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D E L O I T T E | R E a L E s T a T E R E s E a R c h c O R p O R a T I O n | R E a L c a p I T a L a n a L y T I c s

E x p E c T a T I O n s & M a R k E T R E a L I T I E s I n R E a L E s T a T E 2 0 1 1

BALANCING RISK AND RETURN IN AN ERA OF UNCERTAINTY

© 2011 | Real Estate Research Corporation, Deloitte Development LLC, Real Capital Analytics. All Rights Reserved.

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Disclaimer: This report is designed to provide general information in regard to the subject matter covered. It is sold with the understanding that the authors of this report are not engaged in rendering legal or accounting services. This report does not constitute an offer to sell or a solicitation of an offer to buy any securities, and the authors of this report advise that no statement in this report is to be construed as a recommendation to make any real estate investment or to buy or sell any security or as investment advice. The examples contained in the report are intended for use as background on the real estate industry as a whole, not as support for any particular real estate investment or security. Neither Real Estate Research Corporation (RERC), Deloitte, nor Real Capital Ana-lytics (RCA), nor any of their respective directors, officers, and employees warrant as to the accuracy of or assume any liability for the information contained herein. Unless otherwise noted herein, the data presented in this report is sourced from RERC and RCA.

As used in this document, “Deloitte” means Deloitte & Touche LLP, Deloitte Financial Advisory Services LLP, Deloitte Consulting LLP, Deloitte Tax LLP, and Deloitte Corporate Finance LLC. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.

E x p E c T a T I O n s & M a R k E T R E a L I T I E s I n R E a L E s T a T E 2 0 1 1

BALANCING RISK AND RETURN IN AN ERA OF UNCERTAINTYD E L O I T T E | R E a L E s T a T E R E s E a R c h c O R p O R a T I O n | R E a L c a p I T a L a n a L y T I c s

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FOREWORD

April 2011

Dear Readers,

As we put the finishing touches on our annual forecast report, Expectations & Market Realities in Real Estate 2011, we are struck by the challenges facing the commercial real estate industry in this uncertain world. Despite our experience and sense of having been through this all before, we remain cautious with our expectations and about the investment environment over-all. The recovery that took hold in the second half of 2010 continues, but we are well aware of the headwinds that could quickly derail both the growth of our economy and the markets.

As such, Real Estate Research Corporation (RERC), Deloitte, and Real Capital Analytics (RCA) are pleased to present this fun-damental guide for Balancing Risk and Return in an Era of Uncertainty. Our collective viewpoints, commentary, and analy-ses offer you an unbiased look at what you can expect regarding the expanding economy, capital markets, and individual property markets throughout 2011 and beyond.

Thank you to everyone who has contributed to this report, including research analysts and data providers, economists, busi-ness associates, research survey respondents, and the many others who have shared your information and ideas. We also thank you—our readers, clients, and consultants—for your interest in our report, and we hope you find Expectations & Market Realities in Real Estate 2011—Balancing Risk and Return in an Era of Uncertainty helpful as we navigate through a still-fragile recovery.

Sincerely,

Robert M. White, Jr., CRE, FRICSFounder & President

Real Capital Analytics, Inc.

Matthew G. Kimmel, CRE, FRICS, MAIPrincipal & US Real Estate Services LeaderDeloitte Financial Advisory Services LLP

Kenneth P. Riggs, Jr., CFA, CRE, FRICSPresident & CEO




ACKNOWLEDGEMENTS

SponSoRing FiRmS & ChAiRS

matthew g. Kimmel, CRE , FRiCS, mAi Deloitte Financial Advisory Services LLPKenneth p. Riggs, Jr., CFA, CRE, FRiCS Real Estate Research CorporationRobert m. White, Jr., CRE, FRiCS Real Capital Analytics, Inc.

ContRibuting AuthoRS

barb bush Real Estate Research CorporationSam Chandan, phD. Real Capital Analytics, Inc.todd J. Dunlap, mAi, mRiCS, Senior manager Deloitte Financial Advisory Services LLPDavid garcia Deloitte Financial Advisory Services LLPKenneth W. Kapecki, mAi, CRE, FRiCS, Senior manager Deloitte Financial Advisory Services LLPLindsey Kuhlmann Real Estate Research CorporationAndy miller, manager Deloitte Financial Advisory Services LLPDoug murphy Real Capital Analytics, Inc.peter Slatin Real Capital Analytics, Inc.patrick terriault Real Capital Analytics, Inc.nina turner Real Capital Analytics, Inc.brian Velky, CFA Real Estate Research Corporationmorgan Westpfahl Real Estate Research Corporation

EDitoRiAL oVERSight

peter Slatin Real Capital Analytics, Inc.

DESign & LAyout

Luke baldwin 21FingersJeff Carr Real Estate Research Corporation

othER DiStinguiShED ContRibutoRS

Robert bach Grubb & EllisRonald Johnsey Axiometrics, Inc.Robert mandelbaum PKF Hospitality ResearchR. mark Woodworth PKF Hospitality Research

RERC EDitoRiAL boARD

Stephen blank Urban Land InstituteDavid blankenship AEGON USA Realty Advisors, Inc.nicholas g. buss INVESCO Real EstateSusanne Cannon DePaul University - The Real Estate Centergeoffrey Dohrmann Institutional Real Estate, Inc.Stephen Furnary ING Clarion Partnersmichael gately Cornerstone AdvisersDavid geltner MIT Center for Real EstateJacques gordon LaSalle Investment Management, Inc.John Levy John B. Levy & Companymary Ludgin Heitman Capital Management, LLCDennis martin RREEF/DB Real Estateglenn mueller University of DenverScott muldavin The Muldavin Company, Inc.Joseph pagliari University of ChicagoRichard Sokolov Simon Property GroupAllan Sweet AMLI Residential Properties, LLCR. brian Webb UBS AgriVest, LLCCharles Wurtzebach DePaul University-The Real Estate CenterSam Zell Equity Group Investments, LLC



CONTENTS

1 | intRoDuCtion

Balancing Risk and Return in an Era of Uncertainty .............................................................................................................................8

2 | thE CApitAL mARKEtS

Capital Begins to Flow .............................................................................................................................................................................11

3 | thE pRopERty mARKEtS

Perspective and Analysis ........................................................................................................................................................................21

4 | outLooK FoR 2011 AnD bEyonD

Uncertainty and the Need for Balance ..................................................................................................................................................39

SponSoRing FiRmS

................................................................................................................................................................................................................... 44



1 | INTRODUCTION

balancing Risk and Return in an Era of uncertainty

When Real Estate Research Corporation (RERC), Deloitte, and Real Capital Analytics (RCA) first dis-cussed partnering together to publish this forecast report, a distinct sense of uncertainty about the economy, about the capital markets, and about com-mercial real estate dominated our conversation. Our unease was under-standable—we were barely out of the longest and most severe recession since the Great Depression, the level of U.S. debt was reaching epic propor-tions, and the number of new bank failures attributed to their exposure to bad commercial real estate loans was increasing weekly.

It seemed that the invest-ment environment was finally start-ing to turn around when a new Con-gress came to town and tax cuts were extended for businesses and individu-als. We were thrilled when the stock market finally began to grow by leaps and bounds, and even more thrilled when institutional real estate returns increased to approximately 13 percent in fourth quarter 2010, according to the National Council of Real Estate Invest-ment Fiduciaries (NCREIF).

As 2011 got underway, we looked for additional signs of recovery, but major world crises during the first few months of this year—the earth-quake, tsunami, and nuclear power disaster in Japan, the unrest spread-ing throughout the Middle East, the sovereign debt crisis in Europe and the downgrading of those nations’ credit ratings, continued threats of terrorism, to name a few—reminded us how quickly real events can temper optimism. Now, as the year unfolds, the economy still faces a series of speed bumps, and the investment

environment, although improv-ing, remains uncertain. Risk is ever-present and returns seem to be fleet-ing for all asset classes, as investors try to balance these opposing forces.

As such, investors are focusing on why they invested in real estate in the first place. Real estate is a tangible alternative to the more volatile stock market, and is more transparent than stocks. It offers reasonable income returns, which investors are seeking today, instead of the glitz and glamour of Wall Street. No one wants, or can afford, to make mistakes, and by focus-ing on the fundamentals of their prop-erty investments, investors are keeping things simple and direct.

That is what we have tried to do in Expectations & Market Realities

in Real Estate 2011—Balancing Risk and Return in an Era of Uncertainty. In this first introductory chapter to the report, we have focused on the economy and the various risk factors associated with our fragile recovery as the backdrop for investing in commer-cial real estate. Chapter 2 examines the debt and equity markets, as well as the banking practices/new regula-tions affecting the availability of capi-tal. In Chapter 3, we take a close look at the office, industrial, retail, apart-ment, and hotel markets, and analyze volume, pricing, capitalization rates, vacancy/occupancy rates, and rental rates/revenue for the specific property sectors. In our final chapter, we offer our collective assessment and invest-ment outlook for the risk and return associated with the major property markets for 2011 and beyond.



thE EConomy

A “Qualified” Recovery Presents New Challenges

In the aftermath of this genera-tion’s deepest and most destabilizing recession, many of our foundational assumptions about the American economy and investment environ-ment have been upended. While the economy has resumed its expansion, questions about the speed and dura-bility of the recovery have coincided with profound uncertainties relating to the direction of monetary and fiscal policy and the changing relationship between government, business, and the American people. For policymak-ers and businesses alike, new threats to geopolitical and global macroeco-nomic stability have added to the pre-vailing headwinds; the broader context

of the recovery has precluded a singu-lar focus on the issues that are within our control. In the face of this remark-able opacity, commercial property investors and lenders have nonethe-less powered forward, albeit unevenly, anticipating stronger fundamentals as the recovery progresses. In 2010, com-mercial property sales doubled from the previous year’s nadir. The market’s momentum has carried over into 2011, with broad metrics relating to liquid-ity and credit availability reflecting investors’ optimism in the sector’s trajectory.

A Fragile Economic Recovery

Even as investor activity has picked up, the economy and labor mar-kets have measured qualified gains. The recession has been over for longer than it lasted, and businesses and

consumers have recaptured a measure of confidence. Banks and other lend-ers, emerging from unprecedented upheaval, have loosened the strictures on credit, supporting a modest renewal of investment and spending. And whereas the initial return to growth was powered by a dramatic and costly surge in public activity, the private sec-tor has now taken the place of the gov-ernment in sustaining the expansion.

However, employers have a long way to go in replacing the 8.7 million jobs lost in 2008 and 2009. Through early 2011, we have measured the slowest progress in the labor market’s recovery following any post-World War II recession. For most of the past year, the absence of robust payroll growth has followed from slack in the utiliza-tion of currently employed workers and strong gains in productivity. In recent economic history, these are typical fea-tures of a recovery in the labor market that lags the broader economy’s emer-gence from recession.

But exacerbating the expected lag in payroll gains, businesses have been navigating a more complicated route in the current recovery, manag-ing the aforementioned uncertain-ties around the regulatory and policy environment and, more recently, an increasing incidence of mismatch in required skill sets and the skills present in the unemployed labor pool. Job openings remain extremely low by any historic norm, but have been increasing in recent months. However, in many of the sectors that are most crucial for a recovery in spending and direct space demand, hiring has not kept pace.

The most recent data suggest that hiring may accelerate modestly over the course of 2011. Barring any disruptive shocks, the consensus esti-mates suggest that payrolls at midyear may be expanding at a fast enough pace to offset new entrants to the labor force, thereby reining in broader

For policymakers and businesses alike, new threats to geopolitical and global macroeconomic stability have added to the prevailing headwinds…commercial property investors and lenders have nonetheless powered forward, albeit unevenly, anticipating stronger fundamentals….



measures of unemployment. Still, property investors with heady expecta-tions for job growth and space absorp-tion must contend with the possibility that stresses on cash flow may persist.

Rebalancing Investment

The qualified economic tra-jectory has prompted investors to assign unusually large premiums to the liquidity of assets. As a result, the industry’s headline statistics belie a striking and persistent unevenness of the recovery in investment and credit trends. In a flight to quality, investors over the past year have focused their efforts on acquiring properties in the nation’s most visible and most liquid markets. This focus has resulted in a concentration of capital in a small subset of markets—New York City, Washington, D.C., and San Francisco foremost amongst them. It is in these markets that competition for assets has been most intense, supported by a diversity of domestic and foreign investors, with domestic investors frustrated by the absence of opportu-nities in distress and foreign investors less dependent on mortgage financ-ing. In some cases, pricing threatens to decouple from the fundamental basis for value.

Underpinning gains in major markets and for the highest quality properties, the availability of credit in support of significant property sales, as well as for the refinancing of maturing debt, has improved sharply in recent quarters. Buoyed by the aforementioned pricing trends and nascent recovery in property funda-mentals in major markets and some property sectors, a broader range of lenders—including commercial mort-gage-backed securities (CMBS) con-duit originators, foreign banks, and life companies—has re-engaged with commercial real estate investors in the latter half of 2010, albeit on terms that remain conservative by historic standards and even as smaller banks

have curtailed their lending. This improvement in mortgage availabil-ity has been necessary for a broader move towards normalization in the sector’s capital markets.

Coinciding with the improving position of many lenders, the dominant role of agency financing in the apart-ment sector has moderated as other institutions have begun to compete more aggressively for lending opportu-nities. In major markets, in particular, institutional and securitized lenders’ readiness to provide new acquisition financing on performing assets has supported the shift in investor activity away from the agency and private buy-ers that dominated activity in 2009 and early 2010.

As an important facilitator of this healthier new acquisition financ-ing environment, additions to distress nationally fell to their lowest levels in 2 years in third quarter 2010, reflect-ing a slower pace of deterioration in legacy mortgage pools and the positive impact of more stable economic and credit market conditions. Of course, slower inflows to distress and the absence of distress investment oppor-tunities do not mean that deteriorating mortgage performance is not a feature of the market landscape. Rather, dis-tress has been heavily intermediated, left unresolved, or is residing on bank balance sheets. The question of how we manage to draw down these balances,

when some of the most aggressively underwritten loans have yet to mature, remains an issue for the market. While a sudden outpouring of distress would inevitably provide opportunities for

distress investors, it would do so by undermining the price stability that has been crucial in driving improve-ments in sales and credit.

The Year Ahead

Whether in primary markets or further afield, the positive trends in headline transaction volume may continue into 2011, barring a serious reversal in the underlying economic and labor market recovery. But in measuring this recovery, investors will have to remain vigilant, particularly as concerns the magnitude of job growth, the regulatory and policy environ-ment, and the complex, nonlinear rela-tionship between broad interest rates and cap rates.

In the realms of public and pri-vate markets, and at their juncture, significant risks may continue to exert drags on consumer and business con-fidence in a way that is material for the commercial property outlook. Given this unique environment of uncer-tainty, and in planning for the future, investment strategies that anticipate the need for flexibility (as opposed to relying on a rigid and deterministic outlook) remain critically important.



2 | THE CAPITAL MARKETS

Capital begins to Flow

Despite a residential market that is still in decline, anemic employment growth, and a record-high federal debt, the U.S. economy saw positive growth throughout 2010 and is expected to continue to grow, if slowly, over the next few years. This is no small feat, given the recent near-collapse of our nation’s financial system and a reces-sion more severe than any since the Great Depression. It is a tribute to the nation’s economic resilience to have survived this crisis, and although a great deal of uncertainty continues in the economy, the geopolitical land-scape, and the markets, we are hopeful that the broader recovery holds posi-tive prospects for forward momentum in commercial real estate investment.

Capital has become increasingly accessible, as companies, funds, and individuals continue to regain some of the wealth lost in the crash; accord-ing to some estimates, corporations are holding as much as $2 trillion in reserve. Although only a percentage

of this will likely be directed toward commercial real estate, investors

responding to RERC’s institutional investment survey have seen the availability of capital for commercial real estate investment increase sig-nificantly from its low in third quarter 2008 (see Exhibit 2-1). In fourth quarter 2010, the availability of capital began to overtake discipline for the first time since the financial crisis began. Capi-tal flows increased from virtually every sector, including private investors, pension funds, real estate investment trusts (REITs), institutions, foreign investors, and others. Many respond-ents to RERC’s investment survey also stated that they intend to direct more capital toward commercial real estate during 2011 than they invested in 2010.

This changing sentiment is also reflected in the Buy-Sell-Hold recommendations noted by RERC’s

1

2

3

4

5

6

7

8

9

10

Discipline

Availability

4Q 2010

4Q 2009

4Q 2008

4Q 2007

4Q 2006

4Q 2005

4Q 2004

4Q2003

4Q 2002

4Q 2001

Ratin

g

Exhibit 2-1. RERC Historical Availability and Discipline of Capital

Ratings are based on a score of 1 to 10, with 10 being high. source: RERc, 4q 2010.



institutional investment survey respondents (Exhibit 2-2). The Hold reference retains the highest-rated recommendation, reflecting quite clearly the dominant strategy within the market. But more interesting, and perhaps more relevant, is the narrow-ing gap between the Buy and Sell rec-ommendations, indicating increasing agreement on pricing and valuation. While we have seen transactions in the top-tier markets for high-quality prop-erties at record high prices during the past few quarters, demand is starting to extend to core properties in some of the secondary and tertiary markets as well, as investors move out on the risk spectrum.

LEnDing StAbiLiZES AnD iSSuAnCE piCKS up

As commercial real estate own-ers continue to deleverage, many key lending sources have become more flexible in the treatment of existing debt, but have been less accommo-dating concerning new loan origina-tion. Commercial mortgage origi-nations, though increasing, remain significantly below peak-market levels. While new issuances from alternative sources remain minimal, new lending is expected to continue at subdued lev-els in the near term. However, stabili-zation is apparent and signs of revitali-zation are evident.

Bank Lending

Banks initially responded to the financial crisis by rapidly tight-ening underwriting on commer-cial loans, but in general, approval standards began to ease in 2010. The January 2011 Federal Reserve’s Sen-ior Loan Officer Opinion Survey on Bank Lending Practices noted that in fourth quarter 2010, approximately 69 percent of banks left their lending standards for commercial real estate basically unchanged, approximately 8 percent of banks eased standards, and

approximately 23 percent of banks tightened their lending standards (this was down significantly from a high of 87 percent in fourth quarter 2008, immediately following the col-lapse of Lehman Brothers).

Buttressing the warming trend, about 10 percent of domestic banks on net reported increased demand for commercial real estate loans in fourth quarter 2010, the strongest reading since early 2006. Foreign banks also reported that net demand had strengthened, according to the Federal Reserve.

Still, certain commercial real estate loan terms tightened in 2010. The Federal Reserve’s January 2011 Senior Loan Officer Opinion Survey on Bank Lending Practices further stated that about 40 percent of domestic banks on net reported having tightened loan-to-value ratios, and a moderately smaller fraction tightened debt service cover-age ratios and maximum loan sizes during fourth quarter 2010.

Despite examples of tighten-ing, according to preliminary esti-mates from the Mortgage Bankers Association’s (MBA) Quarterly Survey

1

2

3

4

5

6

7

8

9

10

Hold

Sell

Buy

4Q 2010

4Q 2009

4Q 2008

4Q 2007

4Q 2006

4Q 2005

4Q 2004

4Q 2003

4Q 2002

4Q 2001

Ratin

g

Exhibit 2-2. RERC Historical Buy-Sell-Hold Recommendations

Ratings are based on a scale of 1 to 10, with 10 being high. source: RERc, 4q 2010.



of Commercial/Multifamily Mortgage Bankers Originations, mortgage bank-ers originated $110 billion of commer-cial and multifamily mortgages during 2010, up a healthy 36 percent from 2009 originations.

The threat to banks associ-ated with bad loans remains great, but according to the Federal Deposit Insurance Corporation (FDIC), the number of bank failures should decline in 2011. Although 157 banks failed in 2010 (the most since 1992 during the savings and loan crisis) and 884 banks remained on the FDIC’s list of problem banks at the end of fourth quarter 2010, the FDIC expects to see fewer bank failures in 2011. (For com-parison, there were no bank failures in 2006 and only three in 2007.)

Other Sources of Mortgage Originations

Life insurance companies were a leading source of lending in 2010, with originations volume 155 percent higher than 2009 levels, although the dollar volume was low in absolute terms. Significantly, the MBA reported that originations for CMBS conduits increased more than 10-fold in 2010, and that government-sponsored enti-ties (GSEs) also saw strong volumes, with increases in production for FHA/Ginnie Mae offsetting a decline in production for Fannie Mae/Freddie Mac. Although the low absolute levels dramatically inflated the growth per-centage, there were clearly positive changes in borrowing and lending for commercial real estate.

Going forward, the expectation is that more favorable market condi-tions for both lenders and borrowers will likely help boost CMBS issuance in the near term, although the level will remain below the 2007 peak over the longer term. In 2008, CMBS accounted for 25.6 percent of commercial mort-gage loans; however, due to the cen-tral role these and similar securities

played in the financial crisis, issuance dropped to nearly zero in 2009 (just $720 million was issued in 2009). But last year, lenders issued a total of $11.6 billion of CMBS, and improved condi-tions have led most analysts to expect $35 billion to $45 billion of CMBS issu-ances in 2011 according to Standard & Poor’s (S&P’s) estimations. However, that is still far off the market’s peak of $230.5 billion in 2007.

Securitized loans issued in 2009 and 2010 have been dubbed CMBS 2.0, and are characterized by simpler struc-tures that involve greater subordina-tion levels, fewer classes and loans, and thicker tranches, all designed to reduce the level of due diligence

required to execute. Additional fund-ing sources are also emerging, includ-ing covered bonds, which consist of securities issued by banks and backed by a “cover pool” of mortgage or public-sector loans. This vehicle is one of the oldest forms of capital in the European bond market, and could provide a new funding mechanism as the industry attempts to rebound. Another simple and direct throwback that is being uti-lized is seller financing, in which the seller provides a secured loan to the buyer to finance a portion of a prop-erty’s purchase price.

A breakdown of 2010 investment in commercial real estate by investor type is shown in Exhibit 2-3.

Institutional13%Non-Listed

REIT 9%

Equity Fund14%

Private30%

User/Other9%

Cross-Border7%

Listed/REIT18%

Exhibit 2-3. Commercial Real Estate Investor Groups (2010)

source: Rca, february 2011.



Commercial Mortgage Debt

According to the Federal Reserve Flow of Funds, the level of commercial/multifamily mortgage debt outstand-ing decreased to $3.15 trillion in fourth quarter 2010 from third quarter totals. As demonstrated in Exhibit 2-4, the largest holder of commercial debt con-tinues to be commercial banks.

high DEbt mAtuRitiES REmAin A ChALLEngE

While lenience by banks has helped cushion commercial real estate from a more severe downturn, the high level of maturing debt remains a signif-icant barrier to full recovery. The core of the dilemma is that debt incurred at

the top of the market is now coming due at a time when economic uncertainty and barely recovering commercial real estate fundamentals are making it harder for borrowers to generate cash flow needed to make debt payments. In fact, Trepp, LLC noted that as much as 60 percent of current commercial real estate loans maturing between 2011 and 2015 are considered “underwater,” indicating the amount of debt exceeds the market value of the property itself.

How Big Is the Dilemma?

Trepp, LLC predicts that an estimated $1.7 trillion in commer-cial real estate debt is set to come due between 2011 and 2015, a figure that could turn out to be even higher once the impact of “amend and extend” is considered (see Exhibit 2-5). Morgan

Stanley estimates that modifica-tions have pushed CMBS maturities from the 2009-2011 range out to the 2013-2017 time period. As the major-ity of commercial real estate loans are for a period of 5 years, a majority of the debt incurred during the peak of

the market in 2007 and 2008 is set to mature in 2012 and 2013. The peak year for maturities is expected to be 2013, when $367.7 billion will come due, before the amount decreases modestly to $333.0 billion in 2015, and then sub-sides to less than $100 billion by 2020.

Commercial Banks44%

Life InsuranceCompanies

20%

CMBS, CDO andother ABS

9%

Savings Institutions6%

Govt. Sponsored Entities16% Other

5%

Fixed Income Markets - $3.15 TrillionLender Composition

Exhibit 2-4. Fixed-Income Lender Composition

source: federal Reserve, 4Q 2010.

$0

$50

$100

$150

$200

$250

$300

$350

$400

Other

Life Cos

CMBS

Banks

20202019

20182017

20162015

20142013

20122011

Billi

ons

Exhibit 2-5. Commercial Real Estate Maturities Set to Peak in 2013

source: Trepp, LLc, 4Q 2010 update.

The peak year for maturities is expected to be 2013, when $367.7 billion will come due, before the amount decreases modestly to $333.0 billion in 2015, and then subsides to less than $100 billion by 2020.



One of the main reasons for the unique nature of this downturn is the way banks have approached troubled debt. In their efforts to stem write-downs, banks have taken a longer-term approach to potential losses, working to modify and extend soured commercial real estate loans in anticipation of improving values. In previous cycles, the combination of sharply declining property values and the comparatively short duration of commercial real estate loans (generally 5 years) resulted in substantial write-offs for lenders and increased foreclosures for owners. however, this downturn has been characterized by a new willingness by banks to modify and extend the terms of loans unlikely to return full value on principal and interest accrued. This “amend and extend” strategy commonly in-volves permitting below-market interest rates and stretch-ing out maturities for borrowers with troubled loans.

This has enabled owners to retain properties rather than lose assets and investment, and it has also prevented the investment market from being flooded with deeply dis-counted properties—to the frustration of some opportun-istic investors. banks, in turn, have been able to delay and even reduce write-offs on commercial real estate loans until favorable conditions return, which helps to classify some troubled loans as performing, thereby minimizing the amount of reserves banks must set aside.

The main disadvantage for this practice is that a protract-ed period of restructuring limits returns on commercial real estate. In addition, such extensions put a floor under the market, making it difficult to know when the bottom

has been reached, and further delaying the inevitable may cause a more severe downturn in the future.

guidance by regulators has certainly shaped banks’ re-sponse to their troubled loan portfolios. In October 2009, the federal financial Institutions Examination council (ffIEc), which includes the federal Reserve, fDIc, and the comptroller of the currency, responded to concerns about commercial property losses and debts coming due by issuing a policy statement suggesting that performing loans would not be declared troubled solely because of a decline in the value of underlying collateral.

While the ffIEc guidance was intended chiefly to improve consistency and flexibility in the treatment of commercial real estate loans, the initial result was greater confusion in the market, with some lenders misinterpreting the guidance as a form of forbearance and an incentive to restructure maturing loans. In response, in May 2010, the ffIEc held a conference call with 1,400 bank executives, explicitly stating that it did not intend for investors and bankers to interpret the guidance as a call to amend and extend existing loans.

since the ffIEc’s original guidance, lenders have favored workouts over foreclosures. This is an encouraging sign that widespread commercial real estate foreclosures may be delayed until the economy improves; however, it also indicates that a significant number of maturing loans have yet to be included in the process.

impact of “Amend and Extend”



Underlying Factors: Moderating Delinquencies and Defaults

Although a high level of com-mercial real estate debt remains in dis-tress, the recent uptick in restructuring and resolution of commercial loans is a positive sign and the pace of defaults and delinquencies has begun to sub-side, as shown in Exhibit 2-6.

While the majority of outstand-ing commercial real estate maturi-ties are from loans issued by banks, loan delinquencies from other lending sources indicate a similar trend of lev-eling off but not subsiding. For exam-ple, Trepp, LLC reported that 30+ day delinquencies on CMBS loans climbed rapidly from 4.36 percent in Septem-ber 2009 to 7.61 percent in March 2010, before leveling off between 8.5 per-cent and 9.3 percent from June 2010 through January 2011. Analysts expect CMBS delinquencies to continue rising at a modest pace, ultimately peaking between 10.0 percent and 12.0 percent. (Moodys forecasts that this rate will reach 9.5 percent to 11.0 percent by the end of 2011.)

Aided by loan extensions, com-mercial real estate mortgage defaults have followed a similar trend as delin-quencies, climbing rapidly between

2008 and 2010 but at a slower pace in recent quarters.

Although commercial real estate defaults may be moderating overall, there also have been more reports of strategic defaults, a trend that has migrated from the residen-tial to the commercial property sector. Some of the nation’s largest property owners have recently chosen to return

the keys for buildings valued below the amount of debt, and since commercial loans are non-recourse, it is actually easier for commercial owners to walk away from their loans than for home-owners. While this may seem like an extreme step, it is often the result of a pragmatic business decision to exit profit-draining investments in order to divert funds to performing projects or to shareholders.

There has been a shift in direc-tion, however. As demonstrated in Chapter 3 of this report, although properties continue to go into default, there was an inflection point with the pace of resolutions beginning, how-ever slowly, to eat away at the moun-tain of distressed assets during fourth quarter 2010.

REit REbounD ContinuES

Commercial real estate funda-mentals may be in the early stages of a slow recovery, but REITs have already experienced a strong rebound. This disparity has occurred because while

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0

1

2

3

4

5

6

7

8

9

10

11

Delinquency Rate

Charge-O� Rate

4Q 2010

4Q 2009

4Q 2008

4Q 2007

4Q 2006

4Q 2005

4Q 2004

4Q 2003

4Q 2002

4Q 2001

Perc

ent

Exhibit 2-6. Delinquencies Remain Elevated, but Starting to Decline

source: federal Reserve, november 2010.



operating fundamentals such as occu-pancy, rent growth and values are closely linked to the sluggish economy, REIT gains have been driven by inves-tor perception of performance rela-tive to competing asset classes such as stocks and bonds. Return on invest-ment for REITs has outperformed the securities markets, as well as commer-cial real estate in general, during the recovery. Public companies have been taking advantage of the spotlight by raising both equity and debt at histori-cally low costs, and that, in turn, has led to increased acquisition activity for the sector. In 2010, according to RCA, U.S.-based listed REITs acquired $24.7 billion of properties in all main prop-erty types, up from $4.7 billion in 2001; their acquisition market share rose to 18 percent of all transaction activity in 2010 from 6 percent in 2009.

Robust Returns

Following a 7-year run of posi-tive results, return on investment for REITs dipped in 2007, and then dropped sharply to a loss of 37.3 per-cent in 2008. A wave of successful

equity offerings propelled the group to a gain of 27.5 percent in 2009, according to the National Associa-tion of Real Estate Investment Trusts (NAREIT). Even more equity and debt issuance and their aggressive acqui-sition programs gave REITs another 28-percent gain in the past year (see Exhibit 2-7). Much of the growth was driven by the performance of apart-ment, lodging, retail, self-storage, and office REITs. However, the industrial segment lagged.

Competitive Performance

Recently REITs have also out-performed competing asset classes, making the category more attractive to investors looking for vehicles with the potential to provide a hedge against the type of volatility that can be found in the stock market. For example, as demonstrated in Exhibit 2-8, for the period of January 1 to December 31, 2010, REIT returns of 27.6 percent outperformed the Russell 2000 Index return of 26.9 percent, the NASDAQ Composite return of 16.9 percent, the S&P 500 Index return of 15.1 percent, and the Dow Jones Industrial Average (DJIA) Index return of 11.0 percent. The only investment types that have performed more favorably than REITs recently have been the U.S. dollar and gold, both of which perform well in times of turmoil.

REITs Raising Funds for External Growth Opportunities

The share-price rebound for public companies has been driven by investors’ realization that REITs not only took on far less debt than private real estate investors during the com-mercial property market’s run-up from 2005 to 2007, but also that they had sold at (and in some ways defined) the top of the market while private equity investors continued to buy. Conversely,

-40

-30

-20

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0

10

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30

40

20102009

20082007

2006

Perc

ent

Exhibit 2-7. REIT Rebound Underway

source: naREIT, December 2010.


Asset Class 2007 2008 2009 2010

Public REIT (All REIT Index) (17.83) (37.34) 27.45 27.58

Russell 2000 (1.57) (33.79) 27.17 26.86

NASDAQ 9.81 (40.54) 43.89 16.91

S&P 500 5.49 (37.00) 23.46 15.06

Private Real Estate (NCREIF Property Index)

15.85 (6.46) (16.85) 12.55

DJIA 6.43 (33.84) 18.82 11.02

Exhibit 2-8. REITs Outperforming Competition



once REIT shares began their rebound in the spring of 2009, they were able to acquire properties from highly-leveraged investors at deeply dis-counted prices; their greater access to lower-cost capital at a time of severely constrained credit was also a major advantage.

A key advantage for the segment is its ability to tap the stock market, and REITs have been responding to investor interest by raising capital via equity offerings and unsecured debt. In 2009, REITs raised $34.7 billion via equity and unsecured debt, nearly double the $17.9 billion total raised in 2008. As demonstrated in Exhibit 2-9, REITs then surpassed the 2009 total with $47.5 billion raised in 2010, rep-resenting year-over-year growth of 37.2 percent. In 2009, REITs used this capital to strengthen balance sheets by paying down debt ahead of schedule and to cover dividends. More recently, however, a greater share has been used to fund acquisitions, and in 2010, REIT property purchases totalled approxi-mately $20 billion, compared with $4 billion in 2009.

Outlook

Even though low interest rates present a very attractive borrowing environment, the specter of loom-ing loan maturities and the sluggish fundamentals tied to persistently high unemployment rates have fed a relatively slow transaction market, although the demand equation has

begun to shift. With increasing reports of lenders starting to loosen their reins on capital, reports of all-cash investors coming to the table, and record-high prices being paid for trophy proper-ties in select markets, it is clear that the market is finally beginning to move and this should lead to additional for-ward momentum in 2011.

Prevailing trends suggest that lending by commercial banks, life insurance companies, and Fannie Mae and Freddie Mac may remain stable but below peak levels for the next few

years, as underwriting standards ease and maturities are gradually resolved. Subdued levels of new loan origina-tions will likely be somewhat offset by alternative sources, and S&P estimates that lower risk-free interest rates and tighter spreads will result in CMBS issuance of between $35 billion and $45 billion in 2011.

While nobody expected the deleveraging process following the 2001-2007 credit boom to be quick and painless, there is hope that matur-ing commercial real estate debt can still be reduced to a manageable level without a substantial increase in the level of properties that have been fore-closed upon, or returned to the lender (also considered real estate-owned, or REO). There are basically two avenues for unwinding high levels of commer-cial real estate debt, and neither is mutually exclusive. The first is classic loan reduction via default or repay-ment, and the second is robust eco-nomic growth, which would stimu-late demand. Forecasters expect only

$0

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$10

$15

$20

$25

$30

$35

$40

$45

$50

Secondary DebtSecondary EquityIPO

20102009

Billi

ons

$34.7

$47.5

$21.2$26.2

$19.2

$10.4

$2.0$3.0

Exhibit 2-9. REIT Fundraising On the Rise




modest economic performance in the coming quarters, but GDP growth has been positive since second quarter 2009, leading to an improvement in the ratio of commercial real estate debt to GDP, which peaked at 26.3 percent in first quarter 2009, and declined to 24.1 percent by third quarter 2010. While $3.15 trillion in total commercial mort-gage debt remains, an improvement in the ratio of commercial real estate debt to GDP can be interpreted as a move in the right direction.

The willingness of banks to amend and extend loans that are unlikely to return full value on prin-cipal and interest accrued in order to preserve capital, delay write-offs, and avoid taking over properties that can-not be sold for a favorable price, have helped to stave off some delinquen-cies and foreclosures, thus providing mixed loan performance.

Further declines may also be prevented by additional increases in private equity investment, which increased in 2010. The continued accommodative monetary policy actions by the Federal Reserve in keep-ing interest rates low for “an extended

period,” along with the purchase of additional Treasurys have also helped bolster the commercial real estate investment marketplace in a challeng-ing environment.

As for REITs, there is no way to predict whether returns will continue to outpace the stock market, but these companies retain key qualities that suggest they will continue to remain attractive to investors; as the economy recovers, analysts expect another year of double-digit returns in 2011. The dividends REITs provide to investors are supported by hard assets, which traditionally have been perceived as safe havens during economic down-turns, as well as potential hedges against inflation. As recent results have indicated, REITs also have a low correlation to conventional assets such as stocks and bonds. Over the longer term, demand will also be driven by increased popularity of the REIT struc-ture on a global scale.

However, one critical barrier to the recovery of the commercial real estate industry is the bifurcation between the “haves” and the “have nots.” Increased restructuring and

moderating delinquency and default rates suggest progress, but maturities remain at a high level, and not all prop-erty owners holding troubled loans qualify for extensions.

According to RCA, restructur-ings totaled $114.9 billion as of Decem-ber 2010, compared to a total of $187.1 billion of troubled commercial real estate loans. Lenders’ flexible atti-tudes have so far been limited to Class A quality assets, and for the most part, they have turned away from owners of properties at the Class B and C levels and in secondary and tertiary mar-kets, especially those with rollover and lease-up exposure, above-market rents, and vacancy challenges.

The bottom line is that owners of trophy and high-quality properties have been able to obtain new financing from sovereign wealth funds, insur-ers, private equity firms, and even some CMBS, while owners of lower-tier properties have had fewer options. For a timely and robust recovery to take place, it will be necessary for owners of properties below Class A to be included in the refinancing, restructuring, and resolution process.

Regulations Directly and indirectly impacting CRE

In 2008 and 2009, government intervention in the form of stimulus programs including the Troubled asset Relief pro-gram (TaRp) and the Term asset-backed Loan facility (TaLf) impacted commercial real estate by injecting liquidity into the financial system and helping to prevent the financial crisis from intensifying further. stimulus programs also had a direct impact, as when TaLf was extended in august 2009 to include cMbs, helping drive a modest rebound in cMbs issuance.

newly-introduced financial and health care regulations will also impact commercial real estate both directly and indirectly in 2011, likely leading to increased demand for commercial space, and potentially decreased access to capital.

healthcare Reform impact

The newly enacted patient protection and affordable care act (commonly known as healthcare Reform) is expected to have a mixed impact on commercial real estate. On the positive side, the increased insurance universe is expected to lead to de-mand of 60 million square feet of medical space between 2010 and 2019, according to National Real Estate Investor magazine. In particular, retail clinics are expected to increase by 10 to 15 percent between 2010 and 2012, and by 30 percent between 2013 and 2014. however, this healthcare reform regulation could also indirectly limit commercial real estate growth, espe-cially if increased operating costs cause companies with 50 or more employees to cut back on expansion plans.

Continued on next page…



Financial Reforms impact

The following recently-enacted and proposed financial reform regulations are expected to continue to limit access to lever-age for commercial real estate:

� The Dodd-frank Wall street Reform and consumer protec-tion act, which was signed into law in July 2010, includes provisions which tighten capital and compliance require-ments for banks, and could lead to a reduction in real estate lending and investment. More directly, the regula-tion requires cMbs issuers to provide greater disclosure and to retain at least a 5.0-percent stake in the securitized asset, which could create a more restrictive environment for issuers and credit rating agencies.

� The gsE proposal announced in february 2011 aims to reduce substantially the role of fannie Mae and freddie Mac in the u.s. housing finance market. This likely will lead to lower credit availability for the multifamily seg-ment, which has traditionally been underserved by private credit markets. In addition, it will lead to an increase in the insurance and interest costs on mortgages loans making it more challenging for many borrowers to obtain loans.

proposed Accounting Standards

The financial accounting standards board (fasb) and the In-ternational accounting standards board (Iasb) have proposed new lease accounting standards that would require firms to recognize all lease liabilities and assets on their corporate bal-ance sheets. The joint proposal includes:

� The proposed guidelines are expected to be finalized and effective starting in 2013, and would create greater cor-porate transparency and consistency in lease accounting procedures. The proposed changes could cause tenants to look for shorter-term leases, but this may be beneficial to owners because margins are often higher for shorter leases.

� fasb and Iasb have also recently proposed new standards for lenders to account for loan losses. The new standards propose to shift from the “incurred loss” approach, which requires evidence of a loss, to the “expected loss” ap-proach, which is more predictive of future losses. Though the new rule will provide timely and relevant information on future credit losses, the challenge which remains is how to best implement it systematically, in consultation with all the stakeholders.

other proposed Regulations

The government has proposed other new regulations which could have an influence on industry performance. for ex-ample, proposed reforms to the foreign Investment in Real property Tax act (fIRpTa) would raise the level of foreign own-ership allowed in public REITs from 5.0 percent to 10.0 percent, potentially leading to increased foreign investment. In addi-tion, the commercial Real Estate finance council (cREfc) has proposed the introduction of “covered bonds,” which could provide an alternative source of capital for investors.

Impact of Regulation on Commercial Real Estate

source: bloomberg, December 2010.

Regulation ImplicationsDirect Impact

Indirect Impact

The Healthcare Act

Negative Impact Limited business expansion X

Positive ImpactHigher demand for overall medical space, especially retail clinics X

Increased role for retail clinics X

Financial Regulations

Negative ImpactDodd-Frank Act: Restricted investments and credit lending in real estate X

GSE Reform Proposal: Lower credit availability for Multifamily segment X

Positive Impact

Foreign Investment in Real Property Tax Act (FIRPTA): Improved foreign capital flows and stabilized asset values

X

Proposed Introduction of Covered Bonds: Improved real estate lending and investment X

Proposed NewLease Accounting

Standards

FASB and IASB proposed new guidelines in accounting to push lease liabilities onto corporate balance sheets.

XNegative Impact Tenants may prefer short-term leases in order to show lower lease liabilities in their balance sheets.

Positive Impact Shorter leases commonly include higher rent, which could offset the impact. X



3 | THE PROPERTY MARKETS

perspective and Analysis

We expected that commercial real estate transaction volume in 2010 would be well above 2009’s depressed levels, but it was more than encourag-ing when sales doubled the 2009 tally even before the end of the fourth quar-ter. Just as important as reaching that benchmark, however, were the sup-porting factors that guided investment activity and grew stronger as the year wore on. While it is difficult to assign rank to any one of these factors (as they are all important contributors to the growth in commercial real estate investment), it is safe to say that low interest rates and easing access to cap-ital were the chief enablers of acquisi-tions. Although REITs and other listed companies were the prime benefici-aries of a capital market that favored these more liquid, transparent vehi-cles, other capital sectors, especially equity funds, began returning to the market late in 2010, and promise to be quite active going forward.

On the supply side, the seem-ingly careful apportioning out of the most sought-after properties—cash-flowing, stabilized high-quality assets in a small handful of top mar-kets—kept prices for such properties on the rise, along with yields, even as fundamentals struggled to gain trac-tion. And although for most of the year demand was slight for either value-add properties or for assets beyond the leading primary markets, the crush of competition in fourth quarter 2010 began to turn some buyers toward secondary markets and less well-sta-bilized properties. Meanwhile, creep-ing gains in new issues of CMBS—a trend that has freely blossomed in first quarter 2011—have helped smaller private investors get back into the acquisitions marketplace.

One key signal of health in the market was the growing presence of portfolio sales. Large portfolios traded in every property sector, including both distressed and non-distressed assets, and that momentum clearly carried into 2011 as major merger and consolidation activity picked up.

The strength of the rebound in investment activity in 2010 was cemented in November, as significant sales for properties and development sites trading for at least $2.5 million passed the $100 billion threshold. Property sales ended the year at more than $135 billion, the strongest finish since 2007, but still not quite a third of the volume in that peak year, as dem-onstrated in Exhibit 3-1. Nonetheless, the vigor of the turnaround from a rough 2009—especially with a blowout fourth quarter 2010—signaled that the

market’s momentum may be durable and sustainable in 2011.

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$50

Jan 2011

Jan 2010

Jan 2009

Jan 2008

Jan 2007

Billi

ons

Exhibit 3-1. Commercial Property Volume On the Rise

source: Rca, January 2011.



Quarterly acquisition momen-tum grew throughout the year, as play-ers on both sides of the sales equation moved toward greater flexibility. The advantages that public companies availed themselves of in the equity and debt markets began to be matched to some extent by well-capitalized equity funds and institutions, as those inves-tors confronted more realistic pric-ing than they had once anticipated from the vast pool of distressed assets. Improving fundamentals in the apart-ment and hotel sectors appear to have boosted investment in these property types, while the office market was pumped up by investor groups battling hard for the highest-quality properties in the best markets.

Yields and pricing reflected this competitive pressure to vary-ing degrees across all property types, although the positive changes were most pronounced in the office sector, where capitalization rates slid stead-ily through 2010, falling by some 200 basis points. Average apartment yields, the lowest of any property type, com-pressed as well, though not as sharply. Yields fell modestly for retail and industrial assets.

Although cap rates are cer-tainly trending lower, especially for top assets, the prevailing low risk-free rate has offered investors a comforta-ble yield cushion that is advantageous in contrast to yields from other asset classes. This has also been a boon to the commercial real estate market.

As noted above, listed and non-listed REITs used their capital to good effect in 2010. Listed REITs were net investors for the first time since 2005, and have continued as aggressive buy-ers into 2011. In fourth quarter 2010, as other investor groups—especially institutions and equity funds—picked up activity, REITs faced stiff competi-tion. Last year’s other net acquirers—lenders—are bringing more REO to the marketplace, shifting to net sellers as

they begin to unwind exposures built up since the market’s downturn.

Even as investors began to accept the notion that the opportuni-ties they had hoped for were not likely to emerge, lenders began to increase sales out of distress as the year wore on, as shown in Exhibit 3-2. At the same time, they also began to pull back somewhat on extend-and-pretend restructurings and modifications of troubled loans. Still, an important inflection point was reached in fourth quarter 2010 as the volume of sales out of distress began to exceed the level of newly distressed assets in every property type. By year-end, some $186 billion in troubled assets remained outstanding, accord-ing to RCA; the volume of resolutions, split evenly between sale or restructur-ing, reached past $70 billion.

The gains in pricing metrics that are enabling lenders to achieve higher recovery rates have encouraged lenders to bring more assets to mar-ket rather than hold them on balance sheets or try to restructure or modify

loan terms. In fourth quarter 2010 alone, $11 billion in distressed-asset sales accounted for 30 percent of total volume. The recovery rates on these sales, including a large number of full recoveries, have been significantly higher than during previous cycles.

Thus, investors had much to be pleased about by the close of 2010, with improved transaction volume and easing credit conditions chief among them. With the weight of pent-up investment capital from multiple sources, including cross-border inves-tors, institutional capital recalibrated toward commercial real estate, public equity and debt, and slowly improv-ing economic conditions, 2011 should mark another year of increased sales volume.

Several factors could cre-ate headwinds for investors in the months ahead, however. A discus-sion of those possible headwinds and the conditions surrounding the 2011 marketplace is provided in Chapter 4 of this report.

Billi

ons

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$300

$350

Resolved

Restructured

REO

Troubled

Jan 2011

Oct 2010

Jul 2

010

Apr 2010

Jan 2010

Oct 2009

Jul 2

009

Apr 2009

Jan 2009

Oct 2008

Jul 2

008

Apr 2008

Jan 2008

Exhibit 3-2. Sales of Resolved Distressed Properties Increase

source: Rca, January 2011.



thE oFFiCE mARKEt

Market Overview

The office sector was the clear standout for investment in 2010. Transaction volume more than dou-bled from 2009, and cap rates fell by nearly 200 basis points. From a 2009 low of $17.3 billion, sales volume rose 138 percent to $41.2 billion in 2010. Sales volume grew with each quarter, with the year ending in a fourth-quar-ter blowout of $18.3 billion in sales, as demonstrated in Exhibit 3-A1, greater than the entire prior year for office sales and the strongest quarter since fourth quarter 2007.

Office investors clearly pre-ferred well-tenanted properties in just a handful of major markets: New York, Washington, D.C., San Francisco, Bos-ton, and Chicago. Nonetheless, volume increased for stabilized assets across a broad geography, with volume climb-ing year-over-year in the vast majority of the top 40 markets nationwide.

The slow jobs recovery and unenthusiastic lending of value-add situations for much of the year damp-ened such investment. Meanwhile, lenders also held tightly onto their dis-tressed assets, although that practice began to change in fourth quarter 2010; office sales associated with distress exceeded $3 billion in fourth quarter 2010, more than the three prior quar-ters combined.

An important component in the recovery of the office investment market was the return of large deals

and portfolios. Portfolio sales volume quadrupled, rising to $6.2 billion. Average office deal size spiked to $27 million in 2010 from $17 million in 2009. This also reflects a smaller rise in transaction counts, which grew just 49 percent year-over-year, far less than the 138-percent jump in sales volume.

The gains in deal size reflect strong gains in central business dis-trict (CBD) office sales volume, which leaped 237 percent in 2010, compared to an 86-percent increase for subur-ban office sales volume. Capitalization rates also fell significantly (see Exhibit 3-A2), more for CBD properties than for

Volu

me

in B

illio

ns

Average $/Sq. Ft.

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Volume O�ered

Volume Closed

4Q 2010

3Q 2010

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4Q 2005

3Q 2005

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1Q 2005$100

$150

$200

$250

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$350Price $/SF O�eredPrice $/SF Closed

Exhibit 3-A1. Office Property Volume and Pricing

source: Rca, 4Q 2010.

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

O�ered

Closed

4Q 2010

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1Q 2005

Perc

ent

Exhibit 3-A2. Average Office Property Cap Rates


Sales volume grew with each quarter, with the year ending in a fourth-quarter blowout of $18.3 billion in sales…greater than the entire prior year for office sales, and the strongest quarter since fourth quarter 2007.



suburban office properties, but both experienced sharp contractions. CBD cap rates reached 6.1 percent, just 100 basis points above 2007 levels. Reflect-ing more stable fundamentals and a concentration of transactions in Man-hattan and Washington, D.C., average per-square-foot pricing strengthened, rising 47 percent in 2010 to $231.

Investor Composition

REITs, both listed and non-listed, were by far the most active capi-tal sector in office acquisitions. Each added over $4 billion of office prop-erty to their portfolios in 2010. Even so, the marketplace grew increasingly competitive throughout the year, as institutional and private buyers grew more active in the hunt for top-qual-ity assets. As credit conditions sof-tened and average deal size expanded, national banks reclaimed a leading role from the regional and local banks that were more active lenders on the smaller deals more common in 2009. Insurance companies and interna-tional banks also increased their origi-nations. CMBS, which revived in 2010, are widely expected to positively influ-ence the market in 2011.

Only two markets in 2009 exceeded $1 billion in office transac-tion volume, while 13 markets crossed that threshold in 2010. The major urban markets all posted solid growth in 2010 while some secondary mar-kets posted extreme percentage gains over very small 2009 totals. Manhat-tan and Washington, D.C. remained in first and second place, respectively, while Chicago, up nearly 400 percent, muscled into third place from No. 9. Another market that moved rapidly up the rankings was the Washington, D.C./Virginia suburbs, where office sales exceeded those in Boston and Los Angeles. Generally, the Southern Cali-fornia markets underperformed and the Texas markets all outperformed. The Atlanta, Sacramento, and the Washington, D.C./Maryland suburbs

were the only major markets where fewer office property sales occurred in 2010 than in 2009.

Office Market Fundamentals(courtesy of Grubb & Ellis)

In September 2010, the U.S. Bureau of Economic Analysis (BEA) announced that the Great Recession had actually ended in June 2009, mak-ing it the longest and deepest down-turn since the Great Depression. How-ever, job losses continued for another 6 months, eventually reaching 4 mil-lion from December 2007 to December 2009, with 2.5 million of those losses

in the office-using sectors of informa-tion, finance, and professional and business services. As a result, the U.S. office vacancy rate soared to 17.9 per-cent by second quarter 2010, as shown in Exhibit 3-A3, just 10 basis points shy of the all-time high in the 24-year history of the Grubb & Ellis database. Yet the actual net absorption of nega-tive 71 million square feet was only one-third of the potential decline indi-cated by the job losses, suggesting the presence of a substantial amount of shadow space—empty cubes, floors, or wings vacated due to layoffs but still counted as occupied. Had the job losses registered right away as negative

Vaca

ncy

Rate

(%)

Rental Rate ($/Sq. Ft.)

0

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Combined Vacancy RatesSuburban Vacancy RatesCBD Vacancy Rates

2011F2009

20072005

20032001

$18

$20

$22

$24

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$32

$34

Class A Rental RatesClass B Rental Rates

Exhibit 3-A3. Office Property Vacancy and Asking Rental Rates

source: grubb & Ellis, february 2011.



absorption, the vacancy rate would have sailed above 22 percent. Never-theless, 2010 ended on a positive note. Employers added 1.1 million net new jobs during the year, and the office market recorded three consecutive quarters of positive absorption total-ing 14.6 million square feet—enough to nudge the vacancy rates slightly lower, to 17.7 percent at year-end. The increase in occupied space was driven in part by tenants moving up from Class B space to take advantage of the low rents on offer in higher-quality buildings. Thus, average asking rents for Class A space ended the year at $30.90 per square foot per year gross, roughly flat for the third consecutive quarter.

Outlook

All of this data suggests a half-speed recovery in the office market during 2011 and 2012. Job creation is likely to remain subpar at about 1.5 million in 2011—just the level needed to accommodate the expanding labor force—and 2 million in 2012. About 20 percent of these jobs will likely be located in office buildings, and a large

share of those will likely be accom-modated in shadow space—about one-third in 2011 and one-fourth in 2012. This should generate 35 million square feet of net absorption in the coming year (see Exhibit 3-A4) and 47 million square feet in 2012, a moder-ate performance compared with the

2005-2007 expansion when annual absorption ranged from 62 million to 89 million square feet. On the other hand, new space completions will likely be at a minimum during the next 2 years, meaning that even the mod-est absorption forecast will drive the vacancy rate down from 17.7 percent at year-end 2010 to 17.0 percent in 2011 and 15.9 percent in 2012—still above the equilibrium vacancy level of 12 percent to 14 percent. This rate of tight-ening (+/- 1 percentage point in each of the next 2 years) will be about half the pace of a normal recovery cycle.

Asking rental rates may have found their floor, but should rise only slowly during this period at an expected rate of 0.4 percent in 2011 and 1.4 percent in 2012 for Class A space. Class B rates will likely trail until the market tightens enough to create a meaningful cost differential with Class A rates, which remains several years off. Landlords will continue to compete for tenants in 2011, particularly solid tenants with good credit. Tenants, for their part, may be more willing to sign long-term leases to lock in a good deal. This should mark a turnaround from the past couple of years when tenants

Mill

ions

(Sq.

Ft.)

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125Completions

Absorption

2011F2009

20072005

20032001

Exhibit 3-A4. Office Property Absorption vs. Completions


Class B rates will likely trail until the market tightens enough to create a meaningful cost differential with Class A rates…



preferred to sign 1-year extensions as their leases expired in order to keep their options open.

There is some upside risk to this outlook, meaning that condi-tions may improve more quickly than expected. Economists revised their growth forecasts upward as a result of the tax agreement reached by Con-gress in the lame-duck session at the end of 2010. This agreement included a 2-year extension of the Bush-era tax cuts, a 13-month extension of federal jobless benefits, a temporary cut in the share of the Social Security payroll tax paid by employees, and several other provisions. While the bond market swooned on this news, driving inter-est rates higher, the Federal Reserve’s quantitative easing program may help keep interest rates low through 2011, providing more fuel for the economy. Companies are sitting on a record $1.8 trillion of cash reserves, and they may begin deploying some of this cash in 2011 as the economy strengthens, and the half-speed recovery in the office market could turn out to be more like a three-quarters-speed recovery.

thE inDuStRiAL mARKEt

Market Overview

Industrial property sales vol-ume improved steadily throughout 2010. This improvement was driven

by several key portfolio transactions, including ProLogis’ fourth-quarter 2010 sale of its North American assets to affiliates of Blackstone. Volume jumped to $19.0 billion for the year, up 78 percent from a cyclical low in 2009. As shown in Exhibit 3-B1, the fourth quarter 2010 was especially active, sug-gesting that strong sales growth will continue for the sector. Volume for the 3 months ending Dec. 31, 2010 totaled $7.6 billion, up 63 percent from third quarter 2010 and up 132 percent from the same quarter a year ago. And even though the office sector, which has captured so much attention because

of rapidly declining cap rates and a number of high-profile trophy sales, only saw sales volume in the fourth quarter 2010 reach one-third of quar-terly volume at the peak, industrial property sales in fourth quarter 2010 were almost 50 percent of the sector’s strongest peak period in second quar-ter 2007.

Sales of industrial warehouses increased to $12.6 billion in 2010, ris-ing 81 percent from 2009’s low of $7.0 billion. Following a slow start in 2010, sales activity picked up in the third and fourth quarters, even as offering volumes declined. While initial gains were modest, activity spiked in fourth quarter, rising 91 percent higher than the previous quarter and 168 percent ahead of sales in fourth quarter 2009. At $5.6 billion, sales volume in fourth quarter 2010 closed the year at its high-est level since first quarter 2008.

Sales of flex properties increased to $6.3 billion in 2010, rising 69 per-cent from 2009’s low of $3.7 billion. While activity has picked up for flex properties, absolute volume remains low, reflecting a market where price

Volu

me

in B

illio

ns

Average $/Sq. Ft.

$0

$5

$10

$15

$20

Volume O�ered

Volume Closed

4Q 2010

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

4Q 2008

3Q 2008

2Q 2008

1Q 2008

4Q 2007

3Q 2007

2Q 2007

1Q 2007

4Q 2006

3Q 2006

2Q 2006

1Q 2006

4Q 2005

3Q 2005

2Q 2005

1Q 2005$40

$60

$80

$100Price $/SF O�ered

Price $/SF Closed

Exhibit 3-B1. Industrial Property Volume and Pricing




discovery is still maturing. Unlike most other property types and subtypes, which improved consistently over the course of the year and which gener-ally measured their strongest results of the recovery in fourth quarter 2010, sales of flex properties were essentially unchanged from second and third quarter at $1.7 billion.

Still, industrial property pric-ing benchmarks have been somewhat murkier than for other property types. Capitalization rates, as demonstrated in Exhibit 3-B2, were essentially flat between the third quarter 2010 and fourth quarter 2010, barely falling to 8.3 percent, although they were down by almost 50 basis points year-over-year to near-2004 levels. As in other property types, higher-quality industrial assets brought lower yields. Meanwhile, cap rates diverged across industrial warehouse and flex assets, even though sales volume increased at roughly the same rate for both. But while cap rates for flex assets dropped 100 basis points over the year, ware-house yields edged up, and are now almost at par with those for flex.


Regional and local banks were the stand-out lenders for industrial assets, active on one-third of the deals largely because the smaller deal size and private-heavy buyer mix fit their borrower profiles better than other

property sectors. On the other hand, insurance funds were attracted to institutional deal sponsors for higher-quality assets and portfolios.

China’s relative importance in U.S. commerce was reflected in the West Coast’s pre-eminence as a target for industrial property acquisitions. Led by Los Angeles, five West Coast markets were among the top 10 industrial prop-erty transaction locations. Also ranking well was Atlanta, although Chicago lost ground. Dallas moved ahead of Chicago as the Southwest gained importance as a trading center.

Industrial Property Fundamentals(courtesy of Grubb & Ellis)

Fundamentals for the U.S. industrial market bottomed out in first quarter 2010 when the vacancy rate peaked at 10.9 percent (see Exhibit 3-B3), one quarter ahead of the office market (industrial property developers were able to shut down the construc-tion pipeline more quickly as demand evaporated). As the year wore on, the industrial market benefited from an early bounce in two key economic indi-cators—global trade, and the restocking

Vaca

ncy

Rate

(%)


0

2

4

6

8

10

12

14

Industrial Vacancy

2011F2009

20072005

20032001

$0

$2

$4

$6

$8

$10

$12

Warehouse/ Distribution RentR&D/Flex RentGeneral Industrial Rent

Exhibit 3-B3. Industrial Property Vacancy and Asking Rental Rates


6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

O�ered

Closed

4Q 2010

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

4Q 2008

3Q 2008

2Q 2008

1Q 2008

4Q 2007

3Q 2007

2Q 2007

1Q 2007

4Q 2006

3Q 2006

2Q 2006

1Q 2006

4Q 2005

3Q 2005

2Q 2005

1Q 2005

Perc

ent

Exhibit 3-B2. Average Industrial Property Cap Rates

source: Rca, 4Q 2010



of depleted inventories by retailers, wholesalers, and manufacturers. The weak dollar spurred a bounce in exports while a spotty but gradual recovery in consumer spending boosted imports. That fueled demand in Southern Cali-fornia’s Inland Empire and other mar-kets that serve as transfer stations for container shipments headed to the country’s interior. Another support for industrial property demand—compa-nies continued to squeeze costs out of their supply chains during the down-turn, striving for ever greater efficien-cies, which helped put a floor under leasing and user sales activity through the lean times.

After hitting its peak, industrial vacancy dropped sharply to 10.6 per-cent in the second quarter—a rapid shift for the billion-square-foot U.S. market—suggesting that a vigorous recovery was underway. But the pace cooled with vacancy dropping by 20 basis points through the rest of 2010 to 10.4 percent. In hindsight, the second-quarter drop was likely fueled by pent-up demand from an early improvement in manufacturing and the inventory

correction cycle. Indeed, asking rental rates, typically the last market indicator to turn the corner, weakened through most of the year until the fourth quar-ter, when a surprising increase of 1.7 percent pushed the asking rate for all types of industrial space to $5.35 per square foot per year. Rates for avail-able space ended the year at $5.18 per square foot for general industrial usage (primarily manufacturing), $4.27 per square foot for warehouse-distribution space, and $9.31 per square foot for R&D-flex space.

Outlook

All of this data suggests a grad-ual recovery in leasing market fun-damentals for the industrial sector in 2011, with net absorption rising to 60 million square feet, as shown in Exhibit 3-B4, followed by a robust doubling of that rate to 120 million square feet in 2012. With construction starts mostly confined to build-to-suit projects, even these middle-of-the-road absorption totals should push down the vacancy rate, expected to end 2011 below 10 percent and in the low 9-percent range

in 2012. The average asking rental rate across all U.S. markets, which slipped by 16 percent from first quarter 2007 to third quarter 2010 (peak-to-trough), is expected to increase very gradu-ally by 0.6 percent in 2011 and 1.0 per-cent in 2012. Net effective lease rates should rise more quickly, as landlords pull back on concessions. Properties in built-out submarkets near major transportation hubs such as Chicago’s O’Hare submarket, the South Bay in Los Angeles, and a number of other areas should see faster rent gains as user demand picks up.

The wild card in the coming expansion cycle may be fuel prices. When prices spiked in 2008, logistics companies and shippers were mov-ing down the path toward more and smaller distribution centers in order to maximize the use of fuel-efficient rail and to minimize trucking costs. This provided a boost to emerging distribu-tion hubs, such as Phoenix and Kansas City, but the recession and the decline in energy prices put a hold on this strat-egy. With energy prices rising again in the wake of Mideast turmoil, in addi-tion to the weak dollar and the bur-geoning demand in China and other growing economies, expect to see demand return for smaller distribution facilities across secondary markets.

Demand patterns are already shifting as a result of the Panama Canal expansion that will open in 2014. Ports along the Gulf and East coasts have attracted more container volume from shippers intent on diversifying their supply chains and lowering depend-ence on the Southern California ports. New York/New Jersey, Norfolk, and Charleston will be the only ports to efficiently handle the majority of post-Panama ships due to port depth issues. However, New York and New Jersey may have air draft issues related to the Bayonne Bridge.

The trend toward greater reli-ance on the Gulf and East Coast ports,

-150

-100

-50

0

50

100

150

200

Completions

Absorption

2011F2009

20072005

20032001

Mill

ions

(Sq.

Ft.)

Exhibit 3-B4. Industrial Property Absorption vs. Completions




which goes back over 5 years, waned to some extent in 2010 as shippers moved slightly more volume through West Coast ports to speed the restocking of warehouses in the West and Midwest. We have yet to see if this was an anom-aly or a more permanent trend.

thE REtAiL mARKEt

Market Overview

After a sluggish start to the year reflecting continuing consumer concerns, retail property investment increased considerably in the second half of 2010 and ended the year with a flourish. With transactions of $8.3 billion, fourth quarter 2010 volume accounted for over a third of the total volume for the year and was an increase of 29 percent over third quarter volume. As illustrated in Exhibit 3-C1, this was also an increase over the same period 1 year earlier and the highest quarterly volume since fourth quarter 2007 when volume was $12.0 billion. The strong fourth quarter 2010 volume was unan-ticipated following the third-quarter

closing of Simon Property Group’s $2.3 billion acquisition of Prime Outlets, the second largest of any transaction in 2010. Overall retail property volume for 2010 was $22.6 billion, and consisted of the sale of more than 1,700 significant retail property transactions, marking

a 51-percent improvement over 2009 volume of $15.0 billion, although it was still short of 2008’s total of $24.0 billion.

Fourth quarter 2010 was also the first quarter in 2 years in which the vol-ume of closed retail property transac-tions exceeded the value of properties offered for sale, as presented in Exhibit 3-C1. In addition, the gap between offered and closed properties nar-rowed throughout 2010, a positive indi-cation that buyers and sellers of retail assets have begun to negotiate through the large bid-ask spread that has been prevalent over the past 2 years, and are moving toward more common ground on pricing.

The overall retail property sector has been returning to health, although more slowly than the apartment or office markets. Capitalization rates declined over the past year, and the average cap rate in fourth quarter 2010 fell to 7.7 per-cent, representing a decline of almost 40 basis points over the same period in 2009 (see Exhibit 3-C2). Retail cap rates remain slightly elevated over the cap rates for the office and apartment sec-tors. The risk spread over 10-year U.S.

6.5

7.0

7.5

8.0

8.5

O�ered

Closed

4Q 2010

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

4Q 2008

3Q 2008

2Q 2008

1Q 2008

4Q 2007

3Q 2007

2Q 2007

1Q 2007

4Q 2006

3Q 2006

2Q 2006

1Q 2006

4Q 2005

3Q 2005

2Q 2005

1Q 2005

Perc

ent

Exhibit 3-C2. Average Retail Property Cap Rates


Volu

me

in B

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ns

Average $/Sq. Ft.

$0

$5

$10

$15

$20

$25

$30

Volume O�ered

Volume Closed

4Q 2010

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

4Q 2008

3Q 2008

2Q 2008

1Q 2008

4Q 2007

3Q 2007

2Q 2007

1Q 2007

4Q 2006

3Q 2006

2Q 2006

1Q 2006

4Q 2005

3Q 2005

2Q 2005

1Q 2005 $75

$100

$125

$150

$175

$200

$225

$250Price $/SF O�ered

Price $/SF Closed

Exhibit 3-C1. Retail Property Volume and Pricing




Treasurys is 450 basis points. The aver-age price per square foot also improved sharply, increasing 30 percent from 1 year earlier to $168 in fourth quarter 2010. Despite these positive indicators, investors still have moderate concern regarding retail assets. The Moody’s/REAL Commercial Property Price Index (CPPI) indicated a 2.7-percent decline in prices in 2010.

Metrics were healthier in 2010 than in the prior year across all retail property subtypes. Transaction vol-ume for strip centers, including out-lets, totaled $13.1 billion, up 57 percent year-over-year, while sales of malls and other types of retail centers rose 42 per-cent to $9.5 billion over the previous year. Cap rates for both retail subtypes declined at approximately the same rate; however, strip center cap rates averaged 8.2 percent while cap rates for malls were at 7.4 percent.

Much of the gain in retail sales and metrics has come through heightened interest in core markets. Investors seem to have been drawn to quality assets in dense locations. As the availability of these properties becomes more scarce, investors will likely turn to secondary markets and properties, including grocery and drug store-anchored centers that commonly have strong tenancy. The transaction environment is likely to grow increas-ingly competitive as investors seek to place available and pent-up funds, and should sustain continued cap rate com-pression. The race to invest dry powder should expand over the next year, with

better, less risky assets contributing the most to transaction volume.


REITs were the most active equity investor group for retail prop-erties in 2010, and enjoyed the most significant net positive change to their holdings. REITs were followed by lenders, including insurance compa-nies, who jumped to the second most active on the list of net positive hold-ings, not because of active acquisition but largely due to foreclosure activ-ity. Cross-border investors rounded out the net positive holding category. Equity funds and institutional inves-tors were the top sellers of retail prop-erties in 2010, though both groups are

expected to escalate their buying over the next year as available monetary sources expand.

In addition to being a top equity investor in the market, insurance com-panies barely edged out national banks as the largest retail property lender group by volume, with 29 percent of lending market share, followed closely by banks with 28 percent of retail debt placement. CMBS purchases, although extremely modest for the retail sector in 2010, are likely to be a much bigger factor in 2011.

Retail Property Fundamentals(courtesy of Grubb & Ellis)

In the business of real estate market data, it is not unusual to find different sources offering different statistics. However, it is unusual to find competing statistics that point in different directions. Reis, Inc. said that vacancy rates for community and neighborhood shopping cent-ers increased from 10.6 percent at the beginning of 2010 to 11.0 percent at year-end while the average asking rental rate slipped by 0.6 percent (see Exhibit 3-C3). Reis forecasts a further

Vaca

ncy

Rate

(%)


0

2

4

6

8

10

12

14

Retail Vacancy

2011F2009

20072005

20032001

$10

$12

$14

$16

$18

$20

$22

Retail Rent

Exhibit 3-C3. Retail Property Vacancy and Asking Rental Rates

sources: Reis, Inc., grubb & Ellis, february 2011.



market contraction in 2011 followed by a slow recovery thereafter. On the other hand, CoStar, which tracks a broader set of retail property types than Reis, said the overall vacancy rate peaked in first quarter 2010 and retreated slightly toward year-end. CoStar also shows the vacancy rate for neighborhood shopping centers, which appears to conform most closely to the shopping center types tracked by Reis, bottom-ing out in 2010.

What is certain is that some shopping center types and locations out-performed others in 2010. Sales at neighborhood centers with a strong grocery anchor serving a mature, higher-income trade area held up bet-ter than unanchored strip centers on the urban fringe where housing con-struction was halted. During the depth of the recession, discount stores and their respective centers outperformed their more upscale competition as consumers sought to conserve cash. But the stunning rebound in the equity markets emboldened higher-income consumers, providing an early bounce for luxury brands, while the faltering

labor market was especially unkind to lower- and middle-income consumers and discount retailers.

In addition, with construction of new retail properties continuing to slow even as leasing fundamentals begin to turn up, absorption is turning positive and should improve in 2011, as shown in Exhibit 3-C4.

As 2010 drew to a close, retail sales and consumer spending metrics

indicated that consumers, responding well to the promotional environment, were once again spending due to pent-up demand that had accumulated during the recession. In addition, sav-ings rates stabilized in the 5- to 6-per-cent range, suggesting that rates were unlikely to return to the 10-percent level of the early 1980s—good news for retailers.

Outlook

This data suggests that retail sales may ramp up gradually in 2011 and 2012, along with the economy in general and the labor market in particular. However, if the recov-ery remains sluggish or oil/gasoline prices continue to increase, consum-ers will likely remain cautious. Higher inflation remains a double-edged sword, with the potential to curb spending but also to act as a tailwind for spending if consumers believe that purchases will be more expensive next year.

Retailers should continue to reposition their stores to take advan-tage of the favorable rental rates being offered and the ability, in many cases, to move up to better centers that were simply not available to them during the boom years. At the same time, expect them to be selective when car-rying out their expansion plans.

-30

-20

-10

0

10

20

30

40

Completions

Absorption

2011F2009

20072005

20032001

Mill

ions

(Sq.

Ft.)

Exhibit 3-C4. Retail Property Absorption vs. Completions




thE ApARtmEnt mARKEt

Market Overview

Following the worst year on record for apartment investment sales in 2009, apartment volume gained momentum throughout 2010. A total of $33.7 billion of significant apartment properties were sold in 2010, repre-senting an increase of 139 percent from 2009, when sales of apartment prop-erties were just $14.1 billion. Fourth quarter 2010 sales were particularly strong, mirroring the full-year gain with approximately double the sales in fourth quarter 2009. Further, the number of properties sold in 2010 eas-ily outpaced 2009’s tally, which sank an abysmal 57 percent against the prior year. A revitalized portfolio market—with sales of $4.9 billion (triple the 2009 pace)—contributed significantly to the large gain in apartment sales volume in 2010. Although 2010’s transaction volume is still barely one third of the peak of $102 billion in 2007, the growth is certainly an indication of investors’ renewed appetite for multi-family investments, particularly in light of the sector’s improving fundamentals.

As presented in Exhibit 3-D1, the fourth quarters of 2009 and 2010 have been the only periods when the volume of closed transactions actu-ally outpaced the value of properties brought to the market since the end of 2007. In most quarters since that time, offerings have widely exceeded closed transactions, but that margin nar-rowed throughout 2010.

Building upon the pricing trend that emerged in late 2009, prices for apartments increased 11.8 percent in 2010, according to Moody’s/REAL CPPI. This compares to a decline in pricing of 20 percent over the prior 12 months. The significant increase in pricing for apartments reflects capitalization rate compression at the upper tier of apartment proper-ties, as buyers competed for large,

high-priced assets in major markets. As presented in Exhibit 3-D2, average apartment cap rates declined slightly for the sector as a whole through-out 2010, after a sharp drop in fourth quarter 2009 from approximately 6.7 percent. However, for the top quartile of apartment transactions in 2010, cap

rates declined more significantly to 5.5 percent. On the whole, apartment cap rates are generally lower than those for other property sectors. This stems from the greater availability of financ-ing from GSEs Fannie Mae and Fred-die Mac, which contributes to lower interest rates, as well as the perceived

Volu

me

in B

illio

ns

Average in Thousands $/Unit

$0

$5

$10

$15

$20

$25

$30

Volume O�ered

Volume Closed

4Q 2010

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

4Q 2008

3Q 2008

2Q 2008

1Q 2008

4Q 2007

3Q 2007

2Q 2007

1Q 2007

4Q 2006

3Q 2006

2Q 2006

1Q 2006

4Q 2005

3Q 2005

2Q 2005

1Q 2005 $60

$80

$100

$120

$140Price $/Unit O�eredPrice $/Unit Closed

Exhibit 3-D1. Apartment Property Volume and Pricing


5

6

7

8

O�ered

Closed

4Q 2010

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

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1Q 2008

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3Q 2007

2Q 2007

1Q 2007

4Q 2006

3Q 2006

2Q 2006

1Q 2006

4Q 2005

3Q 2005

2Q 2005

1Q 2005

Perc

ent

Exhibit 3-D2. Average Apartment Property Cap Rates




safety of multi-family assets relative to other property types. Apartment cap rates are currently close to those that prevailed during the run-up to the market peak.

Despite the large decline in cap rates for top-tier properties in 2010, average cap rates for apartments are over 200 basis points above borrowing costs, well above the 53 basis points averaged over the past decade.


REITs and institutional inves-tors were among the most active buy-ers of apartments in 2010, a stark con-trast from 2009 when private buyers dominated the sector by accounting for nearly 80 percent of all acquisitions. Institutional investors and equity funds were the most active sellers of apartments in 2010, though the seller profile was more widely fragmented among the various capital sectors.

The majority of transaction activity for public REITs has been focused on core assets in major mar-kets such as New York City, Washing-ton, D.C., San Francisco, Los Angeles,

Chicago, and Boston. The top-quality assets have clearly received the most attention and competition from major investors throughout the year. How-ever, public REITs have also displayed an appetite for value-add assets in mar-kets considered more strategic; some apartment REITs, such as Mid-Amer-ica Apartments and Home Properties, actually focus on secondary markets. Additional buyers of value-add proper-ties in the apartment sector have been primarily private owners, institutional investors, and equity funds.

Cross-border investment in the multi-family sector was typically a minimal 4 percent of total investment in 2010.

Apartment Property Fundamentals (courtesy of Axiometrics Inc.)

The apartment market began one of its strongest performances in almost 15 years in January 2010. This was unexpected following 2009’s record decline in effective rental rates (6.3 per-cent) with the vacancy rate reaching a record high (8.1 percent). In 2010, effec-tive rental rates increased by 4.3 per-cent, with the vacancy rate declining by

154 basis points to 6.6 percent, driving potential rental revenue growth up by 5.8 percent. (Potential rental revenue is the combined change in effective rental rates and occupancy.) The trend of rent-ers continuing to move in at higher rental rates and pushing up occupancy is evidence of a strong rental market with pricing power, as demonstrated in Exhibit 3-D3.

The changes occurred as asking rents increased by 2.5 percent ($24 per month) and the value of concessions fell from the equivalent of 3.5 weeks ($71 per month) of free rent to 2.7 weeks ($49 per month), increasing effective rental rates by $47 per month.

Fourth quarter 2010 was among the strongest in the past 15 years, and potential rental revenue growth of 5.8-percent growth was achieved even though those quarters that have shown better growth have done so in an envi-ronment of much greater job growth (the primary demand driver for apart-ment housing). However, several con-current factors encouraged the posi-tive momentum, including:

� A record low supply of new apart-ments being delivered into the market helped drive increases in occupancy and effective rental rates. With depressed development since the beginning of the financial cri-sis, multi-family permitting for the trailing 12 months ending Novem-ber 2010 was 68.2 percent below its 2005 peak level of 389,300 units. However, as more supply begins to be delivered, this trend should begin to abate in 2012. New prop-erties typically offer substantial concessions and renters often recycle into newer properties and push up vacancy while eroding the pricing power in older properties.

� Job growth begins to contribute to apartment demand.

Vaca

ncy

Rate

(%)

Rental Grow

th (%)

2

4

6

8

10

Vacancy Rate

4Q 2014F

4Q 2013F

4Q 2012F

4Q 2011F

4Q 2010

4Q 2009

4Q 2008

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4Q 2004

4Q 2003

4Q 2002

4Q 2001

4Q 2000

4Q 1999

4Q 1998

4Q 1997

4Q 1996 -10

-5

0

5

10E�ective Rent Growth

Exhibit 3-D3. U.S. Apartment Market Vacancy and Asking Rental Rate Growth

source: axiometrics Inc, January 2011.



In hard-hit Phoenix (population 4.4 million), for example, fewer than 1,500 multi-family units received permitting in the past 2 years combined. Meanwhile, Phoenix job growth turned around from a loss of 115,000 jobs in 2009 to a gain of 28,000 jobs in 2010. Effective rental rates climbed by 5.6 percent, and the vacancy rate for the city’s apartment sector fell 330 basis points to 8.0 percent.

In top markets, even the small gains in job growth for 2010 have worked with the slow delivery of new apartments to push up rent and occupancy, although this did not hold across all markets.

� Renter household formation has increased during the decline of housing sales.

The share of U.S. households that rent homes increased to 33.1 per-cent through third quarter 2010 after bottoming at 31.0 percent in 2004, an increase in renter house-holds of 3.4 million. At the same time, the vacancy rate for apart-ment properties with five or more units fell from 13.1 percent in third quarter 2009 to 11.8 percent in third quarter 2010, the greatest reduction in the vacancy rate over the past 20 years. For conventional market rate apartments, which are more likely to have 20 or more units per structure, the vacancy

rate fell by 150 basis points, the strongest absorption in almost 15 years. Turnover also has fallen to historically low levels, with fewer renters transitioning to ownership as home prices continue to fall and down-payment ratios and credit score requirements rise.

With the recovery well under-way and job growth projections posi-tive for 2011 and beyond (see Exhibit 3-D4), identifying markets that are either cyclical or stable becomes important in determining investment and development priorities and financ-ing strategies. The pressure is greater to

move more quickly in cyclical markets, and to employ a capital structure (par-ticularly the debt) to carry the invest-ment through the cycle. Some of the more stable or “evergreen” markets are Seattle, the New York and Wash-ington, D.C. metro areas, Chicago, and San Francisco. The more cyclical markets include Phoenix, Las Vegas, Orlando, Tampa, Charlotte, Riverside, and Dallas.

Effective rental and occupancy rates in the Washington, D.C. and Chi-cago apartment markets have already returned to peak levels, and more of the 20 leading markets should follow

Actual Forecast

Key Variable 2007 2008 2009 2010 2011 2012 2013 2014

Employment (000) 137,598.0 136,790.0 130,807.0 129,818.0 132,278.2 135,915.1 140,445.0 144,315.8

Job Growth (000) 1,512.0 -808.0 -5,983.0 -989.0 2,460.2 3,636.9 4,530.0 3,870.7

Job Growth 1.1% -0.6% -4.4% -0.8% 1.9% 2.7% 3.3% 2.8%

Total Residential Permitting 1,398,415 905,359 582,963 592,911 943,043 1,429,133 1,863,665 1,667,111

Demand/Supply Ratio 0.8 -0.6 -6.6 -1.7 4.1 3.9 3.2 2.1

Housing Affordability Index 116.7 140.1 189.7 199.5 175.3 161.5 151.2 150.7

Exhibit 3-D4. Key Assumptions for U.S. Forecast

sources: bureau of Labor statistics (bLs), axiometrics Inc., January 2011.



suit during 2011. Exhibit 3-D5 shows the forecasts for the top 20 markets according to potential rental revenue in 2011 and beyond.

Outlook

The overall outlook for the apart-ment sector appears clear and bright, but not without risk. Continued high unem-ployment levels and increases in rental rates, coupled with the attractive com-bination of low home prices and interest rates, have the potential to keep renter demand in check. On the supply side, empty for-sale condominiums or homes could convert to rentals, leading to further increases in available units. Further, the considerable reduction in cap rates has led to situations in certain markets where developing new apartments has become

cheaper than buying, which could trig-ger the development of new units and increased supply in the foreseeable future. However, with continued favorable capital market conditions, a limited new supply of units currently under construction, and an expected uptick in demand, the apart-ment sector is well-poised to continue to strengthen in 2011.

thE hotEL mARKEt

Market Overview

It should come as no surprise, after the past 2 years of economic turmoil and anemic transaction activity, that inves-tors have emerged from their investment coma with a strong appetite for lodging assets, creating one of the most vibrant

comeback stories of 2010. The relaxed pace of transaction activity that became evident in the latter half of 2007 prevailed through 2009, while the dollar volume of transactions declined by more than 85 percent from the peak levels recorded in 2007. In 2009, the transaction mar-ket came to a virtual standstill, with the lowest transaction volume in over a dec-ade; the unavailability of mortgage capi-tal, evaporating equity, and the limited inventory of quality assets for sale were the principal causes of the dramatic drop in lodging transaction activity.

The renewed excitement in the hotel sector in 2010 has been fueled by strengthening fundamentals and thawing capital markets, resulting in a 358-percent growth in lodging sales volume over 2009 results. Fourth quarter 2010 sales volume

Effective Rent Growth Vacancy Potential Rental Revenue

Market 2010A 2011F 2012F 2013F 2014F 2010A 2011F 2012F 2013F 2014F 2010A 2011F 2012F 2013F 2014F

New York Metro 6.8% 7.8% 6.3% 4.8% 4.8% 4.1% 3.7% 3.0% 4.3% 5.0% 7.5% 8.7% 6.5% 3.3% 4.4%

San Francisco 7.1% 7.8% 4.7% 3.8% 3.1% 4.0% 3.5% 2.8% 3.4% 4.7% 8.0% 8.3% 5.5% 2.5% 4.2%

Riverside 3.0% 6.7% 4.9% 4.4% 4.0% 5.9% 4.9% 3.9% 4.2% 5.1% 3.4% 8.3% 5.3% 4.0% 3.0%

Dallas 4.1% 5.5% 5.1% 4.6% 3.8% 7.5% 6.5% 4.7% 4.8% 5.6% 6.3% 7.3% 6.8% 3.9% 3.0%

Atlanta 3.7% 5.1% 4.3% 4.0% 2.8% 9.4% 7.3% 5.4% 4.3% 5.0% 4.6% 7.2% 6.3% 4.8% 1.9%

Austin 6.7% 5.9% 5.8% 5.1% 4.7% 5.4% 5.0% 4.1% 3.5% 4.4% 9.1% 6.9% 6.7% 5.6% 3.5%

Boston 6.9% 6.2% 5.1% 4.9% 3.0% 4.2% 3.5% 4.1% 4.9% 5.7% 7.8% 6.9% 4.0% 4.2% 2.1%

Seattle 6.0% 5.7% 4.7% 4.6% 2.9% 5.5% 4.3% 3.5% 4.4% 5.7% 6.7% 6.7% 5.4% 3.1% 1.7%

Chicago 6.8% 5.8% 3.8% 2.6% 1.8% 5.4% 4.3% 3.3% 4.1% 5.6% 8.2% 6.7% 4.8% 1.2% 0.8%

Charlotte 3.8% 5.4% 4.8% 4.0% 4.0% 7.7% 7.1% 5.5% 4.4% 5.4% 6.0% 6.3% 6.3% 5.1% 2.0%

Orange County 1.4% 5.3% 4.9% 5.6% 5.1% 4.9% 4.8% 4.0% 5.1% 5.4% 2.6% 6.3% 5.1% 5.0% 1.7%

Los Angeles 2.0% 5.0% 5.5% 5.3% 4.4% 5.9% 4.7% 3.6% 4.4% 4.4% 2.0% 6.2% 6.0% 4.3% 4.7%

San Diego 0.9% 5.8% 6.0% 4.9% 4.0% 5.2% 4.0% 3.1% 3.9% 5.0% 0.8% 6.2% 6.9% 3.6% 1.9%

Denver 7.5% 5.2% 4.6% 4.6% 3.9% 5.4% 4.6% 3.6% 4.3% 5.2% 9.1% 6.2% 5.5% 3.4% 3.1%

Orlando 3.2% 5.2% 5.1% 4.1% 3.5% 8.0% 6.5% 5.3% 4.5% 5.5% 4.4% 6.1% 6.3% 4.9% 3.7%

Washington, DC Metro 7.8% 5.0% 4.0% 3.5% 3.3% 6.8% 3.5% 2.7% 3.8% 5.2% 9.0% 6.0% 4.7% 1.6% 2.5%

Houston 1.1% 4.2% 5.1% 4.6% 4.0% 10.2% 8.6% 6.0% 4.3% 5.1% 1.7% 5.9% 8.0% 5.8% 2.7%

Phoenix 6.0% 4.4% 6.0% 4.9% 4.7% 8.1% 8.1% 6.1% 4.9% 5.1% 8.8% 5.9% 7.8% 5.9% 2.6%

Tampa 3.5% 4.3% 4.8% 4.0% 3.3% 4.4% 6.6% 5.3% 4.7% 5.8% 4.7% 5.3% 6.3% 4.2% 2.2%

Las Vegas -2.2% 3.9% 5.2% 5.2% 4.9% 9.3% 7.8% 6.8% 5.4% 5.0% -1.5% 4.8% 6.5% 6.5% 4.4%

U.S. 4.2% 5.0% 4.6% 4.1% 3.4% 6.8% 5.8% 4.6% 4.6% 5.4% 5.9% 6.2% 5.6% 3.8% 2.4%

Exhibit 3-D5. Forecasts of Effective Rental Rate Growth, Vacancy, and Potential Rental Revenue for the Top 20 Markets from 2011 to 2014

source: axiometrics Inc., January 2011.



was the highest dollar volume since third quarter 2007. The lodging sector sales volume experienced a steady ascent dur-ing 2010, even with the $3.9 billion sale of Extended Stay Hotels (680 properties) out of bankruptcy. Manhattan, Los Angeles, Boston, San Francisco, and Chicago round out the top five major metropolitan areas reporting year-over-year change in sales volume of over 190 percent. While activity has improved, however, the recorded level of sales activity for 2010 (see Exhibit 3-E1) is still a fraction of the near $20 billion sold in second quarter 2007.

The improving economy and strengthening lodging sector fundamen-tals, coupled with easing credit condi-tions, contributed to a higher price per room, which rose by roughly 93 percent for full service in 2010, while limited service posted a price gain of 28 percent. Despite positive momentum, limited service is expected to continue to lag full service price per room growth primarily due to a revenue model restricted mainly to room demand.

The vibrant comeback of the lodg-ing sector is further supported by a grad-ual decline in lodging capitalization rates, despite recent interest rate pressure. Due to the market conditions that prevailed in 2010, RERC’s going-in and terminal cap rates compressed by approximately 100 basis points from the high recorded in first quarter 2010. Throughout 2010, there was a narrowing relationship between these two rates which can be expected in an improving market, as shown in Exhibit 3-E2. This phenomenon may occur when investors become comfortable envision-ing that future market conditions may be more stable than current conditions. This also tells us that investors are not comfortable with the relationship of near-term income projections and value. In line with capitalization rate changes, dis-count rates compressed approximately 130 basis points during 2010. When these investment rates were combined with increasing net incomes, the increase in value was further elevated, in some cases ranging from 10 percent to 30 percent.


During 2010, equity funds and listed REITs were the most active buyers/sellers, and increased their net hospital-ity holdings by approximately $2.1 bil-lion. Cleaning up the hangover of over-leveraged properties, lenders reclaimed

approximately $1.8 billion in lodging prop-erties. Private owners that invested at the height of the market were the biggest net sellers, divesting of approximately $1.9 bil-lion in assets. It is noteworthy that institu-tional and fund investors were strong buy-ers at the height of the market, purchasing lodging assets primarily from the public

Volu

me

in B

illio

ns

Average $k/Unit

$0

$5

$10

$15

$20

Volume O�ered

Volume Closed

4Q 2010

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

4Q 2008

3Q 2008

2Q 2008

1Q 2008

4Q 2007

3Q 2007

2Q 2007

1Q 2007

4Q 2006

3Q 2006

2Q 2006

1Q 2006 $25

$50

$75

$100

$125

$150

$175

$200Price $k/Unit O�eredPrice $k/Unit Closed

Exhibit 3-E1. Hotel Property Volume and Pricing


7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

Terminal Cap Rate

Going-In Cap Rate

4Q 2010

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

4Q 2008

3Q 2008

2Q 2008

1Q 2008

4Q 2007

3Q 2007

2Q 2007

1Q 2007

4Q 2006

3Q 2006

2Q 2006

1Q 2006

4Q 2005

Perc

ent

Exhibit 3-E2. Average Hotel Property Required Cap Rates

source: RERc, 4Q 2010.



companies and REIT investors. In 2010, institutional and fund investors have been relatively unchanged regarding their net holdings. Lodging sector investors have been interested primarily in gateway cities with tourist and convention destinations, along with cities that have a concentration of government.

More recent data suggest that equity return requirements have decreased due to the large amount of equity capital entering the lodging sec-tor and the scarcity of available quality assets. Similarly, the mortgage compo-nent is returning to more normal levels. Debt is more abundant, as lenders are able to understand and forecast cash flows more clearly. Although spreads for lodging property debt continue to be at the upper end of the range for commer-cial properties, the prevailing low cost of capital is keeping lodging interest rates at historic low levels. Loan-to-value ratios remain conservative, but are trending up as the market builds momentum with lenders. With lowered debt and equity return requirements, future lodging sec-tor sales volume and pricing are expected to continue to improve into 2011.

Hotel Property Market Fundamentals(courtesy of PKF Hospitality Research)

The recovery of the U.S. lodging industry began in earnest in 2010, buoyed by a 7.7-percent expansion in the demand for hotel rooms nationwide, as reported by Smith Travel Research (STR). However, of concern to hotel owners and operators is the inability to leverage the growth in demand by raising room rates. In 2010, the average room rate (ADR) paid by a hotel guest declined by 0.1 percent.

With the supply of hotel rooms growing 2.0 percent in 2010, the 7.7-per-cent rise in demand resulted in a 5.6-per-cent increase in occupancy for the overall U.S. lodging market. This was the largest annual gain in occupancy achieved since STR began reporting data in 1988. Given the aforementioned stagnant ADR move-ment, the average revenue per available

room (RevPAR) achieved by U.S. hotels for the year grew 5.5 percent.

PKF-HR’s lodging forecasts are developed from its proprietary Hotel Horizons® econometric model. The model utilizes historical lodging data from STR1 and economic forecasts from Moody’s Analytics. Changes in real personal income and total payroll employment are the primary drivers of the forecasts.

According to estimates from Moody’s Analytics, the 2.0-percent pay-roll tax reduction passed by the U.S. Con-gress in December 2010 will be a boon to consumer spending, which in turn should increase overall domestic production and the need for companies to hire additional employees. Moody’s estimates the addi-tional income could boost consumer spending by upwards of $120 billion.

Based on the strong performance demonstrated in 2010, plus the impact of the tax legislation, the March 2011 issue of Hotel Horizons® projects that lodging demand will grow 4.0 percent in 2011, as shown in Exhibit 3-E3. This is more than four times greater than the 0.7 percent pro-jected increase in hotel supply (see expected supply growth in Exhibit 3-E5), and should result in a 3.2-percent rise in occupancy.

In 2011, hotel managers will have the opportunity to be more aggressive in raising their ADR. For the year, PKF-HR is forecasting a 3.8-percent rise in the average

price of a room. However, as PKF-HR has been projecting for some time, pricing power will not fully return until 2012 when we expect to see room rates increase 6.0 percent, as demonstrated in Exhibit 3-E4.

The net result of the 3.2-percent increase in occupancy and 3.8-percent rise in ADR is an attractive 7.1-percent growth in RevPAR in 2011. With RevPAR being driven by growth in room rates, PKF-HR is project-ing that the average U.S. hotel should enjoy a 10.9-percent increase in net operating income. This is superior to the 6.3 percent estimated growth in profits observed in 2010.

sources: pkf-hR, March 2011 hotel horizons® report, sTR.

Year Occ Δ Occ ADR Δ ADR RevPAR Δ RevPAR

2006 63.1% 0.2% $97.98 7.6% $61.85 7.9%

2007 62.8% -0.5% $104.25 6.4% $65.48 5.9%

2008 59.8% -4.8% $107.31 2.9% $64.14 -2.1%

2009 54.5% -8.9% $98.19 -8.5% $53.48 -16.6%

2010 57.5% 5.6% $98.07 -0.1% $56.43 5.5%

2011F 59.4% 3.2% $101.80 3.8% $60.46 7.1%

2012F 61.0% 2.8% $107.89 6.0% $65.87 8.9%

Exhibit 3-E4. National Forecast Summary

source: pkf-hR, March 2011 hotel horizons® report.

The arrows show the forecast direction of change over the next 4 quarters vs. the previous 4 quarters. Olive indicates above the long run average, and black indicates below.

Occupancy

Occupancy will increase to 59.4%, better thanthe previous 4 quarters’ rate of 57.5%, but below the long run average of 61.8%

Average Daily Rate

ADR growth expectations are increasing,positive 3.8% vs. the past 4 quarters’ rate of negative 0.1%, and are above the long run average of positive 2.7%

Revenue Per Available Room

RevPAR growth projections for the next 4 quarters areclimbing to 7.1% as compared to the past 4 quarters’ rate of 5.5%, and are greater than the long run average of 2.3%

Supply

Supply growth is less active, 0.7% vs. the past 4quarters’ rate of 2.0%, and under the long run average of 1.9%

Demand

Forecast demand growth is falling, 4.0% vs. thepast 4 quarters’ rate of 7.7%, but is greater thanthe long run average of 1.4%

Exhibit 3-E3. National Snapshot: Next 4 Qtrs.

1sTR data provided as per PKF agreement.



Exhibit 3-E5. National Horizon Profile

National Horizon Profile: Year Supply Growths are Expected to Surpass U.S. 1988-2010 Long Run Averages.This page showcases the Colliers PKF Hospitality Research Hotel Horizons ® forecasting universe. The map below displays the year when supply growths are expected to surpass U.S. 1988-2010 long run averages.

source: pkf-hR, March 2011 hotel horizons® report.

Albuquerque Detroit Nashville Sacramento

Anaheim Fort Lauderdale New Orleans Saint Louis

Atlanta Fort Worth New York Salt Lake City

Austin Hartford Newark San Antonio

Baltimore Houston Oahu San Diego

Boston Indianapolis Oakland San Francisco

Charlotte Jacksonville Orlando Seattle

Chicago Kansas City Philadelphia Tampa

Cincinnati Long Island Phoenix Tucson

Cleveland Los Angeles Pittsburgh Washington DC

Columbus Memphis Portland West Palm Beach

Dallas Miami Raleigh-Durham

Denver Minneapolis Richmond

2010 2011 2012 2013 2014 Beyond



As 2011 continues to unfold, the economy, the overall investment envi-ronment, and the world are even more uncertain than when RERC, Deloitte, and RCA began planning this report. While we have survived the deepest and most destabilizing recession of our generation, additional challenges are feeding the uncertainty within the investment environment.

The economy, while growing, remains fragile. Most experts agree that spending in the form of various stimu-lus measures was necessary in the depths of the recession, but as a result, our national debt has risen to a record high of nearly $14.3 trillion. State and local governments are facing similar circumstances, and to balance their budgets, they are being forced to reduce services and staff and/or raise taxes. This imbalance is beginning to be felt on a consumer level as well, and although spending has increased during the past few months, consumers are starting to feel the pain of higher food and fuel prices. Despite the Federal Reserve’s insistence that such slight inflation is only “transitory,” the European Central Bank has started to raise interest rates based on commodity price increases. Meanwhile, the credit ratings of some of Europe’s economies are being further downgraded (the S&P cut its ratings outlook for the U.S. economy to “nega-tive”), unrest continues in the Middle East, and earthquakes and aftershocks persist in Japan, further increasing the risk from that nation’s nuclear disaster and endangering the world’s third larg-est economy.

This economic uncertainty leaves us with no easy answers, no all-encompassing solutions, and no sure-fire examples that we can follow to help

speed the recovery along. But for inves-tors seeking less volatility, more stabil-ity, and increased transparency, and those who want a reasonable return on their investment but are willing to sac-rifice some return for less risk, commer-cial real estate potentially offers a sense of balance and proportion not available with other investment alternatives.

As noted throughout our report, we have already seen an increase in investor appetite for commercial real estate as an asset class. In a flight to quality, investors have focused their efforts on acquiring properties in the nation’s most visible and liquid mar-kets. This was made easier as the avail-ability of credit increased in 2010, and more lender types came back to the arena as the capital market contin-ued to normalize. In major markets in particular, institutional and securi-tized lenders’ readiness to provide new acquisition financing on performing assets has supported the shift in inves-tor activity away from the agency and

private buyers that dominated activity in 2009 and early 2010.

The financing environment appears to be healthier, as more stable economic and credit market condi-tions increase. However, deteriorating mortgage performance has continued, although this distress may have been heavily intermediated, left unresolved, or continues to reside on bank balance sheets. How we manage to draw down these balances without undermin-ing price stability, when some of the most aggressively underwritten loans have yet to mature, remains a concern throughout 2011 and beyond.

As such, transaction volume is expected to continue to increase throughout 2011, but job growth—the harbinger of commercial real estate usage—is not expected to increase greatly. Focusing on the individual property markets, as well as employ-ment and property demand in those markets and the vacancy/availability

4 | OUTLOOK FOR 2011 AND BEYOND

uncertainty and the need for balance



rates, will help to minimize investor risk. Being mindful of rental rates, as well as capitalization and yield rates, will help to maximize investor return.

pRopERty tRAnSACtion outLooK

As noted, the world does not stand still, and the full-throttle end to 2010 in commercial real estate invest-ment—with the strongest quarter for investment volume in 3 years—presents a challenge for 2011 that is both inspir-

ing and formidable. Although many of the investment currents that motivated capital in 2010 are still running strong, there are certainly other vectors at play, both newly emerged and longstand-ing, that could destabilize the forward momentum in the market.

That said, there is compelling evidence that the recovery that took firm hold in the second half of 2010 may not only be sustained but could potentially expand in 2011. With year-over-year sales in the seasonally slower first quarter 2011 already up at least 50 percent in most property sectors (according to RCA data), solid invest-ment growth potentially awaits.

What could challenge this posi-tive assessment? Capital has been nar-rowly focused during the recovery, and

investment may need to widen out to create a firmer footing for growth. In virtually every property sector, inves-tors leaned heavily in 2010 toward core/stabilized assets in the major markets and metropolitan regions—New York City, Washington, D.C., Bos-ton, Chicago, Los Angeles, and San Francisco. Indeed, the Moody’s/REAL CPPI showed that pricing in those six markets has begun to recover, reflect-ing the concentration of capital on high-quality stabilized properties there, while values across the nation as a whole have moved sideways.

There were, of course, other markets—such as Seattle, Dallas, and Houston—that also attracted invest-ment capital inflows to high-quality properties. Across most of the U.S., the market struggled to find value in value-add assets in less than excep-tional circumstances. Thus, one of the hurdles facing the market’s full recov-ery is investor willingness to stretch beyond the cluster mentality to lesser primary and secondary markets and properties in advance of improving operating conditions. There has been some early activity in that regard, mostly in the apartment sector but also in large retail portfolio transactions, most notably Blackstone’s blockbuster $9.4 billion acquisition of Centro Prop-erties’ vast U.S. portfolio. Another encouraging sign of improving capi-tal and property markets early in 2011

is the announcement of a merger between industrial REIT giants AMB Property and ProLogis. This consolida-tion of relative equals—although Pro-Logis is larger, AMB is on firmer finan-cial ground—suggests further merger and acquisition activity may surface as the year continues. So far, there has also been one large merger between health-care REITs Ventas and Nation-wide Health Properties. However, some analysts have suggested that the rapidly improving apartment sector is ripe for buyouts.

Such consolidation may differ in one key respect from the wave of activity (notably privatizations) that took place during the last mid-decade. Then, underperforming REITs were often rewarded as investors bulked up on assets. Now, in line with the recorded preference for high-quality properties, there may be acquisitions involving well-performing companies with high-quality properties as the REIT market cycles to the next coordi-nate on its growth curve.

Listed companies, after all, were extremely successful capital raisers—both debt and equity—in 2009 and 2010, and they appear to be following a similar course in 2011. However, the success achieved by these companies in the acquisition marketplace (they accounted for 18 percent of all commer-cial property investment throughout 2010, including one-third of the mar-ket in third quarter) may be difficult to replicate. Equity funds and institutions have ramped up their activity, and the emergence of CMBS 2.0 is opening up the debt market for private investors, who often faced particular difficulty in obtaining financing over the past 3 years. CMBS lending could also ben-efit secondary and tertiary markets in 2011, a fact that could serve to ease the intense pricing pressure that has come to bear in the top tier.

Despite the encouraging and energetic return of CMBS, by mid-March



2011, concerns were being voiced about deteriorating underwriting standards. (Actually, the raising of such questions at this stage of the renewal of CMBS could be seen as a positive signal that the market is being watchful and is not keen to repeat recent mistakes.) In addi-tion, the perceived loosening of stand-ards at this point must also be viewed in the context of the exceptionally con-servative underwriting that has pre-vailed for so-called CMBS 2.0. A recent RCA analysis showed that average loan-to-value ratios, for example, were 59 percent for 2010 CMBS loans.

Beyond fears of weak under-writing, there are, of course, risks to the CMBS revival, most notably in the spreads that determine profitability for issuers. These have already shown high volatility in the wake of the Japan cri-sis, and bear careful watching.

Interest rates are certainly worth watching in 2011; inflation concerns, high federal and state debt levels, and global trade volatility could all contrib-ute to sudden movements in the risk-free rate that could impact mortgage rates as well as unsecured debt. How-ever, the spreads between 10-year U.S. Treasurys and real estate-related debt have so far provided a cushion that not only protects against some volatility, but also showcases real estate to good advantage against other asset classes.

One capital source for both equity and debt that also bears watch-ing in 2011, but of a less cautionary sort, is cross-border capital. International banks, particularly Chinese institu-tions, have shown themselves more willing to participate as mortgage lenders at high volumes than as equity buyers on the property side. Witness the $800 million refinancing by Bank of China for 245 Park Avenue in Man-hattan for Brookfield Properties, which was far larger than the sum total of acquisitions by Chinese buyers in the U.S. in 2010. Australian investors, by contrast, may emerge again as major

acquirers of U.S. properties in 2011 on the back of a surging Australian cur-rency. The director of Singapore’s GIC fund has publicly proclaimed his view that the U.S. property market is under-valued, and some investors may find themselves shifting capital intended for Japan to the U.S., although other developed economies will also com-pete for such inflows.

As much as it offers opportuni-ties to investors, the mountain of dis-tressed property continues to pose a major challenge. And beyond the $180 billion in assets already in trouble through default, foreclosure, or bank-ruptcy, the much larger mountain of maturing loans stretching ahead into the new decade also is cause for con-cern. At present, though, banks appear to be moving judiciously to unwind bad debt by putting assets back on the market at a measured pace. For their part, investors have come to terms with the higher recovery rates that lenders have been demanding. With property values creeping up and absent a huge asset dump that would depress prices, it is possible that the distress situation will continue to be resolved without causing further major disruption to the capital markets.

The overwhelmingly positive increases in both equity and debt capi-tal availability, both on an absolute basis and in the nature and quality of sources, could bode well for invest-ment activity in 2011. At the same time, the slow recovery of fundamen-tals, as described in Chapter 3 of this report, reflects a distressed-property market that may be in better balance with demand than at any time this cycle. There are a variety of weights on the market—inflation and interest rate risk, sovereign and domestic debt concerns, shifting global alliances and political rancor at home—that pose potential roadblocks to continued recovery. However, investors are, per-haps more than at any time in recent memory, making informed judgments

that take these factors into account as they move ahead. As long as this infor-mation-driven, experience-tested bal-ancing of action and restraint prevails among decision-makers, the invest-ment market in 2011 will unfold in a rewarding landscape.

REAL EStAtE VALuE outLooK

Given that it was the unbridled capital flow leading to the credit crisis that melted the global markets (and with it, the commercial real estate market), the level of robustness and bravado in which capital is re-engag-ing in the industry’s recovery in 2010 and 2011 is truly surprising.

The commercial real estate recovery was led by the multi-family sector, which benefited greatly from favorable financing offered via GSEs, driving capitalization rates lower and values toward (and even above) the peak pricing witnessed in mid-2007. In addition, investors’ flight-to-quality contributed to the significant recovery of core assets (i.e., top-tier commercial real estate assets located in first-tier markets), where the transaction mar-ket was surprisingly competitive, driv-ing projected rates of return to levels witnessed in mid-2007. However, as the rates of return for these core deals were falling, the prices were some-what tempered by much more realistic cash flow assumptions, as opposed to the materially optimistic assumptions laced into the underlying pricing dur-ing peak-pricing periods. Unfortu-nately, the market is made up of only a limited number of multi-family and core-style investments, which is why investors are paying steep prices for costal, core properties and are begin-ning to move out on the risk spectrum. There is still the flight-to-quality, focus on current returns, and risk aversion; however, the undercurrent that could drive a full-fledged industry recovery may be much stronger than we can appreciate from the surface.



As documented throughout this report, the substantial increase in transaction volume in 2010 (property sales totaled $134.1 billion, more than double 2009 sales, according to RCA) suggests that the recovery is robust, well underway, and disconcerting to some, although it is important to note that 2010 investment activity was only 29 percent of activity at the market’s peak in 2007. As 2011 unfolds, RERC expects commercial real estate values to continue to increase at a measured pace throughout the year, with these insights tied closely to capital market flows and the relatively competitive transaction market.

In addition, while rates of return for commercial real estate fell through-out 2010, and RERC expects this trend to continue into 2011, it is important to note that RERC does not see a discon-nect between real estate (declining rates) and the capital markets (increas-ing rates). In fact, it is RERC’s opinion that the two markets are more con-nected today than ever before, and the risk associated with rising inter-est rates (i.e., 10-year Treasury) was already built into the rates of return for real estate, whereby spreads through-out much of 2010 were near all-time highs, as demonstrated in Exhibit 4-1.

If there is one message from the market today, it is that commercial real estate investment appeal going forward will continue to be the “assu-rity” of income (dividend) component versus the “speculative” value appre-ciation element—a back-to-basics approach as to why we have, for gen-erations, invested in commercial real estate. Further consideration of the return-to-basic investment strategies can be found by examining the his-torical NCREIF capital (value) Property Index. NCRIEF, in combination with RERC’s value projection, indicates that value “appreciation” would have been almost non-existent over the 33-year reporting history of NCREIF, if one deducted the capital expenditures

spent to maintain the value of the assets during this period of time.

Going forward and as presented in the base case scenario provided in

Exhibit 4-2, RERC forecasts aggregate NCREIF values to increase by approx-imately 6 percent throughout 2011, which would exhibit a cumulative value increase from trough of approximately

-200

-100

0

100

200

300

400

500

600

700

RERC Going-In Cap Rate vs. 10 Year Treasurys

4Q 2010

4Q 2009

4Q 2008

4Q 2007

4Q 2006

4Q 2005

4Q 2004

4Q 2003

4Q 2002

4Q 2001

4Q 2000

4Q 1999

4Q 1998

4Q 1997

4Q 1996

4Q 1995

4Q 1994

4Q 1993

4Q 1992

4Q 1991

4Q 1990

Spre

ad (B

asis

Poi

nts)

Exhibit 4-1. Spread Between RERC’s Going-In Cap Rates and 10-Year Treasurys

sources: federal Reserve, RERc, 4Q, 2010.

-35

-30

-25

-20

-15

-10

-5

0

-4.8

2.5

9.8

17.1

24.5

31.8

39.1

46.4

Downside

Upside

Base

90s Downturn(1Q90 to 4Q95)

Year 6Year 5

Year 4Year 3

Year 2Year 1

% D

ecre

ase

O�

Pea

k

% Increase O

� Trough

Exhibit 4-2. Commercial Real Estate Value Outlook

note: shaded area reflects RERc’s outlook for the base, upside, and Downside scenarios for 1Q 2011 through 1Q 2014. sources: ncREIf, RERc, 4Q 2010.



14 percent (note that trough was reached in first quarter 2010). In addi-tion, RERC’s projection is bracketed by upside and downside scenarios that reflect a 1-year value increase between 3 percent and 10 percent, with a signifi-cantly greater probability of achiev-ing the upside scenario as opposed to the downside scenario. If you add on an income return of 6.5 percent, total returns range from 9.5 percent to 16.5 percent, with a likely outcome of 12.5 percent on an unleveraged basis for 2011. It is important to note that RERC’s estimates are unleveraged, and the use of leverage (even prudent levels exhib-ited by core funds) has a compounding impact on the value increase going for-ward. Thus, if you add positive lever-age onto these estimates, you can see that commercial real estate offers very attractive risk-adjusted returns given a core strategy. Lastly, it is important to note that RERC’s presentation is an aggregate view for the entire commer-cial real estate industry, and is not a projection specific to tiers of funds that exist throughout the industry.

in SummARy

As we look to the remainder of 2011 and beyond, we anticipate that despite the many difficulties still ahead for the economy, capital mar-kets, and commercial real estate indus-try, commercial real estate, as an asset class, will continue to receive favorable marks from those investors looking for a less volatile, more transparent dividend component to their portfolio. As the year progresses, investors may observe that:

� Barring any additional unexpected shocks to the economy, economic growth may continue at a moder-ate pace.

� Although job growth could improve slightly in 2011, unem-ployment is likely to remain rela-tively high.

� According to many experts and assuming growth continues as expected, the Federal Reserve could begin increasing interest rates slightly in late 2011.

� Lenders will likely continue to favor workouts over foreclosures as long as possible, although inevita-bly, a significant number of matur-ing loans will be foreclosed upon.

� Although new regulations will affect investment, lending may continue to expand, and addi-tional capital, including CMBS, should be available to investors in commercial real estate.

� The relative stability of the U.S. economy and of commercial real estate could continue to attract for-eign investment in this asset class.

� Watch for more mergers and acqui-sitions within the industry in 2011.

� Commercial real estate investment appeal could continue to shift to income versus value appreciation, making good property manage-ment more important to achieving reliable performance.

� Look for the potential of a half-speed recovery in the office mar-ket during 2011 and 2012. New space completions may be at a minimum, and the slight absorp-tion anticipated is expected to potentially drive vacancy down to 17.0 percent in 2011 and 15.9 percent in 2012. Asking rental rates are likely to rise slowly, to 0.4 percent in 2011 and 1.4 percent in 2012 for Class A space.

� There is potential for a gradual recovery in leasing market funda-mentals for the industrial sector in 2011 and a more robust recovery in 2012, with absorption expected to drop below 10 percent in 2011 and in the low 9-percent range in

2012. The expected asking rental rate could increase only gradually, by 0.6 percent in 2011 and 1.0 per-cent in 2012. With rising fuel costs, logistics companies and shippers could move toward smaller distri-bution centers to maximize fuel-efficient rail and minimize truck-ing costs.

� Retail sales are likely to ramp up gradually in 2011 and 2012 due to pent-up demand by consumers unless oil/gasoline prices increase or the unemployment rate remains high. However, due to oversupply, retail property vacancy and rents may remain generally flat in 2011, although leasing fundamentals are beginning to improve and absorp-tion is turning positive and should continue to improve in 2011.

� The overall outlook for the apart-ment market remains bright, but not without risk. Continued high unemployment levels and increases in rental rates, coupled with low home prices and interest rates, will keep renter demand in check. Vacancy is expected to continue to decline throughout 2011 and hit bottom at 4.6 percent in 2012 and 2013, but could begin to increase again after that. Effective rental growth is expected to increase in 2011, but to begin declining slightly in 2012 and beyond.

� Lodging demand is expected to grow, and may result in a 3.2-per-cent rise in hotel occupancy in 2011 and an increase of 2.8 percent in 2012. The average daily price of a room is expected to potentially increase 3.8 percent in 2011 and 6.0 percent in 2012, with a 7.1-percent growth in revenue per available room in 2011 and an 8.9-percent growth in revenue in 2012.



SPONSORING FIRM

Leadership

Kenneth p. Riggs, Jr.CFA, CRE, FRiCS, mAi, CCimPresident & CEO312.587.1900

Jules h. marling, iii, CRE, FRiCS, mAiManaging Director312.587.0351

Del h. Kendall, CRE, mAiManaging Director713.661.8880

Donald A. burns, CRE, mAiManaging Director770.623.4922

gregory p. Kendall, CRE, mAiManaging Director251.648.2959

Kent D. Steele, CRE, FRiCS, mAiManaging Director630.430.3865

William L. Corbin, mAiManaging Director310.734.1401

Steven W. thompson, mAiManaging Director713.661.8880

bates mcKee, CRE, mAiManaging Director206.343.8909

John C. Schalka, CRE, mAiManaging Director206.343.8909

Real Estate Research Corporation980 North Michigan AvenueSuite 1400Chicago, I L 60611312.587.1800www.rerc.com


Real Estate Research Corporation (RERC) is one of the longest-serving and most well-recognized national firms devoted to independent research, valuation, consulting, and fiduciary and advisory services. RERC’s clients include institutional and individual investors, development and investment firms, and government agencies at all levels. Corporations, pension funds, and institutions seeking to diversify investment portfo-lios frequently call on RERC to provide fiduciary, valuation, or consulting services.

Independent Fiduciary Services - As a registered investment adviser with the Securi-ties and Exchange Commission (SEC) and with its 80 years of research, valuation, and consulting experience, RERC is ideally suited to provide a variety of real estate-related services for institutions that manage real estate assets for others:

� Independent fiduciary services for a leading investment manager of a 150-prop-erty portfolio with gross asset values of about $11.5 billion.

� Fairness opinions on dozens of major acquisitions totaling over $1 billion. � Valuation consultant for the second largest pension fund in the U.S.

Valuation and Consulting Services - As one of its core businesses, RERC performs independent property valuations and analyses founded in thoroughly researched market fundamentals. RERC’s valuation and consulting services feature:

� Valuation and consulting expertise with office buildings, industrial properties, retail properties, apartments, hotels and hospitality-related property, and multi-use properties in all major U.S. markets.

� Appraisal management services including assisting with third-party appraiser selection, developing approved vendor lists, and coordinating appraisal assign-ments and rotations.

Management and Valuation Information Systems - RERC’s management informa-tion system (MIS) and valuation management system (VMS) services offer completely customizable technology solutions that offer clients real-time data and reporting to help manage their portfolios, track and store important files, and maintain informa-tion security. RERC’s web-based systems manage a variety of equity portfolios valued in excess of $50 billion.

Research & Publications

� The RERC DataCenter™ is a proprietary database that provides current and his-torical survey-based and transaction-based investment criteria, property volume and pricing averages, and library and querying functions.

� The RERC Real Estate Report is considered “the National Real Estate Author-ity” for investment returns and analysis, and has served the industry for nearly 40 years. The report is best known for its survey-based capitalization and pre-tax yield rates and expectations for 10 major property types on an institutional, regional, and metro basis.



SPONSORING FIRM

Contacts

Robert o’brienPartnerU.S. Real Estate Services LeaderDeloitte & Touche [email protected]

Jim berryPartnerReal Estate ServicesDeloitte & Touche [email protected]

matt KimmelPrincipalReal Estate ServicesDeloitte Financial Advisory Services [email protected]

guy LangfordPrincipalDistressed Debt & Assets LeaderReal Estate ServicesDeloitte & Touche [email protected]

Ken meyerPrincipalReal Estate ServicesDeloitte Consulting [email protected]

Larry Varellas Partner Real Estate ServicesDeloitte Tax LLP [email protected]

To learn more, visit:www.deloitte.com/us/realestate

Deloitte

In today’s competitive environment, it is critical to stay ahead of industry trends and respond dynamically to market opportunities.

As a recognized leader in providing audit, tax, consulting and financial advisory services to the real estate industry, Deloitte’s clients include top REITs, real estate buyers, property owners and managers, lenders, brokerage firms, investment managers, pension fund managers, and leading homebuilding and engineering & construction companies.

Our multi-disciplinary approach allows us to provide regional, national and global services to our clients. Our real estate practice is recognized for bringing together teams with diverse experience and knowledge to provide customized solutions for all clients. Deloitte’s national Real Estate services industry sector comprises over 1,200 professionals supporting real estate clients.

Key Real Estate Advisory services include: � Analysis of Distressed Real Estate, Debt and Equity � Real Estate Due Diligence � Real Estate Corporate Finance* � Real Estate Valuations and Appraisals � Regulatory Capital Markets � Lease Advisory � Real Estate Market Studies � Fairness Opinions

Deloitte’s Real Estate practice serves:

Sources: NAREIT, Retail Traffic, NREI, P&I, Builder on Line, ENR

*Investment banking products and services within the united states are offered exclusively through Deloitte corporate finance LLc, member fInRa, and a wholly owned subsidiary of Deloitte financial advisory services LLp. copyright ©2011 Deloitte Development LLc. all rights reserved.

� 7 of the top 10 REITs � 6 of the top 10 retail REITs � 6 of the top 10 apartment REITs � 7 of the top 10 equity REITs � 6 of the top 10 mortgage REITS � 8 of the top 10 retail RE managers � 8 of the top 10 retail RE owners � 8 of the top 10 office owners

� 9 of the top 10 RE investment managers

� 6 of the top 10 industrial owners � 8 of the top 10 managers of defined

benefits assets � 5 out of 10 top homebuilders � 7 of the top 10 contractors



SPONSORING FIRM

Real Capital Analytics

Since their first analyses appeared in 2001, Real Capital Analytics (RCA) has been commended for the quality of their property transactions database and the caliber of their capital trends reports supporting more informed real estate investment decision-making. RCA was presented with the International Real Estate Society (IRES) Corporate Excellence Award for 2009 at the European Real Estate Society Annual Conference.

RCA delivers the most current and comprehensive look at the global commercial real estate investment market. Instead of limiting research to a specific set of geo-graphic areas or markets, RCA covers the entire world, collecting CRE transaction data in any location globally. RCA is able to report on far more transactions than any other provider by focusing on only the information that matters most.

Information & Services

� Transactions. Current, classified and comprehensive property and transac-tion details, including pricing, buyer, seller and property specifics.

� Trends. Exclusive trend analysis of volume, prices and capital flows from industry-leading researchers and analysts.

� Tools. In-depth local and national market reports, investor profiles, powerful search tools and the most complete database of commercial real estate trans-actions and troubled assets.

Publications

� Global Capital Trends: These international reports cover all markets globally and all major property types: office, retail, industrial, apartment, hotel and developable land. All international trend analysis is based entirely on RCA’s proprietary commercial property sales database.

� US Capital Trends: RCA’s weekly online reports identify US trends, interpret recent data and highlight key aspects of the capital environment on a local and national basis. Interactive features help users sort, map or compare aggregate data easily.

� Market Trends & Trades: Users interested in reviewing real estate invest-ments in particular markets can download in-depth regional data reports, each with recent property trades; pricing trends; average cap rates, investor composition; largest and most expensive deals; most active buyers, sellers, brokers and lenders.

� Troubled Assets Radar: From a vast array of sources, including their own transaction database, title records and CMBS filings, RCA’s TAR reports include an analysis of distressed real estate by market, property type and key players. Each report comes with a detailed list of recently reported troubled commercial properties.

Contacts

Joseph A. mannina, Jr.Executive Vice [email protected]

peter SlatinAssociate Publisher/Editorial Director [email protected]

Real Capital Analytics139 Fifth AvenueNew York, NY 10010T: 212.387.7103F: [email protected]

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Documents

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