SpecialResearch
R E P O
COMMERCIAL REAL ESTATE NOT IMMUNE BUT WELL POSITIONED TO
WITHSTAND ECONOMIC SLOWDOWN AND CAPITAL MARKETS VOLATILITY
F
inancial markets and the commercial real estate sector
are in the midst of a somewhat unique shift. Similar to
past turning points, excesses during the run-up are
causing a traditional investor pullback as risk is repriced.
During the first quarter of 2008, however, a full-blown credit
crunch emerged, with much different characteristics than in
past cycles, due to the very nature of the financial engineer-
ing that fueled the boom. The pooling of a broad range of
home loans, including high-risk subprime mortgages, into
Mortgage-Backed Securities (MBS) made it easy and tem-
porarily profitable for lenders to increase originations and
relax underwriting standards. Home sales soared well above
real demand drivers, leading to overbuilding and significant
speculation. Poor risk assessment by ratings agencies and
investors in these pools resulted in an underestimation of
potential defaults, particularly for adjustable-rate subprime
loans that reset at dramatically higher interest rates. The wide
use of related complex financial instruments and derivatives
tied to MBS further exacerbated the risk and has made it dif-
ficult to quantify and reprice the now-troubled portions of
these investments. The resulting liquidity crunch emerged as
uncertainty regarding the magnitude and true “market”
value of these securities pushed investors to the sidelines and
led banks to tighten lending standards across the board.
Better Late Than Never: Federal Reserve Actions Wide-
Ranging, Aggressive. Fed action, which finally turned
aggressive in March, has stabilized financial markets — at
least for now. Its measure to prevent Bear Stearns from col-
lapse, in particular, helped stave off a domino effect that
clearly could have threatened other major institutions. The
reassessment of risk and securities’ valuations is well under
way, as reflected in massive writedowns. The Fed’s steps to
restore liquidity, along with interest rate cuts, are also play-
ing a critical role in stabilizing financial markets. Signs of
gradual improvement are emerging, including private equity
injections into key financial institutions and rising U.S.
Treasury yields, indicating investors are slowly taking on
more risk. It will take a few more months before the benefits
of recent Fed actions are passed along to consumers and busi-
nesses, as financial institutions first focus on stabilizing their
own positions. The successful refinancing of the majority of
maturing fixed-rate U.S. Commercial Mortgage-Backed
Securities (CMBS) loans since the start of this year, along with
a modest rise in conduit lending in recent weeks reflect some
“thawing out” of the previously frozen CMBS sector.
Negative Psychology a Drag on Otherwise Sound
Fundamentals. Until late last year, U.S. economic drivers
outside of manufacturing and housing had been on relative-
ly solid ground. In the second half of 2007, health care, edu-
cation, professional services, trade and tourism added
© Marcus & Millichap 2008
R T
Midyear 2008
Cap Rate Trends by Market Type
Reflect Flight to Safety
10% Primary Secondary Tertiary
Average Cap Rate by Market Type
9%
8%
7%
6%
04 05 06 07 08*
* Through March, Sales $5M+ – Apartment, Retail, Office, Industrial
Sources: Marcus & Millichap Research Services, RCA
733,000 jobs, while construction, manufacturing and finan-
cial services shed 283,000 positions. Negative psychology
and tighter credit markets have since eroded consumer and
business confidence, triggering a downturn. In the first four
months of 2008, companies scaled back capital investments
and cut 260,000 jobs, weighing heavily on U.S. consumers
already burdened by the housing downturn and high ener-
gy prices. The economy has stalled, creating a challenging
environment for commercial real estate owners, regardless
of whether a technical recession (two or more consecutive
quarters of contracting GDP) takes place. The government’s
stimulus package, liquidity injections and lower interest
rates make a technical recession unlikely in 2008 and should
foster some growth later this year. In addition, companies
avoided excessive hiring and capital investments during the
most recent expansion period, supporting expectations for a
moderate downturn.
Commercial Loan Delinquency Still Near Historic Lows.
Commercial real estate loan delinquency rates have
increased modestly, but at less than 0.5 percent, they remain
near historical lows. This is reflective of generally healthy
occupancies and income growth during the past few years.
Spillover concerns from the troubled residential sector and
fears of future problems with late-vintage commercial
loans, however, are keeping many CMBS investors on the
sidelines. In the first quarter of 2008, commercial banks and
life insurance companies tightened underwriting standards
further, and some reached capacity limitations. This group
of lenders initially helped offset the void created by the
CMBS market, and their recent pullback is causing addi-
tional constraints on commercial real estate financing.
Apartment investors have been impacted the least by the
capital markets shift due to increased lending by Fannie
Mae and Freddie Mac.
 Special Research Report Marcus & Millichap Research Services

COMMERCIAL REAL ESTATE OUTLOOK

Fundamentals Rule, Again
Last Economic Expansion Shorter, Fewer Jobs Added
Duration of Expansion - Months (Trough to Peak) The current environment is best defined as a transition from unsus-
Average Monthly Job Creation
120 300 tainable, frothy conditions to a “normalized” market, not a systemic
Duration of Expansion (months)

Avg. Jobs per Month (thousands)

crash. Unlike past cycles, generally healthy commercial real estate fun-
damentals and a lack of significant overbuilding will limit the correc-
90 225
tion. Furthermore, the last period of economic expansion was relative-
ly brief, and companies remained cautious when hiring and leasing
60 150 space. That is not to say that occupancies and rents will not suffer from
the economic slowdown. Vacancy will rise this year as job losses hin-
30 75 der household formation and companies delay leasing commitments.
Unless the downturn deepens unexpectedly, however, the increase in
0 0 vacancy should be moderate, keeping U.S. averages below previous
Feb 61- Nov 70- Mar 75- Jul 80- Nov 82- Mar 91- Nov 01- cyclical highs. Retail is our primary concern, as tenants are directly
Dec 69 Nov 73 Jan 80 Jul 81 Jul 90 Mar 01 Aug 07
affected by the housing slump and reduced consumer spending.
Sources: Marcus & Millichap Research Services, BLS, NBER
Commercial real estate was clearly a beneficiary of the low-interest
rate and high-liquidity environment that began in 2002 and ended
abruptly in 2007, as reflected in the exceptional rise in sales and values
during this period. Subsequently, the credit crunch has caused a sharp
drop in activity. The decline is due largely to the near shutdown of the
CMBS market, which accounted for nearly half of all commercial lend-
U.S. Employment and GDP ing during the first half of 2007. The high-leverage, speculative invest-
9%
9%
U.S. GDP ment climate has been replaced by a renewed focus on underwriting
Nonfarm Employment
to actual operations. Much of this shift back to basics is positive, reduc-
ing speculation and development in the long run. In the short term,
6%
6% however, the market will continue to register slower sales due to a
Annual Change

classic expectations gap — many sellers are expecting last year’s pric-
3%
3% ing, while many buyers are expecting unrealistic price corrections.

Price adjustments are occurring based on asset quality, market

0%
0% strength and buyers’ ability to add value; opportunistic investors
awaiting wholesale discounting are at risk of missing opportunities.
-3%
-3% Cap rates for top-tier assets in primary markets are expected to rise 25
80 84 88 92 96 00 04 08* 09* to 50 basis points this year, as the low-leverage, high-quality buyer
* Forecast pool remains capable of acquiring properties for long-term strategies.
Sources: Marcus & Millichap Research Services, Economy.com Cap rates for lower-tier assets and those in secondary/tertiary markets
are expected to increase 75 to 100 basis points, or more for higher-risk
assets that are challenging to finance. Given the volatility in financial
markets, however, downside risks remain present.

Commercial real estate is not immune to volatility in financial mar-

kets and the broader economy, but it is well positioned to withstand
Banks Tightening Lending Standards turbulence for several reasons.
100%
Net % of Banks Tightening Standards

Commercial
Real Estate ◆ Debt is constrained but available. Some lenders have reached
Loans
capacity limitations, and many have tightened underwriting further
75% Loans to Large
and Medium
as they repair balance sheets. Debt capital is available, however, and
Companies Loans to Small transactions are occurring across markets and property types for
Companies
50% realistically priced assets. Financing terms reflect normalization,
with loan-to-values (LTVs) down and debt-service coverage ratios
25% (DSCRs) up from the aggressive levels of 2005 to early 2007 and clos-
er to historical standards.
0% ◆ Interest rates are low, partially offsetting higher lender spreads.
Fed rate cuts, along with recently introduced liquidity measures and
4Q 7

4Q 7

4Q 7
07

07

07
08
08

08
08

08
08
0

0
3Q

3Q

3Q
1Q
2Q

1Q
2Q

1Q
2Q

the government’s stimulus package, will help stabilize financial mar-

Sources: Marcus & Millichap Research Services, Federal Reserve kets and limit economic contraction. Long-term interest rates will rise
as stability returns to the system; however, this should also tighten
lender spreads, leaving overall mortgage rates relatively attractive.

page 2 © Marcus & Millichap 2008

Special Research Report Marcus & Millichap Research Services

◆ Fundamentals are generally healthy, supply risks contained. Most

commercial real estate sectors are entering this period of economic
slowing with comparatively low vacancy and several years of New Supply More Constrained,
healthy rent growth. Assuming the economic downturn is moderate, Helping to Limit Cyclical Correction

Construction as a % of Stock (Annual Avg.)

the rise in vacancies should be less than previous market shifts. 12% New Supply as a Percentage of Existing Stock
Tighter lending standards will limit development, which is already 1980-89 2000-06
1990-99 2007-10*
more balanced than in past cycles due to higher construction costs, 9%
land scarcity and greater industry transparency.

◆ Replacement costs are above prices in most markets and property 6%

sectors. Despite recent declines in labor, land and certain materials
costs, replacement costs remain historically high. In addition, the 3%
notion of “replacement” has become a virtual impossibility in more
cases than not.
0%
Apartment Shopping Office Industrial
◆ Distress minimal, equity ample. Cap rate spreads based on proper- Centers
* Forecast
ty and market quality will expand further this year; however, strong Sources: Marcus & Millichap Research Services, PPR, Reis
appreciation in recent years will leave owners with substantial equi-
ty even after reasonable price corrections. Strong operations are lim-
iting the pool of distressed assets to failed conversions, high-risk
developments and speculative transactions closed at the height of the
market, which were facilitated by aggressive short-term financing.

◆ A wide array of capital sources remain active. Notwithstanding the Real Estate Returns Outperforming
current “wait and see” mood, private investors, particularly aging Stocks in Recent Years
baby boomers, along with pension funds and foreign investors lifted 5-year 10-year
300% 1-year
by the weakened dollar, have ample capital available and remain
attracted to U.S. commercial real estate. Investors who sense reason-
able risk-adjusted pricing on desirable assets are active in the mar- 225%
Total Return*

ketplace. Realistically priced properties marketed to the correct

buyer pools are generating plenty of qualified offers and transac- 150%
tions. Sales volume will increase as buyers and sellers recalibrate
pricing and financing improves in the second half.
75%
◆ Beyond the next few quarters, prospects for high single-digit
returns are realistic. Turnover of leases signed from 2002 to 2005, 0%
when rents were substantially below current levels, will provide a S&P 500 Apartment Office Industrial Retail
boost to office and industrial NOIs in coming years. A return to eco- * Compounded total returns through 1Q08 (income and capital return)
Sources: Marcus & Millichap Research Services, NCREIF, Standard & Poor’s
nomic growth in line with long-term averages, coupled with limita-
tions on new supply, also points to improving returns during the
next three to five years.

◆ U.S. commercial real estate is competitively priced globally. Much

of the exceptional rise in U.S. commercial property values since 2002
was due to a structural repricing in the global environment. Cap rate Capital Markets Volatility, Economic Uncertainty
compression in the U.S. largely reflected a “catching up” to yields Causing Classic Cyclical Shift in Commercial Sales
typical in other developed economies. While cap rates are moving Dollar Volume Average Cap Rate
up from historical lows as anticipated and a spread by quality is 100% 10%
Dollar Volume (Y-O-Y Change)

returning to the marketplace, the drivers summarized above point to

cap rates remaining below long-term averages. 50% 9%
Average Cap Rate

Risk levels will remain heightened in the near term. Each downturn
has unique characteristics, and this cycle is no exception. Short- to 0% 8%

mid-range risks are elevated, as the economy and financial markets

are closely entangled in the greatest housing downturn in recent his- -50% 7%
tory. The exposure of financial institutions and investor groups, par-
ticularly hedge funds, to additional losses is still somewhat unclear. -100% 6%
Stubbornly high energy prices are exacerbating the issues. While the 02 03 04 05 06 07 08*
weak dollar is helping to offset the impact of the housing downturn * Through March, Sales $5M+ – Apartment, Retail, Office, Industrial
Sources: Marcus & Millichap Research Services, RCA
through increased exports, it is also driving up oil prices. Should an
oil supply shock occur, prices would rise further, potentially deepen-
ing the economic downturn.

© Marcus & Millichap 2008 page 3

 Special Research Report Marcus & Millichap Research Services

ECONOMIC OUTLOOK
The Age of Resilience and Moderation
Fed Cuts Rates, Causing Inflation
Concerns to Rise The most pervasive theme of U.S. economic performance in the past 20
8% Core Inflation years can be summed up in a single word: resilience. From the stock
Fed Funds Rate
Interest Rates/Core Inflation

market crash of 1987, the collapse of the Savings and Loan industry and
10-Year Treasury
6% recession in 1990/91, the Asian financial crisis in 1997/98, the dot-com
collapse in 2001 and the 9/11 tragedies, to a wave of corporate scandals
and job offshoring, the U.S. economy has demonstrated its agility, inno-
4%
vation and better-than-expected performance after each shock.

2% The serious and unique challenges of the current downturn should not
be underestimated; however, if past tendencies to address problems
0%
through market forces and government intervention are any indica-
00 02 04 06 08* tion, a prolonged period of economic contraction is unlikely. By the
same measure, a “snap-back” recovery is not expected, as many of the
* Inflation as of March, interest rates through May 8
Sources: Marcus & Millichap Research Services, Federal Reserve current issues, particularly housing, will take time to correct. What
started out as a subprime mortgage problem has ballooned into mar-
ketwide negative psychology and reversal of the housing-wealth fac-
tor. As prices fall, more financially-able homeowners with little or neg-
ative equity are walking away from their mortgages, driving further
price correction. Therefore, housing and its impact on financial mar-
kets will remain wildcards for the next several months.
U.S. Housing Market Trends
Housing Market Yet to Hit Bottom. Existing home sales continued to
Single-Family Sales
Months of Supply
decline through the first several months of 2008. On a year-ago basis,
30% 12
Existing S.F. Home Sales (Y-O-Y Chg.)

home prices are down 8 percent, and sales activity is off by 18 percent.
Mos. of For-Sale S.F. Housing Supply

For-sale inventory recently increased to a new record-high of more

15% 9 than 11 months of supply. Nationwide, the housing market should set-
tle late this year as the economy improves and credit conditions for
0% 6 qualified homebuyers ease, though the most oversupplied markets
will not hit bottom until 2009. Overall, price reductions and low inter-
est rates should spur buying activity, which, coupled with further
-15% 3
slowing in housing starts, will reduce for-sale inventory next year.

-30% 0 Inflation Risks Elevated. A potential side effect of Fed easing is ris-
01 02 03 04 05 06 07 08* ing inflation, which points to a tightening campaign quickly upon
* Through April normalization of the economy. The headline rate of inflation
Sources: Marcus & Millichap Research Services, Economy.com, NAR remains elevated at 4 percent, but core inflation is only 2.4 percent,
which means high energy costs have not yet translated into signifi-
cantly higher prices for non-energy-related goods. Oil prices
climbed considerably in the first quarter, however, and companies
will ultimately need to pass higher energy costs on to consumers. If
the Fed’s expectation of easing inflationary pressures due to a slow-
Consumer Confidence Falling as er economy fails to materialize, it may be forced to raise interest
Negative Psychology Takes Hold rates rapidly, creating a new round of economic headwinds.
160 Modest Job Growth Expected. The U.S. job market registered four con-
Consumer Confidence (1985=100)

secutive months of net losses in early 2008, and further contraction is

120 likely in the near term. Payrolls are forecast to resume growth in the sec-
ond half, however, as the positive effects of fiscal and monetary stimuli
80
take hold. Education, health care, exports and tourism are forecast to
remain the top drivers of growth, with weakness concentrated in man-
ufacturing, construction, banking and housing-related industries.
40
Corporate Profits Weaken, but Balance Sheets Still Sturdy. Domestic
0 corporate profits declined in the second half of 2007, due mainly to
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08* financial sector losses; however, profits from overseas operations regis-
tered the strongest gain since 1980. Outside of the financial sector, prof-
* Through April
Sources: Marcus & Millichap Research Services, Economy.com it margins are still generally healthy, and many companies have signif-
icant cash reserves after several years of double-digit profit growth.

page 4 © Marcus & Millichap 2008

Special Research Report Marcus & Millichap Research Services

Across the board, businesses should get some relief from easing wage
pressures as slack returns to the labor market.
Growth in Exports a Major Contributor
Weak Dollar Driving Exports. The U.S. dollar has declined nearly 30 to Economic Activity, Offsetting Housing

Trillions of Chained 2000 Dollars (SAAR)

percent against major foreign currencies since 2002. Though discon- $2.0 Residential Investment
Exports
certing to many Americans, the weak dollar is lending support to the
U.S. economy. Foreign demand for U.S. goods has increased, narrow- $1.5
ing the trade gap and contributing to GDP growth. Port markets and
transportation hubs will benefit from this trend, and favorable
$1.0
exchange rates will encourage international travel to the United States,
reducing the impact of slower U.S. consumer spending on the hospi-
tality and retail sectors in gateway cities. $0.5

CAPITAL MARKETS TRENDS $0.0

90 92 94 96 98 00 02 04 06 08*
The Fed has become aggressive in its efforts to contain the downturn
* 1Q Estimate
and prevent a financial sector crash. In April, the Fed cut rates by an Sources: Marcus & Millichap Research Services, Bureau of Economic Analysis
additional 25 basis points and continued its work with foreign central
banks to restore liquidity. The Fed also extended its term auction facili-
ty, which is designed to encourage borrowing by banks, and launched
a new facility that allows securities firms to borrow from the Fed using
difficult-to-trade agency mortgage-backed securities as collateral. In an
unexpected move to prevent further deterioration in the financial sec-
tor, the Fed also extended credit to J.P. Morgan Chase to support the U.S. CMBS Issuance
acquisition of struggling Bear Stearns. Down 90% YTD 2008* vs. Same Period Last Year
Reality Sets In. Until last summer, strong secondary market demand $40
for mortgages allowed lenders to continuously replenish capital.
CMBS Issuance (billions)

Lenders are now proceeding with caution, basing underwriting on $30

actual NOIs as opposed to pro forma figures and raising equity require-
ments. Lenders are also placing greater weight on property quality and
$20
location, shying away from riskier deals that rely heavily on future rent
and occupancy gains. Financing properties in tertiary markets has
become most challenging, with many major lenders avoiding these $10
markets altogether. On average, LTVs have declined from 75 to 80 per-
cent to 60 to 70 percent, while DSCRs have increased to 1.2x or greater, $0
up from 1.1x, or break-even in some cases, as recently as mid-2007. 03 04 05 06 07 08*
* Through April
Uncertainty Causing Frequent, Often Exaggerated Spread Sources: Marcus & Millichap Research Services, CMA
Movement. Investors will remain highly reactive to economic indica-
tors in the near term, causing continued volatility across financial mar-
kets. Lender spreads have been fluctuating in a wide band since last
summer, with moves of 50 basis points in one day not uncommon. In
early May, conduits began to slowly re-enter the marketplace, with
spreads at 325 to 400 basis points or more over the 10-year Treasury.
Portfolio lender spreads have also narrowed and remain competitive
CMBS Delinquency Rising,
compared to conduits, at 225 to 275 basis points over the 10-year
Still Low by Historical Standards
Treasury for apartments and 225 to 320 basis points over for other 4%
property types. Apartment investors have the advantage of using
CMBS Delinquency Rate

Freddie Mac and Fannie Mae, which are pricing loans at 210 to 255 3%
basis points over the 10-year.
2%
Commercial Mortgage Origination Volume Reflects Tighter
Financing Climate. First quarter originations were dramatically below
year-ago levels. The financial market shock caused commercial mort- 1%
gage origination volume to fall 17 percent in the second half of last year
when compared to the previous six-month period. The decline, how- 0%
ever, was due entirely to conduit lenders. While the CMBS market
99

02

03

06
00

08
01

04

05

1Q 7
0
4Q

4Q

4Q

4Q
4Q

4Q

4Q

4Q

4Q

recently began showing signs of life, the sector first needs to work
through a backlog of an estimated $30 billion of mortgages before a Sources: Marcus & Millichap Research Services, Standard & Poor’s
true recovery cycle can gain traction. Some of the loans in the pipeline
were originated prior to the tightening of lending standards, making

© Marcus & Millichap 2008 page 5

 Special Research Report Marcus & Millichap Research Services

new issues difficult to price. It is important to note that even after the
drop in originations in the second half of 2007, lending activity was
Lender Spreads by Property Type still up 37 percent from just three years earlier. It will take some time
Conduits Portfolio
Avg. Spread over 10-Year Treasury (bps)

for the securitization model to be redefined as a source of capital, but

500 the benefits of this vehicle prior to the frenzy will most likely result in
its return to the marketplace in some form.
400
Lack of Overall Distress Preventing Unreasonable Price Corrections.
On average, longer-term loans nearing maturity were originated at least
300 five years ago, during which time owners recorded substantial increas-
es in incomes and values. Refinancing for these assets, even in today’s
200 tighter environment, is available as a result. Loans issued in the 12 to 18
months leading up to the market shift had the most aggressive under-
writing, but many of these mortgages featured interest-only periods of
100
Anchored Unanchored Apartment Office Industrial three to five years, providing operators time to work through the eco-
Retail Retail nomic downturn. Some of these aggressively financed assets in the
As of May 15th
Sources: Marcus & Millichap Research Services, MMCC hardest-hit local economies are likely to default in the near term, though
this is unlikely to cause an overall, systemic distressed environment.
Low Interest Rates Helping Offset Higher Spreads. The yield on the
10-year Treasury fell to a low of 3.3 percent in March but has since
increased; however, at approximately 4 percent, it is still 125 basis points
below last summer. Despite concerns surrounding the weak dollar and
Net Change in Renter Households inflation, investors will continue to look to U.S. Treasurys as a safer alter-
by Age Cohort native to stocks, which have been prone to dramatic swings. As a result,
the 10-year is forecast to end 2008 in the high-3 to low-4 percent range.
2002-2005 2006-2007
Change in Renter Households (000s)

500
REAL ESTATE MARKET FUNDAMENTALS
250 Unlike the last prolonged liquidity crunch in the early 1990s, which
was caused by massive overbuilding, the commercial real estate mar-
0 ket today is generally well balanced. Slower economic growth will
cause softening in fundamentals, but supply-side risks will decline as
the development pipeline narrows due to caution and more stringent
-250
lending requirements.

-500 Under 35-44 45-54 55-64 65+ A P A R T M E N T M A R K E T

35
Sources: Marcus & Millichap Research Services, U.S. Census Bureau Rising Competition from Shadow Rentals. Apartment owners have
more competition from for-rent condos and single-family homes, par-
ticularly in oversupplied housing markets in the Southeast and
Southwest. The number of vacant condos and houses surged in the
first quarter of 2008, due in part to a spike in foreclosures. Metro areas
with the highest homeowner vacancy rates include Orlando, Tampa,
Las Vegas, Atlanta and Jacksonville, though Phoenix, Riverside-San
Vacancy Rising but Forecast to Remain Bernardino, Sacramento and Miami also rank in the top tier. The low-
in Relatively Healthy Range est homeowner vacancy rates are generally in supply-constrained
20% 2000-2007 2008* coastal markets, such as Seattle, Los Angeles, San Francisco, New
York, Philadelphia and Boston. Fortunately for apartment owners,
15% banks typically shy away from residential property management;
therefore, most foreclosures will not hit the rental market directly.
Vacancy Rate

Furthermore, many for-rent houses are in far-reaching suburbs, which

10% given high gas prices are now less attractive to prospective renters.

5% Reversing Homeownership and Demographic Shifts Boost Renter

Demand. Between early 2000 and year-end 2004, total renter house-
holds declined by 1.9 million, as the homeownership rate increased
0% from 66.9 percent to 69 percent; however, the trend began to reverse in
Apartment Retail Office Industrial
* Forecast
2005. Since then, the homeownership rate has fallen to 67.8 percent,
Sources: Marcus & Millichap Research Services, Reis which translates to 2.6 million households that required alternative
housing. The reversal is most pronounced in younger age cohorts,
which typically account for a large share of renters, helping offset com-

page 6 © Marcus & Millichap 2008

Special Research Report Marcus & Millichap Research Services

petition from shadow stock. Apartment owners will also benefit from
the emerging echo boom generation, who have just begun to enter
Rent Growth Slowing
their prime renting years. Most mortgage companies have eliminated
riskier first-time homebuyer programs and require higher downpay-
Across Property Types
ments, reducing the pool of potential buyers able to qualify. 18% 2000-2007 2008*

Completions Rising but Still Restrained by Historical Standards.

12%
Developers will deliver 102,000 apartments in 2008, up from 86,200

Annual Change
units in 2007. In addition, several conversion projects have returned to
apartment stock in recent quarters. Despite the rise in new supply, 6%
development activity in 2008 will remain low compared to the late
1990s to 2003, when deliveries reached an annual average of 150,000 0%
units. Construction starts are likely to fall due to the slower economy
and tighter financing climate, however, potentially resulting in a short-
-6%
age of units during the next three years. Apartment Retail Office Industrial
* Forecast
Moderate Increase in Vacancy Expected. Vacancy increased 30 basis Sources: Marcus & Millichap Research Services, Reis
points to 5.9 percent in the first quarter due to seasonal fluctuations
and job losses. An additional 20 basis point increase to 6.1 percent is
expected by year end as the softer employment market limits house-
hold formation and forces some renters to double-up. The Class B/C
market will remain the most stable as slower economic growth and
high energy costs limit renters’ options. Class A assets will benefit from
reduced migration of renters to homeownership but also face greater Housing Wealth Effect Reversing
competition from shadow rentals, which will push vacancy higher. Change in Housing-Related Net Worth

Owners’ Equity in Household Real Estate

Marketwide, modest softening will result in increased concessions. Home Equity %
Net Change in Housing-Related $600 80%
R E T A I L M A R K E T
Net Worth (billions)

$400 70%
Consumers Pull Back. Retail sales growth stalled in the first quarter
but is forecast to reach 2.5 percent for the year, down from 4.1 percent
in 2007 and a cyclical high of 6.6 percent in 2005. Consumers support- $200 60%
ed the economy during the past several years with the help of low
interest rates, rapid home price appreciation and equity withdrawal. $0 50%
Cash-out refinancing activity was down 50 percent last quarter when
compared to one year earlier and is forecast to slip further. Household ($200) 40%
budgets are also getting squeezed by elevated energy costs and, in 77 80 83 86 89 92 95 98 01 04 07
some instances, higher mortgage payments due to ARM resets.
Sources: Marcus & Millichap Research Services, BEA
Retailers Cut Expansion Plans, Development Declining. Retail
vacancy increased 40 basis points in the first quarter to 10.1 percent.
Fortunately, development has been largely tenant driven in recent
years, and tighter lending will limit speculative development further
as this year progresses. Nonetheless, vacancy is expected to rise by an
additional 100 basis points this year to 11.1 percent, following a 90 Cash from Home Refinancing No Longer
basis point increase in 2007. Smaller retailers will be the most nega-
Shielding Retail Sales from High Energy Prices
tively affected by the slowdown in consumer spending growth,
12% Retail Sales excl. Auto, Gas $160
though many larger chains have announced closures. Housing-Related Retail Sales
Crude Oil (Price per Barrel)
Retail Sales (Y-O-Y Change)

Oil Prices
Markets with the Greatest Near-Term Challenges Boast Strong 8% $120
Long-Range Prospects. Retail developers followed home builders into
far-reaching suburbs of high-growth markets such as Phoenix, Las
4% $80
Vegas, Sacramento and Riverside-San Bernardino. Some retail proper-
ties may fall short of expectations as a result, with many new homes
vacant and a glut of unsold residential lots in inventory. Fortunately, 0% $40
extended household and job growth forecasts for the hardest-hit hous-
ing markets are among the healthiest in the nation. -4% $0
98 99 00 01 02 03 04 05 06 07 08*
Reduced Inflow of Exchange Capital Limiting Single-Tenant Sales.
* Retail Sales Exclude Auto and Gas (Y-O-Y as of April), Oil Prices as of 5/23
Exchange capital coming out of apartments, particularly from Sources: Marcus & Millichap Research Services, Economy.com
California, provided a boost to the single-tenant retail market in recent
years. While single-tenant assets with national credit tenants remain in

© Marcus & Millichap 2008 page 7

 Special Research Report Marcus & Millichap Research Services

strong demand, the pool of private investors targeting these assets has
been limited by the decline in transactions in other property sectors.
Weak U.S. Dollar Boosting Export Activity
I N D U S T R I A L M A R K E T
Dollar Value Exports
Value of U.S. Dollar (March 1973 = 100)

120 20% Slower Development and Healthy Export Activity to Limit Rise in
Vacancy. Following a 150 basis point decrease between 2002 and

Exports (Y-O-Y Change)

110 10%
2007, industrial vacancy increased 20 basis points in the first quarter
of 2008 to 9.7 percent. During the balance of the year, vacancy is
forecast to tick up an additional 50 basis points. While completions
100 0%
are expected to decline to 148 million square feet this year, com-
pared to 160 million square feet in 2007, only one-third of the new
90 -10% industrial space under way has been pre-leased.
Exports Providing Boost to Industrial Demand. The weak dollar is
80 -20%
generating healthy foreign demand for U.S. goods, lending support
90 92 94 96 98 00 02 04 06 08*
to industrial demand as domestic consumers pull back on spending.
* 1Q Estimate of Exports
Sources: Marcus & Millichap Research Services, Economy.com Net exports in 2007 made a positive contribution to annual GDP
growth for the first time since 1991, a trend forecast to continue
through 2008, albeit to a lesser degree.
Tenants Favoring Newer Properties. Companies are facing higher
production and fuel costs, creating a need to improve efficiencies in
the distribution process. Newer warehouse properties typically fea-
ture greater clear heights, larger docking areas, and often fiber optics
for communications and power systems to run high-tech equipment.
With more than 1,300 investment professionals in offices Vacancy rates for properties built in 2005 or later have declined in
nationwide, Marcus & Millichap is the largest commercial recent years, while vacancy among older assets has steadily increased.
real estate brokerage firm focused exclusively on invest-
ment sales, financing, research and advisory services. O F F I C E M A R K E T

For additional information on local or national market Completions on the Rise in 2008, but Planning Pipeline Narrowing.
trends, please visit www.MarcusMillichap.com, or con- Office construction is expected to rise this year but will remain well
tact the nearest local office to speak with one of our invest- below levels recorded from 1999 to 2001, when an average of 125 mil-
ment professionals. lion square feet of new space was brought online annually. This year,
office deliveries will total 63 million square feet, up from 54 million
square feet in 2007. The pipeline is thinning, however, with 45 percent
less space in the pre-planning phase than one year ago.
Moderate Softening in Fundamentals Expected After Strong
Recovery Cycle. Vacancy increased 20 basis points during the first
Report prepared and edited by
Hessam Nadji
quarter to 12.8 percent and is forecast to reach 13.8 percent by year
Erica Linn
Managing Director Senior Analyst end. After declining for 17 consecutive quarters, vacancy began
Tel: (925) 953-1700 Tel: (602) 952-9669 trending up in late 2007 as the financial industry absorbed the
hnadji@marcusmillichap.com elinn@marcusmillichap.com impact of subprime losses. Despite the recent uptick, vacancy
remained low enough to support a more than 10 percent gain in
effective rents last year, the strongest growth since 2000, and rents
continued to rise in early 2008. Slower job creation and rising com-
petition from the sublease market, however, will limit effective rent
growth this year to between 3.5 percent and 3.0 percent.
Capital Markets section written by Previously Hot Housing Markets Taking Greatest Hit from
William Hughes
Managing Director
Subprime Meltdown. Fallout from the subprime debacle is causing
Marcus & Millichap Capital Corporation mass layoffs among banks and real estate services companies. This
Tel: (949) 851-3030 trend is impacting office space demand in primary financial hubs,
whughes@marcusmillichap.com including New York, Chicago and San Francisco, in addition to pre-
viously strong housing markets, such as Orange County, Phoenix, Las
For information and market trends, contact
John Chang
Vegas and Riverside-San Bernardino. In addition to reduced demand,
National Research Manager increases in sublease availability are expected, particularly in higher-
Tel: (602) 952-9669 growth suburbs. Nationwide, sublease space as a percent of total
john.chang@marcusmillichap.com vacancy bottomed at 8 percent in early 2007 but has begun to inch up.

The information contained in this report was obtained from sources deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no representation, warranty or guarantee, express or implied, may
be made as to the accuracy or reliability of the information contained herein. Note: Metro-level employment growth is calculated using seasonally adjusted quarterly averages. Sources: Marcus & Millichap Research Services, AFIRE,
Bureau of Economic Analysis, Bureau of Labor Statistics, Commercial Mortgage Alert, CoStar Group, Inc., Economy.com, Fitch Ratings, Global Insights, Mortgage Bankers Association, National Association of Realtors,
National Bureau of Economic Research, Property & Portfolio Research, Real Capital Analytics, Reis, SIFMA, Standard & Poor’s, U.S. Federal Research, U.S. Treasury, Wachovia.
© Marcus & Millichap 2008