Second Quarter 2008 Report Investment Trends Vol. 4, No. 2 Quarterly Spotlight on Portland Sponsored by: InThisVolume Now Available! National Overview Caught in the Storm Economic Background & Investment Environment A Focus on Real Estate Cap Rate & Yield Rate Expectations Seeking Shelter from the Storm Effect on Real Estate National Market Analysis & Property Sector Highlights “Sustainable Development Shapes Portland Past and Future” Contributors Scope & Methodology Regional and Metro-Level Analyses Coming Soon! East Region Baltimore, Boston, Charlotte, Hartford, Norfolk, Northern New Jersey, New York City, Pittsburgh, Philadelphia, Raleigh, Richmond, Washington, D.C. South Region Atlanta, Austin, Dallas/Ft. Worth, Houston, Memphis, Miami, Nashville, New Orleans/Baton Rouge, Oklahoma City, Orlando, San Antonio, Tampa Midwest Region Chicago, Cincinnati, Cleveland, Columbus, Detroit, Indianapolis, Kansas City, Milwaukee, Minneapolis, Omaha, St. Louis, Toledo West Region Denver, Honolulu, Las Vegas, Los Angeles, Phoenix, Portland, Sacramento, Salt Lake City, San Diego, San Francisco, Seattle, Tucson Investment Trends Copyright© 2008 by Real Estate Research Corporation (RERC) and the CCIM Institute. Quarterly Foreword April 2008 Dear Readers, Property fundamentals for commercial real estate are beginning to reflect the new economic and capital market storm we find ourselves in. Vacancies are up for all property types on a national level, and as noted in the second quarter 2008 RERC/CCIM Investment Trends Quarterly, sales volume and pricing are starting to decline. What’s more, the National Association of REALTORS® (NAR) forecasts that until confidence levels return, commercial real estate investment will remain as much as 40 percent below transaction levels seen in 2007, when a record $427.2 billion of commercial real estate traded hands. Despite this softening, commercial real estate is holding up reasonably well compared to other investments, and CCIM designees and candidates who responded to RERC’s survey remain optimistic about this asset class. While we see a great deal of turbulence in the commercial real estate debt market, according to anecdotal information gathered at the mid-year CCIM Institute business meeting, most CCIM members are expecting only an approximate 10-percent adjustment for commercial real estate this year. Given the turmoil in the markets, return expectations are of special interests—thus our special analysis on yield rates, capitalization rates, and spreads. We hope you find this, and our other analysis of the capital markets, of interest. To make this research report even more valuable to CCIM members, we encourage you to share your completed sales transactions. Here’s how: • At www.ccim.com, go to the Member Services category, • Click on the CCIM Transactions link (you’ll be prompted to enter your regular username & password), • Under the Professional Profile section, click the Manage CompletedTransactions link, and • Enter the transaction. Thank you to all who completed and returned our surveys, communicated your transaction information, or shared re- ports or other details about the various property sectors and markets. We appreciate your information and insights. Sincerely, Kenneth P. Riggs, Jr., CCIM, CRE, MAI Timothy S. Hatlestad, CCIM President & CEO 2008 CCIM Institute President Real Estate Research Corporation (RERC) President, RE/MAX Commercial Investment Investment Trends Copyright© 2008 by Real Estate Research Corporation (RERC) and the CCIM Institute. Quarterly CaughtInTheStorm Few, if any, could have anticipated how much the financial markets and the economy could change over the last 12 months. The commercial real estate market had reached a new pinnacle in early 2007, with The Blackstone Group’s acquisition of Equity Office Properties (EOP), plenty of cheap capital, and a belief that we were on the cusp of a new era of investing with limited downside volatility. The storm clouds then began to roll in with the subprime mortgage meltdown, followed by declining home values, sustained high oil prices, and a slowing economy. The winds began to shift, and we saw the credit markets pause as the rating agencies finally started to sound a warning. Questions arose in the financial arenas about the underlying risk of securitized pools of mortgages involving a string of investors and elements that were unknown to even the most informed. By late 2007, there was a recognized credit crisis and we knew there were rough times ahead for the U.S. economy. Once the broad debt markets seized up and the eventual buyout of Bear Stearns (fifth largest investment bank in the world) occurred, the finger-pointing began in earnest, and even the past two Federal Reserve chairmen were pulled into the fray to comment on the state of the financial markets. These are the shifting conditions that are darkening the climate in which commercial real estate finds itself. The reach of the storm is global, and there is no end in sight. Further, the ripple effect of this storm is immense, with those sitting on the front lines either gone or forever changed in the way they conduct their business or approach the financial world. However, as we have pointed out in the past, the impact on the various investments and the magnitude of the change in investment conditions depend on your perspective and where you are sitting as this storm plays out for the balance of 2008. Real Estate Research Corporation’s (RERC’s) view, from a commercial real estate equity standpoint, is that low-leveraged commercial real estate is doing reasonably well relative to investment alternatives, and we see the market dynamics for this style of low-leverage equity investment from a credit disruption perspective rather than a credit crisis. Although Wall Street may challenge us on this optimistic approach to a world in crisis, RERC has remained focused on commercial real estate investing from a low-leverage equity perspective, and how investors can best cope with the turbulent conditions surrounding us all. This report will lay out our perspective for commercial real estate returns as we are tested and challenged to navigate through a tempest that most of us have never seen before. Economic Background & Investment Environment The year 2007 will be remembered for the many storm clouds in our economy—the global financial markets, the Exhibit 1. Historical Housing Prices U.S. residential housing market, gasoline prices, and geo- political risk, among others. While the storm clouds have been hovering over the commercial real estate arena and the turbulence has affected the debt markets, the com- mercial real estate low-leverage equity market has not been as negatively affected as the residential market. Although the global credit crisis ripped apart the most so- phisticated leveraged structures from a financial perspec- tive, we did not see a collapse of home prices. As can be seen in Exhibit 1, even though home prices fell around 8 percent in 2007, they were still 70 percent higher than in first quarter 2000. We recognize that then was then and now is now, but it demonstrates that the undoing of the housing market lies in the financial package and not in the Source: National Association of REALTORS® (NAR), 4q 2007. Investment Trends Copyright© 2008 by Real Estate Research Corporation (RERC) and the CCIM Institute. Quarterly fundamental value of the asset. There is clear downward are not willing to sell at a discount, and buyers are not home re-pricing taking place in parts of the U.S. that ex- willing to buy at the ask price, given the uncertainty in the perienced the most speculation, and we still have some economy and financial markets. tough realities to face before the market stabilizes. This is important to keep in mind when we examine the financial The profound shift in the sell sentiment can be found in side of the commercial real estate market versus the as- the historical buy, sell, or hold recommendations shown set side. in Exhibit 2. The sell recommendation during first quarter 2003 through first quarter 2007 hovered around 8.0 on a The inability of investors to sort though the financial in- scale of 1 to 10, indicating that it was a good time to sell struments that were created over the past decade has (prices were viewed as strong relative to value). Today, caused them to become more risk averse, and has however, the sell recommendation is about half that level, brought established underwriting and investment criteria back to appropriate standards that focus on the funda- Exhibit 2. RERC Historical Buy, Sell, Hold Recommendations mental value of the asset. Getting back to basics is not 9 9 a bad thing, but one should not overreact to this situa- Buy Sell Hold tion. It is important to avoid the old pendulum paradigm of 8 8 swinging from a sentiment of greed to a sentiment of fear. 7 7 We see this happening on a limited basis, and it tends to 6 6 guide commercial real estate to spots where one needs the pendulum to swing in the opposite direction, although Rating 5 5 commercial real estate did not experience the broad- 4 4 based overselling and overleveraging that we saw in the residential sector. Investors are seeing a bifurcation rela- 3 3 tive to repricing issues in commercial real estate between 1Q 1999 1Q 2000 1Q 2001 1Q 2002 1Q 2003 1Q 2004 1Q 2005 1Q 2006 1Q 2007 1Q 2008 top-quality, low-leveraged assets, versus average-quality, Source: RERC. high-leveraged assets (75+ percent), although each set of assets is facing some level of re-pricing. indicating that it fell quickly alongside the credit market concerns and now is not a good time to sell (properties Investors have a wait-and-see attitude, given the disar- are viewed as underpriced relative to what buyers will ray and disappointment seen in the economy and finan- pay). This reversal occurred right after the Blackstone/ cial markets, but who can blame them? However, despite EOP deal, which will go down in history as a major mar- what one hears in the news, investors are not totally out- ket coup and pricing velocity watermark.