Sacramento Real Estate Office Market Report 2Q 2011

research & forecast reportSacramento region

www.colliers.com/sacramento

overall performance during 2nd Quarter 2011 in the sacramento office market was flat. the following is a summary of the market during the quarter.

• Vacancy declined by only 10 basis points, ending the three-month period at 17.6%.

• total leasing activity remained active with almost 1.2 million sf of available space being occupied during the quarter; however, most of that was offset by consolidation and closures that eventually yielded only 48,873 square feet of positive net absorption for the quarter.

• though gross absorption during 2nd Quarter remained virtually the same as reported in 1st Quarter, the change in net absorption from negative 322,920 square feet to positive 48,873 square feet from first to second quarter is hopefully a sign of a slowing trend in consolidations and closures in sacramento’s office market.

• tenants still hold the upper hand in lease negotiations, as concessions still continue to be a strong tenant bargaining tool to getting leases done.

• still see a continued flight up the class chain as lease rates continue to favor tenants.

• office sales continue to get consummated, but on select assets and mostly at favorable buyer prices.

• Lease rates continue to flutter, and will continue to favor tenants until stable employment sources are identified in the region and the state government reconciles california’s budget woes.

• there remains only 280,000 square feet of new deliverable office space in the market as of June 30, which should provide some much needed relief to the vacancy rate over the next 12-24 months.

2nd Qtr2011

Projected 3rd Qtr 2011*

VacancY

net aBSorPtion

deliVerieS

conStruction

leaSe rateS

sacramento office Market highlights

2nd Quarter 2011 - office

*3rd Qtr over 2nd Qtr change

Market indicators

KeY office metricS - 2Q 2011

Vacancy 17.6%net absorption 48,873 sf

deliveries 0 sf

construction 280,000 sf

average direct rate $21.09 sf

P. 2 | collierS international Sacramento

reSearch & forecaSt rePort | Q2 2011 | office | sacraMento

though net absorption did register positive in sacramento’s office market for 2nd Quarter activity, let us not pop the bubbly just yet. this product sector is clearly fluttering along the bottom of the recovery curve, and as such will post both positive and negative results from quarter to quarter.

the positive results reported in 2nd Quarter are primarily the result of continued strong leasing activity in class a product, posting a fourth consecutive quarter of positive results. in fact, positive net absorption of class a space in sacramento has totaled more than 322,000 square feet thus far in 2011, a stark contrast from the negative net absorption recorded in the product class during 2010 of 110,686 square feet.

Leasing activities in both the class B and class c sectors during 2nd quarter were both negative, totaling just over 72,200 square feet of net negative absorption. these “class” results are fairly consistent with a service line that continues to lag behind the other major product sectors in recovery activity. Market sentiment remains consistent in that this sector is likely to be the last to recover.

as indicated in our last quarterly report, the anticipated slower recovery period is in part from the uncertainty surrounding the government influence present in the sacramento economy coupled with california’s budget woes, as well as the lack of definitive sources currently identified for future employment growth. employment growth in the six-county sacramento region has still not turned the “positive”

corner and continues to fluctuate, but has generally improved over the last 12 months.

as the graph to the left illustrates, year-over-year employment growth in the six-county sacramento region shows a decline from May 2010 to May 2011 of 1.60%, but this is an improvement from the 2.56% decline in the regional employment level reported from May 2009 to May 2010.

it is important to note that gross absorption during 2nd Quarter 2011 was almost 1.2 million square feet, evidence that the market is still demanding office space. though some of this gross leasing is attributable to “class” flight activity, much is the result of new lease requirements. even more encouraging is that consolidation and closure activity in the 2nd Quarter declined from 1st Quarter levels, hopefully a sign of the market bottoming. We believe in general that tenants are holding steady, but that consolidations and departures are still going to be part of the sacramento office landscape for awhile.

though recent construction trends continue to indicate slower delivery activity, it will take some time for sacramento office users to absorb the current excess available space. Until that excess space is absorbed, and lease rates achieve levels consistent with replacement costs, no growth in the office market will occur and the market will continue to bounce along the bottom of the recovery curve, resulting in a much slower expansionary period than experienced from the 2001 recession.

the office recovery

Sacramento MSA

2.00%

Sacramento MSAEmployment

0 00%

1.00%

%

Chan

ge

-1.54%-2 16%

-1.60%-1.00%

0.00%

Year

% C

-2.56%-2.19%

-2.63%

2.16%

-2.78%-3.00%

-2.00%

-ove

r-Y

-5.00%

-4.00%

Year

May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May

20112010

source: Bureau of Labor statistics


collierS international Sacramento | P. 3

several key leasing events occurring thus far in 2011 include insWeb corporation vacating almost 55,000 square feet in rancho cordova, first northern Bank moving out of over 35,000 square feet in rancho cordova as well, and sacramento’s sheriff department leaving 25,075 square feet near Mather airport.

on the bright side, several key absorption activities have been consummated thus far in 2011 including nationwide insurance moving into 99,555 square feet and alta california regional center moving into 77,000 square feet in adjacent buildings located in the point West area of sacramento, and the office of technology services occupying over 77,500 square feet in rancho cordova. numerous leases were inked in-house during the quarter ranging in size up to almost 12,000 square feet, and at lease periods extending up to 5 years.

there was strong leasing activity during the 2nd Quarter related to the medical field, including superior Vision service inking a 25,000 square foot deal in rancho cordova; expect that trend to continue as the medical industry in

sacramento continues to grow.

sale activity for sacramento office space continues to be active, characterized both by opportunistic buyers seeking distressed real estate and by tenants with capital seeking opportunities for acquiring space given the soft pricing market that still exists. in fact, several sale transactions were completed in-house during the quarter.

the table at the bottom of this page is a summary of some of the larger office sale transactions completed in sacramento during 2nd Quarter 2011.

cap rates on sacramento office sales continue to stay above pre-recession levels, but have shown some strengthening thus far in 2011. as the graph to the right indicates, the cap rate on sales occurring during 2008 bottomed at 6.3%, increased the next two years up to 8.8% as a result of the downturn the sacramento office market has been experiencing, and has since declined back to 8.3% as of May 2011. Bank reo’s and foreclosure sales have put upward pressure on the average cap rate during this 30-month period, and

activity round-Up

sacraMento Larger office saLes - 2nd QUarter 2011

Property rentable Buildable area Price Price Per Sf Buyer Seller Submarket comments

parkshore plaza 269,853 $46.3 million $171.57 commonWealth reit JpMorgan chase folsom portfolio of 4

properties

river plaza corporate 75,885 $6.5 million $85.66 ca farm Bureau sakura davenport West sacramento 6 propertiesreo sale

1851 heritage Lane 56,200 $4.3 million $76.51 Balboa funds Marin county retirement point West 42% vacant at

sale

7501 foothills Boulevard 465,000 $53 million $113.98 telefunken nec electronics roseville/rocklin included business operations

9825 goethe road 45,500 $5.75 million $126.37 Victor J. rauch the evergreen company hwy 50 100% leased

8% cap

continue to put pressure on area cap rates.

however, as investor interest trickles back to sacramento as a result of escalating market pricing in the Bay area, more market deals are getting done which is having positive implications on cap rates.

Sacramento Office MarketSacramento Office MarketCap Rate Analysis

Trailing 12-Month Cap Rate

7.60%8.80%

8 00%

10.00%Cap Rate

g p

7.60%

6.30%

8.30%6.00%

8.00%

2.00%

4.00%

0.00%2010 20112006 2007 2008 2009

Dec May

Source: Real Capital Analytics

y

...as investor interest trickles back to sacramento as a result of escalating market pricing in the Bay area, more market deals are getting done, which is having positive implications on cap rates...

...sale transactions for sacramento office space continue...



overall office vacancy in the sacramento region marginally declined during 2nd Quarter 2011, dropping from 17.7% down to 17.6% during the three-month period. additionally, the current vacancy rate is 80 basis points higher than the 2nd Quarter 2010 level of 16.8%.

Metro wide, the class c sub-sector continues to hold the lowest vacancy level at 14.5%, followed by class B at 18.4%, and then class a at 19.3%. Much of this comparative performance is the result of there being no new class c inventory delivered to the market since 1st Quarter 2007, while class a deliveries since that time have totaled more than 3.0 million square feet and class B product completions have reached almost 2.4 million square feet.

Vacancy analysis

KeY VacancY metricS - 2Q 2011

current Quarter 17.6%

previous Quarter 17.7%

previous Year 16.8%

VacancY comPariSon - 2Q 2011

downtown SuBurBan

class a 9.7% 24.5%

class B 12.0% 19.4%

class c 10.4% 15.2%

as of June 30 2011 work continued on three office properties in the sacramento region as follows:

• a 72,000 square-foot, four-story, class B office building located in ranch cordova, that will be the future home to the administrative personnel of the folsom cordova Unified school district, including the superintendent.

• a 53,000 square-foot class a spec building being developed by Jc Morehouse investments LLc at 400 sunrise ave. in the roseville/rocklin area submarket. this project has been put on hold indefinitely and has gone back to the bank.

• a 155,000 square-foot class a build-to-suit facility for the california state Lottery commission built at the Lottery campus north of richards Blvd. in the downtown area, and recently completed in July 2011.

as we reported in our 1st Quarter report, the current development pipeline remains extremely low, and is unlikely to ramp back up until leasing activity begins to outpace consolidations and departures, and lease rates climb back towards replacement costs. it could take several years before measurable progress in leasing and lease rates gives way to new speculative construction, creating a much needed breather for sacramento’s office market to move forward along the recovery curve.

construction summary

new 155,000 sf ca state Lottery hQ building recently completed in July 2011.

net absorption analysis across the three classes paints a very supportive picture of “class” flight activity. since the initial onset of recessionary symptoms in late 2007, class c product in sacramento’s office market has experienced 1.3 million square feet of negative net absorption, class B has experienced 131,477 square feet of positive net absorption, and class a inventory has recorded almost 612,000 square feet of positive net absorption. as rates continue to remain tenant-friendly, expect these flight trends to yield similar results.

Vacancy remains much lower across all product classes in the downtown market compared to the suburban vacancy rate.



performance across the various office submarkets throughout the sacramento region remained stable during 2nd Quarter 2011, with most classes in most submarkets experiencing flat absorption and minor changes in vacancy. there were, however, some very notable movements that are worth identifying, and are summarized in the tables to the right on this page.

submarkets: the have’s and have not’s

Strong aBSorPtion - 2Q 2011

SuBmarKet claSS aBSorPtion

point West class a 91,577 sf

roseville/ rocklin class B 38,722 sf

downtown class a 31,856 sf

roseville/ rocklin class a 31,067 sf

Midtown class B 27,351 sf

noteable submarket performace

weaK aBSorPtion - 2Q 2011

SuBmarKet claSS aBSorPtion

highway 50 class a (59,914 sf)

downtown class B (35,916 sf)

Midtown class c (32,018 sf)

downtown class c (30,863 sf)

south sacramento class B (27,965 sf)

the direct average asking lease rate (annualized) for class a office space was $25.12 per-square-foot as of June 30, 2011, down from $25.41 reported at the end of 4th Quarter 2010, and from the $26.09 recorded one year earlier. class B rents experienced similar declines, with the 2nd Quarter 2011 rate reported at $20.80 per-square-foot, down from $21.35 reported at the end of 4th Quarter 2010, and from the $21.91 recorded one year earlier. class c levels mirror both a and B results, with the 2nd Quarter 2011 rate reported at $16.53 per-square-foot, down from $16.92 reported at the end of 4th Quarter, and from the $17.28 recorded one year earlier.

as noted in our previous reports, asking rents for office space in the sacramento region now stand at similar levels recorded in 2004 and 2005. during the quarter we have seen continued upward pressure on both tenant allowances and free rent, as well as lease recasting.

We do believe that rents in both the downtown and suburban markets have essentially bottomed, but there may be some additional minor fluctuations in these rate levels before consistent improvement is seen.

Lease rate trends

aVg. direct leaSe rateS - 2Q 2011

Q2 2010 Q2 2011

class a $26.09 $25.12

class B $21.91 $20.80

class c $17.28 $16.53

...rents in both the downtown and suburban markets have essentially bottomed...



expect office vacancy, absorption and lease rates to continue fluctuating over the next 12 months, posting minor changes from quarter to quarter. keep a particular eye on the individual “class” vacancy rates, as fluctuations are likely to continue as a result of tenant movement between the classes.

With the construction pipeline virtually non-existent, time should begin to slowly heal the vacancy wounds. the downtown submarket will remain the strongest in the sacramento region, as many of the suburban markets will continue to face local challenges and high vacancy rates. as reported in our 1st Quarter 2011 report, it is unlikely that the market will be introduced to any new substantial speculative development over the next 12 months. the area does have a pulse regarding new deal flow, with some submarkets showing good improvement.

areas such as point West and roseville/rocklin continued to draw strong tenant interest during 2nd Quarter 2011, and we expect this trend to continue as users in point West enjoy close proximity to downtown without the downtown price tag, and roseville/rocklin tenants continue to occupy excellent facilities at affordable rates. tenants are still driving deals in sacramento, as landlords will continue to need concessions to make deals happen. in fact, we believe the sacramento suburban office market will continue to be a tenant-driven transaction environment for at least the next 18-24 months. We have seen some longer term leases being completed in the market, and expect that trend to continue.

With respect to the office investment market, well, “cash is king”, and buyers with cash will continue to seek out acquisition opportunities priced right from sellers just seeking to retire the debt on their assets. there is definitely more capital available in the marketplace today than 12 months ago, and there are buyers in the market seeking to close deals in sacramento. this interest is in part due to the attractive pricing that currently exists in sacramento (below replacement cost), and is also in part due to substantially high pricing excluding investors in other markets close to sacramento such as in the Bay area. though interest in sacramento office real estate does seem to be developing some momentum, it will still be a buyer’s market over at least the next 12-18 months.

Looking ahead

...it is unlikely that the market will be introduced to any new substantial speculative development over the next 12 months...

...areas such as natomas, roseville/ rocklin, and rancho cordova/ highway 50 continued to draw strong tenant interest...

...there is definitely more capital in the marketplace today than 12 months ago...



EyE on thE MarkEtRecent Deals - Select 2011 Office Leases

Building Submarket Sf transacted tenant lease type

2251 harvard street point West 99,555 nationwide insurance new

11125 international drive highway 50 97,632 delta dental of ca renewal

2800 gateway oaks drive natomas/ northgate 76,000 ca dept. of food & agriculture new

1747 n. Market Blvd. natomas/ northgate 52,500 dept. of consumer affairs new

1 sierra gate plaza roseville/ rocklin 51,000 John adams academy new

1107 investment Blvd. el dorado 26,604 alpha research & technology new

1025 creekside ridge dr. roseville/ rocklin 19,675 not available new

3721 douglas Blvd. roseville/ rocklin 18,935 intel - ge care innovations new

930 g. street downtown 18,710 pacific Legal foundation new

3640 northgate Blvd. natomas/ northgate 18,684 Wells fargo renewal

office - aLL cLasses 2Q 20111Q 2010 2Q 2010 3Q 2010 4Q 2010 1Q 2011 2Q 2011

total inventory sf 90,814,205 90,850,227 90,921,891 91,026,891 91,106,891 91,106,891

total Vacancy sf 14,958,215 15,226,139 15,364,174 15,686,688 16,089,608 16,040,735

total Vacancy % 16.5% 16.8% 17.2% 17.2% 17.7% 17.6%

deliveries sf 146,846 36,022 71,664 105,000 80,000 0

Under construction sf 345,686 464,664 393,000 360,000 280,000 280,000

net absorption (growth) (165,163) (231,902) (66,371) (217,514) (322,920) 48,873

average asking rate (nnn - annual) $22.66 $22.32 $21.89 $21.71 $21.45 $21.09

inventory, Vacancy, construction, and absorption

eye on the Market

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Submarket rentable Buildable area

direct Vacancy rate

overall Vacancy rate

availability rate

net absorption Sf

Ytd net absorption Sf

under construction Sf

direct fS average lease rate $/Sf/mo

auburn/ Lincoln 1,441,290 12.1% 12.2% 13.3% 16,894 12,245 0 $1.53

carmichael/ fair oaks 1,742,764 12.4% 12.5% 16.9% (6,020) 2,149 0 $1.29

campus commons 1,526,880 22.4% 22.4% 25.1% (29,863) (43,132) 0 $1.78

citrus heights/ orangevale 1,778,657 17.4% 17.9% 20.2% (6,859) (15,549) 0 $1.36

davis/ Woodland 2,257,750 11.5% 11.5% 11.5% (7,361) (31,530) 0 $1.81

east sacramento 1,930,463 14.7% 14.7% 15.4% (470) 26,850 0 $1.64

el dorado 2,005,006 15.8% 16.8% 24.9% 326 19,901 0 $1.76

elk grove 1,586,357 24.0% 24.0% 24.9% 1,073 20,763 0 $2.03

folsom 4,988,853 15.0% 15.8% 18.8% (14,743) 23,945) 72,000 $1.89

highway 50 corridor 15,956,105 18.3% 18.9% 23.3% (13,402) (138,263) 0 $1.64

howe ave/ fulton ave 2,894,880 20.0% 20.0% 23.8% 9,767 (49,539) 0 $1.54

Midtown 4,742,744 7.6% 7.6% 9.6% (9,246) (42,481) 0 $1.83

natomas/ northgate 6,220,797 24.9% 25.1% 27.2% 9,730 50,239 0 $1.79

point West 2,907,466 22.8% 23.2% 28.4% 75,614 212,587 0 $1.77

rio Linda/ n. highlands 1,185,303 27.5% 38.4% 53.1% 3,673 11,417 0 $1.49

roseville/ rocklin 11,858,007 28.4% 28.7% 30.5% 78,500 (102,259) 53,000 $1.77

south sacramento 3,152,371 14.4% 14.4% 17.1% (23,645) (4,347) 0 $1.46

Watt ave 2,747,200 13.1% 13.1% 13.9% (4,871) (87,723) 0 $1.48

West sacramento 2,313,790 9.6% 9.6% 10.7% (485) (5,239) 0 $1.57

suburban Market 73,236,683 18.9% 19.4% 22.4% 78,612 (187,856) 125,000 $1.70

downtown (all) 18,238,687 10.3% 10.6% 12.4% (34,923) (82,445) 155,000 $2.17

downtown (class a) 8,911,813 9.2% 9.7% 11.8% 31,856 24,153 155,000 $2.71

overall Market 91,475,370 17.2% 17.6% 20.4% 43,689 (270,301) 280,000 $1.76

sacramento office submarket analysis - 2Q 2011

results are from costar and include all office space existing, under construction, or under renovation greater than 5,000 square feet located in all core areas of sacramento, placer, el dorado and Yolo counties.



OFFICE SALES AND LEASING

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INVESTMENTS

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MANAGEMENT SERVICES

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LEASE ADMINISTRATION

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