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THE PATHFINDER

REPORT September 2013

IN THIS ISSUE 2

THANKS FOR WRITING IN

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CHARTING THE COURSE Strategies for a Rising Interest Rate Environment

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FINDING YOUR PATH A Real Estate Investor Looks at 50

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GUEST FEATURE The Time Is Right for Retail Investment

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ZEITGEIST: NEWS HIGHLIGHTS

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TRAILBLAZING Copper Creek, Tempe, AZ

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NOTABLES AND QUOTABLES The Federal Reserve’s “Tapering”

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THANKS FOR WRITING IN Thanks for writing in. Please keep those cards and letters coming. If you have expertise in an area that could be of interest to our readers, please email us at info@pathfinderfunds.com with information about your proposed subject matter. We will be happy to consider it for a future edition.

CHARTING THE COURSE

Strategies for a Rising Interest Rate Environment By Mitch Siegler, Senior Managing Director

rates and are often classic harbingers of inflation – but we’re not yet ready to make that leap. And, maintaining perspective is essential: we’re in the lowest interest rate environment since the 1940s.

“There are known knowns; these are things we know that we know. There are known unknowns; things that we now know we don’t know. But, there are also unknown unknowns; these are things we do not know we don’t know.” - Donald Rumsfeld, Former U.S. Defense Secretary in a 2002 statement The Fed’s target Fed Funds Rate has now remained in the 0% to 0.25% range for nearly five years but this summer’s big jumps in interest rates have spooked many fixed-income investors. Speakers at real estate conferences caution that rising rates will bring higher cap rates and cocktail party chatter is laden with homebuyers bemoaning the rise in their mortgage rates and homeowners whining that they missed the window to refinance for the umpteenth time in the past few years. Yes, the jump in the 10-year Treasury bond rate from about 1.6% in May to over 2.8% at press-time is a lightning-quick and massive move on a relative basis (more than 75%) and the corresponding jump in 30year, fixed rate mortgage rates from 3.6% to 4.5% in the same period represents a 25% spike. Rate rises are sometimes followed by increases in capitalization (cap)

Rather than looking at these rate moves in the context of the summer of 2013, let’s view rates and markets through the prism of the recent five-year economic cycle – both the Great Recession of 2008 and the subsequent recovery. That way, we’ll be able to look past the array of trees and actually have a chance to see the forest. Equity and housing markets have rallied strongly since bottoming in the past few years. During the past four years, the S&P 500 rose more than 1,000 points (over 150%) from its March 2009 low of 677 to an all-time high of more than 1,700 in August before the recent selloff. Home prices in many hard-hit markets increased 20% in the past year alone and the Case Shiller 20-City Composite Index of home prices rose about 12% Mayover-May. Still, home prices remained 24% below their June 2006 peak, fueling speculation that further price increases lie ahead. Although cyclical and fundamental trends – like declines in the unemployment rate, strong corporate profits, productivity gains and low levels of

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housing inventory – have been contributors to the rising equity and home prices, highly accommodative Federal Reserve monetary policy has also played a major – perhaps even a larger – role. Extraordinary Fed measures – three rounds of quantitative easing (read “money printing”) – have fueled ultra-cheap money and pushed interest rates down to the level of inflation. This has driven investors to flee bonds and chase stocks, sending equity prices through the roof. Less restrictive credit has also turbo-charged a rising stock market and investors’ distaste for bonds and fears of inflation have sparked massive demand by home-buyers which, when combined with tight housing supplies has led to an incredible spring-back recovery in home prices. The classic virtuous circle. Now, the laws of financial gravity are coming into play and equity investors are questioning the arithmetic behind today’s stock prices. Do companies’ future earnings potential and today’s dividend yields justify current prices and earnings multiples? It doesn’t seem so. Meanwhile, as rates have risen this summer, bond prices have tanked, making bonds more attractive, especially to those leery of the stock market. So, the investor pendulum could swing back as hot money leaves stocks and moves back to bonds, chasing better yield. Beware widows, orphans and other fixed income investors – it may not end well. When you feel flush about your stock portfolio, you’re also more ebullient when it comes to buying a house, which we think goes a long way in explaining the double-digit year-over-year increases in median home prices – and especially the 20% to 30% jumps in Phoenix, Las Vegas, Sacramento and other previously pummeled markets. As Isaac Newton taught us, what goes up, must come down and the Fed’s influence over capital markets couldn’t have been more apparent than when Chairman Bernanke dropped the “T” word (tapering) in May and the rate on the 10-year Treasury bond skyrocketed while

equity markets swooned, with homebuilding stocks leading the parade down (Pulte Group, D.R. Horton and KB Home have fallen by a third since the Fed’s tapering trial balloon 90 days ago). During the same period, financial gravity caught up with the iShares Dow Jones U.S. Home Construction ETF (NYSE: ITB), which has declined 20% to enter a new bear market even while builder confidence reached its highest level since 2005. This typical, inverse reaction between rising rates and falling stock prices didn’t last long, however, with stock prices rallying strongly over the summer – the aforementioned S&P 500 index rose from 1575 on June 24 to around 1,650 now – that’s 5% in just a couple of months (30% annualized) and that’s with interest rates moving north and giving effect to the recent pullback. You don’t see stock prices increasing with rising rates too often and investors are right to be cautious and nervous, which explains the recent sell-off in equities. So, back to trees and forests. Sure, rates are low and it’s great to borrow on a 30-year mortgage at 3.5% or 4.0% or even 4.5%. Heck, 4.7% isn’t awful and 5.0% is probably manageable for most folks. Yet, rising interest rates have real consequences. Your payment on a $250,000, 30year fixed rate mortgage at 5.0% ($1,654) is about 10% higher than at 4.0% ($1,506) so the $250,000 mortgage you could qualify for at the lower rate gets squeezed 11% to $222,500 at the higher rate. That dampens demand for housing and chills the market. Could happen, right? This summer, Pathfinder borrowed $13.25 million at 3.89% to finance a Phoenix apartment purchase. This is a long-term, fixed rate, assumable loan at an astoundingly low rate that really moves the needle on our returns for this cash-flowing property. Thanks, Uncle Ben. Lenders are making loans like this to real estate investors and to companies of various sizes in a wide array of industries at a torrid pace nowadays. However, we’re starting to see some canaries in the coal mine. In the past couple of weeks, JP Morgan, Citicorp and other major lenders announced thousands of layoffs in their mortgage lending divisions, citing lower demand for loans at the higher rates. And we’re having daily conversations in the office about how to bob and weave in what seems certain to be a higher rate environment in 2014 and 2015. And we told you what we’re hearing at

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cocktail parties. The taxi drivers and barbers won’t be far behind. Economist friends tell us that a more normal Fed Funds rate would be 4.0% (not 0.0%). And a more normal 10year Treasury note rate would be 5.0% (not 2.8%). So, rising rates are likely a “when”, not an “if ” question. So, how do you guard against complacency to protect your portfolio? Here are four strategies to consider: 1. Fix it – the interest rate, that is. If you’re going to borrow, select a loan that locks the rate for at least the next few years – longer if you have a longer time horizon. You might not time the absolute bottom and you’ll pay a little more but you’ll sleep better at night and it’s all about perspective. And, if the loan is assumable by the next buyer, that’s a bonus. 2. Hedge it – The equity markets are vulnerable at current prices so we’re keeping some balance in our portfolio. Many investments could suffer in a rising rate environment so it’s nice to have some counter-cyclical investments, especially ones that produce solid cash flow along the way. Real estate fits the bill with the added benefits that its cash flows are indexed to inflation (rents can rise) and it provides solid collateral that you might not get from a government bond or a junk bond.

of business, credit is more available and people generally feel better about the future, stimulating buyer demand for real estate assets. It feeds on itself. We’re planning for a higher cap rate environment at Pathfinder but it’s equally (or more) likely that cap rates rise because of a downturn in the economy than rising interest rates. Economic downturn – you’re probably not hearing that phrase a lot these days, are you? 4. Keep some powder dry – Pathfinder’s roots go to our contrarian founding in 2006, when everything was roses and light but we knew trees wouldn’t grow to the sky. Today, things again look rosy and many investors are wildly bullish. We wonder if the other side of the trade might be a more comfortable place to be. Certainly, we’re selling a few winners. And, we’re remaining mindful of the risks, maintaining leverage ratios that provide a cushion and keeping a bit of cash in reserve to take advantage of opportunities should upticks in rates spark selling pressure or create a lack of liquidity. Mitch Siegler is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Mitch founded and served as CEO of several companies and was a partner with an investment banking and venture capital firm. He can be reached at msiegler@pathfinderfunds.com.

3. Watch it – The myth, that is, that rising interest rates always correlate precisely with higher cap rates. We read with interest a long-term analysis of how real estate investments fared in periods of rising interest rates. The NCREIF Property Index averaged 9.3% annual growth from 1979 to 2012 but returns were actually quite a bit higher (12.7%) during several periods when rates moved higher, like the mid-‘90s and the mid-2000s. The reason: rates don’t rise in a vacuum – generally, increasing interest rates are associated with an improving economy. That means more jobs and higher consumer spending, which drives demand for commercial space and allows landlords to boost rents. Fewer tenants go out

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FINDING YOUR PATH A Real Estate Investor Looks at 50

By Lorne Polger, Senior Managing Director Turned 50 back late last year. One of those magic round numbers in life that causes you to pause and reflect. And even though 50 is the new 30, the orthopedic aches and pains associated with a lifetime of attempted weekend warrior achievement reminds me that there is more downhill left on this climb than uphill! As I’ve been reflecting on 50, as a lifelong real estate junkie I’ve also spent some time thinking about how the real estate landscape has changed since I was born back in 1962. In some ways, 50 feels like 100 when it comes to the evolution of real estate. With that, a few thoughts on what was, what is, and what will be. Apartments. Remember what we did before WiFi connections were available (which, in reality, wasn’t that long ago although it seems like it now)? You plugged in to your cable connection. Well, that didn’t exist back in the ‘60s. In fact, cable didn’t really start growing in earnest until the ‘80s. Back in 1962, if you were one of the lucky ones, you had a decent-sized black and white television with rabbit ears on top. That enabled you to get occasional reception from the four or five channels that were available for viewing, the three national network channels and if you were lucky, one or two local independents. Yup, we weren’t spending too much time surfing between the Kardashians, the Golf Channel, and Duck Dynasty back then. The changes in how we entertain ourselves these days have significantly changed residential real estate. When we look at renovating older apartment buildings today, a few key things jump out at

us. Can the kitchen countertop space accommodate a laptop or two (better have a plug nearby)? The countertop has replaced the need for an office area. Can we open the area between the kitchen and the living room? Does the apartment have an empty wall with an adjacent plug and cable link? If not, can it be renovated to provide for that, and at what cost? Ledges and cubbies for large television sets are long gone. All you really need now is a wall and nearby outlets. What storage areas are available? Today, we typically own more and buy bigger things. No Costco-sized packs of paper towels and toilet paper back in 1962. Individual apartments can be smaller, provided that communal gathering spaces are available. And those gathering spaces better have a strong WiFi network so we can watch each other engage on our phones, tablets and laptops. Telephone lines? Not really needed anymore. Media or common area offices? Important 10-15 years ago, but much less so today. Most prefer to watch a show on their laptop or tablet (or get work done at Starbucks for that matter). Gyms? An absolute requirement. And forget about that awful Universal machine that was the mainstay of apartment and hotel gyms for 40 years or more. We’re fitter and more health conscious today than ever before. Free range, organic, grass-fed kale anyone? We’ll give you a coupon for some if you sign a 13-month lease today! Condominiums. Back in the ‘60s, you could probably count on one hand the number of condominium buildings in a decent-sized city. Pretty amazing when you think about it. Condominium construction boomed in the ‘70s and ‘80s, and condominium conversions were all the range in the 2000s. Why the surge? Well, condominiums offered the financial benefits of homeownership (tax deduction for your mortgage and potential for appreciation), without the cost and hassle of taking care of a yard and maintaining an exterior. But there are strong headwinds which suggest that condominium development throughout the country will be dramatically reduced over the coming decade, notwithstanding the typical rise in new development that accompanies an economic recovery. In particular, with all deference to my former profession, the lawyers and politicians have killed the condominium business. Any project with a certain measure of size (call it 50 units

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or more) has an extremely high likelihood of being on the receiving end of construction defect litigation within ten years of completion. Put that in context of any other business. You manufacture a product (in most cases, a pretty good product) and more often than not, you’re going get sued for it! It’s why you don’t see any U.S. ladder manufacturers anymore. That’s not to suggest that there aren’t projects that were shoddily built and require repair. But developers have realized that the outrageous costs of litigation simply cannot be effectively passed on to the consumer. There are over 20 residential projects being constructed in downtown Denver at the present time. Not a single one is a condominium. Not one. Why? A few years ago, the Colorado legislature passed a law making it a breach of fiduciary duty resulting in personal liability if a Homeowner’s Association board member failed to sue the developer if construction defects were present. So every board member of every condominium project in Denver receives multiple letters from plaintiff’s lawyers reminding them that they have personal liability if they don’t file a suit. Guess what? Everyone files a suit! Why was that legislation passed? How does it protect the consumer? It’s just politics, but politics that will potentially affect development for decades. Just one example of course, but unfortunately the costs and risks associated with litigation tip the scale away from development. Absent that, the marketplace would be active with entry-level condos for more people. And that is a public policy that is difficult to argue against. Houses. As part of our Pathfinder Raintree program, we’ve purchased about 120 single family homes in San Diego County since 2009, mostly constructed in the ‘70s, ‘80s and ‘90s. We’ve also been involved in a couple of high-end, older home acquisitions in the Los Angeles area. It’s been interesting to walk through a number of the homes and see the renovation process along the way. Much like we’re seeing in apartments, communal, open living spaces are very important in homes now. People would rather have a large kitchen than a large bedroom. Outdoor living space is important, but swimming pools are falling out of fashion. Major themes include use of open floor plans, sustainable

materials, energy efficiency, LED lighting, bold colors, large showers and brushed nickel hardware. Sayonara and good riddance to sunken living rooms, shake shingles, ceiling sound systems, whirlpool tubs, taupe, grass and fountains. It was nice knowing you. Shopping Centers. Turns out we don’t like to shop inside large, captive ocean liners (i.e., malls!) as much as we used to. Huh! Malls, which started springing up in the ‘60s, aren’t exactly dinosaurs yet, but over the last ten years, pedestrian friendly promenades seem to be the rage, even in areas with four seasons. When is the last time you read about the construction of a new large regional mall? Outdoor spaces and features, communal seating areas with WiFi, promenades, walkability and diverse restaurant choices. Hot Dog on a Stick in the big food court? Maybe the last couple in Des Moines and Cleveland, but not so much in Denver and Austin. And the fear that the Internet and Amazon.com would kill off retail? Unfounded. Turns out we occasionally like to go out and interact with other people! Warehouses. Perhaps not surprisingly, but the most basic of buildings has had the fewest changes over the last 50 years. Sure, clear heights have changed, and our power needs have increased dramatically in many cases. And from an architectural perspective, I’m sure glad that the metal building never really took off! But concrete tilt up construction is pretty much the same as it’s been for decades, although we’ve probably improved our technique over that period of time. I think the bigger concerns today are about travel corridors and traffic issues for these types of properties – how close are they to major freeways and railroad lines and how long do employees need to commute? As globalization continues, our regional transportation corridors will become more important, as will, in turn, proximity to those corridors. Office Buildings. A significant revolution in the use of office space has occurred over the last ten years, rendering many ‘60s and ‘70s-vintage buildings functionally obsolete. Most requirements today include open floor plans, massive data pipes, proper server rooms, electric vehicle charging stations, and proximity to public transportation. A gym in the building is probably more important to most tenants today than a snack shop.

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Assuming, of course, that there are other coffee options! Lots and lots of coffee options. Small floor plates with lots of separate window offices may still be important to law firms, but they’re a minority in the market. For many tenants, functional outdoor space is more important than an elegant, large lobby area. Data storage needs have changed as well, as many of us have migrated up to the cloud. Some older buildings are able to successfully

adapt to these changing requirements, but many are not. They will be the ones sitting with 30% vacancies and low rents in the future. I’m looking forward to seeing what 60 brings. Enjoy the fall season, football, and your families. Lorne Polger is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Lorne was a partner with a leading San Diego law firm, where he headed the Real Estate, Land Use and Environmental Law group. He can be reached at lpolger@pathfinderfunds.com.

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GUEST FEATURE

The Time Is Right for Retail Investment By Scot Eisendrath, Managing Director, Pathfinder Partners, LLC Retail Fundamentals on the Upswing Fundamentals in retail investment real estate appear to have bottomed from the Great Recession, and are now on the upswing, although the recovery is a modest one. In the second quarter of 2013, retail property sales volume in the U.S. was $13.5 billion, a 9% increase over the prior 12 months. Average capitalization rates have stabilized in the 7% range, after peaking above 8% in 2010. The overall availability, including vacant space and space available for sublease, declined to 12.5% in the first quarter of 2013, including a 30 basis point quarterly decline, the largest decrease since 2005. In Temecula (southwest Riverside County), California, where Pathfinder made a recent retail investment, the stated vacancy rate has declined from 14% to 10%. But, in the words of a local leasing broker, if you include all the tenants that were occupying space and not paying rent at the worst point of the cycle, the vacancy rate was likely ten percentage points higher. There has been very limited new shopping center and strip mall construction over the past five to seven years, so as the underlying fundamentals improve, the recovery for existing owners won’t get stalled by new supply hitting the market. In the first quarter of 2013, new construction represented only 0.3% of total retail space, significantly below the historical average of 1.4%. The lack of new supply is leading to rent growth in excess of inflation, with the top markets seeing double digit annual rent growth. Fundamentals for consumers are also beginning to improve. Households have successfully deleveraged; debt service as a percentage of household income has fallen from nearly 14% at the height of the credit

crisis, to about 11%, and retail analysts expect it to drop further. Consumers are benefitting from the low interest rate environment, along with an appreciating housing market, which stimulates the wealth effect, driving consumer spending. The improving economy is translating to higher sales for tenants; 2012 saw 5.3% annual sales growth, and Cushman & Wakefield projects 2013 sales growth to be in the 3.5% range. Of all the major property types, retail properties may be one of the biggest future beneficiaries of rising interest rates; rate bumps will likely be the result of an improving economy, which should translate to increased consumer discretionary spending. Changing Landscape Retail real estate is a dynamic market though, and one which is undergoing systemic changes. The worst recession in decades and the resulting changes in consumer sentiment and spending trends, coupled with the dramatic increase in sales from online shopping, have permanently changed the retail real estate landscape. There are several notable trends effecting retailers and consumers, including: • Growth in internet retailing has been astounding, and continues to grow exponentially – the percentage of core retail sales done on the internet has nearly doubled to 7% from 2005 to 2012, a period in which total sales have been flat or declining. E-commerce is expected to grow 7.2% annually from 2013-2017, while total retail sales, excluding automobiles, are projected to grow at about half of that pace, 3.8% per year. By 2017, e-commerce sales are projected to increase to 9% of total core retail sales. • The diminishing middle class will impact the types of retailers that prosper – the growing income inequality will favor retailers at either end of the spectrum – both discounters and luxury retailers. • While the savings rate as a percentage of disposable income hit a near-term high of 6% in 2008-2009, it is currently in the 2% range – consumers are feeling more confident and are spending again.

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• The average store size for many retailers continues to shrink, in part due to “bricks and clicks” strategies, which reduce the need to have a showroom for products and for inventory levels. For example, the average new Target constructed in 2008 was 180,000 square feet; the average new store constructed in 2012 was 150,000 square feet, a 17% reduction in space. Pathfinder History and Outlook I don’t think we have enough fingers and toes on the Pathfinder team to count the number of potential retail real estate investment opportunities we have evaluated (and rejected) during the current real estate cycle. We’ve seen dozens of newly constructed strip centers with shop space in shell condition, most of which should never have been built. We’ve evaluated scores of power centers with vacant big box spaces looking for a new anchor tenant. Nothing against churches, call centers, and charter schools, but at the end of the day, we concluded that the prospects for filling these large vacancies with tenants that would be a good draw for the center, and ultimately provide us with a decent return on investment were tiny. Then, there are shopping centers that housed retailers that are no longer here or are soon to exit the market (think Borders Books and Fresh & Easy); we would hate to be holding the bag with a center anchored by such a tenant. If the old adage that the best deals you do are often the ones you pass on, then we’ve made a lot of dough in retail over the past few years. While our experiences in the recent past have helped us learn the types of properties to avoid, they have also helped us define a strategy for what works. Targeting retailers that should be the least effected by e-commerce, such as apparel or unique purchases (diamond jewelry, large home décor items, wall art, etc.), along with necessity sales (neighborhood grocery and drug stores), should prove to be a successful, lower-risk strategy. Seeking out urban or infill properties, close to transportation corridors and mass transit, with high barriers to entry to

limit future competition will increase the probability of a successful investment. Access to an affluent customer base, with the opportunity to benefit from future residential development as the housing market heals, are additional attractive attributes of a potential retail investment acquisition. And there should be plenty to choose from over the next few years. There is $24.1 billion of distressed retail real estate that has not been resolved to date (see graph below). In fact, of all the major property types, retail

has the highest percentage of distressed properties still to be worked out (35%), not including what will be coming down the pike in the future as a trillion dollars of additional loans come due over the next few years – a good deal of which are still under water. At Pathfinder, we look forward to capitalizing on these opportunities and expanding our presence in the retail space. Sources: CBRE Global Research and Consulting, Cushman & Wakefield, Real Capital Analytics

Scot Eisendrath is Managing Director of Pathfinder Partners, LLC. He is actively involved with the firm’s financial analysis and underwriting and has spent 20 years in the commercial real estate industry. He can be reached at seisendrath@pathfinderfunds.com.

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ZEITGEIST -

SIGN OF THE TIMES Million-Dollar Home Sales Skyrocket Homes priced at more than $1 million are selling at a torrid pace – three times the pace of the broader market, according to real estate research firm DataQuick Inc. Sales of homes in the $1 million and up category rose an average of 37% in the first half of 2013 from a year earlier to the highest level since 2007, per DataQuick. Transactions priced at less than $1 million rose 11% in the same period to the highest since 2009, according to the National Association of Realtors (“NAR”). The $1 million plus segment of the market usually trails the broader market because real estate purchases by wealthier buyers tend to be more discretionary. Those homeowners can generally keep their properties during challenging economic times. Of course, home purchases drive consumer spending, about 70% of the U.S. economy. Spending on home decorating, furniture and appliances is much greater on more expensive homes. Properties priced for more than $1 million accounted for about 2.4% of all home sales in June, up from 1.3% in early 2012 when the residential housing market began recovering, per the NAR. The upper tier of real estate that’s now rising the fastest also fell the hardest during the Great Recession. Sales of $1 million properties fell 41% in 2008. Sales of all homes softened in 2006 with a 39% decline through 2007, according to the NAR. The luxury market took a bigger hit – down 46% according to a Bloomberg survey of sales in the top four cities – because owners lost money when

the stock market crashed in 2008. As owners reexamined their financial situations, they also determined that they no longer needed large mansions. Luxury home prices have since doubled, essentially returning to 2008 levels. Sales of luxury homes in the most desirable cities are on fire, fueled in part by the strong equity markets – the Dow Jones Industrial Average has risen 20% in the first eight months of 2013. Luxury home sales volumes in Seattle are up 61% from 2012 to 2013, according to DataQuick. San Diego and Charlotte’s sales rose 52%. Washington, D.C. rose 44% while Boston jumped 25%. Source: Bloomberg Growing Pains for the Single-Family Rental Market The recent initial public offering by real estate investment trust American Homes 4 Rent, which raised $706 million, well below the company’s $1.2 billion projection, raises lots of questions about the sustainability of the singlefamily rental home market. The Wall Street Journal reported in July that two single-family rental home providers, Waypoint Homes and Colony American Homes have shelved their IPO plans. There are about 14 million single-family rental homes in the U.S., according to John Burns, a leading real estate consultant. While Blackstone, Colony, Waypoint, American Homes 4 Rent and others have poured an estimated $15 billion into the single-family home rental sector, the space remains quite fragmented with investorowners controlling fewer than 150,000 of the 14 million homes.

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TRAILBLAZING: COPPER CREEK, TEMPE, ARIZONA Renovating a Well-Located, 1980s Apartment Community

BEFORE

AFTER

Brown, faded paint scheme

Fresh, colorful paint scheme

Many of us have chosen to forget the gaudy fashion trends of the 1980s, including acid-washed jeans, oversized sweatshirts, shoulder pads, Members Only jackets and formal leotards, to name a few. The decade also brought some similarly unappealing architectural trends, including the over-use of (yaaawn…) beige stucco. When we first toured Copper Creek, a 1980s-vintage, 144-unit condominium project in Tempe, Arizona, we were immediately put off by the sea of beige and brown that engulfed the buildings’ exteriors. We were, however, drawn to the large interiors, balanced unit-mix and functional property layout. The opportunity was also appealing from a financial perspective – the project was being operated as an apartment, was an excellent candidate for low-cost, government sponsored debt and we believed the in-place rents were significantly under market. But no Pathfinder investment is without some “hair”, and Copper Creek’s drab exterior was in need of a serious renovation.

in 1984. The property contains 21 two-story buildings situated on a 7.7-acre parcel consisting of 44 onebedroom/one-bathroom units, 64 two-bedroom/twobathroom units and 36 two-bedroom/two-and-one-halfbathroom townhome units averaging 990 square feet. Each unit comes with a single-car garage (41 with direct access), washer/dryer and wood-burning fireplace.

We purchased the property in May 2013 from a large Real Estate Investment Trust which had owned it for 20 years. The seller was disposing of its entire Phoenix-area portfolio and redirecting its capital to coastal markets and Copper Creek was one of its last remaining assets. The project was built as for-sale condominiums and had not been significantly upgraded since it was constructed

Our renovation strategy is focused on enhancing the project’s bland exterior by adding complementary building colors and stylistic design elements suited to a younger and more design-conscious renter. We completed the property’s new paint scheme earlier this month and are currently in the process of replacing the exterior light fixtures, adding a community dog-park, redesigning the clubhouse and gym, enhancing the landscaping and updating the pool furniture for a more resort-style feel. Concurrently, we are renovating the interiors of several units with upgraded kitchens (modern appliances, cabinets, countertops/backsplashes, light fixtures and flooring), bathrooms (sinks, faucets, light fixtures and mirrors) and flooring. By enhancing the interior and exterior of the project we plan to make Copper Creek relevant to a modern audience – we’ve been taking notes from Paula Abdul and Ray Ban sunglasses. Stay tuned.

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NOTABLES AND QUOTABLES

The Federal Reserve’s “Tapering”

“Monetary policy makers have clearly been divided on the large-scale assetpurchase program (QE3), but let’s be clear: Nobody at the Fed is happy with asset purchases…while openended, the asset-purchase program was never meant to be indefinite.” - Scott J. Brown, Raymond James

“Tapering is a temporary sideshow which will be replaced by disinflation and zero growth in 2014.” - Steen Jakobsen, SAXO Bank

“…the Congressional Budget Office estimates that the U.S. will run a $560 billion deficit for fiscal-year 2014…Compare this deficit estimate with the fact that the Fed is currently printing $45 billion of U.S. Treasuries per month or $540 billion per annum. In other words, if the Fed maintains the status quo, it will effectively be buying, in the secondary market, all of the net new issuance of the U.S. government. This is an outcome that many Fed members may find uncomfortable.”

“We think investors are beginning to worry that the Fed’s comments [on tapering] reflect a lack of faith in the economy’s recovery potential and may spill over into suspicion that EPS growth expectations are overly optimistic, not only for 2014 but also for the remainder of this year.” - Sam Stovall, S&P Capital IQ

“I don’t think Bernanke is going to come this far, and pull the plug and cause a mess for the next Fed chairman. He may still leave a mess but, I say, he’s at least going to go out on a high note.” - Joe Fahmy, Zor Capital

“Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong. About the future, not so much.” - Ben Bernanke, Federal Reserve Chairman

- Brent Schutte, BMO Private Bank T HE PAT HF I N DE R R E PO R T: SE PTE MB E R 2013

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IMPORTANT DISCLOSURES Copyright 2013, Pathfinder Partners, LLC (“Pathfinder�). All rights reserved. This report is prepared for the use of Pathfinder’s clients and business partners and subscribers to this report and may not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, without our written consent. The information contained within this newsletter is not a solicitation or offer, or recommendation to acquire or dispose of any investment or to engage in any other transaction. Pathfinder Partners LLC does not render or offer to render personal investment advice through our newsletter. Information contained herein is opinion-based reflecting the judgments and observations of Pathfinder personnel and guest authors. Our opinions should be taken in context and not considered the sole or primary source of information. Materials prepared by Pathfinder research personnel are based on public information. The information herein was obtained from various sources. Pathfinder does not guarantee the accuracy of the information. All opinions, projections and estimates constitute the judgment of the authors as of the date of the report and are subject to change without notice. This newsletter is not intended and should not be construed as personalized investment advice. Neither Pathfinder nor any of its directors, officers, employees or consultants accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this report or its contents. Do not assume that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended or undertaken by Pathfinder Partners LLC) made reference to directly or indirectly by Pathfinder Partners LLC in this newsletter, or indirectly via a link to an unaffiliated third party web site, will be profitable or equal past performance level(s). Investing involves risk of loss and you should be prepared to bear investment loss, including loss of original investment. Real estate investments are subject to the risks generally inherent to the ownership of real property and loans, including: uncertainty of cash flow to meet fixed and other obligations; uncertainty in capital markets as it relates to both procurements of equity and debt; adverse changes in local market conditions, population trends, neighborhood values, community conditions, general economic conditions, local employment conditions, interest rates, and real estate tax rates; changes in fiscal policies; changes in applicable laws and regulations (including tax laws); uninsured losses; delays in foreclosure; borrower bankruptcy and related legal expenses; and other risks that are beyond the control of the General Partner. There can be no assurance of profitable operations because the cost of owning the properties may exceed the income produced, particularly since certain expenses related to real estate and its ownership, such as property taxes, utility costs, maintenance costs and insurance, tend to increase over time and are largely beyond the control of the owner. Moreover, although insurance is expected to be obtained to cover most casualty losses and general liability arising from the properties, no insurance will be available to cover cash deficits from ongoing operations. Please add msiegler@pathfinderfunds.com to your address book to ensure you keep receiving our notifications. T HE PAT HF I N DE R R E PO R T: SE PTE MB E R 2013

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