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Value Creation Opportunities for Commercial Real Estate Owners

Working paper #649
Michael A. Herzberg, Jonas D. Bordo and Timothy Kessler

Markets can be fickle, as evidenced by recent developments in the commercial real estate debt and equity arenas. Eighteen months ago, the outlook for real estate owners could not have been better. The industry was in the midst of a seven-year run of stellar returns. Cap rate compression, fueled by “cheap” debt and healthy economic fundamentals, was driving up asset values across all sectors. Capital was flowing into real estate in record levels, boosting returns even further. Today, commercial real estate capital markets, particularly on the debt side, are frozen in response to the capital crisis. With “cheap” debt no longer available and the economy heading towards a possible recession, the termination of transactions has led to markdowns in the market value of REIT stocks. As a result, equity REITs generated negative returns in 2007, underperforming the broader equity market for the first time since 1999. These negative returns are particularly frustrating to managers, as operating performance, by most traditional metrics, was strong in 2007. Many public companies saw their share prices decline despite posting double-digit gains in funds from operations. Are company valuations purely a function of real estate and capital market conditions rather than management strategy or efficiency? If so, how can managers separate their companies from the pack? To answer this question the authors conducted an analysis to identify the “real” drivers of shareholder value creation.

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