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UNDERSTANDING CURRENT ECONOMIC INDICATORS AND THEIR IMPACT UPON COMMERCIAL INVESTMENT REAL ESTATE

April 20, 2012

The relationship between various economic indicators and their impact upon commercial

real estate investments can be complex. It helps to understand these relationships with

a an illustration of Commercial Real Estate Demand Drivers.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Let’s start with analyzing consumers.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Although it has rebounded from the decline last summer, overall consumer sentiment remains fairly weak compared to

prior levels.

Why isn’t current consumer confidence higher?

Overall unemployment remains high, especially for lower educated workers. Construction workers have been particularly

hard hit during the past 4 years.

The overhang of the housing market decline remains a significant drag on our economy as national home prices have

declined to a post economic bubble low.

Consumer confidence impacts consumer expenditures. In the U.S. consumer

expenditures account for approximately 70% of total economic output

(as measured by GDP).

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Retail sales continue to show steady growth as and are now up 22.6% from the bottom and 7.8% above the pre-recession peak, which is a

positive sign for our economy.

The U. S. Federal Reserve monetary policy has also a significant impact upon total

economic.

Their goal is to provide economic stimulus but not so much that higher inflation

becomes a problem.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Over the past 12 months, the median CPI rose 2.4% and core CPI rose 2.3%. These measures show inflation is currently

trending slightly above the Fed's 2.0% target.

Although year-over-year inflation has trended higher, the Fed has continued to

maintain a highly simulative monetary policy, resulting in exceptionally low interest

rate levels. Their stated policy is to keep rates low through late 2014.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

During their most recent meeting on March 13, the Federal Reserve Bank directors stated: “To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

The Federal Funds Rate (the interest rate which banks with surplus balances lend to banks in need of funds) remains at historically low levels - this is positive for economic growth.

It’s important to understand the impact that low interest rates have upon the overall

economy.

The Yield Curve is the relationship between interest rates for shorter term 3 month treasury bills and longer term treasury

bonds. The curve is normal, which is a positive sign.

The TED spread is the difference between 3 month LIBOR rates and 3 month treasury bills. Since the start of 2012, it has trended downward, indicating that the risk of bank loan

defaults is considered to be decreasing, another positive sign.

Commercial lending to fuel business growth has been increasing but remains below prior peak levels, as banks continue to deal with problem loans in their portfolios.

What impact has increased consumer expenditures and low interest rates had

upon the U.S. economy?

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Real gross domestic product, the output of goods and services produced by labor and property in the U.S., increased at an

annual rate of 2.8 percent in 4Q-2011. GDP has now grown for 10 consecutive quarters and appears to be accelerating.

The Conference Board’s March LEI suggests that progress on jobs, output, and incomes is expected to continue through the

summer months.

So if the Fed is keeping rates historically low to stimulate our economy and the supply of capital to fund business growth is increasing,

what impact has this had upon corporate profits?

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Corporate profits continue at record high levels but appear to have reached a plateau.

Over time, profitable business owners will expand their workforce if they are

confident that prospects for revenue growth can be sustained.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Business leader optimism has generally trended upward indicating an increased which is a positive indicator of

future hiring expectations.

Now let’s examine the current U.S. employment situation?

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

The impact of employment losses during the recent recession remain much worst than during any other post-war recovery period. The delay in hiring and the slow recovery is a result of

the housing bust and resulting financial crisis.

Total U.S. employment continues to recover slowly with positive year-over-year gains through March 2012 but there are

still 11.9 million unemployed workers (8.2%).

Let’s examine the impact that the slow employment recovery is having upon the

commercial real estate markets? Let’s start with office-using employment demand.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Overall U.S. office markets are in the early recovery phase – led by increasing demand in the Professional & Business Services

Sector, while new supply is at an all time low.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Industrial markets across the U.S. are fully in the recovery phase as absorption trends are tied closely to GDP growth.

Warehouse/logistics absorption is especially prevalent in large port markets.

Adults aged 25-65 choose where to live primarily for employment related reasons.

Therefore, employment growth fuels population growth and household

formations.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

With a fragile labor market recovery and a weak housing market, post recession homeownership rates continue to decline as renter households have increased substantially.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Apartment markets are having a strong recovery but rising rents are attracting construction capital and many markets are

now entering the expansion phase.

More workers with jobs creates more disposable income.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Real disposable income levels have increased since the recession ended but the growth trends have been very

moderate.

Finally, what impact does household formations and disposable income have

upon hospitality and retail markets?

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Hotel markets across the U.S. are mostly in the mid-to-late recovery phase with a several entering the expansion

phase.

Commercial Real Estate Demand Cycle

Employment Growth

Office Demand

Industrial Demand

Population Growth

Residential Demand

Disposable Income

Retail Demand

Corporate Profits

GDP Output

Business Confidence

Federal Monetary Policy

Interest Rates

Consumer Expenditures

Consumer Confidence

Leading Indicator

Lagging Indicator

Coincident Indicator

CRE

Demand

Inflation

Hospitality Demand

Retail occupancies are improving, especially for national chains as most U.S. markets are in the early-

to-mid recovery phase.

Conclusions • Consumer spending has recovered, which

contributes to positive economic growth.

• Corporate profits are strong, capital for business expansion is increasing and business optimism has returned.

• Market fundamentals indicate moderate price inflation longer term.

• Interest rates are expected to remain near historic lows for the foreseeable future as the economy continues to recover.

Outlook for Commercial Real Estate • Barring an economic shock, indicators are pointing

to a continued slow recovery, leading to increasing real estate demand in all sectors.

• Investment performance by market and property type will continue to be very uneven.

• Except for apartments, there will be limited new construction over the next 12-18 months.

• Credit markets have mostly recovered and capital availability has become more plentiful again.

Economic Base Analysis

1-Mar-12 2

Economic Base Analysis

1-Mar-12 3

• Basic jobs - export goods and/or services and import dollars (“export sector”)

• Non-basic jobs - services only the local economy (internal consumption) - “support sector”

Two types of employment

Economic Base Analysis Objectives

• Identify basic employers and/or Industries

• Forecast change in the basic employment

• Forecast change in the total employment & income

• Forecast change in the population

1-Mar-12 4

GROWTH!

Economic Base Analysis

1-Mar-12 5

Changing basic employment FORCES

changes in total employment and total population.

Total Population

Total Employment

Basic Employment

Economic Base Analysis Process

A. Current Economic Base

1. Identify the economic base categories

2. Estimate basic employment

3. Determine total employment and calculate the EBM

4. Determine total population and calculate the PER

1-Mar-12 6

Economic Base Analysis Process

B. Future Economic Base

1. Estimate the future basic employment

2. Multiply future basic employment by the EBM to estimate future total employment

3. Multiply future total employment by the PER to estimate future total population

1-Mar-12 7

Total Employment Basic Employment = EBM

Total Population Total Employment

= PER

Calculating The LQ

1-Mar-12 8

• LQ is a statistical index method of

comparing the local economy to the

national economy

• e = LOCAL employment in industry “X”

as a proportion of TOTAL LOCAL

employment.

• E = NATIONAL employment in industry

“X” as a proportion of TOTAL

NATIONAL employment.

• LQ = e / E

Interpreting The LQ

• LQ > 1 - Industry is part of community’s economic base

• LQ = 1 - Industry is not part of the community’s economic base

• LQ < 1 - Industry is not part of the community’s economic base

1-Mar-12 9

Calculating Basic Employees

1-Mar-12 10

LQ - 1 LQ

percentage of employees in category that are basic

Total employees in category x percentage of employees that are basic Basic employees in category

=

Population Employment Ratio

• Formula

1-Mar-12 11

Total population Total Employment

= Population Employment Ratio (PER)

Future Economic Base

1. Estimate future basic employment

2. Multiply future basic employment by the EBM to forecast future total employment

3. Multiply total employment by PER to forecast total population

1-Mar-12 12

Additional Considerations

• EBA forecasts future conditions for industry categories starting from a snapshot

• But, also would like to know… – Current strength of the economy – Recent trends of those strengths – How competitive specific industries are relative to

their counterparts in other regions – Any fundamental weaknesses in the economic

base industries

• This brings us to…

1-Mar-12 13

Shift-share Analysis

• Examines relative market strengths

• Identifies successful vs. weak businesses

• Measures how well a business category has performed relative to national businesses

• Gives institutional investors the ability to choose markets in which to invest

• Explains why local growth might vary from the national average.

1-Mar-12 14 3

Shift-share Analysis

• Theory: A community’s actual employment growth (AG) over time is explained by… – National growth trends (NG) in general – The community’s industry mix—”share”—effect (IM) – The community’s regional employment “shifts” (RS)

• Formula: AG = NG + IM + RS • Assumption: National Growth (NG) is the “base line”

starting point • Questions to ask If AG is > or < NG…

– Is the community’s industry mix (IM) more, or less, concentrated in fast growing companies?

– Is there a reg’l shift (RS) to or from the community?

1-Mar-12 15

Determining Stabilized Vacancy Rate

- Forecasting Vacancy Rates

- Calculating Absorption

• Market equilibrium is a point

in time during a market cycle

in which rents neither rise or

fall.

• The vacancy rate at that

point of supply & demand

balance is the stabilized

vacancy rate.

Market Equilibrium

• What is the typical range of stabilized vacancy rates?

• It varies substantially by market and by property type.

• Multifamily Residential – 3% to 7%

• Retail – 6% to 10%

• Industrial – 6% to 10%

• Office – 8% to 12%

• Hotel – 30% to 35%

• We can determine a range of stabilized vacancy rates by examining changes in market rents and occupancies over time.

Stabilized Vacancy Rate

Determining Stabilized Vacancy Rate Example #1

The stabilized vacancy rate for this market ranges from 3.0% to 5.1%

Steps:

1. Using Economic Base Analysis, forecast changes for employment, population, household formations, and retail sales.

2. Estimate future demand for households (Units), retail space (GLA), office space (RSF) or industrial space (SF).

3. Estimate future supply for the appropriate property type based upon new construction (pipeline) and demolitions (drain) during the forecast period.

4. Calculate the forecasted vacancy rate.

Forecasting Vacancy Rates

Given:

• 35,228 current total employment in the workforce

• 16,775 basic jobs currently in the workforce

• 275 new basic jobs added to the market

• 22% of workforce are office using employees occupying 1,743,750 RSF of office space

Calculate:

• EBM = 35,228/16,775 = 2.10

• 16,775 + 275 additional basic jobs = 17,050 future basic jobs

• Future basic jobs 17,050 x 2.10 EBM = 35,805 future total employment

• 35,805 future total employment x 22% office using jobs = 7,877 future office employees

Forecasting Vacancy Rates Example # 2

• 1,743,750 current occupied office RSF / 7,750 current office jobs = 225 RSF per office employee [Demand Ratio]

• 7,877 future office employment x 225 RSF per employee = 1,772,325 RSF future office occupancy [Future Demand]

• Given: 1,937,500 RSF is current office inventory with an additional 100,000 RSF in the pipeline to be delivered during forecast period

• 1,937,500 current RSF + 100,000 new RSF = 2,037,500 RSF [Future Supply]

• (Future Supply – Future Demand) / Future Supply = Forecasted Vacancy Rate

• (2,037,500 – 1,772,325) / 2,037,500 = 265,175 / 2,037,500 = 13.0%

Vacancy Rate Example # 2 Continued

Given:

• 35,228 current total employment and 35,805 future total employment in the workforce (from example #2)

• 92,843 current total population living in the market area

• 1,250 non-household persons currently in the market area

• 2.85 persons per household on average in the market area

• 30% of all households occupy rental apartments [Tenure]

Calculate:

• Current population – non-household population = 92,843 – 1,250 = 91,593 current household population

• Current population-to-employment ratio [PER] = 91,593 / 35,228 = 2.60

Forecasting Vacancy Rates Example # 3

• 35,805 future employees x 2.60 PER = 93,093 future household population

• 93,093 future HH population / 2.85 persons per HH = 32,664 future households

• 32,664 future households x 30% tenure = 9,799 future apartment households [Future Demand]

• 10,100 units is current apartment inventory with an additional 250 units in the pipeline to be delivered during forecast period

• 10,100 current units + 250 new units = 10,350 units [Future Supply]

• (Future Supply – Future Demand) / Future Supply = Forecasted Vacancy Rate

• (10,350 – 9,799) / 10,350 = 551 / 10,350 = 5.3%

Vacancy Rate Example # 3 Continued

Absorption

• Absorption is the amount of inventory (units or square feet) within a market area that become occupied during a specific time period.

• It is usually measured over a period of 1 year but can also measured on a monthly or quarterly basis.

• It is typically expressed as a total number of units or SF but can also be expressed as a rate based upon total inventory.

The formula used to calculate absorption is:

The same formula is used for both market and specific building calculations.

EOY occupied units - BOY occupied units

Absorption units

Absorption Formula

Building Name Rentable

Area

Available

Space

Ashland Park 8,990 2,000

Batesburg Office

Complex

7,665 1,000

Bonham Center 6,000 0

Boyd Building 75,000 75,000

Carlisle Offices 8,500 1,980

Dutch Center 93,566 9,238

Executive One Center 20,000 1,000

Hampton Street 13,000 1,000

Sylvan Building 15,000 2,100

Windsor Commercial

Park

26,960 1,100

Assume that the above data is for BOY. If at EOY, the occupied space has increased to 215,360 SF what is the absorption?

Answer: 215,360 EOY occupied -180,263 BOY occupied 35,097 Absorption

274,681 – 94,418 = 180,263

Calculating Absorption Example # 4