000, Greek bond yields converged quickly with other Eurozone countries and typically were within a 100 basis point (bp) spreadtotheGermanBunduntiltheGreatRecession in 2008.

This convergence endured over a period of eight years, irrespective of the fundamentals and behavior of each sovereign country. The convergence carries some eerie parallels to the Long Term Capital Management (LTCM) saga,

where the principals of the famed hedge fund made increasingly large convergence trades on maturity dates and sovereign bonds to take advantage of small arbitrage opportunities. In order to make substantial returns, LTCM’s bets on these minute differences were highly leveraged. Once Russia devalued the ruble in August 1998 and defaulted on its debt, the global investment aftermath resulted in a massive flight to quality, leaving LTCM swamped with debt and margin calls from their short positions.

Meanwhile, the “era of leveraging” led to a dramatic shift in the fiscal make-up of many of the EU countries. As shown in Display 2, the debt-to-GDP ratio grew dramatically in many of the EU economies, including Greece, Ireland, Italy, Portugal and Spain. Some of that increase was a function of declining GDP after the Great Recession, but, regardless, the compound annual growth rate of gross debt in each of the aforementioned countries over the same time period was 10.3 percent, 31.3 percent, 4.0 percent, 12.1 percent and 13.5 percent, respectively.2

Genesis of the Sovereign Debt Crisis

Display 1: 10-year Sovereign Bond Yield Spreads Compared to German Bunds

Sovereign 10-Yr Bond Yield Spreads to German Bunds

Source: Eurostat. Data as of November 2011.

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Greece enters Euro zoneGreat Recession

Sovereign Debt crisis escalates

2 Source: IMF. Data as of December 2011.


What governments did with the money is not the same across the board. In Ireland and Spain, many banks lent to property developers, fueling huge construction booms and real estate bubbles;whereasinGreecethegovernmentramped up social payments in the form of pay and pension benefits.

On an aggregate basis, the EU-17, based on estimates from the IMF, has a debt-to-GDP ratio of 88.6 percent3 and a current account surplus. The latter is driven primarily by Germany. However, the inequality of the proportion of debt by country creates a problem. The imbalance, some economists argue, has

Display 2: Debt-to-GDP Ratio

Debt-to-GDP Ratio 2007-2011

Display 3: Triangulation of Current Account Deficit, Debt-to-GDP Ratio and Real Estate Appreciation

Debt-to-GDP-CA Deficit-RE Appreciation

Source: IMF. Data as of December 2011.

Source: IMF, IPD, Moody’s Data Buffet. Data as of November 2011.

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Bubble size represents RE appreciation from 2003-2007

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3 Source: IMF. Data as of December 2011.


been due to the current account deficits (i.e., trade deficits) incurred by many of the troubled countries. If national currencies were still in existence, then Greece, for example, would devalue the drachma, causing the prices of Greek products to go down and making Greek products more competitive abroad, thereby improving the country’s current account balance. Foreign currency reserves would eventually build up, making it easier to service Greece’s debt.

Within a currency union, this is not an option. Therefore, it becomes an imperative of policy – rather than market forces – to try and impose the measures necessary to simulate how supply and demand forces would have impacted a sovereign currency system. The most likely mode would be through wage adjustment. Byloweringwagesincountriesrunninga deficit, the countries’ labor and products gain in global competitiveness.

However, a lack of discipline on the part of the troubled countries and the detachment from fiscal oversight in the EU created a perfect storm. As shown in the graph below, the current account deficits run in Greece, Ireland, Italy, Portugal and Spain were further exacerbated by increased debt and property bubbles.

Currently, the clock seems to be striking twelve, so to speak, on the EU’s sovereign debt levels and fiscal account imbalances, and, the resulting pressure will likely necessitate even more severe measures. With conditions weakening in part since some of the necessary medicine was not prescribed sooner, over the past eighteen months we have seen various bailouts and austerity measures announced and executed, to various degrees of permanence and success. There is no doubt that policy measures have always had significant influence on investment performance, but at this point in time, investors are essentially sitting on the edge of their collective seats awaiting the next policy decision. The reality is that policymakers will work at their own pace, and investors will as well, sometimes even appearing to be at odds with each other. As such, volatility has been, and is expected to be, higher than usual, at least for the short term. As shown in Display 4, the European Union andECBhaveputforwardaseriesofmeasuresaimed at solving the crisis. The establishment of the European Financial Stability Facility (EFSF) was the first key action taken, whereby a €440 billion temporary facility, hammered out through a “crisis” summit in May 2010, was put in place to help troubled countries manage their debt burdens without triggering further crisis. The gravity of the situation warranted a more permanent solution, and, therefore, the European Stability Mechanism (ESM) was shortly instituted to succeed the EFSF.


Display 4: Summary of Events in Euro Crisis

Date Event

May-10 EU and IMF agree to a €110bn bailout for Greece

May-10 €440bn European Financial Stability Facility (EFSF) set-up

May-10 €250bn IMF emergency measure package

Nov-10 €85bn bail-out for Ireland agreed

Mar-11 EU agrees rules for new €500bn European Stability Mechanism (ESM) from 2013, replacing EFSF

May-11 78bn bail-out for Portugal agreed

Jul-11 EU agrees to boost lending capacity of EFSF and allow it to buy bonds on the primary market

Jul-11 Second bail-out for Greece worth €109bn agreed

Aug-11 ECB intervenes to steady Italian and Spanish bonds

Aug-11 Italy, Spain and Portugal all enact austerity measures through various cuts or tax increases

Aug-11 France calls for a six-month ban on short-selling in its biggest banks

Sep-11 Italian unions hold general strike

Sep-11 Juergen Stark resigns from ECB

Sep-11 S&P cuts Italy's credit rating to A from A+

Oct-11 Fitch cuts Spain's credit rating to AA-

Oct-11 Greek parliament approves austerity bill which includes wage cuts, pension plan reforms and 30,000 layoffs

Oct-11 10th crisis summit held in 21 months where bailout fund is increased to €1tn and require investors to take 50% haircut on Greek bonds

Oct-11 ECB requires banks to build a buffer such that core tier 1 capital ratios are at 9% by June 2012

Oct-11 Greece calls referendum on bailout agreement

Nov-11 Berlusconi resigns

Dec-11 S&P puts Germany and France on review for a downgrade

Dec-11 New "fiscal compact" reached with new rules to tighten future debts and create a €500bn rescue fund for next year. The proposed fiscal compact requires ratification by 12 of the 17 Eurozone members

Dec-11 ECB announced plans to provide funds to Eurozone banks, via Long-Term Refinancing Operation (LTRO). Three-year credit is offered at an interest rate of just 1%, providing liquidity lifeline to banks that were struggling to roll over debt maturities. In the ECB’s largest single liquidity operations to date, 523 European banks tapped the LTRO for €489 billion in credit on December 22

Jan-12 S&P cuts ratings of France, eight other EU countries, and the EFSF itself

Feb-12 Talks between Greece and its private creditors stall amid disagreement over the private sector involvement (PSI) haircut to be imposed on Greek bondholders, before the “troika” (European Union, European Central Bank, and International Monetary Fund) negotiate a haircut of up to 75% on private sector holdings and a second, €130bn, bailout for Greece. Athens is required to implement austerity measures and reforms ahead of its next major debt maturity date, in March 2012

Feb-12 The ECB disburses a second tranche of LTRO funds, providing €530bn to 800 European banks in a second round of 3-year loans at 1%

Source: The Economist, Bloomberg, BBC. Data as of February 2012.


Impact on the Banking Sector

The sovereign debt crisis has significant linkages and serious implications for the banking sector. Many banks invest in government bonds, which are carried as assets on their balance sheets. As yields for these sovereign bonds increase (shown in Display 1), their value drops. Further, depending on a given bank’s exposure to certain sovereign debt, if a government defaults then it would have an even more damaging knock-on effect. The issue at hand is that the fear of a sovereign default, like those experienced in 2002 in Argentina and 1998 in Russia, can cause a run on the bank. Investors and depositors who are concerned with the stability of a bank will pull their money out, causing even greater anxiety and further squeezing that financial institution. In essence, it becomes a crisis of confidence in the banking sector as a whole, as the stability and creditworthiness of the sector come into question. Display 5 depicts the linkages between the sovereign debt crisis and the banking sector.

In this display, the bank receives deposits from customers as well as loans from other financial institutions. These items represent liabilities to the bank. In addition, there are equity investors through

retail or institutional funds that also provide capital tothebank.Banksthenhavetheabilitytoleveragethetotalequityfortheirloanbook.BasedontheIMF Global Financial Stability Report published in September 2011, Eurozone banks have a leverage ratio of approximately 26 times. This means that for every €1 of equity, banks are lending €26. To put this into context, in the fourth quarter of 2007, before beginning to deleverage during the 2008 crisis, U.S. banks had leverage ratios of approximately 21 times. Since the overall deleveraging process has unfolded across the U.S. economy, U.S. banks’ latest leverage ratio sits at 12 times.

The assets on a bank’s balance sheet are essentially the loans made to consumers, businesses and governments. A key distinction here is that, generally speaking, consumer and commercial loans carry some form of recourse or collateral. In consumer loans, a house or car may backstop each loan, giving the bank the ability to seize the collateral should a default occur. The same holds for commercial loans, where generally property, plant, equipment or receivables representthecollateral.Butinthecaseofgovernmentloans, there usually is only the full faith of the

InterconnectivityEffect

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Display 5 : Impact on Banks of Sovereign Debt Crisis Schematic (Illustrative Example)

Sovereign Debt Crisis’ Impact on Banks

Source: MSREI Strategy.


sovereignty backing the loan. The theory is that since governments have the ability to tax and print money, this eliminates (or at least significantly reduces) the risk of a default. However, recall that in the Eurozone each country has the power to set its own fiscal policy, but does not unilaterally control its monetary policy and cannot choose to print money.

As the sovereign loans encounter a default or even the perceived risk of one, a ripple effect of adverse events would likely play out. First, depositors will be concerned about the ability to retrieve their money from the bank due to the risk to its solvency. Many of

us are familiar with the famous scene in the film, It’s A Wonderful Life,inwhichGeorgeBaileyisforcedtocancel his honeymoon plans in order to stave off the run on his family-owned building & loan. A similar run on the bank proved to be a reality in 2008 in the caseofNorthernRock,whichisaBritishbank,nota Hollywood creation. Next, exacerbating the impact is the fact that many other financial institutions are lenders or equity investors in other banks. This creates the “interconnectivity effect.” The poor performance of one bank could, thus, spread to others, even if the latter have little or no direct exposure to the sovereign debt crisis. To illustrate, Display 7 below presents the

Display 7: Foreign Claims on GIIPS Banks by Country (in MM of USD)

$1,842 $1,583 $2,359 $1,052 $433

$21,532 $9,841 $11,657 $16,868 $1,879

$48,338 $44,657 $16,366 $8,898 $4,349

$12,554 $6,170 $2,143 $3,958 $259

$69,144 $38,616 $25,489 $17,980 $4,891

Total GIIPS $153,410 $100,867 $58,014 $48,756 $11,811

Source: BIS Quarterly Review. Data as of September 2011.

Display 6: Bank Leverage Ratios

Source: IMF, ECB (Leverage Ratio is defined as the ratio of tangible assets to tangible common equity for domestic banks). Data as of October 2011

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foreign claims vis-à-vis Greece, Ireland, Italy, Portugal and Spain (GIIPS) by country.

In reaction to the run on deposits, many of a bank’s equity holders may sell their shares for fear of insolvency or continued poor performance. The combination of these events can quickly lead a bank to require infusions of new capital. Exacerbating the issue is an element of circularity where certain banks who have challenges and need bailouts will look to the sovereignty for assistance, but if the sovereignty itself is weak, it forces a bailout by the EU.

Further,oneofthekeymeasurestakenbytheECBis the requirement for European banks to build a buffer such that Core Tier 1 capital ratios are at 9% by June 2012. The need for banks to improve their funding and plug capital back into their system that is being withdrawn may then cause unintended consequences.

Commercial Real Estate LendingThis connectivity has serious implications for the commercial real estate sector. As banks scurry to remedy their capital needs, there can be a multitude of actions undertaken that would affect current investment positions as well as future investment opportunities in the Eurozone and potentially even outside of Europe as well.

First, commercial banks play a more prominent role in Europe’s commercial real estate lending marketwhencomparedtotheUnitedStates.Basedon an analysis by DTZ Research,4 approximately 75% of outstanding commercial mortgage debt is heldbybanksversusCMBSorInsurance/Otherinstitutions. As a comparison, in the United States, banks represent approximately 55% of the real estate debt outstanding.

With regard to the current investment positions, Eurozone banks may find it easier to shrink their balance sheets than to raise new capital, as they seek to meet capital ratio requirements – meaning banks will shed risky or even potentially quality assets. This makes any extensions or refinancings for commercial real estate challenging going forward. Generally, banks which have received government aid or subsidies are ostensibly obliged to shrink their balance sheet and exit non-core markets.

Loan extensions will likely be the preferred strategy for properties that are cash flow positive in order toavoidaworkout;however,thesewillprobablyrequire new infusions of equity and strong equity sponsorship and cooperation. For properties that are struggling, many lenders will have the need to write off or sell their loans, force a sale or foreclose. Thus, recapitalizations at the bank balance sheet level will likely trickle down to specific property loans and requirerecapitalizationattheassetand/orportfoliolevel.BasedonDisplay 8, there has already been a change in loans that are being paid “on time” or “late”, as compared to those in default. In 2010, nearly 50 percent of matured loans were prepaid, paid “on time” or paid “late”. Now the percentage of loans in default is hovering over the 30 percent mark.

Display 8: Loan Repayments

Source: Moody’s. Data as of November 30, 2011. 4 Data as of December 2010.

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� % Prepaid � % Repaid by Agreed � % Repaid After Agreed Maturity Date (“On Time”) Maturity Date (“Late”)

� % Repaid � % in Extension � % in Default With Loss


As another unintended consequence, banks may also close branches in certain locations that are not central or core to their business going forward, even if those locations have been performing well. This may create a need to shed loans that are in a non-core market, irrespective of their overall performance.

Additionally, the interconnectivity effect may have an impact on banks lending or providing equity to other banks. If one bank needs to remedy its capital ratio and elects to pulls equity out of another bank that may be performing well, it may create a funding need for the latter institution.

In terms of future investment, Euro area banks havealreadytightenedlendingstandards;however,based on the most recent survey conducted by the ECB,standardsareexpectedtotightenfurther.

As such, banks are likely to provide more limited financing and to focus on prime properties that are stabilized. This may open up opportunities for new lenders to come to the market to either provide gap financing to current distress situations or for new investments going forward in more non-prime property.

Display 9: Lending Standards Survey

Source: ECB-Changes in standards are measured as the difference between the percentage of Euro area banks tightening standards considerably and the percentage loosening standards considerably plus half the difference between the percentage of banks tightening standards somewhat and the percentage loosening standards somewhat. Data as of November 2011.

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Implications for Investors

As discussed earlier, action has been taken thus far, but many investors feel what has been accomplished has only bought time and has not truly solved the nature of the sovereign crisis. The complexity of the issue is immense, and to understand all the potential interconnectivities and unintended consequences that may play out is nearly impossible. There are myriad possible outcomes and the overall crisis has several component problems. Two critical issues include recapitalizing the banking system and restructuring the Eurozone rules.

In the case of system recapitalization, possible resolutions may be achieved either through the privatemarket,interventionbytheECBorbank bailouts. A private market solution would include a “good bank-bad bank” set-up or the encouragement of solvent banks’ takeovers of troubled banks, similar to those undertaken during the crisis in 2008. However, this scenario seems to be the least likely option as the banking sector as a whole appears to be in a poor state throughout the region. The second possibility is fortheECBtoactasa“lenderoflastresort”tothebankingsystem.TheECBhasbeenactive;however, it is not completely clear its mandate is to serve as a backstop. Lastly, a full bailout of banks from the government by injecting capital into banks, similar to the Troubled Asset Relief Program (TARP) undertaken in the U.S., is also an option. This alternative may be complicated as the governments themselves are inherent to the problem.5 This may then imply that outside help or loan write offs may be other options to potentially resolve the banking situation.

As for restructuring the Eurozone rules, there is a key threshold question on the future of the zone itself. Will it remain intact as it is today or will there be a full or partial breakup? This paper will not attempt to answer what will happen to the Euro, but there clearly need to be changes to the fiscal policy structure in the Eurozone, as well as clarificationsoftherolesoftheECBandEurozonebond market. The political will and consensus to even move forward to redesign the structure of the Eurozone have been elusive, and how it all plays out is still unknown at this point in time. This uncertainty is a very important element to factor into the overall risk and return expectations of investing in Europe today.

In analyzing the impact for real estate investors it is always important to look at both the capital markets and macro economy across the Eurozone. The capital market situation has been discussed above. Clearly banks and investors are signaling a flight to quality. Further, lending standards are tightening and the looming maturity wall will have to be dealt with – either through extensions (for performing assets) or workouts (for non-performing assets).

In terms of the macroeconomic situation, there are certain key indicators pointing towards a recession in the Eurozone. As shown in Display 10, the European Sentiment Index, which is a composite indicator of industrial, services, consumer, retail and construction confidence, has hit a two-year low. This, coupled with the Eurozone Purchasing Managers Index still holding at a value of 48.3,6 has many concerned that a potentially deep or, at least, normal recession in the Eurozone is a near-term possibility.

5 Capital Economics – Does a Sovereign Debt Crisis Always Cause a Financial Crisis? – Oct 24, 2011

6 Source – Bloomberg – A headline value greater than 50 in PMI signals growth, while one below 50 signals contraction, the greater the difference from 50, the stronger the effect.


Display 10: European Sentiment Index

Source: European Commission Economic & Financial Affairs. Data as of December 2011.

Therefore, we believe the general posture of investing in Europe should avoid “beta” or market momentum strategies. Special situation and distress strategies should be the primary focus. Opportunities will not be crystal clear or obvious in all situations. Furthermore, the opportunities will not always look attractive. It is quite likely that many distress opportunities will have high loan-to-value (LTV) ratios or low debt yields upon acquisition. Also, size may matter. Deal sizes may be small, which will require vigilance on chasing deals to aggregate aportfolioofassets;alternatively,theycouldbelarge portfolio deals that will require a significant verification period and greater time, energy and resources to structure and underwrite. The last point is to always ensure that the risk being taken is appropriately compensated. Any potential opportunity must be considered in light of its alternatives in the market, especially when focusing on distress and special situation strategies. Thus, appropriatereturnexpectations/spreadsandbasiswill be of even greater importance in analyzing opportunities in Europe.

In terms of specifics, the key themes to approach from an investment perspective given the current situation in Europe are summarized on the following pages.

Flight to QualityDue to the current economic climate, many investors and lenders are moving towards stabilized assets located in prime markets, which will open up opportunities that are linked to this secular trend. There may be some unique opportunities for refurbishment or repositioning strategies in supply-constrained markets. Essentially,investingina“B”assetinan“A”market and redeveloping close to “Eurozone A” standards for an exit to a core buyer, may be an appropriate strategy at this juncture. Another approach to capitalize on the flight to quality would be to buy high-quality core assets in markets where yield compression has not yet occurred on the same scale as primary markets, such as London, Paris and Germany, and try to ride the wave of potential future cap rate compression.

Recapitalizations & Funding GapAs mentioned earlier, there is an expectation that commercial mortgages in default have been rising. Should the overall economic climate worsen, this may cause many properties to suffer. With a loomingwallofmaturities,especiallyintheCMBSspace, there may be an opportunity to recapitalize or acquire assets due to the current funding needs of many Eurozone banks. As shown below, about €35 billion of securitized loans will need to be refinanced over the next two years. Given current lending conditions, there will be a need to remedy potential funding gaps over the next two to three years. Rescue capital investments from a struggling manager under pressure from its lenders may be a source of strong risk-adjusted returns, but will likely be highly complex transactions that will require careful structuring and underwriting.

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Display 11: CMBS Loan Refinancing Requirements

Source: Moody’s. Data as of November 2011.

Debt Strategies/LendingAs banks actively deleverage in order to address funding and capitalization issues, there is a smaller appetite for commercial real estate lending, especially for non-stabilized product. Furthermore, as previously shown, banks are tightening standards, with lower LTVs, higher debt yields and more stringent covenants required. New lenders have been emerging, such as insurance companies, but are also primarily focused on core assets. Therefore, new capital will be required to finance transaction activity within Europe. Mezzanine or preferred equity positions may be structured that can provide investors with current return as well as some cushion of downside risk mitigation.

Moreover, the fact that many non-prime assets will be difficult to finance may cause a spread play as these assets may deteriorate in value in the short run as they fall out of favor. When debt markets stabilize, there may be the opportunity to sell these assets at a gain or add leverage. However, this must be done on a very selective and careful basis.

Special SituationsAnother area that may be of interest to investors involves special situations. Particular opportunities that may arise include corporate dispositions, bank liquidations and development. In the case of corporates, there may be opportunities to acquire assets from corporations that are in need of capital due to pressure they may be under from their lenders. That said, these opportunities may be rare, as these may not be the most opportune instances for these businesses to shed any real estate holdings. The next possibility lies in rescue capital investments from a struggling manager or bank. Additionally, in cases where banks may be seeking to shed foreclosed real estate portfolios (either nonperforming loans or real estate owned), there may be a “mixed bag” of quality which will necessitate vigilance on the basis being paid. Lastly, the dearth of development across Europe is not likely to pick up. There may be unique opportunities to pursue development that capitalizes on the flight to quality trend for certain markets. An example may be an Irish developer who has locked up a site in Frankfurt, but lacks funds or support for completion.

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With respect to the Eurozone today, we are truly in uncharted territory. The Sovereign Debt Crisis has quickly come on the heels of the Great Recession, making for a more volatile and skittish investment environment. Going back in time, after World War I, the world was also in a state of flux making Yeats’ words quite apropos for today’s environment. The sheer scale of complexity and interconnectivity in our global financial system has amped up fears as the uncertainty of what could happen – monsters lurking in Scottish lochs – stretches our collective imaginations to its limits, or so we hope.

How this all came upon us and how it is resolved are questions that marry human nature with economic theory. Much like Carl Gustav Jung’s theory of synchronicity, the connections in our world may not always be logical, but can be causal or symbolic. The same goes for the financial world. It brings into question whether we impose our nature on the financial system, or whether the financial system is merely governed by the laws of nature themselves.

Conclusion


About Morgan Stanley Real Estate InvestingMorgan Stanley Real Estate Investing (MSREI) is the global private real estate investment management arm of Morgan Stanley. Established in the early 1990s, MSREI has been one of the most active private real estate investors for two decades, acquiring over $180 billion of assets in 36 countries. MSREI leverages the expertise, relationships and franchise of Morgan Stanley with dedicated real estate investing professionals located in fifteen offices around the world providing acquisition, finance and asset management services. For more information about MSREI, please visit our website at www.morganstanley.com/realestate.

About Morgan Stanley Investment Management Morgan Stanley Investment Management (MSIM), together with its investment advisory affiliates, has 620 investment professionals around the world and approximately $287 billion7 in assets under management or supervision as of December 31, 2011. MSIM strives to provide outstanding long-term investment performance, service and a comprehensive suite of investment management solutions to a diverse client base, which includes governments, institutions, corporations and individuals worldwide. For more information, please email us at [email protected] or visit our website atwww.morganstanley.com/im.

7 Assets under management as of December 31, 2011. Morgan Stanley Investment Management (MSIM) is the asset management division of Morgan Stanley. Assets are managed by teams representing different MSIM legal enti-ties; portfolio management teams are primarily located in New York, Philadelphia, London, Amsterdam, Singapore and Mumbai offices. Figure repre sents MSIM’s total assets under management/supervision.


This document is not a research report and has been prepared solely for informational purposes only. It is not a recommendation to buy or sell or an offer or a solicitation of an offer to buy or sell any security or instrument or to participate in any strategy. The information contained herein reflects the views of the author at the time such materials were prepared and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after the date such materials were prepared. Information regarding expected market returns and market outlooks is based on the research, analysis, and opinions of the author. These conclusions are speculative in nature, may change at any time, may not come to pass, and are not intended to predict the future of any Morgan Stanley investment.

Past performance is not indicative of future results. All investing involves risk, including the risk of a loss of principal. There are risks associated with real estate investing can include value fluctuations, market saturation, defaults and economic conditions. Foreign real estate companies depend on specialized management skills, may not be diversified, have less trading volume, and may be subject to more abrupt or erratic price movements than the overall securities market.

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© 2012 Morgan Stanley

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